Hypothecation of taxes – could this be the cure to austerity?

In the first full week back from the Christmas break the NHS has faced its annual existential crisis and many influential pundits have returned to the idea of establishing a, new, specific tax to pay for some, or all, of the funding required by the NHS.

The policy of assigning particular tax revenues to a specific public policy goal is known as “hypothecation” and hypothecation is getting its moment in the 2018 winter sunshine.

As the FT editorial of Thursday 11 January put it:

“An ageing population and rising demand for health and social care meet governments with heavy debt burdens and tax-phobic voters. Result: intergenerational conflict and a loss of faith that governments will provide the public services and welfare states that they promised.

Enter an old, usually bad, idea: hypothecated taxes, defined as levies whose revenues are earmarked for a specific purpose.”

National Insurance Contributions have always been a hypothecated tax which pay for State Pensions, other benefits and some NHS spending. This is not well understood. See the ICAEW hard choice paper for the historical background and the correct position

Is hypothecation a good thing?

The technical answer is, probably, no.

If the hypothecated tax is designed to pay for the entirety of the related expenditure then what happens if the tax increases, or decreases, relative to the expenditure it is designed to cover?

There will soon be too much, or too little, tax revenue coming in.

And as a 2012 IFS report on Tax and Benefit policy noted:

“in general, governments should be cautious of hypothecation – tying particular expenditures to particular receipts would probably lead to less efficient patterns of spending, since in principle there is no reason that the most effective ways of raising revenues and of spending them should be linked. Further, in many cases, so-called hypothecation is meaningless as it is often impossible to verify that the revenues were spent in a particular way. Public support could also erode if it was felt hypothecation was being used merely as a presentational device.”

The political element

A current argument in favour of hypothecation is that it will engender a proper debate about the level of funding that is required to allow, in the context of the NHS, provision of health care that is acceptable to the general public and an informed debate as to what the NHS should seek to deliver and how much money that will cost.

The tax policy problems surrounding hypothecation may conceivably be trumped by the political benefit of a more grown up debate about the sort of national health service that we would like, what that would mean in practice and how much it would cost and how we might be able to afford it

Some earlier discussions on hypothecation

There is a House of Commons Library paper Hypothecated taxation which was published  in September 2011. It has a full section on earlier discussions about a specific tax being introduced earmarked for some or all of NHS spending.

Some further thoughts

A more grown up debate on what the tax system should pay for and how it should do so is potentially for the benefit of us all.

But no one would want hypothecation to lead to everyone deciding which bits of public expenditure they approve of, and are prepared to support, and for taxpayers to be able to restrict their contributions accordingly. While extra taxes to pay for more NHS or more schools might prove popular there are other areas of public finance, which are also important, but which may not have the same level of public support.

Oliver Wendell Holmes, a US Supreme Court judge in the early part of the 20th century, said:

“Tax is the price we pay to be members of a civilised society”

The quote is reproduced above the doorway of the  IRS (Internal Revenue Service) headquarters on Pennsylvania Avenue in Washington.

Cherry picking the bits our public finances that we want to be linked to particular taxes may not create a coherent system.

And if we, individually, decide which bits of the public finances we contribute to then that could be a recipe for anarchy.