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Regardless of the economy’s taxable capacity, we need a strict cap on the budget deficit

Will taxes be able to cope with the growing budget deficits and the spiralling debt/income ratio? Has ‘taxable capacity’ already been reached? These and related questions were of course addressed by David B. Smith in his recent Politeia paper, Britain’s Taxable Capacity: Has it Reached the Upper Limit?

The first serious discussion of taxable capacity really appeared after World War I. During that War and before it, whenever a budget introduced new taxation many said that taxable capacity had been exceeded and dire consequences would follow. But they never did. But extensive discussion of the concept entered the literature on public finance after WWI. That was at a time when there was a ‘flu pandemic, increased public expenditure – especially on house-building – and deflationary policies were being pursued to take us back on to the gold standard. A deep recession had begun. And the debt/income ratio was 250%! That picture looks even deal bleaker than our present one.

Contemporaries worried about coping with the deficits and debt and discussed taxable capacity at some length. One of the authorities was Hugh Dalton who taught at LSE and later served as Chancellor of the Exchequer. In his book on public finance he said it was ‘a phrase with very little meaning’, ‘a dim and confused conception’. He went on to say that when unpleasant effects resulted from the operation of the tax system… ‘‘taxable capacity’ has been exceeded’. We wouldn’t want the unpleasant effects to go so far as social upheaval or revolution so we wouldn’t want to push things too far on the tax front.

The topic was sometimes discussed in terms of the ability of the taxpayer to pay. But this involved all manner of social and political considerations that in turn would be affected by changes in the economy. In other words, it proved extremely difficult to pin down because it had to deal with the nature of the relationship between the state and its citizens and that relationship is difficult to capture and likely to keep changing. It is likely to vary from one set of circumstances to another and from one country to country. And it will surely be different in a crisis and presumably rises so long as there is belief that government will behave responsibly.

There is difficulty defining the concept and in selecting quantitative data and measuring. I would go further than David did in his paper and say that in general much quantitative analysis is pointless because of the inadequacy of the data. But that is not a popular position. No one wants to dwell on the data for too long. If you do, you lose your audience. They say: ‘Yes, yes, fine but let’s get on with the interesting bit – the analysis’. And I say: ‘But the data won’t take it’. And they say: ‘Well they are the best we have, so let’s proceed’.

Well, if the quantitative data are really not up to it, then abandon the exercise. Or proceed by other means and do not provide spurious support with numbers. And that, of course, applies equally to historical investigation as it does to current analysis.

And that is before we get to forecasting, which is treacherous at the best of times. As a historian I don’t have to bother about it. I only do the past. The trouble is there is a great demand for forecasts, even an insatiable demand. As a consumer, I prefer to follow the guidance of the very distinguished and wise Lord Robbins who said: ‘Predictions in economics, you know, are not to be relied upon. If anyone tells you what will happen next year in quantitative terms, write him down as being either simple or talking without justification’.

Where does all that leave us? The problem we are facing is that the response to the Covid crisis is producing increasing budget deficits, leaving us with a rapidly growing amount of debt. And the question is how are we going to pay for it? David’s paper reminds us that increased spending ‘ultimately requires higher taxes’.

I don’t want to be too optimistic. But on this occasion we can move a little in that direction and say that given the difficulties in identifying taxable capacity, we could put it aside for the time being. No doubt there is such a point – but where? That said, I do think that there should be a strict cap on the budget deficit. We don’t know what lies ahead and it would be a good time to be extra-prudent. And even if there is an inevitable continuing rise in spending in response to the crisis, it would probably be a good time to attack the wasteful expenditure that is frequently drawn to our attention. And at the same time put on hold large infrastructure projects too (some of them of dubious merit). Then instead of trying to grapple with taxable capacity, we should address the question of how else the debt can be handled.

There were three occasions in our history when the debt/income ratio was extremely high – very much higher than it is now or is forecast to be. Each was after a major war and was around 250%. The essence of the solution was not inflation or increased taxes, but growth.

So an alternative approach would be that government rolls over the debt and borrows the interest. For debt to be sustainable, the rate of interest needs to be below the rate of growth. Now, currently rates of interest are very low and seem set to remain so for a long period ahead. We do not know what lies ahead but then we never do. But given previous success of the kind described, together with current and likely future conditions, there seem grounds for being hopeful.

The big question is: what is going to happen to economic growth? Growth needs to rise, not at present by very much – but the more, the better. What is the best way to achieve that? Here I come back to agreeing wholeheartedly with David. The best way of getting the economy to do what it is capable of is to get government out of it. And two obvious ways of doing this are, in his words, ‘De-regulation and tax simplification… should be energetically pursued’. If only.

Professor Forrest Capie

Forrest Capie is Professor Emeritus of Economic History at the Cass Business School at City University and was editor of the Economic History Review between 1993 and 1999. His recent publications include Monetary History of the UK (Routledge, 2015) and The Bank of England, 1950s to 1979 (Cambridge, 2012) and for Politeia he was co-author of Banking on Recovery: Towards an accountable, stable financial sector (2016).

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