The government have a lot to think about when looking at how best to serve their citizens with their income tax policy.
‘What the government gives it must first take away’.
Recently income tax receipts helped the government achieve a surplus of £1.3bn (Office for National Statistics) on the public finances and the first July surplus for three years. Income tax was first introduced in 1799 to cover costs of the Napoleonic wars. However, we are no longer at war with France – so why do we have income tax and what incentives lie behind it? Income tax provides the government with a large amount of spending power, to provide us with the public services we have come to expect. It would be hard to finance the NHS, military or police force for example, without it. Yet begrudgingly, every month money is deducted from our pay packet without us even being able to see it How does this incentivise our behaviour?
Incentive to Work
Income tax is one of the main incentives to either work or not. Lets take Sarah, a part-time nurse living in the Southwest. She works alongside her partner, Greg, a full-time maths teacher. They have two children, one in nursery and one in primary school. Naturally both are made worse off by having to pay income tax, than without it. Therefore the income tax should encourage the couple to work harder in order to compensate for this. Therefore to maintain a pre tax standard of living and provide for their two young children, Sarah may want to take on more shifts. This is because with little funds for leisure, she would not be able to afford her time off as before.
Disincentive to Work
In addition to this incentive effect on work effort, the income tax may also provide a disincentive to work. If Sarah was told that the government were changing the income tax boundaries, so a greater proportion of her income would now be taxed at 20%, she may decide that the marginal benefit of work compared to staying at home and providing childcare for her youngest has fallen. Therefore, she would substitute some of her working hours for time spent instead looking after her child. Thus discouraging her to work. Whether the effect on work effort, or the effect on substituting work for leisure is higher depends on the tax increase the government imposes and more importantly, to what group of people in society. Individuals who are just over the tax threshold have a greater disincentive to work than those in the middle of their tax bracket who hold a greater incentive to work. (I can provide an economic explanation why in the comments!) Additionally, if childcare and leisure activities were subsidised for example, this would also change the working pattern of the population.
The problems the government face in regards to issuing income tax are many, the greatest of which is that the tax has to be acceptable to the taxpayers. The current cumulative Pay-As-You-Earn scheme means that taxpayers are relatively confident they are being taxed fairly depending on their income. However, because of the high rates of tax, evasion and avoidance become much more rewarding pursuits. If an individual is suffering tax at 40p in her marginal pound of income, it is clearly worth her while to spend up to 40p to save that pound from tax! Equally this presents the government with the same incentive to prevent such evasion and avoidance.
Why do we have national insurance in addition to income tax? I have often thought about this. It’s been a long time since national insurance contributions were used solely for the social security system and providing benefits to the population. Additionally, enforcement costs are high, needing about 10,000 extra civil servants, and it places a burden on small businesses to calculate. Maybe taxpayers are simply happier to pay a tax called a ‘contribution’. However, if this is the only reason we still have national insurance contributions, maybe then, it is time to merge the two taxes into one more simplified cost-effective structure.
All that’s to say is with continuing debate over issues such as whether to include a 50% tax rate and making work pay, the government have a lot to think about when looking at how best to serve their citizens with their income tax policy.