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Utopian Future or Fiscal Reality?

The conceptual sophistication with which the public spending and tax options are being discussed in the pre-election political debate, strikes many economists and tax specialists as pitched at a sub-primary school level. A number of basic but inconvenient truths have been ignored by almost all the political parties currently lobbying voters. Here I set out ten.

  • First, ‘the government’ has zero resources of its own. Every single public spending pledge implies higher taxes, either immediately or in the future when the increased debt caused by public borrowing has to be serviced. If people anticipate higher taxes in the future, as a result of running a budget deficit in the present, the alleged stimulatory effects of the deficit are likely to be minimal.

The increased business risks that result from budget deficits and other politically-induced uncertainties about the future tax burden reduce entrepreneurial animal spirits and lead to less private investment. Politically induced uncertainty is also associated with a reduced growth of output per head, because it leads to under investment in physical and human capital and more limited scope to implement technological advances.

  • Second, the tax base of the economy is not gross domestic product (GDP), as is generally believed (including by officialdom), but the residual private sector or non-socialised component of the economy left after government spending has been subtracted (see chart). This is because no institution or individual can generate real resources by taxing itself. In logic, such resources have to come from outside the boundaries of the institution concerned. A major reason for the chronic budget imbalances in recent years has been the massive increase in the share of state spending in GDP between 2000 and 2010. This has led to reduced growth in private sector activity and means that there are insufficient taxable resources within the truncated private sector to support the government spending burden.
david-smith-chart1
Chart: Ratio of UK Non-Socialised Sector to GDP Measured at Factor Cost 1870-2014
  • Third, the UK’s massive balance of payments deficit is another indicator that the residual non-socialised part of the economy is too small to support the demands being placed upon it. One result has been that the excess of government-funded and privately-generated demand relative to aggregate supply has sucked in imports – but also labour – from overseas.
  • Fourth, while some individual spending programmes have been reined back hard, particularly defence, overall general government consumption has not been cut in either cash or volume terms since 2010. Using national accounts definitions, real general government current expenditure was 3.9 per cent higher in 2014 Q4 than in 2010 Q2, although general government capital formation fell by 10.8 per cent over the same period. The national accounts definition of government current expenditure makes some (arguably, distinctly ropey) allowance for productivity. That the cash value of current government spending has risen by 3.6 per cent since mid-2010 suggests that the coalition has squeezed out better value for money. However, it is debatable as to how far this reflects a squeeze on public sector wages and how far it reflects enhanced efficiency.
  • Fifth, there are well-established ‘cannons of good taxation’, which go back to Adam Smith in the 18th century, that are being simply ignored in the political debate. Smith emphasised four desirable properties for the tax system. Equality, by which Adam Smith meant that tax payments ought to be proportional to income – i.e., a flat rate income tax in modern parlance. Certainty, in other words, tax payments should be clear and certain. Convenience of payment, taxes should be collected at a time and in a manner convenient to taxpayers. Economy of collection, taxes should not be expensive to collect and should not discourage business. The current highly complex UK tax system breaks almost all these rules, particularly when one looks at the properties of the system as a whole – which one should – rather than at individual taxes considered in isolation.
  • Sixth, the main reason that the UK tax system is of rococo complexity – and needlessly damaging to the wider economy – is that politicians have never tried to create an optimal tax system designed to maximise public welfare and economic activity. Instead, they have sought to minimise the political odium generated by raising taxation and to use the tax system and government spending to favour specific interest groups, especially those funding the party concerned. A particular worry is the breakdown of the link between taxation and representation now that roughly half of the electorate takes more out of the state than it pays in. This allows politicians to form majoritarian coalitions of voters with the intention of expropriating the resources of a minority of the population. This socially undesirable behaviour is explained by ‘public choice theory’. However, there is no reason to believe that the outcome is equitable in terms of natural justice.
  • Seventh, business corporations are a legal fiction and have no real resources of their own. This means that business taxes are ultimately either paid out of reduced wages and more onerous working conditions for their employees or reduced pay outs to their shareholders, which are predominantly pension funds these days. This is a specific example of the general principal that the effective incidence of taxation – i.e., the person whose living standard is hit at the end of the day – can be very different from the formal incidence as set out in tax legislation. So-called ‘stealth taxation’ is often designed to take advantage of the gap between the two. Politicians seldom acknowledge that a tax formally levied on ‘greedy capitalists’ effectively becomes an impost on their workers and ordinary consumers, for example.
  • Eighth, the recent political debate has also been besmirched by the misrepresentation of history, for example the nonsensical claim that Mr Osborne was planning to cut the government spending ratio back to the level of the 1930s. Another such misrepresentation has been the use of the term ‘austerity’ to describe the coalition’s rather half-hearted attempt at fiscal parsimony. Austerity was originally the term applied to the early post-World War II Labour administration of Clement Atlee, in which access to even the most basic goods and services was controlled by rationing, not the market place, and the government was running budget surpluses in order to choke off alleged excess home demand. Austerity in this sense does not apply to a situation where the state is still running large budget deficits. Furthermore, a reduced growth in governmental expenditure is not ‘austere’ in demand management terms if it permits a smaller increase in the tax burden than would have been the case otherwise. Rather than ‘austerity’ this is simply a situation where one part of the economy is losing resources to give another, arguably, more productive part more, leaving overall demand unaltered.
  • Ninth, the consequences of reduced governmental spending and higher taxes may be similar in a Keynesian demand management framework. However, they are most certainly not when it comes to their supply side consequences. Different types of spending and different types of taxation can have noticeably different consequences for the wider economy and this should be recognised when designing fiscal policy. However, demand shocks usually prove transitory given enough time, whereas tax-induced shocks to aggregate supply tend to be permanent in nature. This implies that trying to tax one’s way out of a structural budget deficit is likely to be more damaging to output and employment in the long run than the equivalent cutback in government expenditure. Furthermore, the so-called ‘Laffer curve’ – the idea that beyond a certain point increases in the rate of tax lead to lower not higher tax receipts overall – is both an economic truism and can be found in text books on public finance back to the 19thcentury. The relevant questions are: 1) is there an aggregate ‘Laffer curve’, or are there just numerous micro-Laffer curves applying to individual taxes, and 2) if there is an aggregate curve, what is the revenue-maximising point and does this coincide with the welfare-maximising point where spending is concerned? None of this seems to worry Mr Miliband, whose approach to raising marginal tax rates seems as realistic as believing that the tooth fairy will come along and pay off the national debt. Unfortunately, Mr Osborne’s record as Chancellor, particularly the damaging tax hikes he introduced in his 2010 budget and his ill-considered and duplicitous raid on North Sea oil producers, suggest that the Conservatives also have had a tin ear where the adverse supply-side effects of higher taxes are concerned.
  • Finally and more generally, there appear to have been three main causes of the pressure on voters’ living standards since 2010 that has so damaged the Conservatives re-election prospects. The first is that any economy that suffers from a high and capricious tax burden will only grow slowly because of the limited incentives for private agents to invest or undertake risky new projects. These disincentives to wealth creation are crucial politically because living standards cannot grow faster than national output for long, and real GDP per head in 2014 Q4 was still 1.2 per cent below its pre-downturn peak in 2008 Q1. The second cause of the so-called ‘cost of living crisis’ was Mr Osborne’s decision in 2010 to raise the VAT rate from the 15 per cent he inherited to the present 20 per cent. Returning the VAT to its pre-Crisis 17.5 per cent may have been defensible in 2010. Nevertheless, the extra increase of 2.5 percentage points hit living standards directly, exacerbated and lengthened the recession, and gave a perverse signal to the private sector that, if in doubt, the government would always try to tax its way out. The final reason for the adverse pressure on the electorate’s living standards was the attempt to re-balance the economy through the previous cheap pound policy, which was probably as much a mistake on the Bank of England’s part as the Chancellor’s. Such a policy will work if the price elasticity of demand for UK exports and imports is high and the feed through from the external value of sterling to domestic prices is weak. However, the evidence – even before this policy was implemented – suggested that the facts were to the contrary.

*David B Smith maintains his own macroeconomic forecasting model at Beacon Economic Forecasting, is a member of the IEAs Shadow Monetary Policy Committee and has been Visiting Professor, Derby Business School. He is a co-author of Politeia’s publications 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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