IMF proposals highlight headaches of taxation

The pandemic and subsequent efforts to contain the resulting economic fallout have ripped through countries’ public finances.

Scrutiny on whether governments should turn to innovative ways to strengthen tax revenues to pay for the response to Covid is intensifying, triggered by the International Monetary Fund (IMF) releasing its latest round of policy recommendations.

Taxes are inefficient unless governments use the revenues they raise productively. This will be brought into sharp focus if the money was sourced through a one-off levy on wealthier individuals’ assets, a higher income tax rate surcharge or on companies that have seen their profits rise significantly since the onset of the pandemic – as proposed by the IMF – given they would be spending a greater proportion of people’s estates and companies’ earnings.

New levies should avoid choking demand

All taxes are fraught with trade-offs, so setting a clear desired outcome is essential to ensuring they work effectively. Disincentives to employment and spending should be avoided to prevent choking countries’ economic recovery through suppressing demand. The IMF’s proposals may offer alternatives to pulling conventional fiscal levers such as raising income and sales taxes that typically produce this effect.

Taxes on consumption put greater downward pressure on spending in the economy, compared to taxes on wealth. This is partly due to individuals allocating a lower proportion of each additional pound they earn to consumption as they move up the income ladder, whereas those at the lower end of the income distribution scale tend to use a greater proportion of their earnings on consumption.

As a result, demand falls among less well-off households – who represent a large share of consumers in developed economies – and remains constant among wealthier individuals when taxes on consumption increase.

In the UK for instance, raising the rate of VAT could prompt low and middle earners to adjust their usual spending habits due to higher prices reducing their real income. This group contributes a significant amount of revenue for firms nursing the harshest income shocks resulting from the pandemic, so increasing consumption taxes would involve limiting their recovery prospects.

A one-off levy on assets above a certain threshold or on large, international firms that have generated “excess profits” since the onset of the pandemic could be effective in avoiding the additional costs associated with introducing annual recurring taxes as assets and revenues would only need to be valued and collected once respectively. Implementing a single levy would also limit opportunities for people to change their behaviour to avoid the tax.

Greater transparency would improve confidence in the efficacy of further taxation on households and firms. The IMF’s suggestion that suspicion among taxpayers over how their resources are being used could be tackled by governments providing details on what the revenue is ringfenced for would reduce scepticism. If taxpayers knew the money was being spent on strengthening health care provision, for example, support for a wealth tax would likely grow given that the pandemic has exposed shortfalls in many countries’ health systems.

Middle-income households may have to sell family homes to foot wealth tax bill

Concerns over whether the introduction of a one-off wealth tax on individuals is an infringement on civil liberties are valid. A retrospective levy would limit opportunities for individuals to shape their behaviour so they do not engage in activities that yield a greater tax bill. In essence, they would be charged for their previous consumption and investment decisions in the present, which brings the morality of a wealth tax into question.

The argument that a single wealth tax would avoid distorting investment and entrepreneurial activity may be invalid due to basic human nature. If governments tax people’s homes and pensions once, then that signals they are willing and capable of doing it again in the future. This could hit enterprise and new business creation due to people being disincentivised to set up new companies over fears that additional levies may be imposed on the value of their business holdings and savings.

Incentivising new business creation is crucial to fuelling the recovery from the pandemic and ensuring economies do not suffer in the form of higher unemployment and depressed investment.

Perhaps the most credible argument against a one-off wealth tax is the prospect of households being subjected to double taxation. People caught by the charge are likely to have paid higher rates of income and Capital Gains Tax in their lifetime. They would then face further levies on the assets they have purchased with after-tax earnings.

Depending on what types of assets are included, a wealth tax may inadvertently target people who have liquidity restraints (owning high-valued assets, but low levels of cash). This group are often middle-income households. A large proportion of them may have to sell their family home to foot the bill.

Principle is often tricky to implement in reality

Economic inequalities have been intensified by the arrival of the pandemic, and a truly one-off wealth tax, supplemented by a charge on excess company profits, may serve to narrow gaps between the wealthiest and least well off in society.

However, the sheer administrative scope of implementing both these measures leaves them open to inefficiencies, not to mention their motives differing depending on individuals’ notion of fairness.

Desired outcomes that a one-off wealth tax and profit surcharge could produce may be more effectively achieved by reforming existing taxes.