Is hypothecation - assigning particular tax revenues to a specific public policy goal - a good thing? The technical answer is, almost certainly, no, but why and what are the arguments for and against this hotly debated topic? Read Ian Young's article presenting the facts and then decide.

In the early days of 2018, the National Health Service (NHS) faced its annual existential crisis brought on by its lack of adequate resources. This prompted a number of influential pundits to back the idea of establishing a new, specific, tax to pay for some or all of the extra funding required by the NHS.

The policy of assigning particular tax revenues to a specific public policy goal is known as “hypothecation” and it is being seen by some as a means to improve the funding of the NHS.

An editorial in the Financial Times on Thursday 11 January 2018 suggested that this might not provide the required solution: “An ageing population and rising demand for health and social care meet governments with heavy debt burdens and tax-phobic voters. Result: intergenerational conflict and a loss of faith that governments will provide the public services and welfare states that they promised. Enter an old, usually bad, idea: hypothecated taxes, defined as levies whose revenues are earmarked for a specific purpose.”

We already have some hypothecated tax

National Insurance Contributions (NIC) have always been a hypothecated tax which pay principally for current State Pensions, some NHS spending and a few social security benefits.

Currently about 75% of the contributions go into a special National Insurance Fund and then come straight out to pay current (state) pensioners, while about 20% of the rest goes straight to the NHS without going in to the National Insurance Fund.

This is not well understood by either the public, commentators or many parliamentarians.

• See the ICAEW paper 'Hard choices for national insurance' for the historical background and the correct position.

Is hypothecation a good thing?

The technical answer is, almost certainly, no. If the hypothecated tax is designed to pay for the entirety of the related expenditure then what happens if the tax increases, or decreases, relative to the expenditure it is designed to cover? There will soon be too much, or too little, tax revenue coming in.

As Paul Johnson, Director of IFS, wrote in a piece published in the Times, on 22 January 2018: “In 2007-08 NIC brought in £100bn, while we spent £102bn on the NHS. Three years later, after the financial crisis, NIC were bringing in £96bn while NHS spending had risen to £121bn. In a world of hard hypothecation, NHS spending would have been cut or NIC rates raised during a recession. Either policy would have been crackers.

"Proponents of hypothecation say that you could build up a fund and borrow from it during recessions and pay back in booms. Far from introducing the clear and transparent link between revenue and spending, this would increase complexity and opacity."

A 2012 IFS report on Tax and Benefit policy noted: “In general, governments should be cautious of hypothecation – tying particular expenditures to particular receipts would probably lead to less efficient patterns of spending, since in principle there is no reason that the most effective ways of raising revenues and of spending them should be linked.

"Further, in many cases, so-called hypothecation is meaningless as it is often impossible to verify that the revenues were spent in a particular way. Public support could also erode if it was felt hypothecation was being used merely as a presentational device.”

The political element

A current argument in favour of hypothecation is that it will engender a proper debate about the level of funding that is required to allow, in the context of the NHS, provision of healthcare that is acceptable to the general public and an informed debate as to what the NHS should seek to deliver and how much money that will cost.

But, as noted above, even if the proposed tax covers the cost of the particular public expenditure at the outset, the two will inevitably get out of line with all the problems highlighted by Paul Johnson his recent Times article.

The tax policy problems surrounding hypothecation need to be set against the political benefit of a more informed debate about the sort of NHS that we would like, what that would mean in practice and how much it would cost and how we might be able to afford it.

Earlier discussions on hypothecation

There is a House of Commons Library paper entitled 'Hypothecated taxation' which was published in September 2011. It has a full section on earlier discussions about a specific tax being introduced earmarked for some, or all, of NHS spending.

It also sets out three arguments against hypothecation:

1. If taxpayers all felt that they had a say in what specific public services their tax was going to pay for, then it would make it much more difficult to balance preferences in a way which wasn’t arbitrary.
2. Income will get out of line with expenditure. (As mentioned by Paul Johnson.)
3. Some areas of expenditure would be more popular with the public. While that might favour the NHS and schools, the government has to ensure that there is adequate financing of all public services, including those that might be less popular with the public such as defence.

But there could be benefits

If taxes are hypothecated the link between tax revenue and government spending is more transparent and it also makes it easier for the public to determine how much they are going to be required to pay.

There would be a roadmap in which government will have announced that the proceeds of a particular tax have been allocated in advance to a particular area of public expenditure. This binds the hands of government, but it also indicates to the public that the same government is committed, in advance, to a particular course of action.

The public will know that a particular tax is going to go towards a particular area of public spending and if they support that particular area of government spending then they may be more sympathetic to increases in the particular tax.

Hypothecation would ring fence the particular source of public finance and prevent governments from commandeering the money to shore up deficits elsewhere in the public finances.

Further thoughts

Amore grown up debate on what the tax system should pay for and how it should do so is potentially for the benefit of us all. But no one would want hypothecation to lead to everyone deciding which bits of public expenditure they approve of, and are prepared to support, and for taxpayers to be able to restrict their contributions accordingly.

While extra taxes to pay for more NHS or more schools might prove popular there are other areas of public finance, which are also important, but which may not command the same level of public support.

Oliver Wendell Holmes, a US Supreme Court judge in the early part of the 20th century, said: “Tax is the price we pay to be members of a civilised society.” The quote is reproduced above the doorway of the Internal Revenue Service headquarters on Pennsylvania Avenue in Washington.

Cherrypicking the bits of our public finances that we want to be linked to particular taxes will not create a coherent system for our public finances. And if we, individually, decide which bits of the public finances we contribute to, then that would be a recipe for anarchy.