Lateral thinking and the economics of taxation

By Evan Davis

Here's an interesting way of thinking about a tax: ask the people who pay it, how much they would pay to have it abolished.

For example, suppose I told you that you can expect to pay £6,000 of income tax next year other things being equal. How much would you be willing to give up not to have income tax?

It's clearly worth at least £5,999. But would you pay more than £6,000 to buy your way out of a £6,000 tax bill?

The answer is you might. If there was no income tax next year, you wouldn't need to administer your tax, you wouldn't need to fill out a tax return, and you could then do unlimited overtime tax free.

In fact, you might decide you would happily do a lot of overtime next year if there was no income tax to pay on it, so yes, you would be willing to pay something for that privilege.

It is a hypothetical thought experiment rather than a practical idea, but if people would happily pay the government £1.20 to avoid a tax that raises only £1, there is a wastage in the tax system. It is not collecting as much in money as it is hurting the taxpayer. This provides an interesting measure of a tax's effectiveness.

I mention this concept, because arguably it would be interesting to know how inheritance tax (IHT) would fare if we sold people the right to be exempt from it. I certainly know people who would happily pay a lot more not to have the tax there at all, than they will actually hand over to the government. The reason is that they avoid the tax, but it costs them a lot of accountancy bills and stress to do so.

Remember the basic rule of tax administration: the public can quite rationally spend 99p to save a pound of tax. But if they do, they still lose 99p and the state gets not a penny. So taxes which allow or encourage us to engage in costly legal avoidance are expensive ways of raising money.

Which leads to the question of the day, should the Conservatives abolish inheritance tax?

It is an oft-avoided tax, with expensive consequences. It can have different effects on families depending on how much trust they put in each other. (Parents might be willing to give away assets to children well before they die to avoid the tax, if they can trust the children to look after them should hard times come. Less trusting parents may choose to hang on to their cash until they know they don't need it).

IHT can also lead to some odd discrepancies in the lifetime tax bill paid by similar people who just happen to die at different times. (Someone who dies earlier than anticipated, and who has not given away, or spent their assets can end up paying more tax on the same lifetime income than a similar person who dies to plan.)

However, one can't avoid mention of the reasons why the tax has persisted in different forms under governments of different colours for hundreds of years. In some ways, death is a good time to catch people for tax purposes, and it is also one when they usually have free assets available to pay it.

And don't forget its goal - apart from raising money - is to enhance social mobility by limiting the degree to which inherited advantage can help the offspring of the wealthy. It probably succeeds in that to a small degree.

Perhaps most of the debate about IHT comes down to one salient point: that only about 6% of estates pay it (although that is probably rising fast). The vast bulk of us do not.

Yet, while that is most frequently mentioned as a defence of IHT, it is arguably a measure of its inefficiency. It appears unpopular with far more than the 6% who are actually handing money over, which implies it hits an unspecified larger number of people who go to some effort to avoid it, or who wrongly worry about paying it.

Those are costs to the tax that generate no revenue whatsoever.

Of course, these arguments are all relative. In actually deciding on a policy towards the tax, the government and opposition have to weigh up its unpopularity and costs against the alternative taxes that would raise the same money.

John Redwood's Economic Competitiveness Commission has made the proposal for the Conservative party to abolish it, echoing previous calls both before and since the last election for this to be seen as one of the main pinch points needing attention in the tax system. Just a quick three points to make about this.

• The first thing to note that it is not currently Conservative policy to abolish the tax, and even though George Osborne has not shut the discussion about inheritance tax down, he has not changed his stance on it at all. He is not committing himself to it now.

• The second thing is that Mr Osborne will be able to afford some tax cuts by the next election, because he can announce some green tax rises that will pay for them. We just have to be patient to see what they are.

• Thirdly, the prominent inclusion of inheritance tax abolition in the presentation of the economic competitiveness report - when it actually has rather less to do with economic competitiveness than other suggested tax changes - more or less seals it as now holding the number one slot on the Tories tax cut priority list.

So, whatever the merits of abolition, these three points led me to the view it would probably occur under a Conservative government, at an exchequer cost of about £4 billion a year, perhaps a little less if some of the lost tax is recouped through the capital gains tax system as the Conservatives propose.