Philip Hammond delivers his budget on Monday 29th October 2018. He may be tempted to suggest that any new taxes he introduced are hypothecated. Is this a good idea?

Hypothecation: Beyond the ‘factory model’ of taxation (Part One)

There is an argument that we should oppose hypothecation on the grounds that it is misleading, reducing the economy to a ‘factory model’ of inputs and outputs.

The hypothecation of taxation implies that politics works like a factory making many products. This factory model of taxation implies that you get out of the economy what you put in. Taking the example of a cereal factory, if you Increase the inputs of oats and wheat and sugar and ramp up the amount of cardboard you buy, more packages of cereal will come out of the other end of the production line. In essence, you give the public power over the inputs and they will get more of what they want.

The factory model of taxation is misleading in a similar way to how misleading it is to think that the economics of a whole economy is similar to the economics of a household. That household – or ‘handbag’ – model of economics suggests that if you are frugal, and spend less, you will prosper.

There is, of course, some truth in all models. The handbag model of economics is an analogy that will at times appear to be pertinent. For instance, at some point it will not be possible for the United States of America to carry on spending vastly more money than it raises in taxes every year, increasing its national debt to astronomical levels. Rising to as high as $14,344,566,636,826.26 even as long ago as June 15th 2011 (according to Friedman, T.L. and Mandelbaum, M., 2012, That used to be us: What went wrong with America and how it can come back, London: Little Brown). However, the reason it will not be able to do that is not because the United States economy is like the household budget of a family. For a state, which is made up of many millions of households, money does not play the same role as the money you might have in your handbag. A country’s current account does not determine what its people are able to buy at the shops that same day.

The factory model of taxation, like the handbag model of economics, is initially attractive and intuitive because it reduces a process to something you think you understand well, although most people have never been in a factory and most of us run our household economics on debt. For example, I have a mortgage and no one calls me profligate. The handbag model is Most closely associated with Mrs Thatcher, the first person to call herself a “handbag economist’ (according to James, A. (2015) Orwell’s Faded Lion: The Moral Atmosphere of Britain 1945-2015, Exeter: Imprint Academic Press).

Consider health care. The factory model of health care implies that the more you spend on health care the better your health will be. I am not saying that the opposite is the case – just that it is not as direct a process as simply putting more in to get more out.

The USA is, again, a useful example for this. Far more is spent on healthcare in the USA, per head, than in any other country in the world. As much is spent from the country’s public purse on schemes like Medicare and Medicaid as is spent privately, and yet the results are not good. On closer inspection it turns out not to be health spending that best predicts health outcomes in the separate states of the USA and other affluent countries of the world, but the influence of factors such as historical levels of economic inequality, especially income inequality

 

Take of the 1% and life expectancy in 19 countries and all US states

And an interactive version of the graph above can be found here.

 

Of course, you have to consider multiple issues at once when considering tax. Health spending matters to improve health, but so many other factors also contribute to health outcomes. For example, housing policies to ensure that doctors and nurses can afford to live near their patients. Affordable housing is required so that most of the taxes spent on healthcare do not simply end up being wasted on higher salaries used to pay the rent to private landlords or financing mortgages so that home can be purchased from an older generation who will be cash-rich but health-poor.

The same applies to education policy. Again, it is not just the amount that is spent on education that contributes to the education levels of the population as a whole. When societies are more mixed, children end up better educated.

Social policy is not like a cereal factory. All the inputs go in and all the outputs come out, but they are mixed up in the middle in ways that we are still learning about. All this lends itself to an argument against hypothecation of taxes, which is too heavily reductive about inputs and outputs. However, there is one case were the argument for hypothecation is stronger, and that is in the introduction of new taxes.

For the on-line version of the first half of this blog on the covi website and a PDF click here.

 

Part 2: The case for Hypothecation: in the introduction of new taxes

The article above makes the case that hypothecation is misleading in that it reduces public spending to a ‘factory model’ of inputs and outputs, whereas in fact there are many complex factors which achieve social outcomes.

However, there is one case where I believe the argument for hypothecation is strong, and that is in the introduction of new taxes.

Taxes can easily be made unpopular when they are first introduced by government. However, after the introduction of a tax, citizens tend to adapt quickly – most people do not perceive the taxes they pay as unreasonable. It is the threat of a new tax that is often imagined as only having bad outcomes.

Indeed, evidence shows that affluent countries that tax at a higher rate have far better social outcomes in terms of health, education, housing, pollution, transport use and happiness levels. In contrast, affluent countries that tax at a lower rate – and especially ones that tax the rich less – have the worst health and educational outcomes, the most inefficient and insecure housing systems, the highest rate of pollution per head, worse public transport provision and higher intake of anti-depressants. All of these factors are, of course, inter-related, but a government generally helps its people by taxing more as long as that government spends wisely.

 

State spending as a proportion of GDP, twelve rich countries, 2002-2020 (%)

From “A better Politics” (2016) A free copy of the book is available here. It only contains two figures. This is Figure no. 2.

 

In England, I would support the introduction of a hypothecated Land Value Tax to be spent on health and social care. This would free up general tax revenues to be better targeted on education, welfare, housing and much else in the UK that is in urgent need of attention. A land value tax would replace council tax and business rates, and the tax would enhance intergenerational equity as it would be levied mostly on older people.

A land value tax could be introduced to replace inefficient wealth taxes with the promise that all the monies initially raised would be paid on enhancing health and social care. As taxes are tapered in when they are initially raised and as the need for extra health and social care funding is acute this promise could be made to be kept for at least a decade.

Inevitably, the revenues collected from hypothecated taxes reduce over time, and become less ‘ringfenced’. This is what occurred with National Insurance payments, which is now a general tax. But at its point of introduction, people would know what they were voting for when they voted for the political party that proposed such a tax. On implementation, only a very few of the extremely rich would feel much financial pain, but they could bask in the knowledge that they were being taxed for a great cause – to increase babies’ chances of surviving their first year of life across all of the UK and helping more elderly people live with more respect and less fear and pain. It is this sort of social contract on which the tax system is based in the first place, so if hypothecation helps make this case, then it could be effective.

For the on-line version of the second half of this blog on the covi website and a PDF click here.