7 April 2017

Britain needs a free market in taxes

By Mark Feldner & Mathew Bonnon

If the events of the past year have shown us anything, it is that the global integration of markets alone is not sufficient to increase prosperity for all.

While reductions in trade barriers have transformed the fortunes of billions, bringing some of the world’s poorest closer to Western standards of living, this positive effect has not been felt by the bottom third in advanced economies. Indeed, in countries such as the UK, the notion that liberalisation can result in greater material equality is widely seen as wishful thinking.

But free markets are not the cause of inequality. The probelem is that the liberalising spirit has not gone far enough: the principles underpinning the magic of markets – competition, accountability and choice – are equally applicable to areas that do not involve trade in goods or services.

In particular, we need to apply free-market ideas to one of the few remaining monopolies: the highly centralised taxation systems found in many advanced economies.

In Britain, for example, inequality is, to a significant extent, a regional phenomenon. According to data compiled by Eurostat, the gap between the richest and the poorest region in the UK is larger than in any other western European country. The Bank of England’s chief economist, Andrew Haldane, recently said that regional inequality may be “one of the most important issues that we face today as a country”.

Britain is also a remarkably centralised country. Analysis by the Centre for Cities found that the concentration of political and economic power in London is virtually unique among OECD countries. And nothing shows this geographic focus better than the way in which the UK raises its taxes. As the Institute for Fiscal Studies notes, taxes in the UK are “exceptionally centralised, with only five per cent of revenues raised locally”.

In England, all revenue streams except council tax are set in Whitehall. This is in stark contrast to those from other advanced economies, such as Sweden or Finland, where local taxes account for approximately one-quarter of total revenue.

The link between regional inequality and centralised taxation has been widely studied. It also makes intuitive sense. Fiscal policy devised in Westminster might be welcomed by City firms and large corporations. For employers and workers in Sheffield or Plymouth, plans made at 11 Downing Street are often less helpful.

A single tax policy, imposed on a large and heterogenous country, inevitably benefits some regions over others. The capital’s economic and political dominance thus leads to a self-perpetuating cycle, working at the expense of those who are already disadvantaged.

As well as neglecting varying regional needs, centrally determined taxation also runs counter to established economic principles. Fiscal policy is about finding the right balance: how much revenue can be raised to finance schools, hospitals and infrastructure while still attracting performance and investment? What combination of taxes – and at what rates – is the fairest or most efficient way of ensuring public needs are met?

At present, the Chancellor of the Exchequer makes that judgement on the basis of fiercely disputed economic models, ideological beliefs – or his own gut instinct. In this respect, our current tax strategy suffers from the same flaws as centrally planned economies.

If there is no room for experimentation, if we cannot trial competing tax policies in real life, then we are unlikely to find the best system of taxation.

The answer to the problem described above, of course, is competition and choice. No bureaucrat can know how much of a given good or service we need. But if thousands of entrepreneurs offer different products at varying prices, the most attractive options will quickly become apparent.

Successful business models inspire competitors to adapt their own products to customers’ needs, thus creating a constant drive to improve. So what if the most defining feature of the state – the power to tax its citizens – were subjected to the same innovating pressures of competition and choice?

Imagine a Britain in which taxation is radically freed. Regions and cities are no longer almost exclusively dependent on transfers from the Treasury – they can now raise their own taxes, at their own rates. In doing so, they express their inhabitants’ personal priorities: do they want to encourage investment by offering attractive tax cuts, or would they rather focus on generous public services?

By taking into account local views and regional competitiveness, each city or county can tailor its fiscal policies to its unique circumstances. This flexibility translates into real choice for individuals and companies. A fiscally liberalised system would give regions that have seen a decline in jobs and productivity a powerful tool to raise their economic profile – and to achieve what economists call “spatial rebalancing”, a move away from the cluster-building that we have seen in the small number of cities, mostly in London and the South East, at which current tax policies seem heavily targeted.

At the same time, this radical reform would avoid picking winners and losers. Rather than choosing a single “Northern Powerhouse”, this approach would set no limits to regions’ creativity in attracting talent and business.

For the bottom third of the income distribution, this would mean that high-paying jobs are no longer limited to a small area of the UK. With dozens of counties and cities vying for local tax revenues and a satisfied public, getting the balance right would be more important than ever.

Unlike in our current system, punitively high taxes or underfunded public services would provoke an almost immediate response: if companies and individuals move to other parts of the country, the feedback given to local authorities is unambiguous.

As a result, politicians know exactly which tax policies encourage investment and are popular with their constituents, thus promoting good governance.

This natural discovery process, spurred by competition and local accountability, mirrors the tried and tested market forces that bring us better and more affordable goods and services every day. Like successful entrepreneurs, prosperous regions would serve as a model for other areas of the country to follow. The result would be a process of continuous adjustment and improvement, leading to more efficient fiscal policies and a more balanced distribution of income.

But the benefits of fiscal liberalisation do not end there. The decentralisation of tax powers also promotes self-governance, reinforces communal identity and enhances individual liberty. If Brexit were a signal that millions of people demand greater participation in the political process, then limiting central tax powers and handing them to regionally elected representatives would be a sign that these concerns are taken seriously. It would strengthen the democratic link between citizens and their governments by ensuring that locally raised money is spent on local priorities.

Regional tax sovereignty would therefore amplify the voices of citizens – and offer them real exit opportunities should they feel dissatisfied with local politics. After all, if regions can determine their own public spending, the prospect of voting with one’s feet is much more realistic.

Perhaps most important of all, the proposed reforms would contribute to our economic liberty. Because cities and counties would seek to attract firms and individuals, inefficiently high levels of taxation would soon be cut. Faced with competitive pressures, bloated public bodies would be forced to innovate, improve and streamline their services. Competition thus leads to lower average rates of taxation – particularly good news for those with little disposable income. And for workers tired of hearing that tax cuts will eventually “trickle down”, the visibly positive impact of regional tax reductions on local jobs and investment would be a welcome change.

That, at least, is the theory. But how has fiscal federalism worked out in practice?

Well, in the country most frequently associated with regional tax competition, the system has been a resounding success. With a population of about eight million, Switzerland is divided into 26 highly independent cantons, all vested with extensive tax-raising powers. It is regularly ranked as one of the wealthiest countries in the world in per-capita terms, and it has repeatedly been named the most economically free country in Europe.

Despite having some of the lowest average tax rates in Europe, Switzerland is known for its high-quality infrastructure, its world-class healthcare and its administrative efficiency. Far from triggering a race to the bottom, tax liberalisation promoted efficiency, democratic accountability and wealth creation.

The track record of fiscal federalism has been similarly positive in Canada, where tax powers are divided between the national government, the provinces and the territories. Canadian federalism is so pronounced that the country’s 10 provinces collect more revenue than the federal government.

Ranked in the global top 10 in terms of per-capita income as well as in the Human Development Index, Canada has benefited from geographically diverse development across its different regions. Moreover, the Canadian system is renowned for its transparency and openness, suggesting that sub-national competition has a positive effect on administrative authorities.

The last example to consider is Australia, whose federal structure is made up of six states and two territories. As in the Swiss and Canadian cases, Australian taxes are highly decentralised and comparatively low: government spending relative to GDP is almost 10 percentage points below the UK’s.

This fiscal efficiency has not come at the expense of public services or general welfare. In fact, several Australian cities are regularly included in the list of the world’s most liveable conurbations, including Melbourne, Adelaide and Perth. That all three are located in different states shows that regional competition can raise standards of living across the country.

That countries of any size can flourish under systems of fiscal liberalisation has been confirmed by a wide range of economic studies. In 1998, for example, two World Bank economists, Jeff Huther and Anwar Shah, created an index of 80 countries ranked by various measures of good governance. Using an extensive data set, they rigorously examined whether fiscal devolution between regions influenced a country’s performance in areas such as social development, bureaucratic efficiency, lack of corruption and political stability.

Their analysis produced a “surprisingly strong positive correlation between fiscal decentralisation and quality of governance”, allowing them to reach “unambiguous conclusions regarding the net positive effects of fiscal decentralisation on public sector performance”.

By decentralising the tax regime, developed countries can empower workers in currently underperforming regions. Through the devolution of tax powers to sub-national governments, cities and counties can actively create a competitive advantage and thereby attract talent and investment.

The resulting rebalancing particularly benefits those who might feel neglected by the political and economic system. In addition, it would make governments leaner and more efficient, enhance economic freedom and strengthen political representation.

Fiscal liberalisation can be the next transformative step in the history of ideas: a free-market revolution with no one left behind.

This article is based on their winning entry for the Richard Koch Breakthrough Prize, organised by the Institute of Economic Affairs.

Read the other shortlisted entries on why we should scrap Britain’s planning laws, how to boost entrepreneurship among the poorest, the case for expanding private tutoring and how to liberate the education system from the state’s stifling grip.

Mark Feldner is a recent graduate with degrees in Law (BA, Cambridge) and Political Theory (MSc, LSE). Mathew Bonnon is in his final year studying Asian and Middle Eastern Studies at the University of Cambridge.