Economics: Transparent tax is just an illusion

IMAGINE that a group of politicians stumbled across Aladdin's lamp, coaxed the genie out of it and were offered the fulfilment of one wish. The chances are that they would ask for the secret of making voters happy to pay their taxes.

As politicians go, the Liberal Democrats have rubbed a lot of lamps, but so far have been rather short on genies. Last week they offered their own magic solution to the unpopularity of taxes - hypothecation*. This ugly word means simply that the revenue of particular taxes should be devoted to particular areas of public spending, rather than put into one large pot and distributed willy-nilly.

It is not a new idea. Harold Wilson imposed the 'Eady levy' on cinema tickets in the 1940s, devoting the revenue to subsidising the British film industry. And residents of parts of London, such as Montpelier Square in the City of Westminster, have to pay a supplement on top of their council tax for the upkeep of communal gardens.

The tax and the type of spending to which its revenue is devoted need not be related, however. Britain's first state secondary schools were financed somewhat inappropriately by a 'whisky tax' imposed by the Treasury in the late 19th century. And the state government of Victoria, Australia, recently used a temporary petrol tax specifically to bail out the depositors of the collapsed Pyramid building society, which it was supposed to have been regulating.

The Liberal Democrats argue that hypothecation should be extended because it would make the tax system more transparent. They believe that if taxpayers have a better idea what their taxes are being spent on, they are less likely to begrudge the Exchequer the money.

It would be nice to believe that. Liberal Democrat strategists point to opinion poll evidence that their pledge to raise the basic rate of income tax by a penny, and spend the revenue on education, was enormously popular at the time of the last election. But one need only look at the inaccuracy of the pre-election polls of voting intentions to see the fallacy of that argument. Many people told the pollsters that they would not be voting Conservative, only to do just that. And if they are prepared to lie about their voting intentions - simply so as not to appear venal, uncaring or self-centred to a complete stranger with a clipboard - then they are just as likely to lie about their willingness to pay for better schools. After all, the Liberal Democrats' education policy - while entirely creditable - seemed to do the party little good at the ballot box.

It is an unfortunate fact of life that people tend to complain about those aspects of government that they dislike, but are ungratefully silent about those of which they approve. So hypothecation would probably make tax-paying more, rather than less, unpopular. Indeed, one of the Treasury's main objections to the whole idea is that it would be inundated with letters from people demanding that they be allowed to opt out of those parts of the tax system to which they object. Pacifists might refuse to pay for defence, while football supporters might complain about subsidising the leisure pursuits of the metropolitan elite by helping to fund the Royal Ballet or the English National Opera.

While hypothecation might make the tax system more transparent, it could also make it much more complicated. In political, and certainly in economic, terms this is probably undesirable.

Imagine splitting income tax or excise duties, for example, into a health tax, an education tax and a defence tax. This would make it much more difficult for people to assess just how much the state was confiscating every time they earnt or spent another pound - a determinant of whether and for how long some people choose to work.

This already happens to some degree, because people are much more conscious of the rate of income tax they pay than of their rate of national insurance contributions. It is hardly surprising that Norman Lamont decided in March last year to raise money by increasing the rate of NICs rather than the basic rate of income tax, even though the economic effect would have been much the same.

The national insurance system is already an example of bastard hypothecation. The proceeds of employees' and employers' national insurance contributions are paid into the National Insurance Fund. This, in turn, is used to fund contributory social security benefits, such as pensions and unemployment benefit. But the hypothecation is not really airtight, as the Treasury has to meet any shortfall between the size of the fund and the benefits bill. The Liberal Democrats argue that 'this is quite a small element relative to the whole'. But in fact it is around 17 per cent, not a small sum at all.

The Liberal Democrats propose to replace employees' NICs with special payments earmarked to pay for state pensions. Non- pension benefits would be funded from general taxation. They argue that the current contributions system requires a costly bureaucracy to maintain individual records. But in reality the national insurance fund has much lower administration costs per person than a private insurance system, all the more so as the pool of people relying on state pensions gradually shrinks to a low-paid rump.

But even the Liberal Democrat plan will still require injections into the state pension system from general taxation, unless the party is prepared to let those who have not been able to make their pension payments starve. At the moment general taxation pays for credits into the national insurance fund for the unemployed. So in theory a person who has made a minimum level of contributions over a period in work as short as six months can be entitled to a basic state pension without making any further contributions for the next 431 2 years. Other taxpayers would pick up the bill.

They may be over-optimistic about its application to pensions, but the Liberal Democrats have made a sensible and largely realistic assessment of the limitations of hypothecation. They recognise, for example, that earmarking is unsuited to tax revenues or areas of public spending that are sensitive to the economic cycle.

Imagine that the road building programme was paid for with revenue from petrol duty, which was indeed partly the case between 1911 and 1937. Do you really want road building to slow when the recession means that individuals and businesses use their vehicles less often? Public spending on infrastructure projects should surely offset recessionary pressures, rather than exacerbate them.

Linking particular areas of public spending to different taxes also makes it more difficult to control the overall level of public spending. Efficiency improvements are much easier to squeeze out of departments that are fighting with each other for shares of a pre-determined revenue cake than from those that have independent sources of funds.

It is certainly true that taxpayers should be given a better idea what their taxes are spent on, but hypothecation may be using a sledgehammer to crack a nut. As the Liberal Democrats argue, it would be a good idea for national government to send each citizen a statement detailing revenue, spending and borrowing for the coming year, a summary of current tax rates and allowances, and, if possible, a calculation of the marginal and average tax rates they face when all the components of the tax system are fitted together.

But extending the principle of hypothecation much further will simply create the illusion of choice, without the reality. In the long term that may frustrate the electorate more than it reassures it. Where possible, taxes should be replaced by user charges - pay- per-view funding for the BBC, inner-city road tolls and fees for the use of local authority leisure facilities, for example. A truly liberal tax and benefit system would redistribute income fairly and let people spend it as they wished.

The interest in hypothecation among both the Liberal Democrats and the Labour Party demonstrates how enduring the swing from collective to individualistic attitudes is proving. Extending user charges might help to cement public support for the collective provision of a smaller core of tax- funded services, but the politicans should not hold out much hope.

Cynicism rules. When politicians talk about reforming the tax system, most people know that it is time to feel for their wallets. The great Liberal, David Lloyd George, described the art of tax-raising thus: 'I have no nest eggs. I have to rob somebody's hen roost next year. I am on the lookout for which will be the easiest to get, where I shall be least punished, and where I shall get the most eggs.' Whatever the jargon, nothing has changed.

*'Being Honest About Taxation', Liberal Democrat Policy Unit.