How the tax system works

Suppose that every day, ten men go out for beer and the bill for all ten comes to £100. If they paid their bill the way we pay our taxes, it would go something like this:

• The first four men (the poorest) would pay nothing.
• The fifth would pay £1.
• The sixth would pay £3.
• The seventh would pay £7.
• The eighth would pay £12.
• The ninth would pay £18.
• The tenth man (the richest) would pay £59.

So, that's what they decided to do.

The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve. 'Since you are all such good customers,' he said, 'I'm going to reduce the cost of your daily beer by £20.' Drinks for the ten now cost just £80.

The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men - the paying customers? How could they divide the £20 windfall so that everyone would get his 'fair share?'

They realized that £20 divided by six is £3.33. But if they subtracted that from everyone's share, then the fifth man and the sixth man would each end up being paid to drink his beer. So, the bar owner suggested that it would be fair to reduce each man's bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

And so:

• The fifth man, like the first four, now paid nothing (100% savings).
• The sixth now paid £2 instead of £3 (33%savings).
• The seventh now pay £5 instead of £7 (28%savings).
• The eighth now paid £9 instead of £12 (25% savings).
• The ninth now paid £14 instead of £18 (22% savings).
• The tenth now paid £50 instead of £59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the restaurant, the men began to compare their savings.

'I only got a pound out of the £20,' declared the sixth man. He pointed to the tenth man, 'but he got £10!'

'Yes, that's right,' exclaimed the fifth man. 'I only saved a pound, too. It's unfair that he got ten times more than I did'

'That's true!!' shouted the seventh man. 'Why should he get £10 back when I got only two? The wealthy get all the breaks'

'Wait a minute,' yelled the first four men in unison. 'We didn't get anything at all. The system exploits the poor'

The nine men surrounded the tenth and beat him up.

The next night the tenth man didn't show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill.

And that, ladies and gentlemen, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

The tax cut battleground

Cameron has outlined a national insurance tax break for companies as an incentive to take on staff. It would be funded from unemployment benefit savings. In other words, companies would receive a proportion of the benefit payment in the form of a tax break. Cameron said it costs the taxpayer over £8,000 every time someone takes unemployment benefit and his proposal would see approximately £2,500 of that sum used to fund a cut in the amount of NI paid by businesses. The Conservatives say their plan would create 350,000 jobs and cut the tax burden on companies by £2.6 billion.

Cameron described his announcement this morning as a "budget submission," rather than a future policy pledge for an incoming Tory government, to help alleviate unemployment which he hoped Brown would accept and Darling would implement next week in the Pre-Budget Report.

Brown has already disappointed Cameron though by rejecting it as a "one-off initiative," said the figures "simply do not add up" and said "serious policy" was needed for "serious times." The government line continues to be that the Conservatives have an incoherent economic strategy.

Moreover, as Guido has pointed out, it is more of a tax credit than a tax cut. He said that although it was more welcome help for small businesses, the problem with it was that the £2,500 tax credit was only for new created jobs and did not apply to companies that were thinking of laying off workers to cut costs. In other words, it might help small businesses, if implemented, who want to grow and recruit staff - thus cutting unemployment; but will do nothing for those who want to retain staff but cannot afford to do so - thus doing nothing to prevent unemployment.

One must conclude that this is another welcome proposal but nothing revolutionary and once again small in scope. It thus can be added to other initiatives announced by the Tories on council tax, NI and VAT.

It will undoubtedly disappoint those who wanted to see something more substantial.

If Cameron is moving towards acknowledging that monetary policy alone is going to be insufficient to get us out of recession, "fiscal stimulus," as the PM puts it, will be necessary. So again we are back to two choices. Increased public spending or cut taxes. A Keynesian spending splurge will not work; it is far too slow. So we are left with tax cuts as even Brown seems to have come to admit.

Three more questions arise:

1) What taxes to cut? 2) By how much? and 3) How to pay?

1) WHAT TAXES TO CUT? The Conservatives have thus far focused most of their attention on measures to help small businesses (council tax pledge being the exception). They reason that it is SMEs that are the driving force of the economy so that by keeping them going, the economy will be stronger.

The Lib Dems (and possibly Labour - we'll see possibly next week) have argued that income tax should be cut to help stimulate demand. The Lib Dems, for example, have said they would cut the basic rate of income tax from 20% to 16% thus helping low and middle income earners.

Ordinarily I would be all for a cut in income tax but there is a problem with it. For it to have the desired effect, the government would need to ensure that people spent the extra money they were being allowed to keep. However, given the constant flow of bad economic news, it is quite probable that a majority of people would try and pocket the tax cut, saving the money in anticipation of worse times ahead. I can't see how the government can compel people to spend the money from the tax cut given the fear being whipped up by the media.

Nevertheless, in an ideal world a combination of the Conservative and Lib Dem approach - measures to help business and a cut in income tax would probably be the best option to help alleviate the effects of the recession and help stimulate demand.

But that leads us on to 2) BY HOW MUCH? How large should the tax cut be? The Institute for Fiscal Studies (IFS) has said that a tax cut would need to be in the region of £15 billion to have any effect.

The Conservatives are wedded to their 'fiscal responsibility' approach, which Rachel Sylvester in the Times today has called the 'housewife strategy' (households are having to tighten their belts and make sacrifices, so should government - it is no time to get another unaffordable credit card). He can't claim that the cupboard is bare to then suddenly magic up £15 billion worth of tax cuts. So if we really are entering the ‘tax cut war’ between the parties, the Conservatives will lose in the battle of who can promise to cut tax the most. Cameron will be trumped by both the Lib Dems and Labour which is a surprising position for a Tory leader to be in. Yet, ‘sound money’ is also a strong Conservative principle. Cameron is taking a punt that the British people will reward him for his pledge not to saddle future generations with large debts and high taxes. He is essentially saying that Gordon might have left Prudence at the alter, but she's dating Dave now. In contrast, Brown is saying to hell with Prudence, in 'unique' times like these, he needs Miss Profligate Spendthrift on his arm.

This leads us to the last question: 3) HOW TO PAY? This is the clear dividing line between Brown and Cameron. Brown is willing to borrow to cut taxes while Cameron is behaving like the Brown of old saying there should be no unfunded tax cuts. Brown is hoping that the British people will let him borrow and spend and ignore the fact that for decades he has been accusing the Tories of offering unfunded tax cuts but is now proposing to do just that himself. Cameron is hoping that the British people, and the media in particular, will not let Brown get away with it and instead will reward, prudent Cameron, the responsible steward of the economy. Cameron is setting himself out as responsible and therefore Brown as irresponsible.

There is of course more scope for Cameron to offer ‘funded’ tax cuts but he seems unwilling to go down that route, to the dismay of many Conservatives. He could pledge to cut public spending but Cameron would probably argue that cutting spending at such a time would not be ‘responsible’ as it would cut demand in a recession. However, many on the right disagree, including Nick Clegg, and say that public spending has increased by vast amounts over the last eight years or so, a significant proportion of which is wasted and spent inefficiently. But Cameron will know from his experience of the 2005 general election working for Michael Howard that a policy of tax cuts funded by pledges to cut government waste has not proved successful. Cameron might also be fearful of opening up another unnecessary front in which he is open to attacks from Brown that he is cutting vital frontline services – whether true or not. We all know that Brown doesn’t let truth and honesty get in his way. But nonetheless, if Cameron wanted to be bolder, there clearly is scope to offer funded tax cuts – though it is true that cutting waste is often easier said than done.

This is a ‘game’ of high stakes. Whoever wins the battle of borrow and spend vs. fiscal responsibility could very well have the keys for Number 10 in 2010. Cameron's approach is sensible, though not flashy, will help minimise the effects during the recession and will significantly reduce the hurt after the recession and place Britain in good shape globally ahead of the upturn. Brown's approach is likely to prove bold and brash, may very well have a greater effect during the recession (though this is not guaranteed as it could hurt the value of pound sterling, for example), but its recklessness will prove damaging after the recession as the costs of his borrow and spend policy are borne by us all through higher taxes and/or significant cuts in public spending. This could leave Britain behind the curve internationally in trying to benefit from any economic upturn.

What seems clear, however, is that Brown looks like throwing everything, including the kitchen sink, at this recession in the hope that it wins him another term in office after 2010. Brown is obviously in power so we will get what he wants and Cameron can only warn, criticise and set-out what he would do differently. Unfortunately for us, that means we will ultimately suffer the consequences and if Cameron does win the next general elections he will be left picking up the pieces of an economic wreckage caused by a reckless driver by the name of Gordon Brown.

UPDATE: Adam Boulton makes a good point I meant to include. He's written: "The challenge for the Tories will be whether they hold their nerve and oppose hand backs which are likely to appeal to hard-pressed voters and businesses." Will shall see...

UPDATE 2: Been thinking... If Brown does indeed offer unfunded tax cuts Cameron needs to hit home the message hard that we will all pay for it through higher taxes. Labour may offer short-term gain, but it will end in long-term pain!

Labour's irresponsible tax cuts

It is being widely reported that in Alistair Darling's Pre-Budget Report (expected in the next couple of weeks) he will announce tax cuts - funded by borrowing. The government will argue it is another step they are taking to help people through a recession. However, implicit in their plan - as political as ever from our Dear Leader - is that they hope it puts the Conservatives in a bind. This is because Osborne is likely to reject the tax cuts as irresponsible, because they are funded by government borrowing, but this will then leave the Tories out of touch with the electorate who want tax cuts and will also foster disunity within the Conservative Party where many MPs and activists want tax cuts offered.

ConservativeHome has an excellent post on this today. They have been broadly supportive of Osborne's attempts to articulate a credible Conservative policy position on the economy - as was i yesterday - but now argue, faced with this new threat from Brown, that "the Tories need a responsible tax cut plan to beat Labour's irresponsible tax cut plan." ConservativeHome argues that "If Labour intend to finance their tax plan with extra borrowing we should put forward our own tax relief plan and it should be funded by tighter control of public spending," and they conclude that "The Tory tax cut plan does not need to be as big as Labour's" but that the Tories should remember "You don't beat something with nothing."

I agree with ConservativeHome that the party's 'fiscally conservative/responsible' stance, in other words, the country should live within its means, is one that could resonate with voters but that there is real danger with the government's tax cut approach. If it is funded by borrowing then it should be condemned as irresponsible. But i am not convinced that the Tories should respond to the government's political games with tax cuts of their own.

One question i have is how big is this tax cut from Labour actually going to be? The government seems to be promising more government spending and now tax cuts. It is all adding up. It is unlikely that the tax cuts will be huge in scope. But I'd expect they will, nevertheless, try to be as eye-catching as possible - possibly something that helps individuals and families (though Brown has already had to borrow (£2.7 billion to make up for his 10p tax rate cock-up).

So, what should Cameron/Osborne do about it?

1) Do nothing - Brand the tax cut as irresponsible and desperate. Government has lost all credibility on the economy and is set us up for further ruin etc etc

2) Offer modest tax cuts paid for through pledges to cut government waste (always easier to say than do)

3) Offer substantial tax cuts paid for via cuts in public spending or increased borrowing.

To my mind, only options 1) and 2) are serious contenders. Option 3) just wouldn't fit the Conservative's 'fiscal responsibility' agenda.

Another dilemma also presents itself. If the Tory leadership decides to offer tax cuts, do they:

1) Wait until Darling announces his, try and trump him, but risk Labour saying they are making the running and the Tories are copying them - the opposite of 12 months ago.

OR

2) Pre-emptive strike on tax cuts to say the Tories are making the running, but risk being trumped and derided for being panicked into the move. There is also the risk that Labour is just flushing out the Tories and won't in fact offer tax cuts.

The more i think about it, the more convinced i am that the Conservatives should not respond to Brown's politically calculated tax cut ploy. The Conservatives are rightly positioning themselves as the 'responsible' party in sharp contrast to Brown who has borrowed, taxed and spent and got us into the mess only now to offer more borrowing, spending and another cynical tax cut (remember the 'Tax Con' Budget and the 10p rate of income tax anyone?) to get us out of it.

If the Conservatives are spooked into responding all they will be doing is showing that Brown is setting the agenda and they are merely jumping through his hoops. Osborne and Cameron need to stick to their agenda. I'd doubt Labour's tax cuts would be substantial - if they materialise at all - and the Conservatives have already offered modest tax cuts, including pledging not to to raise corporation tax on small businesses as the government plans.

I also doubt whether Brown would win much media support for his type of irresponsible tax cut. Headlines such as "Spend, spend, spend" were also met with critical editorials denouncing higher spending funded by yet more borrowing. I'd expect the newspapers to be as critical, if not more, of a cynical move by Brown to outflank the Tories on tax funded by more borrowing.

As a final point, I'd remind readers that whenever Brown tries to play political games, such as the 10p tax fiasco and last years Pre-Budget Report with inheritance tax, he always ends up...

In the Brown!!!

Time for tax cuts

Nick Robinson has a good post today arguing that David Cameron has a problem with the economy; that is, he does not have much to say. Robinson argues:

• He can’t say that he predicted the banking crisis because he didn’t;
• He can’t say he has a better answer because he has backed the government’s recapitalisation;
• He seems to have ruled out tax cuts saying that the “cupboard is bare” and as a “fiscal conservative” he won’t borrow money to fund a tax cut; and
• He won’t spend his way out of trouble arguing that it is not a cost free answer.

What Cameron has been able to offer has been measures to give small businesses help such as a 6-month VAT holiday and a short-term 1% National Insurance cut. These may be worthy and all will help, but they are hardly sufficient in themselves to pull us out of a recession.

Cameron has said that Government has made two key errors – 1) profligate borrowing and spending during the good years and 2) removing the regulatory powers of the Bank of England. However, Cameron’s previous pledge to match Labour’s spending levels (it seemed clever at the time as it negated Brown’s ‘Tory tax cuts’ attacks) undermines his argument that Labour spent and borrowed too much as does the lack of serious and sustained warnings from him about government debt levels.

Before the financial crisis and economic downturn, Cameron’s economic policy was “Spending the proceeds of growth” – a mixture of tax cuts and government spending/investment – which is clearly no good anymore given there is no growth. Cameron has yet to offer an alternative economic policy.

Cameron’s argument that the Conservatives wouldn’t have got us into this problem is not enough on its own. The media do not seem interested in his “we wouldn’t start from here” argument as they seem far more interested in what remedies he has for the future – as do voters.

Labour have made it clear that they will head off to the Left with their Keynesian stimulus package – i.e. they are going to try and borrow and spend their way out of trouble like all Labour governments do. The Lib Dems have shifted to the Right unexpectedly with pledges to cut taxes. And what are the Tories doing? They are tinkering at the edges with small initiatives while essentially saying the economic realities they face precludes them from offering a strong lead in any direction. This is what Cameron is doing by trying to link his lack of options to Labour’s decade of economic mismanagement. But this is not what the other parties are saying and doing.

Cameron seems determined to cling to the centre, matching Labour’s current spending plans while avoiding any specific pledges to cut taxes. This just won’t do anymore. The situation has changed and that means new ideas are needed. He cannot continue playing safe indefinitely. Fiscal levers need to be pulled and Cameron needs to make up his mind and pull one of them properly. His choices are more and more spending or tax cuts.

This is back to the future territory. The Conservatives need to re-fight and win the arguments of the 1980s all over again. How has it come to this that the Tories have let Labour turn ever higher public spending and ever higher public debt (the highest in the world) into a positive? How have the Tories let Gordon Brown spin public spending as ‘investment’? How have the Tories let Labour smear tax cuts? The answer unfortunately has to be successive weak and misguided leadership.

The Conservatives need to have the intellectual confidence to win this ideological battle.

Cameron should be bold and courageous and offer tax cuts. The political climate has changed. Nick Robinson says this is a trap Brown is laying so that he can once again use his favourite ‘Labour investment versus Tory cuts’ attack. So be it. Cameron should take him on and make the case for tax cuts.

For too long Tory leaders have been silent. It is not as if he would be sticking his neck out anyway as the Lib Dems have led the way and this should make it easier for him. Also the Tory supporting newspapers of the 1980s and early 1990s will return to the fold. The Murdoch papers and Daily Mail in particular would relish the battles of the 80s again.

To fund his tax cut Cameron should either cut public spending (unlikely in a recession and will play into Brown’s hands) or borrow money. He should do the latter. Labour and Gordon Brown no longer have a foot to stand on. They cannot claim Cameron is offering unfunded tax cuts Cameron when its own spending commitments are unfunded paid for by more and more borrowing. Cameron should also inject some economic realism into the debate. He should tell the voters some hard truths and link them relentlessly to Brown’s handling of the economy. He should also attack Brown’s spending, destroying the spin of ‘investment’, and hammer home the message of a wasteful, bloated state. Brown should not be allowed to just create unproductive public sector jobs. In a time of a recession, Britain does not need more bureaucrats! Finally, Cameron needs to stop Brown’s argument that a big state is the solution from taking hold. We have had Brown’s big state for 11 years and all his spending, regulation, tax increases and red tape have not stopped us from entering recession but have helped lead us here!

And if Cameron does not offer tax cuts and continues with his cautious strategy? He could still win at the next general election. He still holds a 8-9 point lead in the opinion polls and the “time for a change” sentiment among the electorate remains strong. Furthermore, the Item Club says we’re now in recession and won’t come out until 2010. Consequently, the economic recovery is unlikely to be in time to save Gordon from the wrath of voters upset with becoming unemployed, having their houses repossessed and their living standards fall. But there is still a small chance Brown could win, especially if Cameron lets him frame the terms of the debate around more public spending and a bigger state. Finally, remember 1992 – John Major won despite being in a recession.

Cameron should be bold, not cautious. He should take the fight to Brown!!!