Politicians may be squeamish about taxing the population but, argues Richard Whiting, an earnings-related graduate levy is the logical solution to HE's funding crisis.

At the heart of the funding crisis gripping universities lie two important questions: what relationship should universities have with the state and how should students pay for their education?

University funding is a difficult question for the Labour Party because over its history it has seen striking changes in attitudes to the role of the state and the legitimacy of taxation. In the past, Labour saw no difficulty in relying on the state to achieve high levels of public provision, or with taxation being the proper method for financing services.

Taxes were not paid for specific services, but were a general contribution to the various activities the state supported. We might not have benefited directly, but as good citizens we funded them because of our commitment to the wider society. There was nothing wrong with a dustman contributing towards a banker's education, as long as the overall system of taxes and benefits was fair.

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But Labour cannot rely on this traditional view. In the 1970s the legitimacy of the state as a provider of public services and a redistributor of tax revenues was undermined. The government was no longer trusted to use resources effectively, so people's willingness to pay taxes declined. This factor was at the heart of the Conservative Party's success under Margaret Thatcher.

Labour's election victory in 1997 depended on Tony Blair and Gordon Brown coming to terms with these developments by ditching their party's "tax and spend" image, and it has subsequently maintained the major reductions in rates of income tax inherited from previous governments. But the position is complex because voters remained attached to the welfare state and concerned about the quality of public services. Universities, in particular, have suffered, with the amount paid per student declining by 38 per cent from 1988 to 2000, at the same time as student numbers have increased. There is pressure for the government to provide better services, but unwillingness to hand over the taxes to pay for them.

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The tax system as it stands does not offer an easy way out. Although low rates of income tax show the political constraints under which Labour has to operate, it has not been easy to find less "visible" sources of revenue. National insurance contributions, a key element of the 2002 budget, are widely recognised as another form of income tax. The traditional view of taxes on expenditure being more easily tolerated than those directly levied on income has not proven successful, as shown by the hostility to fuel tax in 2000. As the Fabian Society's study Paying for Progress (2000) has demonstrated, at the heart of the problem is the fact that taxpayers do not see their contributions linked in a convincing way to services they think desirable. Brown's 2002 budget showed some scope for raising taxes, but these have had to be linked to the National Health Service, a concept with almost universal appeal.

Universities therefore have to take their place within a public-finance setting of some complexity and, straitened though their circumstances are, other projects will have more weight.

One way forward is to use the argument that university education confers a significant financial benefit. Should this private gain be the basis for students paying a bigger share than they already do through subsidised fees as a way of remedying the financial crisis in universities? This avenue is fraught with problems, not least for a Labour government. Labour not only believes in the value of universities for the economy, but it also retains a good deal of its traditional attachment to equality and redistribution, as Brown's budgets have demonstrated. Higher tuition fees, even if they are paid after graduation, could deter those from modest backgrounds. Fees may be a funding solution but they threaten the goal of equal access that Labour also wants universities to uphold.

Can a graduate tax get Labour out of this trap? It would certainly make a substantial contribution to the cost of university education. A tax paid by graduates of 1.6p in the pound on basic and higher rates would raise, according to some estimates, the cost of tuition fees and maintenance as currently paid by students. Existing fees are heavily subsidised; a tax at 2.5p would cover the entire cost of tuition at economic levels. A contribution of this size would give scope for the state to reintroduce, out of its own funds, a basic maintenance grant, that would tackle the problem of student debt, most of which arises from living costs.

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It is the characteristics of a graduate tax that give it the advantage over a fees-and-loans system. The crucial point is that graduate taxpayers would be contributing over their lifetime, and would not be simply paying off their own fees. They would be making a contribution to university education in general, as is proper for taxpayers to do. This is a major difference from the fees-and-loans method. The tax would be markedly progressive, since graduates tend to be in the higher earning levels. The problem of a high earner who graduated from a "cheap" university subsidising a ne'er-do-well from Cambridge is taken care of by the legitimacy of competing for a limited number of university places. As long as that competition is perceived to be fair, no difficulty arises.

It is an important point that arguments in favour of fees assume universities will set them at different levels. The great advantage of a graduate tax is that such differentiation would not be an element in student choice, as it must be under a fee system. The government may give more money to some universities than to others, but the student does not participate in this exercise as a taxpayer. So there need be no anxiety about students holding back from trying for the "best" (more expensive) university because of the disincentive of future loan costs. In fact, there is a positive incentive to do the best you can, to get the most from the tax you will pay. Because the tax would come in only at a certain level of income, there is no need to provide cumbersome scholarship schemes to minimise loan costs for the poorer students, as proponents of even postgraduation schemes seem to require. So the state would have no need to favour its own employees by agreeing to write off loans - a scheme that runs the risk of distorting career choice in favour of the public sector by encouraging school leavers, faced with different "prices" for a university education, to opt for a career based on the ease with which the loan burden might be discharged.

Because of politicians' squeamishness about taxing their population, and the belief that services are less controversially funded the more their users are seen to pay for them, the benefits of taxes have been overlooked. Ideal solutions in public policy are hard to find, and the graduate tax has two main flaws. It does not provide money immediately, but then neither does the fees solution because payment at the point of entry has been ruled out.

Some experts have recommended extending the tax to those who graduated before the introduction of tuition fees. It would be hard to get complete coverage, but in a rough-and-ready way this would provide immediate funds and be a nice blow for inter-generational fairness. Some universities will be unhappy because a graduate tax does not deliver funds directly to them. Governments will still have a say in who gets what. But this is an inevitable cost of being part of the welfare state, from which universities have benefited for so long.

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Labour has clearly accepted that it cannot return to general taxation as the sole source of funding for universities' restoration and expansion. That would be to turn against the heart of the new Labour project.

Differential fees, however, threaten to distort student choice and frustrate Labour's social goals. The graduate tax removes a particular university's costs from the calculation about where to apply, and its progressivity ensures that those most able to bear the burden do so. For once, the middle way is an attractive option.

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Richard Whiting is reader in modern history at the University of Leeds. His book The Labour Party and Taxation (2001) is published by Cambridge University Press.