Hypothecated tax

The hypothecation of a tax (also known as the ring fencing or ear marking of a tax) is the dedication of the revenue from a specific tax for a particular expenditure purpose. This approach serve as the opposite to a classical approach when all of the government spending are financed from a consolidated fund.

History

The history of hypothecated taxes goes way back. As one of the first examples of earmarking can be considered a ‘Ship Money’ or in other words the tax paid by English seaports used to finance the Royal Navy.
Later, in 20th century, the hypothecated tax became to be discussed among the politicians in the United Kingdom. For example, the Vehicle Excise Duty from 1920 when earned revenues were used for the construction and maintenance of the roads, , assigning 1p on the income tax directly to education in 1992 or giving £300 million per a year from the revenues from tobacco industry to help the fight against smoking-related diseases since 1999. Nowadays, earmarking of the taxes is mainly connected to the health care system, education or the upkeep of the roads.

Types of hypothecated tax

The hypothecated tax can be divided into three groups based on the main characteristics. The emphasis can be put on the final use of the revenues, on the vastness of the area financed from the money earned or on the type of the tax. Each group then has two subsections.
In the first case, we distinguish between strong and weak hypothecation. Strong hypothecation means that the revenues from tax go only to financing the particular service and the service is financed only through the revenues from this tax. Strong earmarking is thought to be appropriate for pure public goods where voters must reveal their preferences about the consumption. If at least one of the two conditions is not met, we say that the hypothecation is weak. This distinction is the most heard about as many of the argument for and against hypothecated tax are based on it.
Secondly, we differentiate between wide and narrow earmarking. When the tax revenues finance the entire public service such as the health care, we talk about wide hypothecation. Narrow hypothecation means that only a specific area such as nursery education is funded.
The third level of splitting is based on the type and the reason of imposing of the tax that is hypothecated.
The most supported type is a combination of strong and narrow earmarking. In this case, the hypothecation can serve as a beneficial link between demand and supply. An example can be financing the roads in the U.S. by the gasoline tax.

Benefits

There are three main ideas of which benefits the earmarking can bring – believing that people will be willing to pay more for better services, demonstrating the real cost of services to people and supporting the democracy. These can be broken down into 4 main earmarking-supporting points.

• Transparency – Hypothecated taxation makes the link between revenues from taxes and government spending more visible and consumers can better decide how much they are willing to pay.
• Accountability and trust – Hypothecated taxes may help when the government is not trusted. With the earmarking, it will have to follow a plan made in advance and will have no flexibility.
• Public support – The knowledge that the money paid on taxes will go directly to some needed service (Health care) can help to reduce the dissatisfaction of the population with increase in taxes.
• Protecting resources – Earmarking can protect resources for financing the services such as health care from being spent on politics or other fields.

Criticism

The arguments against earmarking come mostly from the traditional way of viewing of the taxes where they were confined to compulsory, unrequited payments to general government as defined by the OECD in 1988. Firstly, public spending should be determined by policies and not by the amount of the revenue raised. With earmarking, inappropriate funding levels may occur as the strong hypothecated tax implies the dependence of spending on the tax revenues and thus on the macroeconomic performance of the country. Secondly, the flexibility of fiscal policy and thus the ability to influence the economic situation is reduced.
In 2012, Mercatus Center pointed out the negative effects that dedicating tax revenues to specific expenditures can have on the policymakers. In their report they stated that earmarking can be used to mask the increases in total government spendings.

Examples

The problem of ambiguousness of earmarking occurs in many countries all over the world. As mentioned before, revenues of hypothecated taxes are often used to finance health care or education because in these sectors the aggregate preference can be made easily.
One of the most known cases of hypothecation in Europe is the National Insurance contribution in the United Kingdom. Money that are earned goes to the National Insurance Fund from which the benefits are paid. This is also an example of the combination of wide and weak earmarking.
The health care system is also often supported of the taxes on tobacco as smoking is considered as a serious thread. For example, in Egypt, the revenue earned from these taxes is used to help to cover the health insurance and provide prevention and rehabilitation for students. Besides United Kingdom and Egypt, hypothecation helps to finance health care in many countries including Finland, the Republic of Korea, Portugal, Thailand or Belgium. (Hypothecation of tax revenue for health Ole Doetinchem, World Health Report (2010) Background Paper, 51)

As an example from different sector can serve television license. Users of television sets are obliged to pay an annual fee and the revenues are then used to fund public broadcasting. For example, in the UK, the money raised goes to the BBC but this type hypothecation is applied in many European countries.

See also

• Earmark (politics)
• Motivation, Agency, and Public Policy
• Benefit principle
• Bundling (public choice)
• Consumer sovereignty
• Tax choice
• The Other Invisible Hand
• User charge

Further reading

• Buchanan, James M. – The Economics of Earmarked Taxes 1963
• Le Grand, Julian - Motivation, Agency, and Public Policy: Of Knights and Knaves, Pawns and Queens 2003