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Bringing in more: democratic socialist tax policy for the 21st century

July 13, 2020

 

Funding effective public policy

 

There are six generic aspects to successful public policy:

 

  • The first is clearly identifying

    the problem or need that requires dealing with.

  • The second is setting realistic objectives that will resolve the problem or fulfill the need, or at least ameliorate the problem and satiate the need as much as is practicable.

  • The third is good policy design i.e. developing policy solutions that are likely to deliver the desired outcomes and which can evolve over-time as circumstances change or if the original plans do not deliver what was expected.

  • The fourth is having effective organisations to implement the policy i.e. ones that are well-managed, suitably capable to implement the policy or policies, transparent and accountable and flexible in the face of experience about what works and what does not.

  • The fifth element is having sufficient resources in-place to deliver the desired policy outcomes and deal with contingencies.

  • The final factor is ensuring there is feedback and evaluation built-into the ‘system’, to learn lessons and continually improve over time.

 

The effectiveness of policy is particularly pertinent at the moment because of the current UK government’s emerging ambitions for administrative reform to improve the delivery capabilities of the state. Most recently summarised by Michael Gove in his Ditchley lecture.  

 

The left, in order to be credible, must have a response to this aspect of the Conservative government’s agenda. It is particularly critical for any future democratic socialist government to have a highly capable state, because a democratic socialist government will be relying on the state to implement its radical programme. A programme which should have at the heart of it the transformation of the UK’s model of political economy, into a new British Social Model (BSM).

 

Reform of the state’s capabilities is for another time. This post is going to concentrate on the fifth element that is needed to deliver successful public policy – resourcing. In other words, maximising the effectiveness of what political economists and sociologists call the ‘extractive state’ or in the words of Joseph Schumpeter, the ‘tax state’.

 

If a democratic socialist government wants to develop a BSM, a crucial aspect of which will be spending more on health and care services, on education, on pensions, on protecting the environment, industrial policy, regional policy, housing and on security (policing, defence and bio-defence), then the state needs to be effective at extracting the resources in taxes required to fund that expenditure. This necessitates two conditions to be met:

 

  • An economy that generates a substantial productive surplus and consequently more tax revenues as a result of that growth.

  • The ability to raise substantially higher revenues than currently, whether long-run growth rates can be increased or not.

 

The rest of this post mainly focusses on the second of the two conditions outlined above, through a comparative analysis between the UK’s ‘tax state’ and that of ‘Denmark’. A country that raises much more tax revenue as a proportion of its GDP than the UK and has performed, economically, at least on-a-par with the UK over many decades and in some ways has done better than the UK.

 

How much UK government’s raise in taxes compared to other countries

 

According to the OECD, in 2018, the UK’s tax-to-GDP ratio was 33.5% (OECD, 2019). This was just below the OECD average of 34.3% (OECD, 2019). The UK’s tax-to-GDP ratio was slightly up on where it was in the year 2000. At the turn of the millennium it stood at 32.9% (OECD, 2019).

 

Individual income taxes are the category of taxes which raise the most revenue in the UK (27.2%), followed by VAT (20.7%). National Insurance Contributions are the third most lucrative source of money for the state (19.2%) (OECD, 2019).

 

The most successful ‘extractive’ states in the OECD have a tax-to-GDP ratio around 10% higher than the UK. One country that is consistently near the top of the tax-to-GDP ratio ‘league’ is Denmark. In 2018, the Danish tax-to-GDP ratio was 11% higher than in the UK - 44.5% of GDP (OECD, 2019). Further, Denmark has manged to tax at a relatively high, overall, level – sustaining taxation levels at approximately the mid-40% mark - for a long time (OECD, 2019). 

 

In 2017, the UK government raised approximately £682 billion in taxes (OECD, 2019). In 2017, the tax-to-GDP ratio was at 33.3% of GDP (OECD, 2019). In a (more than) £2 trillion economy, such as the UK, this suggests that increasing the tax-to-GDP ratio to the levels that prevail in Denmark could see a UK democratic socialist government taking-in an additional £228 billion a year. Of course, there would be no guarantee of a revenue boost on such a scale. Economists will point out that, for example, likely behaviour changes as a result of higher taxes, could decrease the ‘rate-of-revenue-return’ on any increases in tax rates. Such economists would no doubt point to the considerable ‘tax leakage’ which occurs at the current, and much lower, tax-to-GDP ratio. What HMRC calls the ‘tax gap’ (HMRC, 2019). The ‘tax gap’ is described by HMRC in the following terms:

 

The tax gap is the difference between the amount of tax that should, in theory, be paid to HMRC, and what is actually paidThe tax gap provides a useful tool for understanding the relative size and nature of non-compliance…[and is the result of]…Some taxpayers make[ing] simple errors in calculating the tax that they owe, despite their best efforts, while others don’t take enough care when they submit their returns. Legal interpretation, evasion, avoidance and criminal attacks on the tax system also result in a tax gap’. (HMRC, 2019)

 

The 2017-18 ‘tax gap’ was estimated to be in the region of £35 billion (HMRC, 2019).

 

Despite the kinds of complications described above, that a higher tax burdens might create, the crude calculation suggesting an 11% tax-to-GDP ratio could raise more than £200 billion in extra revenues a year, indicates that considerable additional resources could be raised if the tax (and benefits) system in the UK could be calibrated in the right way, in order to maximise revenues while minimising any deterrence effect on the drivers of growth. Although, as will be demonstrated later in this post, the right kind of social conditions are an important underpinning to the successful Danish model and there are questions about whether the UK can replicate those and therefore, the extent to which the UK will fall short of what a country like Denmark can do, in terms of revenue raising.

 

Sustaining a high tax-to-GDP ratio

 

Why Denmark has been able to maintain taxation at over 40% of GDP

 

The Nordic countries in general, and Denmark in particular, offers some lessons as to how a higher tax burden can be sustained over time. According to a paper by economist Henrik Jacobson Kleven, there are three ‘policy-based reasons’ why the Scandinavian countries, and Denmark in particular, have been able to sustain a high tax burden:

 

  • The tax system is designed and administered in order to maximise the availability of information about tax liabilities and utilise third-parties as much as possible to collect and report information.

  • Taxes are broad-based and relatively simple, ensuring behavioural distortions are minimised.

  • A substantial proportion of the taxes raised are used to subsidise goods which are complements to working e.g. care services, education and training, public transport, etc.

 

The combination of these factors have helped reduce, in Denmark, what economists call the ‘elasticities of taxable income’ i.e. the scale of the behaviour response of those impacted by tax changes. The size of the ‘elasticity’ helps determine the increase or loss in revenues that is likely to occur due to a tax. Typically, if taxes increase the response is expected to be a negative one e.g. individuals either ‘step-up’ their tax avoidance or evasion practices or reduce their work effort or alter their risk-taking and investment plans, or some combination of these actions. It should be further noted that while at the population level the ‘elasticity’ of the response in Denmark has been ‘modest’ (Kleven and Schultz, 2009) for the reasons listed above and explored in more detail below, perhaps expectedly, it does vary across different dimensions. For example, Kleven and Schultz estimated that ‘elasticities’ for capital income are greater than those for labour income, that the ‘elasticity’ among the self-employed his higher than for those that are employed and finally, ‘elasticity’ is greater among those in higher income brackets. (Kleven and Schults, 2009). Perhaps 2 to 3 times larger among those in the top income quintile than those in the bottom income quintile (Kleven and Schultz, 2009).

 

The importance of information

 

Kleven argues that the overall ‘tax gap’ in Denmark is as low as 2.2% (Kleven, 2014). The Danish ‘tax gap’ is about a third of the size of the UK’s estimated ‘tax gap’. An important reason for this small ‘gap’ is that:

 

‘…the Scandinavian tax systems have very wide coverage of third-party information reporting and more generally, well-developed information trails that ensure a low level of tax evasion’. (Kleven, 2014)

 

In Denmark for example:

 

‘…tax enforcement is very effective and overall tax compliance is high due to the widespread use of double-reporting by third parties such as employers and financial institutions’. (Kleven et al, 2011)

 

The largest scope for ‘leakage’ is among those who self-report their income i.e. the self-employed. However, Kleven, argues that in Denmark self-reporters are relatively compliant, resulting in, proportionately, a higher tax-take from such groups compared to that of other countries such as the United States (Kleven, 2014). Nevertheless, self-reporting remains among the main reasons for the on-going rates of ‘tax leakage’ in Denmark, with an estimated ‘evasion rate’ of around 50% (Kleven, 2014).

 

Broad-based and simple

 

The second reason that Denmark is able to sustain a much higher (than the OECD average) tax-to-GDP ratio is the broad-based and comparatively simple nature of the Danish tax system. As Kleven argues:

 

‘…broad tax basesfurther encourage low levels of tax avoidance and contribute to modest elasticities of taxable income with respect to the marginal tax rate’. (Kleven, 2014)

 

Behind the technical phraseology, Kleven is pointing out that the comprehensive tax systems in-place in the Nordic countries in general and Denmark specifically, i.e. ones with few exemptions, allowances and other distortions, mean that the scope for (the comparatively) high tax rates in these countries to deter productive economic behaviour or incentivise avoidance, are limited. Consequently: 

 

‘…taxable income elasticities in Denmark are considerably smaller than…[many]…found for other countriesThe relatively small taxable income elasticitiesallow for higher levels of taxation without incurring larger losses in economic efficiency’. (Kleven and Schultz, 2014)

 

The macroeconomic evidence for Kleven’s argument is evident in Denmark’s comparative growth and unemployment data, at least as it compares to that of the UK. The comparative macroeconomic performance of the UK and Denmark is explored, briefly, later in this blog post. 

 

Supporting labour supply through the welfare system

 

The third leg of the policy-stool that Kleven suggests helps ensure the Scandinavian countries in general and Denmark in particular, can sustain a higher tax-to-GDP ratio is some of the way the revenues are spent. Kleven describes how governments in Scandinavia, spend:

 

‘…relatively large amounts on the public provision and subsidization of goods that are complementary to working, including childcare, elderly care, and transportation. Such policies represent subsidies to the costs of market work, which encourage labor supply and make taxes less distortionaryFurthermore…[they]…spend heavily on education, which is complementary to long-run labor supply and potentially offsets some of the distortionary effects of taxation’. (Kleven, 2014)

 

The provision of a wide range of services, on a universal or near universal basis, act as a ‘subsidy’ to participation in the labour market, according to Kleven. As such they are less distortive of the incentives to supply labour into the labour market (Kleven, 2014). Consequently, Denmark and other Scandinavian countries have high levels of labour market participation. The result of the latter is the generation of more tax revenues to pay for the provision of public services and a visible return by most people on the taxes they are paying.

 

However, it should be noted that Kleven fails to explore, to any great degree, the role of ‘active labour market’ policies in countries like Denmark, which have been an important part of the Danish model of political economy for a long time. As welfare state scholar Gosta Esping-Anderson points out, the costliness of the ‘social democratic welfare regime’ in countries like Denmark incentivise the prioritisation of high-levels of employment (Esping-Anderson, 1990). The significant amount spent by the government in Denmark, for example, illustrates the importance of ‘active labour market’ policies. The OECD estimate that the Danish state spends just under 2% of GDP on such measures (OECD, 2017). Any comprehensive analysis of how Denmark has manged to be successful in keeping unemployment relatively low and employment levels high over long periods, while sustaining a high tax-to-GDP ratio, would need to take account of such measures.    

 

The harder to replicate, elements

 

While the policies that help Denmark maintain a high tax-to-GDP ratio can, to a large extent, be copied by other countries, there are harder to replicate aspects, which are also likely to contribute to the ‘extractive’ success of the Danish state i.e. non-policy factors which help reduce the ‘negative elasticity’ response to higher taxes. Many of these other factors are cultural and historical and are captured in the term ‘social capital’. Social capital is a convenient summary phrase for:

 

‘…the links, shared values and understandings in society that enable individuals and groups to trust each other andwork together’. (OECD, 2007)

 

Kleven presents a range of evidence suggestive of a strong link between the levels of social capital in countries like Denmark and high levels of compliance with heavy tax burdens. Levels of social capital in the Scandinavian countries of Denmark, Sweden and Norway are high. So too, is social capital in the other Nordic countries of Finland and Iceland. For example, in one global attempt to measure and rank social capital, Denmark was 11th, Sweden 4th, Iceland 3rd and Norway 2nd and Finland 1st (SolAbility, 2020). In contrast, the UK was ranked 40th for social capital, in the same research (SolAbility, 2020). Compounding the low ranking is evidence from the Office for National Statistics (ONS) which suggests that social capital in the UK is, on the whole, in decline:

 

At the UK level, trust in national government fell by 11 percentage points in the year to autumn 2019In our communities across the UK, positive engagement with our neighbours, such as exchanging favours or stopping to talk, fell by three and four percentage points respectively between 2011 to 2012 and 2017 to 2018…Our sense of belonging to our neighbourhoods across the UK declined between 2014 to 2015 and 2017 to 2018…Within our families, parents in the UK were less likely to regularly give help to, and receive help from, their adult children not living with them in 2017 to 2018 than in 2011 to 2012, falling by four and six percentage points respectivelyOn an individual level, reported membership of political, voluntary, professional or recreational organisations declined by five percentage points in the UK between 2011 to 2012 and 2017 to 2018…’. (ONS, 2020)

 

Scandinavian countries, it has been suggested, have avoided some of the decline in social capital experienced in other societies in recent decades (Rothstein and Stolle, 2003). Which has no doubt helped them sustain their high tax-to-GDP ratio over time. If high-levels of social capital are an important prerequisite for reducing the elasticities of taxpayers’ responses to higher taxes, then the UK’s much lower levels of social capital are going to hinder the ability of a future democratic socialist government to substantially increase the tax-to-GDP ratio in the UK.   

 

In addition to the levels of social capital, there are other challenges (often linked in various ways to social capital) that any democratic socialist government in Britain is likely to face, when trying to significantly increase the UK’s tax-to-GDP ratio. These will not only effect the ability to design and legislate for a more Scandinavian approach to taxation but will also influence the potential scale of the 'economic reaction' (i.e. ‘taxable income elasticities’) of the UK population, when faced with any tax changes. These other challenges, include:

 

  • The social preferences of the British public for higher taxes and spending have varied over time. The latest data from the British Social Attitudes Survey for example shows the just over half the public would support higher taxes to fund greater public expenditure (NatCen, 2020). This has fallen in recent years from what were much higher levels (NatCen, 2020). While, at other times, the majority of the public has been opposed to higher taxes (NatCen, 2020). In-depth research by Britain Thinks, the research company, found a highly nuanced view among the public, about the UK tax system. There was, reportedly, considerable scepticism about heavily redistributive taxation but a preference for primarily taxing income over consumption and wealth (Britain Thinks, 2014). Social preferences are not just limited to topics of taxation however, they encompass attitudes to important issues like privacy, the meaning of ‘justice’ and the ‘role of the state', among others. Each of which is likely to have bearing on what the public might be willing to vote for i.e. the public's willingness to accept tax reform along Danish lines.

  • A different model of political economy in the UK compared to Denmark. For example, self-employment is relatively high in the UK (around 15% of those employed) compared to Scandinavia in general and Denmark in particular. In the latter, self-employed people make-up 8% of the employed (OECD, 2020). One implication of this, is that the proportion of tax that is based upon self-assessment is likely to be much higher in the UK than in Denmark, increasing the likelihood of ‘leakage’ through under-reporting. Further, the UK economy is dominated by a highly internationalised financial sector, the influence of which is extensive on UK economic policymaking (Oren and Blyth, 2018; Baker, 1999). In addition, the UK’s exporting and importing sectors are less Euro-centric than those of Scandinavian countries. Consequently, the UK’s internationally exposed businesses (whether that be to exports or imports) face competitive pressures from businesses based in a wider range of countries, frequently operating with lower cost bases than businesses in the UK. Finally, the UK’s model of political economy has persistently demonstrated a number of structural pathologies over many decades, including comparatively low levels of business and infrastructure investment, a long-running deficiency in workforce skill-levels, regional divergences and financial short-termism. The various structural features of the UK’s political economy listed in this bullet-point will inevitably influence the response, not only of interest groups to any proposals to alter the UK’s tax-to-GDP ratio, but more importantly the macroeconomic and microeconomic responses of the UK economy, to actual changes in the tax-to-GDP ratio.

  • The UK’s model of welfare provision is very distinct from that which prevails in the Scandinavian countries. The UK’s welfare model is what Gosta Esping-Anderson called a ‘Liberal welfare regime’ (Esping-Anderson, 1990). The Scandinavian countries are the exemplars of the ‘Social Democratic welfare regime’ (Esping-Anderson, 1990). The complex interrelationship between the tax system, labour market and welfare benefits system that has embedded in the UK over decades (albeit with tweaks and amendments by various governments) will be difficult to untangle and re-organise.

 

Other factors, which might also have a constraining role are likely to include:

 

  • The UK’s adversarial political system (in contrast to the Social Democrat dominated and more consensual Danish political culture).

  • Agitated influential interest groups who may oppose changes because they will lose out as a result of them.

  • The lack of decentralised political authority particularly in England and the challenges of the UK’s particular asymmetrical model of devolution.

  • The size of the UK and the inherent inflexibility and elongated, even opaque, lines of accountability that a state making and implementing policy for more than 60 million people inevitably results in, compared to the agility and the accountability of the state in smaller countries (Rae and Westlake, 2014; Frankel, 2012).

 

There are no doubt others, too that would hinder the scope for radical yet practical change and which could be added to this list, but for the sake of brevity, this list will stop where it is.  

 

The economic consequences of Denmark’s higher tax-to-GDP ratio

 

It is noteworthy that the comparative long-run performance between the Danish economy and the UK’s economy is similar. As the three comparative economic data points below highlight:

 

  • Between 1961 and 2018, both economies grew, on average, at about 2.4% per annum (Macrotrends, 2020).

  • The average annual unemployment rate in both economies between 1991 and 2018 was just over 6% (Macrotrends, 2020).

  • Danish GDP-per-capita in 2018, calculated on a Purchasing Power Parity (PPP) basis in 2019 US$, was estimated to be around $56,102 (Trading Economics, 2020). The UK’s GDP-per-capita was estimated to be in the region of $46,310 (Trading Economics, 2020). A difference of just under $10,000.

 

It is clear from the data above, that Denmark’s higher tax burden has not made it a less successful economy than the UK’s over the long-term, despite what some economists might argue should be the growth consequences of such a high tax-to-GDP ratio. Indeed, on the ultimate measure of economic success, GDP-per-capita, the Danes have done notably better than the UK. Therefore, on-the-face-of-it, there is little to fear from a higher tax-to-GDP ratio if the monies raised are spent effectively through a state apparatus that is effective at delivering what the public want.     

 

Investment in HMRC

 

Beyond the factors described above, which have helped Denmark in-particular, succeed in sustaining a high tax-to-GDP level, it has been argued by UK academics that there are additional measures which can be taken, which would boost tax revenues in the UK for any given level of tax levied by the state. In other words, actions which could be implemented that would close the £35 billion ‘tax gap’ (HMRC, 2019). Such measures would no doubt be helpful for minimising any ‘tax gap’ that would no doubt emerge if the tax-to-GDP ratio in the UK was higher than it currently is. Indeed, it is fair to contemplate the likelihood that with a higher tax burden, the risks of a persistent ‘tax gap’ are higher, as the incentives to take avoidance and evasion measures increase, as a result of the higher tax rates.  

 

Analysis has suggested that a large proportion of the UK’s ‘tax gap’ can be sourced to those who self-report their tax liabilities. As was noted earlier, this is also the case in Denmark. Analysis suggests that around £48 billion in tax should be paid by self-reporting taxpayers, annually, to HMRC. Yet, there is a shortfall of around £8 billion a year. Most of that £8 billion is owed by a small minority (2%) of self-assessment taxpayers (Advani, 2019).

 

Research by Warwick University based academic Arun Advani found that HMRC audits can do an effective job of increasing tax-take and reducing the ‘tax-gap’ (Advani, 2019). Targeted audits have proven particularly effective at identifying tax avoidance:

 

  • An individual targeted audit can increase yield from the taxpayer that has been audited by between £10,000 and £15,000 (Advani, 2019).

  • Audits have been shown to improve compliance behaviour for at least five years after the audit took place (Advani, 2019). Generating a higher tax-take 1.5 times the direct revenue raised from the audit (Advani, Elming and Shaw, 2019).

  • Overall, a targeted auditing approach has been estimated to bring in £4 for every £1 spent on employing an auditor to undertake such audits (Advani, 2019).

 

Unfortunately, as Advani notes:

 

While HMRC has become increasingly good at doing targeted auditsthey havereduced the number of audits they do to less than a third of their peak’. (Advani, 2019).

 

There would seem to be an obvious policy change that could be made, which would make a considerable difference to the rate of ‘tax leakage’ that takes place in the UK. 

 

Being outside the EU

 

It wouldn’t be a DLN blogpost without the obligatory mention of the EU. Although the prospect of not having to mention the EU again, as its influence over UK policy-making wanes (except where the UK may voluntarily enter-into specific international arrangements with the EU) is welcome. Nevertheless, any discussion of tax, while the UK remains under the auspices of EU law as it currently does, without mentioning the EU’s role in facilitating tax avoidance (DLN, 2019) would be negligent.

 

While the UK was a member of the EU and indeed while the jurisdiction of the EU still applies to the UK, the Court of Justice’s interpretation of the Treaties and the ‘foundational’ EU principles of the ‘freedom of movement of capital’ and the ‘freedom of establishment’ contained within them, have allowed corporations to:

 

  • Write off losses in one Member State against profits made in another.

  • Engage in intra-company loans across Member State boundaries to reduce tax liability.

  • Structure themselves across-borders to minimise tax liability.

 

Further, being outside the auspices of the Court of Justice will mean that anti-avoidance measures, which a future democratic socialist government in the UK may wish to utilise (e.g. a general presumption of abuse in anti-avoidance measures and defining ‘tax efficient structuring’ as ‘abuse’), will no longer be unlawful in the UK. Such measures will no longer be ‘struck down’ by a neo-liberal ‘constitutional court’ but rather, could be made the ‘law of the land’, because the UK will have the freedom to take tougher measures against avoidance and reduce the significant ‘tax leakage’ that has resulted from Court of Justice jurisprudence.

 

Democratic socialist tax reform

 

The cumulative evidential picture created by the Kleven research (outlined in this post) along with the work by Advani and the re-gaining of national legal freedoms – as a result of the UK’s exit from the EU - suggests that a democratic socialist government will find it possible to increase the UKs tax-to-GDP ratio by several percentage points without too much to be concerned about. If, that is, the lessons alluded to in this post are heeded and inform the approach of any future democratic socialist Chancellor of the Exchequer.  

 

Whether the UK could increase its tax-to-GDP ratio by 11% to reach Danish levels of taxation is an open question. The UK will be constrained by the various factors listed earlier, such as lower levels of social capital, among many others. With those constraints in mind, below are a series of suggested reforms that try to apply the lessons of Denmark in particular, to the UK. Successful implementation of a tax reform agenda broadly based-upon (although not identical to i.e. adapted for the UK’s circumstances) Denmark’s tax system, would enable a future democratic socialist government to collect significantly more tax to spend on the country’s priorities.  

 

Information

 

A democratic socialist government would need to ensure the tax authorities had access to adequate levels of information about economic activity and assets subject to taxation. The lesson from Denmark is that this can best be achieved by minimising self-reporting and maximising the role of third-parties in the recording and reporting of taxable activities and thereby ensuring there is a proverbial ‘paper trail’ that can be followed by the tax authorities should they need to. A future democratic socialist government would need to implement measures which increased the amount and availability of good quality information about economic activities subject to taxation. This should include:

 

  • Extending ‘deductions at source’ wherever possible i.e. where it is practical and proportionate to do so.

  • Placing more recording and reporting requirements onto firms (particularly larger ones) that hire independent contractors and the platforms facilitating the ‘gig economy’.

 

Audits also have an important role in generating information and HMRC needs to conduct more. This issue and other actions that could reduce evasion and avoidance are touched on again, a bit later on.

 

While ad-hoc measures will improve the current position, a more thorough and systematic approach is needed to identify the full panoply of ways that access to information germane to tax collection can be improved, including how and which kinds of third parties can play a more extensive role in collecting and reporting such information. As such, a time-limited expert commission needs to be established to look into various aspects of tax policy (see more below) including undertaking a thorough examination of these information related issues and how improvements can be made which will help significantly reduce the ‘tax gap’, especially the risks of considerable ‘tax leakage’ that will arise at a higher tax-to-GDP ratio.   

 

Tax structure

 

As Kleven observed, it is the combination of policy approaches which deliver sustainably higher tax revenues. Therefore, in addition to improvements to the availability of information about tax liabilities and widespread involvement of third parties in recording and reporting, the UK would need to implement extensive reforms to the structure of its tax system. The UK’s tax system has been described by the Mirrlees Review, established by the Institute of Fiscal Studies (IFS) in 2011, as

 

‘A jumble of tax rates…[without]…a coherent visions of the tax base, and arbitrary discrimination across different types of economic activities are hallmarks of the system’. (Mirrlees et al, 2011).

 

In other words, the UK’s tax system falls short, across a number of dimensions, of the kind of system needed to minimise the negative ‘elasticity of taxable income’ and thus the reduce the likelihood of the emergence of downsides to heavier taxation.

 

The structural tax reform lessons from countries that have successfully sustained a higher tax-to-GDP ratio than the UK and done so while continuing to enjoy relative economic success (i.e. the Scandinavian countries and Denmark in particular) are that a broad and (relatively) simple tax framework is needed. Such a framework will deliver ‘horizontal equity’ (i.e. similar kinds of revenue sources are taxed similarly) and a sense of ‘vertical equity’ (i.e. the burden is broadly distributed on an ability-to-pay basis). Specifically, the Danish tax system is a variation on a dual-income tax (DIT) system, as is common in all the Nordic countries (Sorenson, 2010),

 

Therefore, if a future democratic socialist Chancellor of Exchequer wanted to move the UK towards a simpler and more comprehensive tax system modelled on the successful Danish approach to taxation i.e. a DIT structure, they would need make a slew of reforms. In broad terms, these reforms would require a reorientation of the tax structure towards:

 

  • Placing more of the national-level tax burden on labour income, capital and consumption and away, for example, from payroll taxes.

  • Much more consistent treatment of similar categories of economic activity and assets (i.e. revenue sources).

  • A more decentralisation of tax raising powers.

 

Adopting the Danish approach to a DIT, for the UK, would specifically require:

 

  • A relatively flat income tax structure with few rates. In 2019, the lower income tax rate in Denmark was around 12%. The higher national rate was 15%. The base for calculating income tax liabilities is personal earned income plus ‘net positive’ capital income (PwC, 2020). In particular, the UK would need to fully integrate income tax and Employee National Insurance Contributions (NIC) into a single tax, as recommended by the Mirrlees Review (Mirrlees et al, 2011). Such a move would be likely to find considerable public support (Britain Thinks, 2014).

  • Placing clear limits on the amount of capital income ‘losses’ that can be written off against other tax liabilities and simultaneously introducing a ‘tax ceiling’ for income and capital taxation.

  • The decentralisation of supplementary income tax levying power to localities. About two-thirds of the marginal income tax rate paid by Danes is a result of local income tax. The average local income tax rate in Denmark is just under 25%, against which certain deductions are able to be made e.g. interest paid is deductible up to a threshold.

  • Introducing a flat-rate supplemental ‘gross earnings’ levy, levied on all pay before other tax liabilities are calculated. In Denmark, the ‘Danish Labour Market Contributions Rate’, which funds unemployment and sickness benefits as well as some of the Denmark’s ‘active labour market policies’, is currently levied at 8%.

  • A simplification of the UK’s complex approach to taxing dividend income and capital gains by bringing in an aligned two-tier taxation of dividend income and realised capital gains, with a basic-rate similar to the level of the corporate income tax and a higher rate on annual dividend income and realised capital gains over a prescribed threshold. The lower rate in Denmark is 27% and the higher rate is 42% (PwC, 2020).

  • Bringing in an annual levy on pension fund assets. The levy in Denmark is set at approximately 15%.

  • Returning the UK to a higher corporate tax rate (Denmark taxes profits at 22%) with less complexity and a limited number of deductions e.g. full deductions in the year of purchase for capital equipment and intangibles acquired for R&D purposes, along with a R&D tax credit so that companies can recover tax losses (up to a threshold). Additionally, the cost of investment in computer software is also fully deductible under Danish company taxation rules.

  • A substantial broadening of the VAT base, simplification of rates and an increase in the standard rate. The standard rate in Denmark is 25%.

  • Replacing the UK’s outdated system of land and property taxation with an imputed rent tax on privately owned dwellings and a Land Value Tax (LVT). It is notable that a Land Value Tax for the UK was recommended by the Mirrlees Review (Mirrlees et al, 2011).

 

It should be noted that not all the elements of the Danish tax system will be replicable in the UK, due to some of the factors outlined earlier in this blogpost, that are specific to the UK. Indeed, a straight 'copy and paste' approach, when trying to learn lessons from the success of other countries, rarely works. Therefore, the following kinds of adaptations should be made, in order to ensure that ‘Danish-style’ reforms to the UK's tax system are politically, socially and economically successful:

 

  • The UK may want to rely more heavily on property and land taxation than Denmark currently does. Not least because of the importance of property to the UK’s political-economic model and the unearned increases in wealth that can, and have, accrued in recent years, due to rises in land and property values. The economic rationale for doing so is also strong, land and property are less-mobile assets and therefore relatively easily to tax and less economically distorting if taxed appropriately. The reform of the system of property and land taxation in Britain is long overdue. A LVT should be at the heart of such reform (Mirrlees et al, 2011).

  • The popularity of the reforms, in recent years, to the Personal Allowance in the UK’s income tax system suggests that any democratic socialist Chancellor of the Exchequer would find it difficult to significantly reduce it from its current £12,500. Although the recent increases in it have undoubtedly brought about tax relief for individuals on low wages they have had a more ambiguous overall impact at the household level (Browne, 2012) However, going-back on the reforms to the Personal Allowance that have taken place and thus raising taxes on some of the lowest paid would be politically, economically and morally difficult to justify. Therefore, maintaining it, even though it is considerably higher than that which prevails in Denmark would make sense. Further, a UK Chancellor may want to make the incidence of national income tax more progressive than the Danish national rates of income tax. However, care will be needed on exactly how to calibrate the national income tax rates if a considerable proportion of income tax (perhaps nearly two-thirds) is to be devolved and raised through local additional income tax rates, as is the case in Denmark. 

  • It may be prudent to design-into a new company taxation regime rules which lower the cost of capital even further than the Danish tax system does, to encourage plant and machinery investment, given the UK’s historically poor levels of private business investment and the (now well established) inverse relationship between the effective marginal tax rate on capital investment and the quantum of such investment that takes place (Hassett and Hubbard, 2002; Ohrn, 2017). Notably, under the Danish tax system, the ‘net present value of capital allowances’ for investment in plant and machinery is estimated to be around 83%, compared to the UK, where the ‘net present value of capital allowances’ on plant and machinery is around 76%, placing Denmark 9 places higher than the UK in the OECD rankings (El-Sibaie, 2018). Maximising the incentive to invest in plant and machinery and the importance of keeping the tax regime simple would suggest that 100% first year capital allowances would be the most sensible policy choice for a future Chancellor. Although it has been suggested that this may cost around £18 billion a year in lost revenues. However, looking at such a measure in such a way is short-sighted, given the longer-term economic and thus revenue gains that would accrue from such a reform. Further, increasing the UK's Corporation Tax (CT) rate to the same as Denmark's would generate (using HMRC estimates) around £7 billion in extra revenues per annum (HMRC, 2020), reducing the short-term revenue gap to something in the region of £9 billion. Further, other changes (such as the one proposed in the next bullet point) would see the Exchequer end-up, in the short-term, net-gainers from the reforms outlined here.

  • A longstanding criticism of the company taxation regime in the UK has been the unequal treatment of debt and equity finance. As part of any reform package, a future Chancellor may want to finally eliminate the distinction. It would make the corporate tax system less distorting and simpler. As an additional incentive to make such a change, it has been estimated that this kind of change could bring in £11 billion a year in additional tax revenues and (along with a rise in the CT rate) wholly eliminate the short-term revenue shortfall due to the introduction of 100% first year capital allowances.

  • Denmark has incentives for R&D expenditure in its corporate income tax rules. However, rather than uprooting the UK’s own existing R&D tax credit system, which has taken many years to ‘bed-in’ and has shown signs of being a successful policy intervention (Dechezleprêtre et al, 2016), in order to copy the Danish approach a future democratic socialist Chancellor would be better off focusing on how to improve the UK’s exiting R&D tax credit scheme and make it more helpful to innovative businesses (COADEC, 2019). As well as perhaps ‘trimming off’ its excesses (HMRC and HMT, 2019).   

  • A future government may be content with broadening the VAT base and not increasing the rate, because the former alone ends-up bringing in sufficient revenue. Further, there is a potential ‘double whammy’ of negative distributional consequences as the result of both a higher rate of VAT on top of a wider VAT base. Although compensating income tax or benefits changes could be made to minimise distributional concerns (Mirrlees et al, 2011). As part of the base broadening a future Chancellor should look to extent VAT to financial services, as recommended by the Mirrlees Review (Mirrlees et al, 2011). In Denmark financial services are exempt from VAT. As well as ending many of the exemptions and zero and reduced ratings that currently exist, other ways the reach of VAT should be extended include ending the exemption for UK sales of overseas goods. In addition, it would be important to simplify the administration of VAT wherever possible, to reduce the compliance burden associated with what is a complex tax. Therefore, a democratic socialist run government should implement many of the simplifications proposed by the Office of Tax Simplification (OTS) in 2017 e.g. a ‘smoothing mechanism’ to help small businesses ‘ease into’ the VAT regime and improving certainty for businesses over errors and penalties (OTS, 2017). Other simplifications that should be considered include rationalising and consolidating the VAT laws, including taking up the idea of ‘layered’ VAT legislation, as proposed by the OTS (OTS, 2013) and ensuring all guidance from HMRC and processes for reporting to HMRC are in ‘plain English’. More flexibility for firms over the timing of VAT payments should also be considered e.g. opening up the monthly payment option to more businesses and also offering the possibility of less frequent payments such as half-yearly payments rather than quarterly or monthly payments.

  • A UK Chancellor may want to consider taxing interest income at the same rate as dividend income and realised capital gains and not wage income, as it is in Denmark (KPMG, 2019). Thus avoiding what seems like an anomaly in the Danish approach to the taxation of savings, and thus adhering more closely to the principle of ‘horizontal equity’, which, as highlighted in Mirrlees Review, will minimise distortions in economic decision-making and the opportunities for avoidance (Mirrlees et al, 2011).

  • The centrality of private pensions to many peoples’ retirements in the UK may mean a future Chancellor thinks twice about imposing the kind of ‘levy’ on pension assets that the Danish government does. Instead, efforts to tidy up the taxation around pensions along the lines advocated by Mirrlees may be a better option. Mirrlees proposed eliminating the current ‘generous’ treatment of employer NICs on pension contributions and ending the tax-free lump-sum compensated for by either a reduced rate of pension income tax or a one-off government contribution when a pension fund is annuitized (Mirrlees, et al, 2011).

 

In order to sort out the full details of tax reform, the expert tax commission (mentioned above in relation to identifying ways to improve access to information and utilise third parties better in the tax system), should place its main focus on designing a structure that embodies simplicity and is broadly based in-order to bring-in a considerably greater quantum of tax revenues, while minimising any distortive effects from higher taxes. However, the commission should go further than identifying the optimal design. It should set out a timetable as to how such a system could be implemented and publish draft legislation that would implement the reformed tax system. Taking these additional steps would mean that, if a democratic socialist Chancellor of the Exchequer was elected to office, there would be available an ‘off-the-shelf’ set of tax reforms that could raise substantial additional revenues. The added advantage of the commission undertaking implementation preparatory work would help reduce the opportunities for powerful interest groups to delay and frustrate tax reform.    

 

Evasion and avoidance

 

In addition to access to better information and a more central reporting and reporting role for third parties and structural reform to the tax system, in order to further reduce the risk of avoidance and evasion, in the context of a much higher tax-to-GDP ratio, HMRC would need to be required to conduct more audits of those self-reporting their tax liabilities.

 

As the work of Advani has showed, audits in general, but targeted audits in particular, not only ensure the under-payment of taxes are paid but they generate vital information about taxpayers which helps increase compliance going forward. The number of audits that take place each year needs to be increased by at least two-thirds to get numbers back up to what they used to be.

 

Attempts to stop avoidance and evasion should not stop at more audits, better information and a simpler and broader based tax system. Specific anti-avoidance measures should also be implemented.

 

As was described earlier in this blogpost, finally being free of the EU’s legal order opens up a host of possibilities for clamping down further on ‘tax leakage’. Not least limiting the ability of corporates to shift profits abroad, structure themselves across borders to minimise their tax liability. There are no doubt numerous approaches that could be taken, and the expert tax commission should examine as many of them as possible to identify the most effective ones. There are two specific changes that could make a significant difference to HMRC’s ability to tackle evasion and avoidance, that will become available in January 2021. These are:

 

  • The introduction of a ‘general presumption of abuse’ in any anti-avoidance measures.

  • Defining ‘tax efficient corporate structuring’ as ‘abuse’.

 

The welfare state

 

Finally, to complete the policy package that needs to be put in place to support a sustained increase in the UK’s tax-to-GDP ratio there needs to be welfare reform. As was acknowledged earlier on, the UK’s welfare model is very different to the one in Denmark. The nature of path dependency is that it is unlikely that the UK will be able to replicate the Danish welfare state and provide the full panoply of services that ‘subsidise’ labour supply and thus help legitimate and sustain support for the high tax burdens that Danish taxpayers bear.

 

Consequently, a future democratic socialist Chancellor would probably find it difficult to introduce an 8% ‘gross earnings’ levy similar to that which Danish taxpayers pay, in order to fund unemployment and sickness insurance. Nevertheless, it does not mean that a future democratic socialist government cannot make significant strides towards putting in-place high quality complementary services, which will help legitimise a higher tax-to-GDP ratio in the UK and help make that tax-to-GDP ratio sustainable over the longer-term. Making changes on sufficient scale to achieve its goal of supporting labour market participation, however, will require thinking differently about the appropriate mix between universalism, means-testing and the contributory principle, and which services should be based upon which principle.

 

As a supplementary piece of work to its main efforts on taxation, the expert commission which this blogpost recommends being established, should examine what kinds of public services can be the most supportive of labour supply. Kleven identified care services, education and transport as being particularly important to support labour participation (Kleven, 2014). The commission should propose future directions for further policy work which should be taken up by others on the left, who will work to develop an array of specific proposals to ensure such services are put in place, on sufficient scale and that are of high enough quality to be effective over the long-term and will consequently legitimate at least some of the higher taxes, that taxpayers are being asked to pay. How this might be done, and the state reformed to deliver it, is a topic, or rather series of topics, for another day.   

 

One aspect of the Danish welfare system that could be more readily copied by the UK, is Denmark’s more extensive ‘active labour market’ policy. Well-designed ‘active labour market’ policies have never secured sustained support from governments in the UK. Yet ‘active labour market’ policy is a cornerstone of the Danish ‘model’ and sustaining an extensive ‘social democratic welfare regime’. It is reasonable to expect that the UK may also need to adopt such a policy, as a future democratic socialist government strives to build a new BSM, which in-part at least, more closely resembles some aspects of the Scandinavian political economies. To start with the UK would need to establish an effective institution, like the Danish ‘Agency for Labour and Recruitment’ (STAR, 2020) to manage the government’s labour market policies. If a future government went down this route, then there might be grounds for the introduction of a small flat-rate ‘gross earnings’ levy hypothecated to fund the active labour market policy of the government and the agency that is implementing the policy. 

 

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