Everyone loves to beat the system

We all, so it would seem, like a tax break. After a week of synthetic fury it looks as though Kenneth Clarke will modify the tax status of share options so as to allow the middle managers their tax-efficient perk, while still hitting the fat cats. A victory for ordinary hard-working employees? Well, maybe.

The counter argument - why should employees of commercial companies get a tax-free bonus when civil servants, nurses and train-drivers cannot? - has hardly been heard. In fact, precisely the opposite argument was made this week to help justify the enormous increase in the salary of Michael Grade, head of Channel 4. He had to be paid much more in salary because, it was argued, Channel 4 was unable to offer share options like other commercial television companies.

This debate over tax breaks tells us something about our capacity for self-delusion. We are, according to opinion polls, prepared to pay more tax - but only, in reality, when we know we can also dart through the loopholes that inevitably accompany the higher rates. Since every tax "incentive" has to be paid for in higher taxation elsewhere, should you have lots of incentives for those activities or people you wish to encourage, at the cost of much higher rates overall? Or should you have lower rates of tax for everybody and let people make their own choices undistorted by tax considerations?

For most of the post-war period the first approach has predominated - across the political divide. Take mortgage tax relief. Both Labour and Conservative parties thought it the right mechanism to encourage people into borrowing to buy houses. Until 1974, all mortgage interest payments could be set against income tax up to even the top rate. When the Heath government fell, the incoming Labour government capped the rate at a mortgage of pounds 25,000. That might sound like a serious curb, until you appreciate that that would be equivalent to about pounds 150,000 in today's money. Not even the most carnivorous Tory would today think of raising the present pounds 30,000 limit to anything like that. And it is the Tories who have cut the rate at which interest can be deducted, first to the standard rate, and most recently, to 15 per cent.

Remember some of those other Seventies tax breaks? There were incentives for people to switch income into capital gains, to have company cars, to take out life assurance, to spend at least a month working abroad, to have overseas income paid into Jersey bank accounts, and so on. And companies were similarly treated, with an array of incentives to build plants in particular places, or, if they were in the services sector, not to take on new employees. (Yes, bizarre though it sounds now, the Selective Employment Tax made non-manufacturing companies pay an additional tax based on the number of people they employed!)

Because there were so many loopholes, nominal tax rates had to be very high. Or looked at the other way round, because tax rates were so high, there had to be a vast array of loopholes.

To some extent this system has been modified, with loopholes closed and tax rates cut. The process was started by Denis Healey, the last Labour Chancellor, in the second half of the Seventies, and carried further by successive Tory chancellors. But as old loopholes were closed, new ones have been created: PEPs to encourage personal investment in equities; then Tessas because PEPs were unfair on the building societies; Business Expansion Schemes, which did little to expand private-sector businesses but helped the public sector by allowing the country's universities to fund new halls of residence on the cheap.

And of course our VAT system discriminates: it is levied on only half of our spending, so we pay 17.5 per cent tax on chocolate digestive biscuits, which count as confectionery, but nothing on the regular sort, which count as food. (In fact, we do pay taxes on food, but this is concealed in the form of high prices, with the money being recycled to support inefficient EU farmers)

If the broad trend since the Seventies has been to reduce distortions, the lobby for tax breaks remains extremely powerful - and it still cuts across politics. At this very moment the right wants tax reliefs for home- owners to be restored, perhaps by an increase in the pounds 30,000 ceiling; while this week's report on income generation by Lord Dahrendorf suggests that general levels of taxation should rise, and seeks to limit the economic damage that that would do by proposing extremely generous tax incentives for small businesses.

Why do we still put up with, let alone promote, all these distortions in the tax system? It is because politicians perceive that with this complex and muddled system of sticks and carrots they can manipulate aspects of it to their electoral advantage. And the lack of transparency stops voters from realising the extent to which one person's tax break is another's burden.

The problem is compounded by being linked with the case for lower taxation in general. In principle, a more neutral tax regime can work at any level of public spending, although in practice it is easier to simplify the tax system if you are cutting taxes.

But eliminating all tax breaks brings a fundamental benefit: it makes the system more honest and open. If people want more public services, they have to pay for them - there's no escape for the clever middle classes.

In its most radical form, such a system might have a flat rate of VAT at, say, 10 per cent, on absolutely everything. We would pay a little more for our children's clothes but a little less for our own. We would pay more for regular digestives and less on the chocolate ones. On income tax there would be no special tax-free allowances for pensions, for mortgages, for PEPs and so on. There would be no loopholes for profit-related pay, no concessions on share options, nothing. Instead, there might be a couple of flat rates of tax, say 15 per cent and 30 per cent, at which all income and capital gains would be charged. Or we might have just one rate of 25 per cent. Or we might keep the present rates and increase the threshold by several thousand pounds, removing millions from the income tax net altogether.

Company taxes would be simplified, too. We would not take millions in corporation profits tax and then give it back to persuade companies to build plants in Birmingham, England rather than Birmingham, Alabama. The aim of taxation would be to raise revenue, not to give favours. Attractive? It should be. Trouble is, we all like to feel we've beaten the system.