The concept of earmarking sources of taxation for particular items of expenditure (hypothecation) finds common appeal both from people who want to see an increase in spending on a particular thing and those who want to cut the amount of tax the public pay.
The UK Government's decision to impose a tax on sugary soft drinks to fund sport in schools is an example of a hypothecated tax and one that is regularly in the news. The Government will legislate for this in Finance Bill 2017, with implementation from April 2018.
The idea behind hypothecated taxation is that you create a special tax or levy and the proceeds are applied to spending on a particular priority. The most common calls come for taxes to fund additional spending on education, health and social security.
There are degrees of hypothecation, which can range from fully funding the targeted expenditure to only partial funding.
If you are a spender of tax revenue, the appeal is that you have a source of money to meet what you have decided is particularly important.
For cost cutters, the concept also has appeal, in that it allows the spending department a source of income and if it is not enough for what they want, then it makes it easier to say ‘tough’ and they must cut their cloth to meet whatever objective the hypothecated tax was created to fulfil.
National insurance comes close to being hypothecated. The tax is intended to fund contributory benefits, for example state pension and contributions based employment support allowance. However, government accounts show that the income received from national insurance contributions is about £86.5 billion in 2015/16. This does not actually cover the cost of pensions and benefits - about £95 billion - so the fund has to be topped up with a substantial grant of £9.6 billion from general taxation.
In 1996, the Conservative government introduced a landfill tax (LFT) and promised that it would be revenue neutral. It committed to apply the proceeds of the tax to reduce employers’ national insurance contributions (NICs). This was done in the year ending 31 March 1998 when the rate for employers’ national insurance was reduced from 10.2 per cent to 10 per cent
However, any link between proceeds of LFT and rates of employers’ NICs was soon lost. Significant increases in landfill tax collections and an increase in the rate in 1999 from £7 to £10 (it now stands at £84.40) were accompanied not by cuts in employers’ NICs but by a rise to 12.2 per cent the following year.
A number of problems arise with hypothecation.
First and foremost, it must be recalled that how to tax is a political decision taken by governments that may have different priorities. The promise to apply the proceeds of landfill tax to reduce NICs was made by a Conservative government that was replaced in 1997 with a Labour one, which did not see a need to continue the hypothecation.
Next there is a tension between how it is applied. Do you give the spender the power to raise rates to ensure they have enough to meet their perceived priorities or do you limit what can be raised, as was the case with Scottish Rate of Income Tax, and thereby effectively constrain what can be spent?
Then you have to consider what happens if there is a surplus or deficit? Some years back there were calls by politicians to appropriate the balance in the National Insurance Fund (then about £30 billion) for other purposes apparently without the realisation that that money barely covered about three to four months of benefits.
A further problem arises from public perception. Say there was a special tax to fund the NHS. The amount everyone pays for health would be somewhat more transparent but it might lead to the young and healthy asking the question why they should fund the treatment of older and unhealthy people on whom is spent rather more than is collected.
Nevertheless there is a debate that needs to take place on hypothecated taxes.
Blog by Maric Glaser, Indirect Taxes Technical Officer, the Chartered Institute of Taxation