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Is It Time to Raise Income Tax

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The current global economic and financial crisis is sometimes often described as a "perfect storm" combining, as it does, severe debt crises in the UK, USA and Eurozone countries, stagnant (or declining) economic performance and loss of trust in elected politicians.

In the UK the Coalition Government elected in 2010 entered office with its key policy being to eliminate the huge UK public budget deficit over a four year period through a combination of means including increases in taxation (most notably VAT), major changes to the welfare benefits system and sharp reductions in public spending. However, for this policy of deficit reduction to be successful it was necessary for the UK economy to achieve reasonable levels of economic growth in order to increase Government revenue.

At the time of writing, it is clear that this policy is just not working. The UK economy is back in recession with the IMF forecasting minimal levels of growth for the foreseeable future. In spite of reductions in public spending, Government borrowing is above targeted levels and the Government has already admitted it cannot achieve its objective of eliminating the deficit in four years. Its latest plan suggest show that financial austerity will need to be extended for at least two years after the next general election and some including the Permanent Secretary to the Cabinet and the Prime Minister are suggesting that austerity might run into the next decade. This cannot go on. If the financial markets perceive that we cannot manage the public deficit downwards then we are in danger of losing the existing privilege of having low borrowing costs and we could go down the road of Spain, Greece, Italy etc in facing spiralling borrowing costs.

So what is the Government to do? The danger is that it will introduce yet another round of spending cuts (on top of those contained in the 2010 Spending Review) thereby delivering another downward kick to the economy - similar to what has happened in Greece. The alternative is to raise taxes but the impact of the VAT increase in January 2011 on retail sales suggests this would also not be good for the economy. In terms of direct taxes the Government is set on making the UK business friendly and so would not want to increase corporation tax. This leads us on to the question: "what about income tax?"

Income tax was first implemented in 1799 by Prime Minister William Pitt the Younger as an emergency measure in order to pay for weapons and equipment in preparation for the Napoleonic wars. Such a tax was vigorously resisted in many quarters. However, income tax was supposed to be a temporary measure described as a tax to beat Napoleon. In fact it is still a 'temporary' tax in that it expires each year on 5 April and Parliament has to reapply it by an annual Finance Act. For up to four months until the Finance Act becomes law, the Provisional Collection of Taxes Act 1913 ensures that taxes can still be demanded.

Over the last three decades, UK Governments of all parties have been unwilling to increase the basic rates of income tax although they have increased the tax take by fiddling with higher rates of tax, tax allowances etc. In the current fiscal and economic crisis that we face, perhaps now is the time to avoid all this "smoke and mirrors" and consider raising the basic rate of income tax. Keeping down the rate of income tax became something of a political macho symbol which all parties accepted but there are other successful countries that have higher income tax rates. Raising the basic rate of income tax would have the advantage of raising large amounts of money but would not bear down on consumption in the same way as an increase in VAT. Thus it would not hit the domestic economy in the same way as a VAT increase.

There may be some negative effects such as the impact on work effort and the poor but the allowances could be altered at the same time in order to protect the poor. Since a lot of the burden of increasing the basic rate of income tax would fall on the middle classes it would seem equitable and politically desirable to ensure that the rich and super rich also pay their fair share. It might also be the case that certain types of people might flee overseas to avoid the increased tax burden but I suspect this is always overstated.

It must be emphasised that like the Napoleonic wars this is an emergency and emergency measures are needed as they were in 1799. Moreover might it not be possible to build into the annual tax legislation a clause which says that the basic rate will only be raised for say 3-5 years and would then automatically lapse back to the previous rate? Hopefully, by that time the economy would have recovered enough to be able to retain the basic rate at the lower level.