Is it time to flatten the black economy?

We now have confirmation that the Chancellor of the Exchequer is just guessing what he should do, he has admitted that his decision to increase the top rate of income tax from 40% to 50% was not based on any evidence or analysis but was a personal judgment.

As the Director of the Adam Smith Institute, Eamonn Butler, points out in an article in The Times today, increasing rates of income tax, particularly at the higher bands, does not increase the overall tax take. It's all pretty obvious really. The more you have to pay in tax the more cost-effective it is to pay an accountant to keep your bill to the absolute minimum and the more fastidious your accountant must be to keep you happy. Equally, if earning above a certain level will result in you having to pay a rate of income tax you consider to be excessive you might well choose to keep your earnings below that level. Or you could just move to Papua New Guinea and be done with it. On the other hand, being liable to income tax at a rate you consider fair reduces your incentive to find ways of reducing your tax bill. Not only does the cost of hiring an accountant form a greater proportion of your tax liability, such that he has to find substantial savings to justify his fee, but there is simply less inclination to do so if you feel you are being asked to pay a fair amount.

I rather like the idea of income tax being set at a level which provides very little incentive for avoidance. It's not that I want to put accountants out of business, although I am happy to allow them more time to formulate their proposals for Land Value Tax. Reducing tax avoidance is something of an empty concept. By definition, tax avoidance involves careful examination of the tax laws so as to ensure you take advantage of ways in which those laws allow you to reduce your liability to tax below what it might otherwise be. Everyone who lawfully claims an expense against tax is engaged in tax avoidance. Say you have a gross income of £20,000 and you spent £15 on travel from one place of employment to another, a taxi from one of your employer's offices to another because you were needed at the other office. You can put that expense against tax and reduce your taxable income by £15. You don't have to make the claim, you can pay the extra tax if you want to, but the law allows you to set that expense against your income so that you are taxed on a smaller total sum. There is absolutely no difference between the shy paper-pusher who reduces his tax bill in this way and the brash multi-millionaire who sets up complex trusts or has money paid to an overseas management firm rather than to his bank account in the UK. Each is doing exactly as the law allow him to do - he is arranging his affairs within the law so as to reduce his liability to UK income tax. It should not be forgotten, however, that those who engage in tax avoidance are complying with the law, not breaking it.

Changing the law so that various forms of avoidance are no longer available is aimed only at those who comply with the law. Very often such changes merely make available new means of avoidance because closing one "loophole" opens another, the risk they run is to be too effective and encourage those who previously complied with the law to operate outside it.

The "black" economy is, in my view, the real black hole in the UK government's income stream. It is anyone's guess how big it is. Some parts of it, like organised crime, are so far outside the law that there is no reasonable prospect of them being brought into the tax net, but I believe an awful lot is a direct consequence of tax and national insurance being at the rates they are at the moment. The headline standard rate of income tax of 20% doesn't sound too bad, but employees pay national insurance on top at 11% and employers have to chip-in a further 12.8% on all but the first £110 a week. A base weekly wage of £400 will cost an employer more than £430 yet the employee will receive in the region of £300. Pay half the wage in cash, half through the books and both employee and employer benefit, the employer's weekly outgoing is reduced by around £19 and the employee's take-home pays rises by around £65.

There are two further incentives for employers operating small businesses to keep a proportion of their turnover off the books. The first is to ensure that they personally only pay income tax at 20% rather than 40%. Declare a taxable income above £37,400 in the current financial year and you retain only 60 pence for every pound above that figure whereas you keep 80 pence in the pound below £37,400. Having said that, I suspect many of those who under-declare their income are more interested in finding a figure that will not leave them open to enquiry rather than just avoiding the top rate of tax and so will declare around £25,000 or £30,000 rather than being too cute and running right up to the limit. Nonetheless, they will steer well clear of the 40% tax band.

The other factor is VAT. A turnover of £67,000 triggers the need to register for VAT and, therefore, to charge VAT (currently 15%) to all your customers. The £67,000 threshold is on turnover not profit. I was speaking just the other day to a neighbour who is having a new kitchen installed. She engaged the services of a specialist kitchen fitter who is certified to do electrical and gas work, so that he can undertake all the work himself, but who is not registered for VAT. He advised her that he does not provide any materials, units or appliances because he needs to keep his turnover below the VAT threshold in order to be able to charge a competitive rate for his services. My neighbour chose and bought units and appliances herself and the fitter told her what additional materials he needed (including cables, copper pipes, solder, a gas canister for his blowtorch, tiles, grout, filler, paint and even tubes of silicone sealant) which he asked her to pay for (she paid him cash, he bought them, provided her with the receipts and, of course, gave her the change).

Not every tradesman has a customer willing to engage in this circuitous process. The others have to buy materials themselves and it doesn't take long before their turnover exceeds the magic figure and they have to put their prices up, thereby doing themselves out of business. Building materials, in particular, are quite staggeringly expensive. Their only practical option is to seek payment in cash so that they can buy materials in cash and pay their staff in cash, thereby keeping enough off the books to avoid having to charge VAT.

I believe the scale of this type of tax evasion to be enormous. It happens all over the country with tradesmen who fear that strict compliance with the law will make their services too expensive. As a consequence they not only jiggle figures to keep their overheads and prices down, they also see an opportunity to declare a lower personal income then they would be happy to declare if only they didn't feel the need to fiddle the system in the first place. Once they are fiddling to reduce staff costs and fiddling to keep prices down they have nothing to lose by also fiddling to keep a proportion of their own income away from the taxman. It is a cumulative process, each fiddle that is considered necessary to stay in business encourages a further fiddle to make additional profit.

I wonder what would happen if the first £15,000 of income were free of income tax and then a flat rate of 20% applied to everyone with no additional national insurance contributions. My guess is that a great part of the black economy would be brought onto the books because the incentive to work outside the system, with the risk of detection and penalties necessarily involved in doing so, would be cut drastically. I would also guess that the vast majority of those currently taxed at 40% and those who will be taxed at 50% when the new rate comes in (if it ever does) will readily pay 20% rather than spending money seeking to reduce their liability. Of course this is just a guess, but it accords with my idea of common sense.

There is no way of knowing what a radical change like this might do to the tax take, perhaps it will provide enough for the government to do the things it really needs to do, perhaps it won't; it's anyone's guess. What it will most certainly do, in my view, is trim the costs of collection enormously. Plenty will bleat about it being wrong that someone on £100,000 a year of taxable income should pay "the same" as someone on £10,000. This raises an aspect of so-called "progressive" taxation I have never really understood. The person taxed on £100,000 does not pay the same as the person on £10,000; under a flat-rate system at 20% the former pays £20,000 and the latter pays £2,000. My maths might not be particularly good, but I see a factor of ten differentiating these amounts.

To my mind there are only two arguments for "progressive" taxation. One is that the person on a lower income necessarily pays a higher proportion of his money on subsistence, so it is fair that the tax paid on the amount available for discretionary spending should rise. That is all very well when subsistence costs have to come out of income that is taxed. For the current financial year income tax is payable on earnings above £6,475. Assuming £15,000 to be subsistence level (as I have for the purposes of this piece), Mr Modest is required to earn over £17,000 just to reach subsistence level because he pays tax at the current rate of 20% on everything above £6,475, so to end up with £15,000 he must earn an additional £2,000-odd. Even if true subsistence level is £10,000 or £8,000 he is still paying tax on part of his income within the subsistence bracket. In that situation I can see that a modest up-lift for those earning comfortably more than subsistence can be justified. The other argument is essentially similar, it is that above subsistence level everything is an optional extra but some optional extras are a normal part of life in this country and others are real treats. In essence the argument is that true subsistence level is higher than the base costs of housing, heating, food and clothes. Actually there is a third argument, that people earning more are some sort of wicked parasite and should be punished; attractive though that might be to some I consider it to be mindless nonsense.

That is all very well, but the sensible answer is surely to lift the personal allowance to subsistence level and then concentrate on bringing everyone into the fold rather than providing incentives for some to escape. This is what lies behind the flat rates applied in some Eastern European countries after they shed the yoke of Soviet rule. The black economy was rife as was corruption by both municipal and tax authorities. A system had to be adopted which reduced incentives to operate outside it otherwise the well-established evasion techniques would just be adopted by even more people. Introducing flat rates at modest levels was a huge gamble because the new governments could only guess whether those operating outside the system would play ball. The result was that they did in sufficient numbers to make the new system work, both in terms of tax raised and in being easy and cheap to administer.

Britain's black economy is rarely addressed by our main political parties other than through bland assertions that they will clamp down on evasion. A few builders and car mechanics are caught each year and a few shops are monitored and discovered to be taking far more in cash than they declare. So what? Has it done anything to bring substantial sums onto the books and into the tax system? Of course not. There are some jobbing gardeners, builders and plumbers who issue formal tax receipts for everything they do, for every one of them there are dozens who ask for payment in cash and when pressed to issue a receipt give a document signed in the name Michael Mouse.

Enforcement against those operating outside the system is a fantastically expensive exercise which might or might not provide a return in excess of the costs. That, however, is the wrong way to look at it. It is not a trading enterprise in which the Revenue can be seen to be successful if it costs £100million to collect £101mlillion because it is not about the net £1million they collect, it is about the countless hundreds of millions that escape their attention completely. All that money is outside the tax system because the risk of being caught is small compared to the benefit of saving income tax and national insurance by doing things on the sly.

I have heard it argued that those operating in the black economy are such thoroughgoing rogues that they will evade tax no matter what. I find that impossible to accept. Of course some are, but the jobbing handyman or gardener who earns £400 in a week and declares £220 is just trying to earn a living wage and the builder who keeps his declared turnover below the VAT threshold is just trying to stay in business. These people are not major criminals, they work for every penny they receive. The effective cause of them fiddling their books is the current tax system under which they fear (rightly or wrongly) they could not make a living if they kept by the rules. Any system containing such an incentive is necessarily flawed.

It would take a bold government to make such a radical change. My guess is that it would pay off in spades.