The Endowment Effect, PAYE and Indirect Taxation

A brief introduction to the UK tax system for foreign readers: income tax is paid upon all income above £9500 per annum, at a rate between 20% and 45%; National Insurance is essentially another income tax, levied at a rate of 2% on the employee and up to (IIRC) 12.8% on the employer, and if you're paying it at that rate then there's no NI-free allowance; Corporation tax is 22% for small companies and 28% for large ones; VAT is essentially a sales tax of 20%, though with exemptions for certain basic goods. There are heavy duties on fuel, alcohol, cigarettes etc. Inheritance tax is 40% beyond a certain threshold. Council Tax is charged upon an outdated estimate of the value of your house. Businesses have to pay Rates based upon the value of the land they occupy.

Reading a post by Bryan Caplan and watching a lecture by David Friedman, I started thinking about the endowment effect and loss aversion in relation to the State. The remarkable thing about modern tax collection is how little of it is collected directly from the taxpayer: income tax is paid automatically when he receives his wage; National Insurance and Corporation Tax are both supposedly paid by the employer, even though it is well established that the burden falls upon the worker; VAT is paid by the seller, although everyone knows that the burden falls upon the buyer; indeed, a key driver of inflation a year or two back was a rise in VAT from 17.5% to 20%. This goes for the various taxes on individual goods - alcohol, cigarettes, petrol etc. As such, the public faces higher prices but does not think of it as taxes.

If tax is inevitably going to be paid, then perhaps these are not bad things. It's certainly more efficient for a boss to send one cheque for all his employee's taxes than for them each do so individually. (It also reduces the ability of individuals to evade taxation, though I'm not exactly thrilled by that). But this is going to have a sizable effect upon public perception of taxation. Imagine that instead of receiving pay of £22,000 a year and paying current prices, you received £30,000 a year, prices were about 17% cheaper, and every year you had to send the government a cheque for £15,000. I can't help but think you'd be considerably more reluctant to do so.

To what extent might this be a factor leading to larger government? Well, not necessarily much of one. My understanding of the evidence is that reducing taxation does not cause governments to cut spending by much, if at all. But it almost certainly has some effect, and it can serve an example of how subtle the State's influence can feel.

For a view of this issue from a different perspective, see http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2013/05/taxes-norms-belief-equilibria.html