Economics : US raises flag for an assault on income tax

A NEW year; a new US Congress; and a set of new and radical ideas about taxation - such as abolishing income tax.

The immediate reaction of most people in Britain to such a concept must be to think it is nuts: the sort of wacky, irresponsible, absurd idea that US politicians trot out on the hustings, only to be swamped by the reality of government if and when they gain power. But since many US initiatives on taxation - from California's Proposition 13 in the 1970s through to the income tax cuts of the 1980s - have subsequently been imitated elsewhere, including here in Britain, the thoughts of the new Republican Congress deserve attention.

It is not just that from the disorganised, even incoherent thoughts of the American far-right may come some "big ideas" that take on a worldwide influence a decade from now; some of them are not so far from those developed by the thoughtful centre-left here in the UK.

The problem, as always, is to distinguish the reality from the rhetoric. The Republican "Contract with America" promises to place 10 bills before the House of Representatives that put into legal form some of the more high-profile Republican promises - including welfare reform, tax credits to families, a halving of capital gains tax and more favourable tax treatment of savings for retirement. This is all pretty standard tax-cutting stuff; no big ideas there. Much more interesting are the ideas that mightfollow, as articulated by the new chairman of the key Ways and Means Committee, Bill Archer.

Once the House has finished work on these bills, Mr Archer says the committee will debate how the present income tax might be replaced. Obviously, the revenue would have to come from somewhere, and a number of ideas are floating around. These include theintroduction of a national sales tax, or even a value-added tax, a flat tax on all income, or a tax on consumption, rather than savings.

This is not wacky at all, for were it to introduce VAT, the US would simply be adopting a world standard. Looked at globally, the US is unusual in not having a system of VAT, which for all its irritations and disadvantages does provide a way of collecting revenue from the sale of services as well as the sale of goods. As for replacing income tax with an expenditure tax, not only has such an idea been debated in academic circles for at least two decades but in practice most countries' taxatio n systems have been moving towards such an ideal, by increasing tax at point of sale and finding new ways of exempting different forms of savings from the tax net.

Beyond these tax reform proposals, there is another layer of US thinking about fiscal policy, of which the key element is the need to find some way of imposing discipline on public borrowing. The headline proposal here is a constitutional amendment requiring the budget to be balanced. The rationale behind such a notion is as much a moral as a practical one. It is practical in that it would give politicians a protection from the often unrealistic expectations of the electorate. It is moral in that failing to meet current spending by current taxation represents an intergenerational injustice - the current generation creates borrowings that future generations will have to repay.

In the past, large increases in public-sector debt have taken place only in wartime: during periods of peace most industrial countries have tended to pay back debt. So the recent rise in public-sector indebtedness is historically unusual.

It is also, given the age structure of all the developed countries, particularly inappropriate at this time. For by rights, voters who are still relatively youthful ought to be asking governments to pile up surpluses that could be run down to help to payfor their pensions in the early part of the next century.

To what extent are these US fiscal ideas likely to strike chords here in Europe? And what is the transmission mechanism? Ten years ago, it would have seemed odd for European countries to look to the US as a model. True, Britain looked to the US, but thatwas a function of the ideological parallels between Reaganism and Thatcherism. At that time, people outside the US criticised its lack of fiscal responsibility, as well as the inadequacies of its social policies.

It is much harder now to be sniffy about the US. Look at the graphs. They show that the three countries least responsible in their fiscal policies this year - Italy, Spain and France - also have the worst record on unemployment. Of course, the figures are not adjusted for the different points on the economic cycle: the US is well into its recovery, while the continental economies are only just emerging from their recessions. Nor is there any close causal relationship suggesting that fiscal irresponsibility leads to unemployment. In so far as there is such a relationship, it must to some extent be the other way round: continental Europe has large deficits in part at least because it has to support people who are unemployed. But it is an inescapable factthat on these measures the US is performing better than Europe.

It is also inescapable that these are among the measures by which the financial markets judge countries. If there is an international market in ideas, there is a more immediate and brutal international market in money. And, in general, governments running large deficits are having to pay a premium for their funds. In the short term, the transmission mechanism is the bond market. The more successful the Republicans are perceived to be, both in their ideas on taxation and in their attempts to create a mechanism to curb the deficit, the more likely they are to establish a new world standard that other countries will be forced to follow.

There are a number of reasons why British politicans of both left and right might welcome this. For the present Government, there is the obvious attraction of finding a respectable intellectual justification for tax cuts. It would be cutting income tax not as a pre-election bribe (perish the thought) but because high taxation on income acts as a barrier to the job market.

The implications for the radical left are even more interesting. The idea of abolishing income tax is a touch too carnivorous even for the new Labour leadership. But remember that it was a thoughtful Labour MP, Frank Field, who first proposed cutting thestandard rate of income tax to 15 per cent by eliminating tax breaks.

We are not, 10 years from now, going to eliminate income tax. But suppose, quite aside from the Field idea, we were also to raise the threshold to the level of average earnings, so that only people above it paid income tax and, as a result, the tax barrier to employment in effect disappeared. That would simply be taking income tax some way back towards the position between the wars, when it was a tax on relatively high earners. Governments would have to find other ways to raise revenues, perhaps with the emphasis on environmental taxation. There would be political costs to such a switch. But once it was accepted that income tax is a tax on jobs (which one wants to encourage) whereas taxes on, say, petrol or energy in general are a tax on pollution (which one wants to discourage) then such costs might appear acceptable.

Let's see where America goes. But remember as we watch that once a mainline US politician puts the abolition of income tax on the intellectual agenda, all tax taboos have gone.