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David Cameron’s Tax Pledge

Measuring the results, not the motives

One of the key insights in Adam Smith’s 1776 Wealth of Nations was the idea that the actions of people undertaken for self-centred reasons could still produce a socially optimal outcome: i.e., it was the consequence that mattered, not the motivation. Mr Cameron’s 1st October pledge at the Conservative Party conference to raise the personal income tax allowance to £12,500 and to raise the threshold for the 40p rate to £50,000 – but, significantly, not until 2020 – may have come from deep personal conviction, or simply been a ploy to bolster his personal position as party leader and buy votes ahead of the May 2015 general election. However, Mr Cameron’s motives are not relevant to the economics of the proposed tax cuts, no more than is Mr Miliband’s jibe that the offer was a “vague, pie-in-the-sky commitment”. Certainly, the Coalition government‘s decision to tackle the unprecedented fiscal crisis it inherited from Labour by increasing tax probably set back the current recovery by a couple of years – while not leading to real aggregate spending cuts, at least, where vote-buying public consumption was concerned. In fact the latest UK national accounts show that the volume of general government current expenditure was 4% higher in 2014 Q2 than when the Coalition gained office in 2010 Q2, although the much smaller volume of general government capital formation (one of the measures for wealth acquisition) has fallen by 24.8% over the same period.

Tax Cuts and their Context: What does the evidence tell us?

First the proposed tax reductions have been criticised by the opposition and public spending lobbies as being irresponsible and unaffordable. However, that ignores the facts that they probably do no more than offset the fiscal drag that pulls more and more people into any given tax band as the economy grows and the price level rises: their effect tends to be a return to the status quo. The Coalition has presided over a substantial hike in the tax burden already, compared with the situation when they took office, much of it covertly through fiscal drag. Despite the proposed tax reductions the average citizen will almost certainly be left facing a more substantial total tax burden in 2020 than they faced under Gordon Brown in 2010.

Second, the concentration on the Budget deficit or surplus as the main policy tool in crude Keynesian economics has obscured the fact that spending and taxes have quite different effects on the economy, especially the private sector. Public spending crowds out private economic activity. Tax cuts boost it. How does this work? Government spending is included in the definition of Gross Domestic Product (GDP) so in the first instance the effect of a £1bn hike in government spending is to add £1bn to GDP. However, the evidence suggests that over time, private activity is crowded out. For instance several decades of economic model simulations have indicated that, within a year or two, the hike in GDP is quite close to zero, implying that a significant chunk of private activity has been crowded out. By contrast, unlike spending, tax cuts have two effects not just one. First, they boost private demand and it is always possible to cut by more than the intended stimulus if it is feared that some of the cut will be saved rather than spent. Second, reductions in marginal rates of tax are likely to lead to a strong supply side response, boost national output, and reduce the so-called ‘dead-weight’ costs of taxation.

Third, the model based evidence suggests that, after appropriate allowance for subsequent, including second-round effects, the cost (expost cost) to the budget balance of a tax cut may be no more than one third or one half of the static costs beforehand (ex ante costs) Unfortunately, the organisations – often prestigious but misguided – whose expertise lies in the detailed microeconomics of the tax structure tend to admit only the last point. In fact the same point applies in reverse to attempts to reduce a structural deficit through tax increases. If one wants to cut the ex post Budget deficit by, say, £10bn, then the ex ante tax burden needs to rise by, perhaps, £20bn or £30bn. This is not just because of the possibility of ‘Laffer curve’ effects on the revenue side. It is also because of the harmful indirect effects of tax hikes on the government spending side. One example is that welfare benefits will be increased by the less buoyant private sector supply side induced by a tax increase.

Fourth, the UK Office for National Statistics (ONS) introduced a ‘once-in-a-generation’ set of conceptual changes to the UK national accounts on 30thSeptember 2014 and the public sector finances data (23rdSeptember) in order to comply with the European Union’s ESA-2010 conventions. These changes will have dramatic consequences on how and whether public spending can be measured accurately or on a consistent basis. They also appear to allow public spending ratios to appear in more favourable light than had the previous measures been used. The important implications of these data changes for the fiscal debate have not yet been properly recognised, however. The alterations to the official figures included: a £100.5bn (6.2%) upwards revision to money GDP last year; an upwards revision of £38.7bn to Public Sector Net Borrowing (PSNB) in 2012-13 followed by one of £5.6bn in 2013-14 and £1.4bn in the first quarter of 2014-15, and a whole host of other major changes to the historic data. The effect of the upwards rewriting of GDP in 2013-14 has been to reduce the general government spending ratio on the old spending definition from 49.1% of basic price GDP to 47.6%, representing a purely definitional change of 1.5 percentage points. However, the PSNB ratio has also been boosted by some 0.4 percentage points of GDP as a result of changes to both the borrowing and national output figures.

Fifth, one conclusion from the new ONS data is that the government finances are in a worse structural situation than was previously believed, something none of the political parties have yet taken on board. Not only is the deficit larger than was previously shown, but the revised growth figures suggest that the economic recession was shallower, and the recovery more marked. This means that the poor public finances cannot be ascribed to a large degree of economic slack as much as before.

Sixth, a conundrum arising from the new enlarged definition of GDP is what it means for spending commitments that are expressed as a fixed proportion of national output, such as defence (2% of GDP) and overseas aid (0.7%). The UK’s tribute to the EU will also be based on the ESA-2010 measure of money GDP. In theory, the £100.5bn added to the ESA-2010 measure of GDP should involve an extra £2bn on the defence budget and £0.7bn on overseas aid. It is not clear that officialdom has thought about this.

Finally, one technical result of these ONS data changes is that they have blown the existing macroeconomic forecasting models out of the water as far as their ability to track and project the economy is concerned. This must be a massive concern for the Office for Budget Responsibility (OBR) who will be responsible for having a complete set of forecasts on the new definitions available for inclusion alongside the Chancellor’s Autumn Statement in early December. It may not be until after that that the full implications of these dramatic data changes for the fiscal debate become fully apparent.

Conclusion: From tax hike to tax cuts: good politics today, better economics tomorrow?

Mr Cameron’s pledge to raise the tax thresholds for income tax was possibly shrewd politics. However, it leaves the UK facing a historically onerous and indefensibly complex tax system and also ignores the covert parallel income tax represented by National Insurance. Even so, the consequences of taxes are not symmetrical with public spending as naïve Keynesianism would suggest. The second-round supply-side effects are sufficiently powerful on both the revenue and expenditure side of the public accounts that cutting taxes is frequently a rational gamble where the public finances are concerned. Tax hikes do so much collateral damage that they are almost certainly best avoided as a fiscal stabilisation tool. Unfortunately, the Coalition has been a tax-hiking administration until now. Mr Cameron’s pledge thus looks rather too much like a death-bed conversion – on the assumption, that it is sincere and will be acted upon in the event.

*David B Smith is Visiting Professor, Derby Business School, a member of the IEAs Shadow Monetary Policy Committee. He is a co-author of Politeia’s The Financial Sector and the UK Economy: The Danger of Over-Regulation (2013) and the author of Crisis Management? – How British banks should face the future.

David B. Smith

David B. Smith is a City economist who worked as a macroeconomic modeller and economic forecaster, predominantly in banks (including the Bank of England) and security houses (1968-2006). He maintains his own macroeconomic forecasting model at Beacon Economic Forecasting. His Politeia publications include Britain's Taxable Capacity: Has it Reached the Upper Limit? (2020), The Brexit Settlement and UK Taxes (2018) and Banking on Recovery: Towards an accountable, stable financial sector (as co-author, 2016).

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