Parliament and the Laffer Curve

Britain's MPs respond to incentives. Why don't they think the public does?

RUPERT DARWALL

London

The inventor of the Laffer curve also uses a more colorful way to illustrate the impact of incentives on behavior. Hit a dog with a stick, Arthur Laffer says, and you won't know where to find him. Leave him a bowl of food and you can be sure to know where he is. The British public now certainly knows where the parliamentary dog bowl is thanks to almost daily revelations of how their elected representatives have abused the system of tax-free allowances.

Reuters

It hasn't been a pretty sight. British taxpayers have learned over the past few weeks that, among other extravagances, they paid for the cleaning of moats, repairs for a duck house and the maintenance of a helipad.

The scandal also shows the power of incentives, to which some members of parliament so easily yield in their personal conduct but just as easily ignore when it comes to raising taxes on others.

On top of their annual salary of £63,291 ($100,910), lawmakers are entitled to claim up to £24,006 in additional costs allowance for the costs of living away from home. While their salaries, like everyone else's, are subject to income taxes, their expense reimbursements are not. MPs therefore face a zero tax rate on this part of their remuneration. And other than filing a claim and chasing it through the House of Commons fees office, they don't have to do any extra work for it.

Put another way, MPs face a 100% tax rate on their unclaimed allowances. Given the way this scheme invited abuse, perhaps the most remarkable aspect of the story is the number of parliamentarians who didn't milk the system -- or at least not to its fullest. According to an analysis by the Taxpayers' Alliance, less than one-fourth of parliamentarians claimed the maximum allowance.

The media quickly focused on the difference in lifestyles between the man on the street and MPs (inevitably Conservative ones even though the abuse was cross-party). But more important is the difference in tax treatment between them and the people they are elected to represent.

Politicians encounter problems of legitimacy when there appears to be one rule for the governed and a different rule for the governors. For example, several members of parliament, including Alistair Darling, the Chancellor of the Exchequer, were claiming the cost of tax accountants -- an expense that ordinary income taxpayers can't deduct. And while parliamentarians can claim tax-free interest payments on their second homes, the Labour government abolished mortgage-interest tax relief for everybody else in 2000.

The beneficial tax treatment of interest on parliamentarians' second homes in effect turned the House of Commons into a tax shelter for investments in the residential property market. One hurdle needed to be overcome. The gains from selling a primary residence are tax-exempt, but lawmakers can only claim back mortgage interest payments on their second homes and have to pay capital gains tax on that same property. A number of members of parliament got around this by "flipping" -- claiming the tax exemption on their second home and then redesignating it as their main residence when it came time to sell.

Britain would have a far better tax code and lower tax rates if those who make the tax laws reflected a little on their own behavior and what it says about people's ability to arrange their affairs to avoid excessive taxation. As chancellor, Gordon Brown wrote more legislation designed to fight tax avoidance than any of his predecessors. The result is that the U.K.'s tax code is impossibly complex. The 2004 Finance Act ran to 746 pages, and the 2005 Finance Act was so long it had to be published in two books. The publication of the lawmakers' expense claims revealed the delicious irony of Mr. Brown making arrangements to pay his cleaner in a way that reduced her National Insurance taxes.

The details of the claims scandal has now sparked talk of a constitutional crisis for what in reality is simply a loss of legitimacy. Politicians and pundits on the left are using it to argue for a change of the electoral system. The constitutional palliatives on offer -- such as proportional representation, MP recalls and referenda -- do not reform the system of paying members of parliament that led to this political disaster.

Instead they would make Britain as ungovernable as California, rendering it much more difficult for the next government to tackle the country's real challenge -- its yawning government deficit, vying with that of the Obama administration and Japan as the worst of any major economy.

On this, the verdict is inescapable: It is the government rather than the constitution that needs changing. Consider how last month the Labour government presented the most ill-judged budget since the 1970s. Confronted with a dramatic worsening of public finances, the government basically gave up on the task of governing. Rather than rein in spending, it raised the top rate of income tax to 50% from 40% in what it gambled would be a populist move. Labour's poll ratings only fell further. The justification for the tax hike was to finance higher spending "to help pay for additional support for people."

The public's current insurrectionary mood encourages politicians to defer to voters rather than offer a new direction and strong leadership, neither of which Mr. Brown -- an unpopular prime minister and the man more responsible for Britain's economic problems than any other -- is able to offer.

Little wonder that British voters are now taking a hard look at Tory leader David Cameron. So far, he has responded more swiftly and boldly than Mr. Brown by forcing a number of Conservative members of parliament to stand down at the election. His lead in the polls means he's most likely to lead the next government. The economic success of a Cameron government will depend on its ability to tackle the deficit without damaging incentives for economic growth. All the pressure on him will be from the opposite direction -- to avoid cuts in public spending and to increase taxes on the rich -- and to divert his energies to unnecessary constitutional change.

The cause of Britain's economic problems does not lie in its constitution and will not be solved by tinkering with it. Under Mr. Brown, Britain has a weak government that cannot summon the strength to offer a way forward. It cannot afford another.

Mr. Darwall is a research fellow at the Center for Policy Studies.