Why is tax reform so hard? Reviews such as the Henry Review often point to ‘low-hanging fruit’ where efficiency gains can be made without any significant equity costs. One oft-noted example is property stamp duty, where the Henry Review recommended its replacement by land taxes. Taxes such as stamp duties, it is argued, discourage residential mobility and the most efficient use of the housing stock.
In general, tax theory tells us that the most efficient way to raise a given amount of revenue is to use a tax which does not distort behaviour. Taxes on transactions such as stamp duty and insurance taxes are rated as particularly distortionary because people can easily change their behaviour to avoid them. Taxes that are hard to avoid (eg land taxes) are much more efficient. Putting this another way, the change in behaviour as people respond to distortionary taxes means that the tax rates must be higher than otherwise in order to compensate for this inefficiency. Okuns ‘leaky bucket’ has to return more often to the well, the larger are the leaks in the bucket.
But if there is such consensus about tax efficiency, why has there been a distinct lack of political enthusiasm for replacing transaction taxes such as stamp duties with alternatives such as land tax (or even more ‘radical’ proposals such as death duties)?
An explanation that is often advanced against taxes on assets, is that someone with large assets might not have the cash flow needed to pay tax. On the other hand, when a large transaction is taking place, it’s easier for the tax office to cream off its take. While this may have been a valid issue in the past – it is hard to see it as a serious constraint now. As the HECS scheme shows, there are ways of delaying liabilities until people have the required cash flow. In the case of a tax on assets, this could be delayed until the asset is liquidated.
A more fundamental problem, I suggest, is that efficient taxes are politically unpopular precisely because they are efficient. That is, people don’t like taxes on assets where they cannot easily change their behaviour to avoid them. Now, from the perspective of utilitarian welfare economics, this doesn’t make sense. The more behavioural change associated with a tax, then the higher must be the tax rate (to raise a given revenue) and so the average person is made worse off.
But the average person is irrationally optimistic. We have unrealistic views of how easily we might be able to avoid transaction taxes. To take property stamp duty as an example, people can push stamp duty taxes on hypothetical future home purchases (for themselves or their children) out of their mind – but an equivalent land tax is something that they would have to face immediately.
Can this political challenge be solved? I don’t know, but think that continued debate and discussion of tax reform (as exemplified by the recent tax forum) can only be a good start. Practitioners of the ‘dismal science’ need to work harder at spreading realistic pessimism.