tl;dr
Income Tax is a friction that prevents many beneficial but marginal transactions from taking place, particularly in labour heavy industries. A re-designed tax system would avoid income tax.
Benefits of Specialisation
A plumber and a plasterer are doing up their homes. Both houses have a similar amount of work to do, a week of plumbing and a week of plastering – a specialist however, could get each job done in three days. They could do all of their own work in eight days (three days doing the job they excel at and five doing the job they are less skilled at) or, if they are good friends they could swap houses – one do all the plumbing and the other all the plastering and they’d be done in six. Economic specialisation in action, saving each 25% of their time.
This example is a bit like a barter system. It relied on the plumber and the plasterer having something the other wanted at the same time – an unlikely event. In modern society we have solved the barter issue using money – now the plasterer and plumber don’t have to be doing home improvements at the same time. Say they charge a day rate of £200 – the plumber could pay the plasterer £600 to do work in his house in May and the plasterer could pay the plumber £600 in July. They result is cash neutral and allows both to get the job done in six days.
This also means that the two are no longer tightly coupled, the plumber could employ and be employed by two different plasterers and still the maths would work out. 6 days of work, economic benefits for all!
Except, we interfere with this nicely functioning market with taxes.
The Tradesman’s Swap Bug
In reality our tradesmen pay tax and charge VAT. Of the £600 for three days work, £190 is taken in Tax and NI and £410 goes to the individual. VAT is additionally charged at 20%, so instead of invoicing £600, you invoice £720.
Looking back at the sums our plasterer now:
- Spends £720 on plumbing work
- Gets £410 from plastering work
- Gets two days back in productivity for spending £310 in cash
- By putting those days to work plastering will only make £270 (post tax)
- Is £40 worse off
Therefore this trade doesn’t happen. Both workmen do the whole job themselves, taking 8 days and not reaping the benefit of specialisation.
By taxing labour too heavily we have made the economy less productive in a very real sense.
Childcare
This may seem like a niche example. But the implication is that this is happening all over the economy. One particularly clear example is that of childcare.
A household can look after it’s own children or employ childcare to do so (in the form of a nursery or childminder). To make this decision economically viable, it stands to reason that the person returning to work should make more than the cost of the childcare. However, similar to the above example, tax enters the equation and the amount that must be earned increases by the earners marginal tax rate. This means that many parents who (absent tax) could return to work are unable to do so.
Childcare Vouchers
A poor solution to this issue (from the perspective of the market, it may be desirable from the perspective of the child) would be the issuing of childcare vouchers that entitle everyone to a set number of hours of free childcare a week.
- For high earners already willing to pay for childcare it acts a pure windfall
- For middle earners it may in some cases compensate for the tax issue and allow some parents who want to to go back to work
- For low earners it encourages irrational transactions (where the parent may make less than the childcare costs absent of the voucher)
In all it is an expensive policy that doesn’t help a huge amount from the perspective of ‘getting parents back to work’.
Repeal Income Tax
The solution to this problem? Move the tax burden away from income. Reduce, or ideally repeal, taxes on earned income such as Income Tax and National Insurance.
Levelling Up 