Wednesday, August 31, 2011

Wealth is Income – and vice versa!

There is a very curious debate going on at the moment in (mainly) Tory circles about whether Income or Wealth taxes are preferable. For example see this article from Tory polemicist Tim Montgomerie and the graphic reproduced here that argue that Wealth taxes are (comparatively) good whilst Income Taxes are bad.   Now I may not be a practising Economist but I have to say Mr Montgomerie’s arguments are both politically puzzling and economically illiterate. I’ll leave an analysis of what political game Montogmerie is playing to someone closer to Conservative circles – but the economics of his case are patently

Lets start with the basic premise of the so-called “Mansion Tax.” Essentially the argument is that is you own a home which has a value of £1m or more you can afford to pay more tax and it is right that you should be asked to do so. Not a particularly contentious proposition in itself and I don't want here to argue its merits. But what I must do is point out the bleeding obvious - and that is that such is tax is not, in the short term, really a tax on wealth at all but a tax on income! Income tax by any other name. Why? Well the only way that most homeowners could pay such a tax is out of income. You may live in a house worth £1m but that value is tied up in its bricks and mortar. You cant sell off a room to pay a Mansion Tax!

In the same way that a tax nominally on an asset such as a property tax is a form of Income Tax so also excess income leads to wealth creation. If a taxpayer has the good fortune to have income in excess of his outgoings, and he sees no reason to increase his expenditure beyond its current level, then his main option is to turn that income into wealth. He may do this by buying a bigger house, or a painting to hang on the wall or by investing is a Pension scheme and/or stocks and shares. But in all these cases, and others, he is turning a positive cash flow into an asset – and that asset will in may cases be income generating as well as, if he is lucky, an appreciating one. This is the rich man’s virtuous circle – the more you earn the more you can invest which then increases the amount you “earn”. An upward spiral of personal wealth creation.

The main taxes most of us pay are related to our income (Income Tax on earnings, dividends etc.) our property (Council Tax) and our expenditure (VAT and duties). Income Tax is progressive – the more we earn the more we pay. Council Tax is a form of wealth tax albeit paid out of income. And VAT is regressive – a rich man pays exactly the same rate of VAT as a poor man. The common thread in the case of all of these taxes is that in any one year we have to pay them out of income (usually by PAYE for the earnings related tax) or, in some special cases, out of the cash generated by an asset sale. For some the Income Tax bill is met by relinquishing assets but I suspect that this applies to a small number of mostly fairly wealthy individuals.

If we believe in a truly progressive tax system which is built on the sold moral rock that the richer you are the more you should contribute to the cost of running the country (and to helping those less fortunate than you are) then Income Tax is the way to do it. If you see that both a Mansion Tax and its close relative Council Tax are really income taxes by any other name why not simplify matters by consolidating them into Income Tax (and maybe introducing a local Income Tax) rather than messing around with trying to generate property related tax revenues? As many have pointed out the fact that you live in a highly valued house does not necessarily mean that on a day to day basis you are rich – i.e. that you have a high income. There will be thousands of anomalous cases, as there are with Council Tax, that special tax exemptions will have to be applied to cover. A recipe for bureaucracy and intrusion. Keep it simple stupid. Use Income Tax - its the fairest Tax system we have.