Spencer Thompson is an economic analyst at the IPPR
According to a story in yesterday’s Telegraph, David Cameron has been praising the Latvian tax system, calling it ‘attractive-sounding’ during a speech at the Northern Future Forum Conference in Riga.
In particular, he singled out the Latvian 24% flat rate of tax as a potential alternative to the UK’s progressive-style income tax.
Is he planning something similar? Who would gain or lose from a flat rate of tax in the UK?
Well, it depends a lot on how the tax is designed, as well as the way it interacts with other aspects of the tax and benefit system, including VAT and tax credits.
But one study by the IFS, looking at four plausible and revenue neutral flat tax scenarios, found two main reasons why flat taxes might not be as attractive as they sound:
1) Flat taxes are regressive: In order to pay to lower tax rates for higher earners you have to increase the tax rate on lower income individuals. Therefore, compared to a progressive system of taxation, flat taxes are more regressive, hitting the poorer hardest as a proportion of their income.
2) Flat taxes weaken the work incentives of lower-income individuals: By increasing the tax rate for those at lower incomes, a revenue neutral flat tax would decrease the benefit to the poorest of moving into work or increasing their hours, hard to square with the Coalition’s welfare to work agenda.
In all likelihood, any government introducing such a tax in the UK would at the same time increase the level of benefits paid through tax credits to lower-income households, meaning their losses would be contained while the gain to those on higher-incomes would be preserved.
This makes the change more expensive, however, or requires a higher flat tax rate, limiting the effects of the reform.
But proponents of flat taxes often argue that they increase tax revenue, by improving the work incentives for higher earners. As their tax rate would be lower under such a system, the argument goes, they would be encouraged to work more and increase their incomes, paying more tax but at a lower rate.
One country often used as an example in this regard is Russia, where the introduction of a flat tax in 2001 was followed by an increase of 26 per cent in the revenue from personal income tax.
The ever-reliable IFS have crunched the numbers, however, and they found that very little of the revenue rise was attributable to the reform, with the majority of extra revenue caused by better performance of the economy as a whole, and more interestingly by those households and families little affected by the change.
While Cameron’s comments can hardly be construed as a firm policy commitment, it may indicate that the Conservatives are trying to sketch out a future position on personal tax reform.
With Labour adopting the largely symbolic 10p tax, and the Lib Dems committed to the worthy but extremely expensive goal of increasing the personal allowance ever higher, perhaps the flat tax will be the Conservatives own distinctive, if flawed, big tax idea.