A neutral tax structure shows respect for the consumer

Nowadays hardly anyone still advocates price controls, restrictive licensing to carry on a business, or other discredited restrictive measures of interventionist governments and closed economies. A simple thesis has instead gained ground – government actions should not bias and distort national economies. Markets, whether for movie tickets or tractors, should be left to find their own balance. That is to say, people should be left to make their own choices, whereupon prosperity appears to follow, because people generally choose more wisely for themselves than government does 'on their behalf'.

With tax policy, however, government is left a free hand. The legitimacy and sense of taxing one activity, not taxing another, and subsidising a third is hardly questioned. Yet it is only common sense that you get less of what you tax and more of what you subsidise, or tax negatively. Almost everyone takes selective taxation for granted, perhaps seduced by the effects on some groups of fellow citizens whom they particularly resent or favour. Thus government is encouraged to keep exercising its 'superior wisdom' to correct whatever it sees as the 'market failures' arising from consumer choice.

Other than by reducing overall taxation, the only way to minimise distortion is by applying a so-called neutral tax. This is easier to define in principle than in detail, but the critical point is that it should apply to 'all things' equally, so as to neither encourage nor discourage any particular activity.

Switzerland applies a flat 4% import tax, and Hong Kong has none. These neutral tariffs do not favour particular products over alternative products, and being so low, they do not favour local producers over foreign ones either. But at whatever level is chosen, import tax should obviously be flat in order to be neutral. Less obviously, it should also be roughly level with other taxes such as internal excise duties, property taxes, and taxes on income, savings and expenditure.

Neutral tax rates remove the incentive for government to play favourites for the indirect reward of electoral support. The direct reward to government of collecting high taxes and tariffs encourages pandering to every vested interest that can form a concentrated lobby. A topical example is the high tariff on imported sugar which yields large benefits to government and a few local producers, while dispersing the costs over many millions of consumers who are not moved to offer much resistance.

It is false to assume that some kinds of economic activity are preferable to others – for example, that everyone should save, invest and manufacture more, so a capital gains tax is a mistake. This is no more correct than the old Keynesian notion that everyone should consume more. Few of us work only for pleasure – we produce in order to be able to consume. We may choose to consume sooner or later, and if later, we save meanwhile.

The engine of economic growth is driven both by consumption providing the demand for goods and services, and saving providing the capital for their production. There is no optimal trade-off, and no judgement of relative value is possible. We should leave it to people in the marketplace to decide whether to learn or have fun, to exercise or play, to indulge themselves now or make short-term sacrifices towards later indulgence and consumption. Government should not pre-empt consumer choice by skewing the tax structure in favour of current consumption or deferred consumption (saving). Government should not be selecting one tax rather than another, as if to say 'we don't like the way people behave when we leave them alone.'

The principle of a neutral tax system does not imply an entirely flat tax rate. The need is to ensure that each type of tax has a similar impact where it falls, rather than any distorting effect. The philosophy informing tax policy should be that government should not distort the market. Thus the optimal ratio of tax levels on consumption, savings and production should as far as possible be market-driven rather than ideology-driven.

Some claim that a single tax, such as on land, income, transactions, consumption or currency holdings (the 'inflation tax'), would be easiest to administer, but clearly that would maximise distortion. At the other extreme, neutral taxation of everything sounds complicated but may prove simpler to collect, since the lower rates involved would prompt less evasion and leakage. Obviously, over-specific taxes such as hut licenses, dog licenses and contract stamps can cost more to collect than the revenue they yield, and should be avoided. A practical system of neutral taxation would avoid all the hidden costs of distorting consumer choice, lowering economic efficiency and reducing consumer satisfaction.

Source: Leon Louw is the Executive Director of the Free Market Foundation. This article may be re-published without consent but with acknowledgement. The views of the author of this article are not necessarily shared by the members, directors, or staff of the Foundation.

FMF Feature Article/ 31 August 2004 – Policy Bulletin/ 26 January 2010