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Final Exam Project
AP Degree
Adam Peter Mills
FIE 4
FINAL EXAM PROJECT
University College Northern Denmark
Financial Management, 4th Semester, 2012
The effects of a drastic income tax reduction on the UK’s economy
This report has been prepared by Adam Mills – FIE 4
Supervisor: Nina Røhr Rimmer
Delivery Date: 29.05.2012
Number of Keystrokes: 64,364
Number of Pages: 46
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Contents
1. Preface................................................................................................................................................. 4
2. Introduction ......................................................................................................................................... 4
3. Problem Statement .............................................................................................................................. 5
4. Methodology ....................................................................................................................................... 5
5. Motivation ........................................................................................................................................... 6
6. The UK’s Current Income Tax System............................................................................................... 7
6.1 Overview ....................................................................................................................................... 7
6.2 Allowances.................................................................................................................................... 8
6.3 National Insurance ........................................................................................................................ 9
6.4 Income Tax Receipts................................................................................................................... 10
7. Fiscal Policy ...................................................................................................................................... 11
7.1 Aggregate Demand ..................................................................................................................... 12
7.1.1 Consumer Spending ............................................................................................................. 12
7.1.2 Investments .......................................................................................................................... 13
7.1.3 Government Spending.......................................................................................................... 14
7.1.4 Net Exports .......................................................................................................................... 15
7.1.5 Sub-conclusion ..................................................................................................................... 17
7.2 The Impact of Increasing Other Taxes ........................................................................................ 18
7.2.1 Fuel Duties ........................................................................................................................... 19
7.2.2 Tobacco Tax......................................................................................................................... 21
7.2.3 Alcohol Tax ......................................................................................................................... 22
7.2.4 Transaction Tax.................................................................................................................... 23
7.3 Sub-conclusion............................................................................................................................ 25
8. Monetary Policy ................................................................................................................................ 26
8.1 Causes of Inflation ...................................................................................................................... 26
8.1.1 Monetary Transmission Mechanism .................................................................................... 26
8.1.2 Demand – Pull / Cost – Push Inflation ................................................................................. 28
8.2 Contractionary and Expansionary Monetary Policy ................................................................... 30
8.3 Philips Curve............................................................................................................................... 33
9. How Successful Are Other Tax Havens ........................................................................................... 35
9.1 Introduction ................................................................................................................................. 35
9.2 Monaco ....................................................................................................................................... 35
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9.3 Switzerland ................................................................................................................................. 37
10. Conclusion ...................................................................................................................................... 38
11. Appendices...................................................................................................................................... 40
11.1 Appendix 1 ................................................................................................................................ 40
11.2 Appendix 2 ................................................................................................................................ 40
11.3 Appendix 3 ................................................................................................................................ 41
11.4 Appendix 4 ................................................................................................................................ 42
11.5 Appendix 5 ................................................................................................................................ 43
12. List of Sources ................................................................................................................................ 44
1. Preface
I would like to thank Nina Røhr Rimmer, Niels Karl Jacobsen, Torben Jakobsen and Henning
Gerner Mikkelsen at UCN for helping me gain the knowledge that was necessary in order to
complete such a project. The project was created under the supervision of Nina Røhr Rimmer
and the purpose of the project was to investigate how successful the UK would be as a tax
haven. I find the topic very interesting and I was quite surprised at what I discovered. I hope
the readers of this project feel the same way about it as I did.
2. Introduction
Income tax has been in the UK for over 200 years and was introduced in the UK in order to
pay for weapons during the wars against the French. The maximum rate that was payable
back then was 10% on incomes above £200. Over the years income tax in the UK began to
increase, and hit the highest point in 1974, when it rose to 83% of income earned over
£155,000 (inflation adjusted to 2012 prices). During this time, an additional rate of 15% tax
was charged on income made through investments. This meant that someone earning £1
million per year through investments would be required to give away almost 98% of their
earnings. This of course led to many wealthy people that were living in the UK to move
abroad. When the income tax was eventually reduced to a more appropriate level, the people
that left the UK never returned. Therefore the UK permanently lost tax revenues due to
having high taxes, and are no doubt still paying the price for that. Today the UK still has one
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of the highest income taxes in the world, at up to 50%. It is therefore interesting to know if
the UK is worse off having such a high income tax rate, or is it not possible to lower it.
3. Problem Statement
Could an extreme reduction in income tax be successful in the UK’s economy? Is it possible
to use other taxes in order to compensate for the lost income from this reduction in income
tax?
4. Methodology
The methods that will be used in order to answer the problem statement will be:
1. Analyse of the UK’s current income tax system
2. Analyse the effects that an extreme reduction in income tax would have on the UK’s
economy
3. Analyse the effects that increasing other taxes would have on the UK’s economy
4. Analyse the effects that an extremely low income tax has had on Monaco and
Switzerland
The report will begin with an analysis of the UK’s current income tax system. The following
areas will be looked at in order to give a greater understanding of the system:
-
How much income tax is currently required to be paid?
-
What is the current value of the tax receipts the government receives from income
tax?
The source of this information will come from http://www.hmrc.gov.uk. This website is run
by Her Majesty’s Revenue and Customers (HMRC), which is the department of the UK
government responsible for the collection of taxes.
The next points that will be discussed are the effect that a reduction in income tax and an
increase of other taxes would have on the UK’s economy. Macroeconomic policy will be
used to explain this. The first issues that will be looked at here are how the new fiscal policy
will affect consumer spending, investments, government spending and the net exports. Using
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the knowledge gained from this, the equation GDP = C + I + G + (X – M) can be used to
determine if GDP increases or decreases, which in turn would represent economic growth or
economic decline.
The report will then go on to discuss monetary policy, the theory behind monetary policy,
and what monetary policy will need to be implemented in order to control the effects caused
by the new fiscal policy. The conclusion to this will then be backed up by using the Monetary
Transmission Mechanism which shows the link between the interest rate and inflation. Then
by using this information on a demand / supply curve, it will be possible to show what will
happen to the exchange rate of the pound sterling, and describe the consequences of this. The
impact to inflation will be explained with demand–pull, and cost-push inflation. Next, a
Phillips curve will be used in order to explain what will happen to unemployment when
inflation changes due to the changes in policy.
Next, the tax system of Monaco and Switzerland will be discussed. These two countries have
the lowest taxes in the world, and yet are ranked 1st and 6th respectively for GDP per capita.
The benefit of analysing their tax systems is to investigate if their method, which has proven
to be successful, could be adopted in the UK. The way in much this will be done, is to use
information gained from online sources, and then use these figures to make calculations
showing the result of these systems being adopted by the UK.
5. Motivation
My motivation for writing about this problem statement came from a congressman in the
USA called Ron Paul. He is an advocator for zero income tax in the USA, and plans to regain
the income lost from this tax in other areas, such as an increase in other taxes and by making
savings elsewhere. At first this idea seemed crazy, as income tax is the number one source of
income for the USA government. However the arguments he presents sound convincing.
Countries that have very low levels of income tax are known as tax havens and they tend to
have small populations. Examples of these are Andorra, Monaco and Switzerland. These
three countries have hugely successful economies and yet have an income tax of close to 0%.
For a long time I have thought that it isn’t fair, that just because you are successful and earn a
lot of money, you should be forced to give away more of your income. It doesn’t seem fair
that someone earning £1million per year must pay around 50% of their income to tax, even
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though they might want to invest that money to help the economy, or even create jobs. When
someone earning £250,000 per year lives like a millionaire and contributes nothing to the
country, pays less in tax. Therefore with the arguments presented by Ron Paul, and the
success of the other tax havens in the world, it is interesting to know for the general
population of the UK, and other countries, if such a tax system could be of benefit in the UK.
It is of interest to the UK because there is the possibility that a drastic decrease in income tax,
along with an increase in other taxes could increase the country’s GDP. This report should
show that governments should think outside the box, and not be narrow minded by thinking a
decrease in income tax defiantly means a decrease in total income for the country. The
reason this problem statement is interesting for the general population of the UK is because if
such a tax system was to be adopted, it could put more money in their pockets, along with
living in a more economically successful society. Other countries will be interested in this
topic as well because if this tax system was to be successful, they could look into adopting
the same system.
6. The UK’s Current Income Tax System
6.1 Overview
The UK has what is called a progressive tax system. This means that as the taxable income
increases, then so does the percentage of the tax rate the person will pay on their income.
This system was regarded as the best income tax system by the highly respected economists
Karl Marx and Adam Smith. By many, it is seen as the most fair system as it distributes the
country’s wealth, allowing the less wealthy to live a comfortable life. The system however
doesn’t come without opposition. Many people believe that it brings negative effects to the
country such as reducing people’s savings, and encouraging the wealthier people to move to
countries with a lower income tax.1
The basic rule for which tax rate a person in the UK; can be seen in table 1.
1
http://www.wisegeek.com/which-countries-use-progressive-taxes.htm
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Table 1
Table Source http://www.hmrc.gov.uk/rates/it.htm
From table 1 it can be seen that the UK has a progressive income tax from 20% - 50%. Over
the years the income tax system has become less favourable to the people with a lower
income. Between the years of 2010-2011, a person was required to pay 40% tax on income
above £37,401, but this was reduced to any income above £34,371 for the year 2012 – 2013.
And with the average salary of a 30+ year old in the UK being £36,978 per year, this change
means that this lowering of the higher rate tax hits most people.2
Many people in the UK would argue that this isn’t fair, and it would be more beneficial to
either increase the higher tax rate threshold and reduce the additional tax rate threshold in
order to increase the less wealthy people’s disposable income, and make this lost revenue up
by making the higher earners pay for it. In 2010 there were 583,045 people in the UK earning
above £100,000 per year3, but around 300,000 earning at least £150,000 per year. Therefore,
reducing the additional tax rate threshold to £100,000 would mean that an extra 280,000
people would pay the additional tax rate.4
6.2 Allowances
Most people in the UK are entitled to a personal tax free allowance. Table 2 shows who is
entitled to which allowance, and how it has changed over the past few years.
2
http://career-advice.monster.co.uk/salary-benefits/pay-salary-advice/uk-average-salary-graphs/article.aspx
3
http://www.bbc.co.uk/news/magazine-11382591)
http://www.tuc.org.uk/economy/tuc-20726-f0.cfm
4
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Table 2
Table Source http://www.hmrc.gov.uk/rates/it.htm#1
We can therefore see that from 2010 to 2013, the personal tax allowance has been increases.
This has been to benefit the people with the lowest incomes. Therefore if someone in the UK
earns only £8,000 per year, they have a tax rate of 0%. We can also see that there is a limit to
this allowance. This means that once someone begins earning over £100,000 per year, their
allowances reduces by £1, for every £2 they earn over £100,000 per year. Therefore, someone
earning £116,210 will receive no personal allowance. The system is also set up to benefit the
elderly, as when people retire, they generally have a lower income.
6.3 National Insurance
Within the UK if you are employed or self employed, you could be required to pay National
Insurance. National Insurance payments are contributions towards the following areas:




The NHS (National Health Service)
Unemployment benefits
Sickness and disability allowances
The State Pension
The UK government consider National Insurance separate from income tax, because the
income the government gain from National Insurance contributions can only be spent on the
above items. However the government is allowed to borrow from this fund and spend it on
other services. And since National Insurance is charged as a percentage of the person’s
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income, the people of the UK consider it to be the same as income tax, but with a different
name.
As with income tax, you are only required to pay national insurance if you earn a certain level
of income. The amount of National Insurance one pays depends on if he/she is employed by a
third party, or is self employed. National Insurance is split into 4 categories, and can be seen
on table 3.
Table 3
National Insurance class 1 is payable by anyone that is employed through a company, while
class 2 and 4 are payable by people that are self employed. National Insurance class 3 is
optional and can be chosen to be paid by people earning below the threshold of £7,605. 5
6.4 Income Tax Receipts
Between April 2011 and April 2012, the UK’s total tax receipts totalled £562.4 billion. Of
this amount, £150.9 billion came from income tax.6 A breakdown of the different areas in
which this revenue came from can be seen on graph 1.
5
http://www.direct.gov.uk/en/moneytaxandbenefits/taxes/beginnersguidetotax/nationalinsurance/introductio
ntonationalinsurance/dg_190048
6
http://www.hmrc.gov.uk/stats/tax_receipts/tax-receipts-and-taxpayers.pdf
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Graph 1
Chart information source http://www.hmrc.gov.uk/stats/tax_receipts/tax-receipts-and-taxpayers.pdf
From the above we can see that income tax is responsible for the majority of the
government’s income, at 27%. This increases to 45% if national insurance is classed as
income tax. Therefore any plan to reduce this income completely or drastically, will need to
be followed with increasing other taxes in order to make up for the lost revenue. It isn’t as
simple as assuming that doubling VAT, Corporation tax and Fuel duties would recover the
lost income, as doubling these taxes may have negative consequences that result in lost
income for the government. These topics will be discussed in the following chapters.
7. Fiscal Policy
In this chapter, we will analysis the effects that a reduction in income tax and an increase in
other taxes would have on the UK’s economy. To do this, we need to look at Fiscal Policy,
and what Fiscal Policy should do in theory. Fiscal Policy is used as a tool by governments for
managing demand, and it involves changing taxes and government spending. To establish the
effect of the new Fiscal Policy on the UK’s economy, we will use the equation
GDP=C+I+G+(X – M), where:

GDP = Real Gross Domestic Product

C = Consumer Spending

I = Investments

G = Government Spending
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
(X – M) = Net Exports
We can therefore in theory establish whether or not GDP should increase of decrease as a
result of the new fiscal policy.
7.1 Aggregate Demand
7.1.1 Consumer Spending
Between April 2011 and April 2012, there were 30 million tax payers in the UK. Of this
amount, 25.5million were required to pay the bottom rate tax of 20%, 3.6 million were
required to pay the top rate tax of 40%, and 294,000 were required to pay the additional rate
tax of 50%. Would consumer spending increase if for example the government was to
introduce an income tax system, where everyone earning under £100,000 paid 0% income
tax, and everyone earning above £100,000 paid 20% income tax? This would mean that 30
million people in the UK had between 20% - 40% extra disposable income per month.
From the past, it has been evident that consumer spending is hard to change. Studies have
shown that if there is a temporary tax reduction, people tend to spend the same amount of
money. However it appears that people do spend more money if there is a permanent tax
reduction. It should therefore be assumed, that if any increase in consumer spending is to take
place, then this extreme reduction in income tax would need to be permanent.7
If people are spending more money, because they have a higher disposable income due to the
decrease in income tax, this will have a positive effect on the GDP in the equation.
Removing income tax for people earning below £100,000 and having a 20% income tax for
people earning above £100,000, would mean that the government stands to lose around £111
billion in income tax revenues – about 73%. Every since the 50% tax rate in the UK was
brought into effect, there has been doubts as to how beneficial it is to the economy. From
2010 – 2011, the 50% tax rate only managed to add an additional £1 billion to the
governments tax revenues. In order to make up for this difference, it would be of great benefit
for the government to raise VAT by 5%, to 25%. This is the maximum allowed by the EU. In
7
http://www.newyorkfed.org/research/current_issues/ci7-11/ci7-11.html
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2011 the government raised VAT from 17.5% to 20%, and they estimated that this rise would
earn them an extra £13billion per year.8 If this were to be correct, then a 5% increase in VAT
could earn the government an extra £26billion per year. Table 4 shows the effect a VAT rise
to 25% would have on the price of goods.
Table 4
Table 4 shows that a 5% increase in VAT would have little impact on people’s lives, and yet
still raise a large amount of money for the government.
7.1.2 Investments
Within “consumer spending”, it was mentioned that a permanent reduction in taxes increased
consumer spending which in turn meant that people would pay more money in VAT. A
similar positive side effect occurs when investments increase as well, and this creates an
increased revenue in stamp duty and corporation tax. Stamp duty is tax that is paid when
shares are purchased, and is currently charged at 0.5% of the transactions value, and accounts
for £2.8 billion in revenues, or 0.5% of the UK’s tax revenues.9 It isn’t possible to calculate
how many more shares would be purchased, but even if they increase by just 5%, that is still
an increase in revenues of £140million. Corporation tax is paid by limited companies
according to their taxable income.10 Corporation tax is currently charged at 20% on profits
below £300,000, and 24% on profits above £300,000.11 As with stamp duty, it isn’t possible
to calculate how much corporation tax would increase by, but if it were to increase by as little
as 5%, that would be an increase in revenues of £2.2 billion. In the “consumer spending”, it
was advised that the VAT rate was also increased, as this has little impact on people’s
disposable income, but contributes a large amount to the government’s revenues. The same
cannot be said with stamp duty and corporation tax. The tax rate of 0.5% is already higher
8
http://www.bbc.co.uk/news/business-12099638.
http://www.direct.gov.uk/en/MoneyTaxAndBenefits/Taxes/TaxOnSavingsAndInvestments/DG_10013514
10
http://www.hmrc.gov.uk/ct/getting-started/intro.htm
11
http://www.hmrc.gov.uk/rates/corp.htm
9
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than that of Germany and the USA, and is already argued that it is threatening the UK’s
economy. Therefore any rise would make the situation worse. 12
Revenue from stamp duty and corporation tax is not the only positive from the increase in
investments. As there would be a higher supply of money with a reduction in income tax, it
would allow more people to open their own business, which creates jobs and then in turn
would reduce the amount of money the government pays out in unemployment benefits.
Between 2009 and 2010, there were 292,400 people in the UK claiming unemployment
benefits,13 which adds up to £1.1billion per year. We can then show that if there were enough
new jobs created through higher investments, and unemployment fell by 10%, it could save
the UK government up to £100million per year in unemployment benefits. However this is
only 0.10% of the value that the government would lose with a severe reduction in income
tax.
7.1.3 Government Spending
Increasing or decreasing government spending has its pros and cons, depending on the
economic climate of the country at the time. The famous and well respected economist called
John Keynes was a supporter of increased government spending, even if the country has to
run into a deficit. The reason he gave for this is that increasing government spending helps to
reduce unemployment and help boost the economy in a recession.14 The arguments that could
be used against increasing government spending are that the UK already has a huge
government deficit, which stands at £92 billion.15 Currently in the UK, the government is
spending £43 billion per year on debt interest payments, or £120 million per day.16 To put
that into perspective, the total revenue the government earns from corporation tax per year is
£43 billion.17 With all fiscal policy, there is a lag from when it is adopted, to the benefits it
creates. Therefore the benefits from the tax reduction could take years to have a positive
effect on the governments balance, and therefore any increase in government spending would
need to be from borrowed money. The government is already struggling to pay back their
debts, and increasing these debts won’t make the situation easier.
12
http://www.lowtax.net/lowtax/html/offon/uk/uk_gotaway.html
http://www.ifs.org.uk/bns/bn13.pdf
14
http://mercatus.org/publication/does-government-spending-affect-economic-growth
15
http://www.guardian.co.uk/news/datablog/2010/oct/18/deficit-debt-government-borrowing-data
16
http://www.direct.gov.uk/en/Nl1/Newsroom/SpendingReview/DG_191762
17
http://www.hmrc.gov.uk/stats/tax_receipts/tax-nic-receipts-info-analysis.pdf
13
14
Another argument against increasing government spending in this situation is that if the
reduction in income tax was successful, increased government spending wouldn’t be
beneficial. The reason for this is that government spending is used to help reduce
unemployment, but as mentioned in the previous section “investments”, an increase in
investments would help reduce unemployment anyway.
As a result of the above, if the government was to keep government spending the same, they
would have to increase their deficit in the short term, as any income generated from the
reduction in income tax could have a lag time of years. As this may not be sustainable for a
country with such high debt, in the short term it is likely that government spending would
have to be reduced, which would have a negative effect on the equation GDP=C+I+G+(X –
M).
7.1.4 Net Exports
The effect that a reduction in income tax would have on net exports is indirect. As mentioned
in the previous sections, when people have a higher disposable income, they spend more
money. As people spend more money this causes inflation, and this then causes the
government to adopt monetary policy, where they must increase interest rates in order to
control the inflation. When the interest rates increase, there is a greater demand for the pound
sterling, which causes the pound sterling to strengthen. This strengthening of the currency is
bad for net exports, because it means British goods become more expensive. Graph 2 shows
the relationship between demand and value of the currency.
Graph 2
Table source – UCN Intranet
15
On graph 2, the y-axis shows the exchange rates and the x-axis shows the quantity of pound
sterling. When interest rates increase, there is a greater demand for the currency, and so more
people purchase pound sterling. From graph 2, we can see that an increase in quantity of
pound sterling, creates an increase in exchange rates.
The UK’s net exports increased from 2008 to 2009 by £3 billion.18 The reason for this is that
the pound sterling became very weak against the Euro currency, which is the currency of the
UK’s most important trading partner. Graphs 3.1 and graph 3.2 show how the net exports
and exchange rates changed through the same time period.
Graph 3.1
Graph 3.2
Graph source – http://uk.finance.yahoo.com/q?s=gbpeur%3Dx&ql=1
18
http://www.tradingeconomics.com/united-kingdom/exports
16
The relationship between exchange rates and net-exports is clearly seen from graph 3.1 and
graph 3.2. From 2008 to 2009, the exchange rate fell from around 1.35 to 1.05, and within
this same period the net exports increased by £3 billion. However this conclusion can also be
backed up by use of a regression analysis. A regression analysis showing the relationship
between the net-exports in the UK and the exchange rate of the pound sterling can be found
in appendix 3. The regression analysis used a confidence interval of 95% and was found that
the p-value was 0.0004. This means that the nul hypothesis is rejected, and therefore there is
a relationship between the net-exports and the pound sterling exchange rate. Another
important point about this result is that the p-value result was very robust. This means that
even if the confidence interval was 99%, then the same conclusion would be made, the nul
hypothesis would be rejected. Another statistic that is important to look at is the R^2 value.
The value of R^2 tells us how good one statistic is at predicting another. An R^2 of 1.0
means that if you have one statistic, then you can perfectly predict what the next statistic will
be. We see from the results that there was an adjusted R^2 of 0.698.
Therefore, due to the strengthening of the Pound Sterling against the Euro, it can be assumed,
that the severe reduction in income taxes, would have a negative effect on net-exports, and so
have a negative effect on the equation GDP=C+I+G+(X – M).
7.1.5 Sub-conclusion
When this information is used with the equation GDP=C+I+G+(X – M), it can be determined
if the reduction in income tax can create an increase in GDP in theory. From “Consumer
Spending”, it was established that consumer spending would increase if there was a
permanent reduction in income taxes. Due to this increase in consumer consumption, the
government would have increased revenues from VAT and this would have a positive effect
on the GDP. Revenue from VAT could also be boosted by increasing the tax to 25%,
potentially raising an extra £26 billion per year.
It was also determined that investments would increase, and therefore have a positive effect
on the GDP. This increase in investments would also cause unemployment to decrease, which
in turn would cause an increase in inflation. This reduction in unemployment benefit payouts
could save the government £100 million. The increased investments would also increase the
revenue from stamp duty tax and corporation tax.
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Government spending would need to be reduced so that the countries deficit didn’t increase.
This may only be necessary in the short run, as eventually the government could begin to see
the extra revenue from the increased VAT, stamp duty and corporation tax revenues.
Therefore this reduction in government spending should cause a negative effect on the GDP
in the short term, but could be expected to have little impact on the GDP in the long run.
Another negative effect on the GDP is the net exports. This was determined to be a result of
increased inflation causing interest rates to rise, which in turn strengthens the pound sterling,
causing British goods to become more expensive and reducing demand.
Therefore when we look at the equation GDP equation, we can see the following:
Whether GDP increase or decrease depends on how much each item in the equation is
affected.
7.2 The Impact of Increasing Other Taxes
As previously mentioned, between April 2011 and April 2012, the UK’s total tax receipts
totalled £562.4 billion. Of this amount, £150.9 billion came from income tax.19 If it were
proposed that everyone earning below £100,000 per year paid 0% income tax, and people
earning over £100,000 paid an income tax rate of 20% on income over £100,000, then the
UK government would stand to lose around £111 billion in lost income tax revenues.20 The
calculation for this can be found in appendix 1. It’s therefore essential for the majority of this
amount to be made back through other means. This could be by increasing the rate of other
taxes, or tax revenues increasing due to economic development. From the drastic reduction
in income tax, we established it could create the following extra revenues:

VAT – £26 billion

Reduction in unemployment benefit payouts - £100 million

Stamp duty - £140 million
19
http://www.hmrc.gov.uk/stats/tax_receipts/tax-receipts-and-taxpayers.pdf
20
http://www.ifs.org.uk/bns/bn09.pdf
18

Corporation tax - £2.2 billion
With the above figures added together, it can be estimated that the UK government could
earn £28.44 billion through an increase in tax receipts which were a result of the reduction in
income tax. However, the income tax revenues to the government would reduce by £111
billion, therefore there is still £82.56 billion that needs to be earned by means of increasing
other taxes.
The HM Revenue and Customs website displays a total of 27 different taxes when displaying
the breakdown for tax revenues. As some of these taxes aren’t significant enough to help gain
the £82.56 billion that the government would need to earn, this report will only discuss a few
of them, how much they could be increased by, and the impact it will have on the UK’s
economy.
The taxes that will be discussed are as follows:

Fuel duties

Tobacco tax

Alcohol taxes

New transaction tax
The above taxes currently account for £46 billion of the UK’s tax revenue. 21 One of the
reasons these taxes have been selected to be analysed is that they are inelastic products, and
therefore price increases may not have a large effect on their demand, allowing the
government to increase their income. Another benefit to increasing these taxes is that it could
help reduce costs in other sectors, such as health care.
7.2.1 Fuel Duties
In the UK, tax is added to all petrol, diesel and LPG (liquid petroleum gas) that is sold. It
accounts for £26.8 billion in revenue for the government, which is 5% of the UK’s total tax
revenues.22 Fuel in the UK is very much an inelastic product. This means that the price can
rise a lot, but there will be little change in demand. The reason for this is that people’s lives
21
22
http://www.hmrc.gov.uk/stats/tax_receipts/tax-receipts-and-taxpayers.pdf
http://www.hmrc.gov.uk/stats/tax_receipts/tax-receipts-and-taxpayers.pdf
19
depend on using fuel every day, whether it is in their personal cars, or for trucks and
machinery in a business. Table 5 shows how much fuel duty is currently charged.23
Table 5
There are however a number of exceptions to the value of
fuel duty that is required to be paid. The fuel duty is for
example not required to be paid on jets fuel. Busses also
get a rebate for the fuel that they use. The rebate ranges
from £0.33 per litre, to £0.35 per litre.24
The disadvantage to raising fuel duties is that it has a negative impact on companies that
heavily rely on fuel, such as haulage companies. The Daily Mail, a major newspaper in the
UK wrote a report in March 2012 discussing the effects of the planned £0.03 rise in fuel duty,
a mere 5% rise. The news of the rise sparked major strikes from fuel tanker drivers, which
then created shortages in fuel. The Daily Mail continued to discuss how the rise would have a
great impact on businesses, and could cause businesses to go bust, which would reduce the
amount the government earns in corporation tax, and increases the amount they pay out in
unemployment benefits.25 It is therefore hard to justify recommending a rise in fuel duty if it
would have such a great negative impact on the economy. It is widely acknowledged that in
fact a fuel duty reduction would be the best option for the economy, as it would create a lot of
extra income through business development and consumer spending.26 Another negative
effect a raise in fuel duty is that it is widely regarded a regressive tax. This means that the
lower your income, the higher the percentage of tax you pay. This is because fuel duty is a
fixed value, and therefore the lower your income, the higher the proportion of your income
you pay towards the tax.27 It therefore isn’t possible to help make up the lost £111 billion by
increasing fuel duty, due to the negative impact it would have.
23
http://www.hmrc.gov.uk/budget2012/ootlar-rates.pdf
http://assets.dft.gov.uk/publications/changing-bsog-rates-letter-20120330/annex-a-new-bsog-rates.pdf
25
http://www.dailymail.co.uk/news/article-2118129/BUDGET-2012-Fuel-prices-WILL-3-02p-August-145plitre.html
26
http://fairfueluk.com/FairFuelUKCEBRreport.pdf
27
http://www.supanet.com/business--money/motorists-urge-fuel-duty-freeze-13793p1.html
24
20
7.2.2 Tobacco Tax
In the UK, tax is added to all tobacco products sold. It accounts for £9.55 billion per year,
which is 1.70% of the UK’s total tax revenues.28 Cigarettes are currently taxed at £0.155 per
cigarette, and an additional 16.5% tax per packet.29 Increasing cigarette tax offers better
possibilities to increase tax revenues, as the economy doesn’t depend on people smoking.
Cigarettes are classed as inelastic, as their demand doesn’t respond much to a price increase.
A report mentioned on www.plain-sense.com, states that a 10% rise in cigarette prices would
result in only a 4% drop in demand amongst adults.30
The following calculation shows that cigarettes are an inelastic product.
A value of between -1 and 0 is considered to be inelastic, therefore the above is inelastic.
Even though tobacco products are considered an inelastic product, there are still people that
respond to price rises. Because of this, there are people that would quit smoking if prices got
too high. This tax rise can therefore not only bring extra income, but it can be used as a way
of reducing the health care costs to the NHS (the UK’s National Health Service). Between
2010 to 2011, Policy Exchange, who is a leading thinking tank in the UK that help develop
new ideas for better public services, estimated that the total cost to society per year due to
smoking is £13.74 billion.31 It was previously mentioned that the elasticity of cigarettes was 0.40, which means that for every 10% increase in the price, the demand for cigarettes only
falls by 4%. Therefore if it was assumed that the elasticity was constant, then a 100% price in
cigarettes would result in a 40% fall in the demand. Currently in the UK, a pack of 20
cigarettes costs around £5.10, of which 80% is tax.32 Table 6 shows what will happen to the
tax, if the price of a packet of cigarettes is to be doubled.
28
http://www.hmrc.gov.uk/stats/tax_receipts/tax-receipts-and-taxpayers.pdf
http://www.thisismoney.co.uk/money/news/article-1716621/Each-cigarette-earns-the-State-26p-intax.html
30
http://www.plain-sense.com/2009/04/04/cigarettes-are-price-inelastic/
31
http://ash.org.uk/files/documents/ASH_121.pdf
32
http://siteresources.worldbank.org/INTPH/Resources/4Taxes.pdf
29
21
Table 6
Therefore for the price of a packet
of cigarettes to be doubled, the tax
on the cigarettes would have to
increase by 125%. Therefore assuming that the elasticity of cigarettes is constant, the demand
for cigarettes would fall by 40%. With £13.74 billion being the current cost to society in the
UK due to smoking, in the long term with the new proposed tax, this theoretically could
reduce by 40% to £8.24 billion, saving of £5.5 billion per year. The additional income from
the tax increase would add £3.3 billion to the current £9.55 billion in tax revenues. Therefore
with a saving of £5.5 billion from the cost to society, and an extra £3.3 billion in tax
revenues, the UK government could theoretically be £8.8 billion per year better off due to a
125% tax increase on cigarettes. This however is only 8% of the revenues the government
would lose through a severe reduction in income tax.
An issue with raising the taxes on tobacco products is that it increases the likely hood of
smugglers dealing illegal cigarettes, which haven’t had tax paid on them, therefore meaning
the government would lose out on revenues. Between 2005 and 2006, the UK lost £2.2 billion
in revenues due to cigarettes being smuggled in.33 Therefore it is likely that the government
would be less than £8.8 billion better off due to the increase in smuggled cigarettes.
7.2.3 Alcohol Tax
In the UK, tax is added to alcoholic products sold and account for £10 billion per year in tax
revenues, which is almost 2% of all tax revenues. The tax on alcohol varies depending on
what type of alcohol is being sold. They are broken down into four categories, they are;
spirits, beer, wines and cider.34 According to an article written by Frank J. Chaloupka,
Michael Grossman and Henry Saffer, the elasticity for beer, wine and spirits is -0,3, -1.0 and
-1.5 respectively.35 These numbers mean that for every 1% increase in price, the demand for
beer, wine and spirits reduces by -0.3%, -1.0% and -1.5% respectively. This means that beer
is a lot less sensitive to price changes than wine. The cost of alcohol misuse to society per
33
http://www.guardian.co.uk/uk/2012/mar/21/budget-2012-hits-smokers-37p
http://www.hmrc.gov.uk/stats/tax_receipts/tax-receipts-and-taxpayers.pdf
35
http://findarticles.com/p/articles/mi_m0CXH/is_1_26/ai_90681217/
34
22
year amounts to as much as £25.1 billion per year,36 whereas the revenues gained from
alcohol taxes are only £10 billion per year. A tax increase could be recommended in order to
make up this £15 billion per year difference, however it would require that taxes are
increased above 100%, and this effectively punishes the responsible drinkers for the
irresponsible drinkers actions. Another problem with increasing alcohol taxes is that a large
amount of the UK’s economy is based on the alcohol industry. In 2005, 89,209 people in the
UK were employed within bars and pubs.37 Therefore any increase in tax that would be
needed to reduce the cost to society and increase tax revenues, would have a serious impact
on these industries. Not only could it cause people to become unemployed, but it could also
cause businesses to fail, which not only would result in the government paying more in
unemployment benefits, but would also result in a reduction in corporation tax revenues.
Brigid Simmons, who is the chief executive of the British Beer & Pub Association
commented on the government’s plans to increase alcohol tax by 5% in 2012. He said “It
means the loss of over 5,000 jobs this year, and hundreds of pub closures.”38 Therefore if a
tax rise of 5% can result in 5,000 jobs being lost, and it would require a much larger tax
increase to have an impact on making back the loss due to the income tax reduction,
increasing alcohol taxes is not a realistic method of earning back the lost revenue.
7.2.4 Transaction Tax
A transaction tax is a tax on financial transactions within the financial sector that many
countries around the world have already proposed. The tax is backed by a thousand
economists from around the world, and people including Microsoft’s Bill Gates, 39 and would
involve taxing banks and investments firms for every trade they make. The tax that many
countries are discussing ranges from 0.005% to 0.5% of the value of the transaction. This
means that if a bank was to invest £100, they pay a tax ranging from £0.005 to £0.50.40
It is
estimated that such a tax could generate from between £20 billion to £100 billion in the UK
alone.
36
37
41
One of the reasons for putting this tax on the financial sector is that they were
http://www.direct.gov.uk/en/Nl1/newsroom/DG_170745
http://www.drinksindustry.ie/easyedit/files/DIGI%20Economic%20Contribution%20of%20the%20Drinks%20In
dustry%20FINAL%2008%2007%2008.pdf
38
http://www.morningadvertiser.co.uk/General-News/Budget-2012-Pub-industry-condemns-beer-duty-rise
39
http://www.independent.co.uk/news/business/analysis-and-features/a-richtopoor-robin-hood-tax-maysound-good-but-is-it-6257750.html
40
http://robinhoodtax.org/how-it-works/everything-you-need-to-know
41
http://robinhoodtax.org.uk/how-it-works
23
responsible for the latest financial crisis, which was due to risky investments. Having a tax on
financial transactions would mean that investments cost more, and therefore more care should
be taken when investing. Another reason for putting this tax onto the financial sector is that
they can afford it. The financial sector in the UK is the most profitable industry, and they
continue paying themselves the highest salaries. Therefore putting a tax on this industry
should have the least negative impact. In the UK, the four biggest banks are HSBC, Barclays,
Lloyds and Standard Charter. In 2011 they had combined profits of £21.5 billion.42
On the other hand, there are opposing arguments to this financial transactions tax, most of
which come from the financial sector. One of their arguments is that it would cause many of
the biggest banks in the UK to move their business out of the country, which would result in
the UK losing money and skilled workers.43
Evidence of this happening comes from
Sweden. In the 1980’s, Sweden introduced a financial transactions tax of 0.50%, which
resulted in 90% - 99% of bond traders moving out of Stockholm and into London. The result
was that Sweden’s tax revenues fell drastically.44 The Chancellor, George Osborne, is also
against the idea of a transaction tax. He claims that it would lead to lower investments within
the UK and increase unemployment.45
With at least a thousand economists around the world saying that the financial transaction tax
is just what the UK needs, and with estimates saying that it could generate between £20
billion and £100 billion per year for the economy, it is hard to see why it wouldn’t be the
perfect solution to making up the lost income from a reduction in income tax. Most of the
opposition to the idea comes from people working within the financial sector, so the question
has to be asked, are they just saying that so they don’t have to pay extra tax? Even though on
paper, the tax seems like a great solution, it is concerning however that when Sweden
introduced the tax; it turned out to be a catastrophe for the economy.
42
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/8291190/Big-banks-to-unveil-24billion-profits.html
43
http://www.independent.co.uk/news/business/analysis-and-features/a-richtopoor-robin-hood-tax-maysound-good-but-is-it-6257750.html
44
http://articles.businessinsider.com/2011-09-30/europe/30228552_1_tax-revenue-tax-money-borg
45
http://www.independent.co.uk/news/business/analysis-and-features/a-richtopoor-robin-hood-tax-maysound-good-but-is-it-6257750.html
24
7.3 Sub-conclusion
From the previous section, it appears it will be difficult for the UK government to earn the
£111 billion that is lost due to the reduction in income tax. In the first section when
discussing the results of the income tax reduction on the UK’s GDP, it was concluded that
there was chance the GDP could fall due to the reduction in government spending and net
exports. However it was concluded that the government could earn £28.44 billion in
additional income through the increase in VAT, reduction in unemployment benefit payouts,
increase in stamp duty and corporation tax. It was therefore necessary to find an extra £82.56
billion by increasing other taxes. The result of which is the following:
Increase in fuel tax
This was highly discouraged because of the negative impact it could have on the economy.
The increase in fuel prices would need to be of a considerable amount to make up much of
the lost income. It was reported that the planned 5% rise in fuel tax would result in businesses
closing, and therefore unemployment rising. A 5% rise is only a fraction of the amount
needed to make up part of the £82.56 billion, and therefore cannot be recommended.
Increase in tobacco tax
An increase in tobacco tax was recommended for a number of reasons. One of these reasons
is that tobacco consumption is considered inelastic, and therefore high tax rises result in a
small reduction in demand. It was calculated, that if the elasticity of tobacco demand is
constant, then a 100% rise in price would result in a 40% reduction in demand. This could
then generate an additional £3.3 billion in tax revenues, and could also reduce the cost to
society by £5.5 billion due to reduced health care bills and less people taking sick days from
work, resulting in a possible saving of £8.8 billion per year.
Increase in alcohol tax
It wouldn’t be possible to increase alcohol tax to help make up the lost £82.56 billion. The
reason for this is that it would have such a hard negative impact on the economy. It was
reported that a tax rise by as little as 5% could result in 5,000 jobs being lost.
Introduction of a financial transaction tax
25
This tax offers the greatest chances of earning the lost income from the reduced income tax.
It was reported that it could possibly generate between £20 billion and £100 billion per year.
If this was the case, it could make up the difference. However the greatest concern is what the
transaction tax did to the Swedish economy. If it has such a huge negative impact on
Sweden’s tax revenues, it could have the same impact on the UK’s.
Therefore if the above tobacco tax increase and introduction of the transaction tax were to be
completely successful, it theoretically could generate an additional £108.8 billion for the UK
economy, which is £26.24 billion more than the £82.56 billion the government would need to
make back.
8. Monetary Policy
As mentioned in the previous section, a permanent reduction in income taxes would result in
an increase in consumer spending and increase in investments. This is good as it allows the
government to earn more money through VAT, stamp duty and corporation tax. This increase
in investments would also cause the unemployment to fall. The side effect of this increase in
consumer spending and a decrease in unemployment is an increase in inflation. Some of the
problems associated with inflation are as follows:

Peoples savings become devalued

Price uncertainty could cause lack of investment from businesses

Higher prices are bad for exports

Difficult to make long term decisions
In order to control these side effects of fiscal policy, the government would need to adopt
monetary policies.
8.1 Causes of Inflation
8.1.1 Monetary Transmission Mechanism
The relationship between interest rates and inflation can be further explained by the monetary
transmission mechanism theory. Diagram 1 shows how the interest rate has an indirect effect
on the inflation rate.
26
Diagram 1
Graph Source - http://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdf
Diagram 1 shows the different areas of the economy that are affected by the change in
interest rate, and how that leads to a change in inflation.
When the central bank, in the UK’s case it is the Bank of England, changes the interest rate, it
is the short term interest rate that is changed. From the table above we can see that this has a
direct influence on exchange rates and asset prices. For example, asset prices, such as bonds
on the stock market, are affected by the change in short term interest rate, because the short
term interest rate can have an influence on the long term interest rate. The long term interest
rate and price of financial assets tend to be inversely related. This means that when the long
term interest rate goes down, then the price of financial assets goes up. The reason that the
price of financial assets increases when long term interest rates are low, is because there is a
higher demand for financial assets during times of low interest rates, as they usually offer a
higher interest rate.46 However the long term interest rate isn’t necessarily related to the short
term interest rate. This is because the long term interest rate is also influenced by future
expectations and confidence in the market.47 This can be seen to have an influence on asset
prices on diagram 1. Therefore the price of assets isn’t always affected by a change in the
short term interest rate.
46
47
http://stocks.about.com/od/understandingstocks/a/Bondint111004.htm
http://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdf
27
The exchange rate can be defined as the relative price of both the domestic and the foreign
currency. The exchange rate is therefore not only influenced by the interest rates of a
currency, but also the economic situation in both the domestic and foreign market. The reason
that the short term interest rate can have an effect on the exchange rate is because as the short
term rate of the domestic market increase, then the pound sterling becomes more attractive to
foreign investors, which means there is an increase in demand for the pound sterling,
meaning that the price of the pound sterling increases.48 This is shown on graph 2 within
“net-exports”.
The increase in exchange rate has a direct impact on the UK’s exports, as the increase in
exchange rates means that it becomes more expensive for foreign buyers to purchase British
products. Therefore since prices are increasing, inflation increases.
8.1.2 Demand – Pull / Cost – Push Inflation
Inflation can be broken down into two main types, they are Demand – Pull inflation, and
Cost- Push inflation. Demand – Pull inflation is caused by an imbalance in the aggregate
supply and demand. Therefore as prices increase, aggregate demand rises and exceeds the
aggregate supply.
49
When we look at the equation GDP=C+I+G+(X – M), it can be
determined that Demand – Pull inflation occurs when the following:

Increase in private consumption

Increase in investments

Increase in government spending

Increase in net-exports
Graph 4.1 shows what happens during demand – pull inflation.
48
49
http://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdf
http://www.investopedia.com/terms/d/demandpullinflation.asp#axzz1vhABESTE
28
Graph 4.1
Graph Source – UCN intranet
So when private consumption, investments, government spending or net-exports rises, it
causes the line AD1 to shift to the right, which can be seen at AD2. The price is set where
AD2 intersects AS.
Cost – Push inflation occurs when the aggregate supply falls and is then lower than the
aggregate demand. This happens when there is an increase in the prices of goods that have an
inelastic price. An example of Cost – Push inflation is when the price of oil increases. The
supply is reduced and yet the demand for oil remains the same. Graph 4.2 shows what
happens during cost – push inflation.50
50
http://www.investopedia.com/terms/c/costpushinflation.asp#axzz1vhABESTE
29
Graph 4.2
Graph Source – UCN intranet
So when a product that is inelastic, such as oil decreases in supply, the line AS1 shifts to the
left, which can be seen at AS2. The new price is where AS2 intersects the line AD.
The type of inflation that would therefore occur in the UK is demand – pull inflation, as the
changes in fiscal policy will have an effect on UK’s aggregate demand.
8.2 Contractionary and Expansionary Monetary Policy
Monetary policy is an action the monetary authorities of a country use in order to control the
supply of money. This is often done by changing the interest rates, which in turn changes
peoples demand for money. For example, when interest rates are high, people are being
encouraged to keep their money in the bank to take advantage of the high interest they will
receive. This is called “contractionary monetary policy”. The opposite of this is
“expansionary monetary policy”. This is often adopted in times of recession, in order to make
borrowing money cheap, discourage people from saving, and spend more money in order to
help kick start the economy. An example of monetary policy working can be seen in on
graph 5.1 and graph 5.2
30
Graph 5.1
Table source - http://www.tradingeconomics.com/united-kingdom/interest-rate
Graph 5.2
Table Source - http://www.tradingeconomics.com/united-kingdom/inflation-cpi
From these tables, it can be seen that between 2001 and 2008, the interest rates in the UK
were between 4% - 6%. This kept the inflation at a controllable level; however it was still
rising due to the economic boom that was taking place. Then in 2009 the financial crisis hit,
having a huge impact on inflation due to a severe reduction in demand. The Bank of England,
who controls the interest rates, reduced the rates to a record low of 0.50%. The impact of this
can be seen on the inflation rate. Just 4 months after the interest rates are cut the inflation rate
jumps back up. The relationship between interest rates and inflation within the UK during
this period, can be seen in appendix 4. Here it was calculated that the p-value is 0.000001,
which means it is a very robust result. We can also see from these results, that the adjusted
R^2 value is 0.907, which means that one result can be used to have a very high chance of
31
predicting the next result. This is an example of the government using expansionary monetary
policy.
By learning how effective monetary policy was during the economic downturn, the UK
government could use it to control the inflation that would be caused by the increase in
consumer spending. But instead of expansionary monetary policy, contractionary monetary
policy would need to be adopted which would bring inflation back down. An example of
contractionary monetary policy being adopted can be seen on graph 6.1 and graph 6.2
Graph 6.1
Table Source - http://www.tradingeconomics.com/united-states/interest-rate
Graph 6.2
Table Source - http://www.tradingeconomics.com/united-states/inflation-cpi
We can see from these graphs how the U.S government continued to raise interest rates for
each quarter for two years in order to keep inflation down. This was necessary at the time as
the USA was experiencing an economic boom, with plenty of money in the economy, just as
32
the UK would have if the government was to severely reduce income taxes. However with
this case, when the regression analysis was used on the figures, the nul hypothesis was
accepted. The results for this analysis can be seen in appendix 5. This means that in this case
there was no relationship between the interest rates and the inflation rates. The results show
that the p-value is 0.0901, with a confidence interval of 95%. These results are not robust
however. This is because if a confidence interval of 90% was used (which wouldn’t be
unusual), then the nul hypothesis would be rejected instead, and this would mean the two
variables were related. The results do also show that the R^2 is only 0.4411. This means that
there is a low chance of predicting the next result.
8.3 Philips Curve
The Philips curve was first developed by an economist from New Zealand called Alban
William Housego. He suggested that there is a stable relationship between inflation and
unemployment.51 The reason that this is of interest is because a reduced unemployment that
could come from an increase in investments can increase inflation.
An example of a Philips Curve can be seen on graph 7.
Graph 7
Graph source - http://www.econlib.org/library/Enc/PhillipsCurve.html
51
http://www.investopedia.com/terms/p/phillipscurve.asp#axzz1w45YZuoG
33
We can see that during the 1960’s in the USA, as the unemployment decreased, the inflation
increased. The reason for this is that as unemployment reduced, there was a greater demand
for labour, which was pushing wages higher. This increase in wages means that there was
more money in the economy and people were spending more money, and therefore inflation
was increasing.
Since 1958 when the Philips Curve was first produced, it has come under scrutiny from
economists and is often considered not relevant anymore.52 Many economists still believe
that the Philips Curve is true in the short run, but in the long run there isn’t a relationship
between unemployment and inflation.
Graph 8 shows the unemployment rate and inflation rate between 1989 and 2006 in the UK.
Graph 8
Graph source - http://tutor2u.net/economics/revision-notes/a2-macro-phillips-curve.html
The graph shows that over this period, there isn’t the same relationship between
unemployment and inflation as the Philips Curve suggests. Between the years of 1995 and
2000, the inflation rate and the unemployment rate were both declining simultaneously, as
opposed to being related inversely like the Philips Curve states.
52
http://tutor2u.net/economics/revision-notes/a2-macro-phillips-curve.html
34
9. How Successful Are Other Tax Havens
9.1 Introduction
A tax haven is a country or region of the world that offer individuals who reside there the
opportunity to pay little or no tax. As of 2011, there are at least 80 regions of the world that
are considered tax havens. Two of the most well known places are Monaco and
Switzerland.53 For many years these countries have been a popular place to live for high
worth individuals. As these countries have been tax havens for so long, and yet their
economy appears to function the same, if not better than the UK’s, it is interesting to know
what benefits their low taxes have brought to the country and why it has been successful for
so long. This section of the report will also focus on the pro’s and con’s of being a tax haven.
9.2 Monaco
Monaco is the second smallest independent state in the world and is located in the South of
France. Monaco has a population of around 32,000 people, but of that figure, 80% of them
are foreigners enjoying a tax free life style.54 A comparison of some of the taxes that are paid
in the UK and in Monaco is shown on table 7.
Table 7
Information from - http://www.monaco-consulate.com/index.php/useful-links/tax-system/
As these three taxes make up more than 50% of all the UK’s revenues, it is important to
know if Monaco has to sacrifice anything in order to have these low taxes. In order for
Monaco to survive, they need to make their income in other sectors. Monaco boasts a 0%
unemployment rate and inflation rate of only 1.5%. This backs up what economists have said
regarding the Philips Curve. They said that the Philips curve was only relevant in the short
53
54
http://www.pwc.pt/en/guia-fiscal-2011/paraisos-fiscais.jhtml
http://www.expatfocus.com/expatriate-monaco-overview
35
term, and in the long term inflation would be unaffected by low unemployment.55 This holds
true with Monaco.
As Monaco is so famous for having a huge proportion of expensive cars, a harbour with the
biggest boats in the world, and the world famous Monte Carlo Casino, it is a popular
destination for tourists. So popular in fact that 25% of government income comes from
tourism.56 To put that into context, the UK would need to have a tourist industry that earned
the government revenues of £140 billion, which is close to the £150 billion that was
generated through income tax in the UK between 2011 and 2012.
In 2010, the government of Monaco generated 50% of all their tax revenues from corporation
tax57, and as a comparison, only 8% of the UK’s taxes came from corporation tax. The
reason for this is that even though Monaco has a higher corporation tax, there are exceptions
to this rule. One of these exceptions is that there are huge tax benefits on new companies in
Monaco. For example, the first year that a company is formed in Monaco, the company is
required to pay a tax rate of 0% on all profits. The corporation tax increase gradually over the
years and it isn’t until the sixth year that the company has done business, that it is required to
pay 33% tax.58 Therefore Monaco is an attractive place for people looking to start a business.
Much of the businesses that are in Monaco are in the financial sector, such as large banks.
They are attracted to Monaco because of the high proportion of people with a high net worth.
In fact, Monaco has the highest proportion of high net worth individuals in the world. The
average net worth of the country’s population is €4.5 million.59 Most of these rich people
have been attracted to the country due the 0% tax rate.
It is clear that the economies of Monaco and UK are so different, that it isn’t possible know if
the UK could adopt the tax system of Monaco and make it successful. It does however seem
unlikely that it wouldn’t work. The reason for this is that Monaco is able to make up 75% of
all tax revenues from only tourism and corporation tax. This isn’t possible in the UK, because
the UK’s tourist industry is much smaller, and to increase it to £140 billion per year is
unrealistic. Even if corporation tax in the UK was tripled to 60%, and no businesses closed
down, it will still only generate 24% of all tax revenues. So again, this isn’t possible.
55
http://tutor2u.net/economics/revision-notes/a2-macro-phillips-curve.html
http://www.qfinance.com/country-profiles/monaco
57
http://www.state.gov/r/pa/ei/bgn/3397.htm
58
http://www.lowtax.net/lowtax/html/jmcdctx.html
59
http://www.igougo.com/story-s1364044-Rome-A_Day_in_Monte_Carlo_and_Nice.html
56
36
9.3 Switzerland
Switzerland is considered by many as a tax haven, but not in the same way as Monaco. In
comparison to the rest of Europe, Switzerland does offer a low income tax rate to the
residence. However, it is hard to compare this income tax with the UK income tax as the
taxation rate in Switzerland varies so widely depending on where each individual is living. In
general though, people are required to pay less than 30% of their income as tax.
60
In
Switzerland there is a tax called “wealth tax”, and it is taxed at a maximum of 1% per year of
a person’s assets. If this tax were to exist in the UK, it would have the potential to increase
UK tax revenues by £53 billion (see appendix 2). However, there could be a number of
negative side effects to adopting such a tax, which would result in this tax revenue not being
gained. For example, in 2010 in the UK there were 284,317 people with a net worth of more
than £1million, with an average wealth of £4.5million.61 These people therefore would be
required to pay £45,000 per year in wealth tax. The UK could therefore risk losing wealthy
tax payers. This may not be the case however as the proposed tax reduction would mean this
income group would be paying a tax of 20% instead of 50%. If therefore a wealth tax in the
UK did not result in people leaving the country, then it could be a successful way of earning
back the lost revenue due to the income tax reduction. Another problem the UK would have
in adopting Switzerland’s tax system in the level of VAT that is paid in Switzerland. The
standard rate of VAT is 8%62, in comparison to the UK’s 20%. This would mean that the UK
would stand to lose 12% of VAT income, which equates to a £95 billion loss.63 This would
therefore be catastrophic for the UK economy as it wouldn’t be possible to make up a £111
billion loss in income tax revenues, along with a £95 billion loss in VAT revenues. The
reason that this will work in Switzerland is because the low income tax of Switzerland
attracts some of the richest people in the world. In 2010 Switzerland had an average annual
income per person of £41,87564. In comparison, the UK has an average annual income of
60
http://www.expatica.com/ch/essentials_moving_to/country_facts/Get-your-head-around-the-Swiss-taxsystem.html
61
http://www.telegraph.co.uk/finance/personalfinance/8033505/Number-of-millionaires-in-Britain-rises-tomore-than-280000.html
62
http://www.taxation.ch/index.php?id=36
63
http://www.hmrc.gov.uk/stats/tax_receipts/tax-receipts-and-taxpayers.pdf
64
http://www.state.gov/r/pa/ei/bgn/3431.htm
37
£26,244.65 Therefore the high proportion of high earners means that the government is
gaining a lot through VAT, even though it is such a low rate.
Introducing wealth tax in the UK could be an option, as it is small percentage of a person’s
wealth. And together with a 100% tax reduction for people earning below £100,000, it
wouldn’t be difficult for each household to pay on average £2,000 per year.66 And with the
possibility of earning a revenue of £53 billion (see appendix 2), it could be a tax worth
considering.
10. Conclusion
The objective of the report was to establish if a drastic reduction in income tax could be
successful in the UK’s economy. It was first established that the effect that this could have on
the country’s GDP could go either way. The equation GDP=C+I+G+(X – M) was analysed,
and from investigated the individual parts of the equation, it wasn’t possible to know if GDP
would increase or decrease. The reason for this is that the reduction in income tax would
cause consumer spending and investments to increase due to people having a higher
disposable income. However it was also established that government spending would
decrease in the short run due to the reduced tax revenue. Net-exports would also decrease
because as inflation increases, interest rates need to be increased, which in turn would create
a higher demand for the pound sterling. The increase in demand means that the pound sterling
becomes expensive, and so demand for British products decreases. Therefore, for the GDP
increase, the reduction in tax would need to have a greater influence on the consumer
spending and investments, than government spending and net-exports.
GDP is not the only determining factor to whether or not the reduction in income tax would
be successful. For the tax to be successful, the government would also have to at least make
back the lost income, which was calculated to be a possible £111 billion. It would therefore
be necessary for the government to increase other taxes to make up this difference.
65
66
http://www.guardian.co.uk/money/2011/nov/23/uk-household-earnings-fall
http://www.guardian.co.uk/uk/2009/dec/10/ons-report-uk-wealth
38
It was calculated that the following income could potentially be gained from increasing other
taxes:

VAT Increase – £26 billion

Increased investments reducing unemployment benefits – £100 million

Increased revenues from stamp duty and corporation tax – £2.3 billion

Tobacco tax - £8.8 billion

Financial transaction tax - £20 billion – £100 billion
Therefore if the above were to be completely successful, it could potentially generate £137
billion in revenue, which covers the £111 billion that would be lost when severely reducing
the income tax, meaning that a severely reduced income tax in the UK could potentially be
successful.
39
11. Appendices
11.1 Appendix 1
Source - http://www.ifs.org.uk/bns/bn09.pdf
11.2 Appendix 2
Source - http://www.guardian.co.uk/uk/2009/dec/10/ons-report-uk-wealth
Source - http://www.ons.gov.uk/ons/rel/family-demography/families-and-households/2011/stb-familieshouseholds.html
40
11.3 Appendix 3
41
11.4 Appendix 4
42
11.5 Appendix 5
43
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