What do we mean by ‘hot’?

One of the unexpected benefits of having worked on projects to design and implement government policy is a greater appreciation for words. We take words for granted and we don’t often give them much thought. That’s a mistake.

Take the word ‘hot’ (no, not that ‘hot’). ‘Hot’ has been in the news recently, in the UK, as a result of the budget. The problem is that there are different rates of VAT for food that is ‘hot’ and food that is ‘not hot’.

For most foods this is not a problem. Fish & chips are ‘hot’ so VAT applies. Sandwiches are ‘not hot’ so VAT does not apply.

What about pasties though? Pasties are prepared freshly in bakeries and then offered for sale. However, the pasties may cool down before they are sold. When is a pasty ‘hot’ and when is it ‘not hot’? If you visit a bakery and there are some pasties fresh from the oven should you buy the pasties and pay VAT, or should you wait half an hour until the pasties are ‘not hot’ and save yourself some money? What do we mean by ‘hot’ anyway? In summer, the ambient temperature will be higher so pasties will cool down more slowly. A ‘not hot’ pasty in summer will be ‘hotter’ than the same pasty in winter. Should VAT apply more in summer than in winter?

Of course, this is complete nonsense, but it arises because someone decided it would be a good idea to have different VAT rules for ‘hot’ and ‘not hot’ food. We elect these people so it is really our fault.

When governments make laws using terms such as ‘hot’, there are always examples at the boundary where the distinction is dubious. This means that these examples are then ‘unfair’. ‘Unfair’ is another word which takes on a life of its own when associated with government policy. ‘Incentives’ is a further example.

Take income tax. If we introduced income tax today, we might create a few simple rules. A flat tax is clearly ‘unfair’ so we might settle for a fixed non-taxable allowance for each individual plus a fixed percentage of all income above that point. Some politicians would then decide that this was still ‘unfair’ while other politicians would decide that the system could be improved by introducing ‘incentives’. Over time, politicians would introduce new rules corresponding to their views of ‘fairness’ and ‘incentives’. Unfortunately, ‘fair’ taxes often result in ‘perverse incentives’, and taxes which promote ‘incentives’ are often ‘unfair’. Redistribution is ‘fair’ but discourages wealthy people from working. Reducing the tax on capital gains is an ‘incentive’ to invest but is ‘unfair’ to those whose income comes only from their labour.

Over time, by introducing these new rules, the politicians would create a tax system which was not particularly ‘fair’ and which did not do much for ‘incentives’. However, it would be very complex. The same politicians would then react to the problems in this complex system by introducing more rules to correct the anomalies arising from the ‘unintended unfairness’ and ‘perverse incentives’. This would result in even more complexity but would still not be very ‘fair’, nor would it produce more effective ‘incentives’. What it would do is to spawn an industry of accountants who would offer to help reduce tax bills by exploiting the many loopholes in the system. Of course, the only people who could afford these services would be large businesses and rich individuals. And that would not be ‘fair’.

‘Fair’ is a word whose meaning is in the eye of the beholder. Child Benefit is a universal benefit. For some reason, that is deemed to be ‘fair’ even though it involves paying government money to millionaires who don’t need it. In most other contexts, using government money to make rich people even richer would be deemed ‘unfair’. Yet, in the case of Child Benefit, we make an exception. Perversely, the current centre-right government has plans to stop paying Child Benefit to millionaires while the left-wing opposition protests that this is ‘unfair’. Imagine if the policy were being implemented in reverse. Suppose that Child Benefit were not currently paid to millionaires and that the government proposed to extend it to millionaires in the middle of our extended recession/depression. I am certain that this would be seen as ‘unfair’ on the Left, so we have two polar opposite policies both of which are seen as ‘unfair’ by the same people.

Actually, there is a germ of logic in the Child Benefit criticisms. The government needed a practical mechanism to decide who should be eligible to receive the benefit. It decided to use the income tax system. The income tax system taxes individuals rather than ‘families’. As a result, the proposed new rules discriminate against ‘families’ with one ‘high’ wage earner and a stay-at-home non earner. ‘Families’ with two ‘lower’ wage earners can avoid losing the benefit even when, in some cases, their combined ‘family’ income is higher than the income of the ‘high’ wage ‘families’.

You’ll see that I have used quotes for ‘family’ and for ‘higher’ and ‘lower’ wages. That’s because these words have their own issues. For example, the ‘lower’ wage earners in my example have incomes which are substantially ‘higher’ than the average national income. As for ‘family’, well that would need an entire post to itself.

Tim Harford wrote a funny article on the subject of the pasty tax this week. He also mentioned last year’s Mirrlees Review (and at BBC and The Guardian) which put forward proposals for a more rational tax system.

These issues are not specific to the UK. Gregory Mankiw wrote an article in The New York Times last month on the problems of defining ‘ordinary income’ and ‘capital gains’ ‘fairly’ in the US.