Monday, August 10, 2009

Value Added Tax and Adam Smith

The Liberal Conspiracy blog is carrying a piece by Paul Sagar on Britain's Conservative Party, and reports that it is studying plans to increase Value Added Tax (VAT). One can argue about the merits of Value Added Taxes as part of a broader tax system (Clive Crook in the FT today says the United States should now adopt them to dig itself out of a colossal fiscal hole), but their big drawback is that these taxes tends to be highly regressive - that is, the poor pay a higher share of their income in VAT than the rich do. (See this picture to understand the potential impact of what the Conservatives want to do.)

Regressive taxation is wrong from two perspectives: first, from a moral standpoint - it is clearly unfair. Second, from a practical standpoint: one only needs to look at the recent book The Spirit Level (which the Guardian said "might be the most important book of the year") to understand why inequality, and more specifically income inequality, matters so much.) Tax, and more specifically whether tax systems are progressive or regressive, is an important, indeed a central part of this issue.

Back to Paul Sagar, who rightly says the Conservatives (or "Tories", for those not familiar with British politics) should shun higher VAT rates:

"I suggest pointing the Tories back to the founder of modern economics: Adam Smith. For his Wealth of Nations has some very interesting things to say about the “indirect” taxes of which VAT is a modern manifestation.

The present VAT system of adding a percentage tax to transactions for goods and services is one Smith would have recognised, as he wrote at length about “taxes on consumable commodities”. He would also have recognised, and applauded, the exemption of certain goods from VAT on the grounds that they are necessities. Smith divided all consumable commodities into those that “are either necessaries or luxuries” – and he was clear that the first ought not to be taxed.

But his reasoning was not born of a simple altruism towards the poor:
Any rise in the average prices of necessaries, unless it is compensated by a proportionable rise in the wages of labour, must necessarily diminish more or less the ability of the poor to bring up numerous families, and consequently to supply the demand for useful labour.

Taxes upon necessaries, by raising the wages of labour, necessarily tend to raise the price of all manufacturers, and consequently to diminish the extent of their sale and consumption.

The middling and superior ranks of people, if they understood their own interest, ought always to oppose all taxes upon the necessaries of life.

Smith thought increasing taxes on “necessities” would be counterproductive. Not just for the poor, who are hit with higher effective prices, but for the better-off, who suffer from the economic stagnation higher indirect taxes on necessities produces.

Yet this alone only takes us so far. After all (a Tory in favour of a VAT-increase might reply) necessities are already exempted from modern VAT. Thus the rise to 20% would not incur Smith’s disdain, because only “luxuries” would be affected.

Yet that seems not in fact to be the case. Here we come to a fascinating passage from the Wealth of Nations that all in favour of increased rates of VAT should take note of:
By necessaries I understand, not only the commodities which are indispensably necessary for the support of life, but whatever the custom of the country renders it indecent for creditable people, even of the lowest order, to be without. A linen shirt, for example, is, strictly speaking, not a necessary of life. The Greeks and Romans lived, I suppose, very comfortably, though they had no linen. But in present times…a creditable day-labourer would be ashamed to appear in public without a linen shirt, the want of which would be supposed to denote that disgraceful degree of poverty, which it is presumed, no body can well fall into without extreme bad conduct.
For human beings embedded in the context of society, the idea of a “necessary” good extends beyond mere food and shelter. There are some things people must have, without which their lives go intolerably worse. And those things should not be taxed.

The present VAT regime exempts most food and drink, children’s clothes and other things deemed necessities. Yet many things are not exempt nor receiving the 5% reduced rate: adult clothing is a fitting example, given our context.

Raising the VAT rate to 20% would increase the cost of many goods which are necessities to poorer people and middle income households struggling with recession in the wider, socialised context that Smith was pointing to.

Regardless of what Tory policy-makers think about the (de)merits of regressive taxation in terms of equality of the popular tax burden, they should carefully consider Smith’s contention: that increasing taxes on the necessities of life will be counterproductive and damage the interests of everybody, wherever they happen to stand on the income scale.

All quotes from: Wealth of Nations, Volume II, Book V – “Taxes upon consumable Commodities”

See here to get an idea of what some basic principles of a good modern tax system should look like - though we'd dispute the idea expressed here that these principles are solely the territory of the political "Left" as Richard Murphy states - and let's not forget that Adam Smith is, rightly or wrongly, generally taken to be a darling of the political "Right."


Blogger Physiocrat said...

Smith said a lot about taxation. These were set out somewhere in WON as "Canons of Taxation"

He came out in favour of taxation on the rent of land. Which is embarrassing for his latter day supporters.

7:51 am  
Blogger Jock Coats said...

...not forgetting that he ended his career an excise duty collector!

7:22 am  
Blogger Tim Worstall said...

High VAT is terrible, clearly an injustice and shouldn't be part of the tax regime of any progressive country?

Someone's going to have to go and tell the Nordics you know. Norway, Sweden, Denmark, all have VAT at 25%......

1:48 am  
Anonymous TJN said...

Yes, indeed - and that's why we said "One can argue about the merits of Value Added Taxes as part of a broader tax system" and left it at that.

6:32 am  
Anonymous TJN said...

Actually, taking a look at Wikipedia, you'll find that Norway and Sweden don't have VAT at 25%: they have three levels of VAT, of which one rate is 25% for each country.

6:35 am  

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