Why Livingstone is a tax genius

Financial Times : August 5, 2004 : Martin Wolf

Reproduced here by kind permission of Financial Times.

The Labour politician who has been both boldest in introducing market forces and most successful in demonstrating the effectiveness of a rational approach to public finance is neither Tony Blair nor Gordon Brown. That hero is Kenneth Livingstone, the mayor of London. By introducing the congestion charge, he has opened the way for more cautious politicians to follow. But those who do so should not limit their attention to the pricing of congestion, important though that is. They should use the opportunity to rethink their inefficient fiscal systems.

Policymakers should, so far as they can, exploit opportunities for taxes that either enhance overall economic welfare (taxes on socially undesirable externalities” such as pollution and congestion) or at least do not reduce it (taxes on scarce resources such as land). Only then should they turn to taxes that are bound to reduce welfare (those on final consumption, capital, labour and intermediate products).

Rana Roy, an influential transport economist, makes these points in a recent paper prepared for The Railway Forum, an industry-wide body.* He calls for a “comprehensive tax review” to accompany the spending reviews that have generated big improvements in the planning of public sector expenditure.

Furthermore, any such review of taxes needs to be closely integrated with the spending reviews, particularly as they relate to public investment. London's congestion charge shows why this is so.

Before the charge, the only ways to reduce road congestion would have been to invest in road space or to subsidise an expansion of public transport. But introduction of the charge has eliminated much of the congestion: according to Transport for London's second annual report, published in April, congestion has fallen by 30 per cent. Thus, there is less need for additional road space.

There is, instead, need for additional capacity in London's public transport. But, with the congestion charge, it is possible to charge users of public transport higher prices, at the margin, than would otherwise be the case, thereby reducing the public subsidies required to achieve any given level of supply and usage. Furthermore, the charge has itself raised some of the needed revenue.

So what would happen if these admirable principles were applied to the UK's transport infrastructure as a whole? Work by Dr Roy on optimal transport pricing for the European Conference of Ministers of Transport provides a rough and ready answer.**

In the UK case, the theoretical increase in revenue in 2000, over and above the sums collected from the inefficient charges then in effect on transport, turned out to be about £24bn. About half of this came from taxes on obvious externalities and half from charges on space used for parking. To put it in context, this sum was roughly 6 per cent of total government receipts.

Such a rational charging scheme could also be integrated directly into the planning and finance of investment in infrastructure. The obvious rule would be to expand capacity whenever incremental revenues from the charges would fund the total costs (including environmental and amenity damage) of providing the extra capacity. Underinvestment in infrastructure has been long standing and huge, as the recent white paper from the Department for Transport states, so the case for additional investment will surely prove very strong.***

Introducing charges that raise revenue and make life better is ideal. But taxes on economic rent - that is, taxes on the scarcity value of resources - are almost as good, because they do at least avoid distorting economic behaviour. As I have argued in previous columns (“Grounds for a new way to look at land use”, May 14 2004, for example), the most important innovation would be site-value taxation of land. A properly designed system would also automatically recoup much of the costs of infrastructure investment from its principal beneficiaries: land-owners.

Plans for extending congestion and pollution charging and for taxing economic rents need to be developed as rapidly as possible. But such ideas need also to be set in the context of a thorough analysis of the fiscal system as a whole. It is astonishing that governments that raise close to 40 per cent of gross domestic product in tax devote next to no thought to maximising the benefits and minimising the harm of how they do so. They, and we, can do far better. Mr Livingstone has shown the way. The government should now go boldly in a similar direction.

* Not By Spending Alone. www.railwayforum.com. June 2004
**Optimal transport pricing (Chapter 2 of Reforming Transport Taxes, Organisation for Economic Co-operation and Development)
***The Future of Transport. www.dft.gov.uk. July 2004