In The Wealth of Nations, Adam Smith put forward four general principles that he judged a tax system should satisfy. While the economic system then was much smaller and much less complex than now – the revenue required by the state funded a much narrower range of activities – principles are relatively enduring across changes in contexts.
Smith set out the principles before going on to assess the taxes in place in his time: here we repeat the exercise for today’s tax system, with emphasis on the first two of the four, based on the judgment that they are the more significant for current public policy choices.
P1: Equity/proportionality
“The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.”
Taking “revenues enjoyed” as synonymous with ‘income’, strict proportionality would imply completely flat rates of taxation, i.e. the same rate is levied on all income. Smith, though, was not a utopian: hence the qualification “as nearly as possible”. It is reasonable to contemplate varying degrees of flatness: e.g. to say that an East Anglian landscape is flat is not to assert that it is perfectly flat.
The principle in effect takes income as a proxy for the benefits to citizens of a state’s existence. Thus, those with higher incomes should pay proportionally more in tax, because they would lose more if the state collapsed. It corresponds with a basic notion of proportionate reciprocity, a fundamental operating principle of all commercial societies, i.e. those with a ubiquitous reliance on exchange transactions. It is also an ancient normative principle of equity: “to whomsoever much is given, of him shall be much required”.
Clearly, the UK system is nowhere close to approximating a flat structure. For example, the income tax rates are banded progressively, with large jumps in incremental rates at the band boundaries – e.g. 0%, 20%, 40%, 60% and 45% in the UK ex Scotland – we are in a ‘camel is a horse designed by a committee’ territory.
P2: Certainty
“The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and to every other person.”
Smith was concerned about arbitrary use of the discretion afforded to tax officials of the time. He thought a small degree of uncertainty had greater deleterious effects than higher or less flat rates of taxation.
Today the concern is more about the uncertainty created by tax changes instigated by government, but both the basic point and the reasoning behind it are the same. Current decisions are based on forward expectations of their consequences and, particularly for investment decisions, whether in physical or human capital, uncertainty about future rates tends to impair forward planning. In a nutshell, if the rules-of-the-game keep changing, this political volatility reduces the degree of confidence that can be attached to any plan of business.
The problem is a special case of the issues raised by policy uncertainty more generally. Taken to the limit, the rules-of-the-game cease to be rules, being subject to potentially arbitrary, discretionary decisions of a political executive. The formation of stable expectations about the future, is degraded.
P3: Convenience
“Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it.”
This is a less contentious principle and is generally followed, although current levels of government deficits may lead to it becoming a more significant issue in the future, as governments scrabble around for extra sources of revenue.
P4: Efficiency
“Every tax ought to be so contrived as both to take out and keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the state.”
Again, this is not particularly controversial in a modern setting and we simply note that it provides a basis for a deviation from the first principle, particularly at low levels of incomes and revenues: if the costs of collecting the revenues are high in relation to the amounts raised, allocation of Treasury administrative resources to collecting revenue from those accounts would be inefficient. A zero-rate band at low-income levels is consistent with the Smithian canons.
It can, though, be questioned whether the UK Government gives sufficient weight to this principle in practice. The freezing of the zero-rate income tax threshold and (for much longer) of the zero-rate threshold for inheritance tax bring ever more accounts into the taxpaying net. The result is that there is steady downward pressure on the productivity of the activity that we call tax collection.