Tax cuts then and now

William Norton authors this ten point briefing on tax policy.

(1) The share of British output absorbed by the state is increasing.  In 2004/5 current tax receipts by the Exchequer were 38.3% of Gross Domestic Product (“GDP”, the market value of goods and services produced by a country).  This is forecast to rise to 41.0% by 2008/9, and stay there for the foreseeable future.  (Budget 2006, Table C9 page 266).  By way of comparison, in 1978/79 tax receipts represented 40.2% and in 1996/97 37.0% of GDP (Budget 2006, Table C25, page 286).  It could be said, then, that in fiscal terms the Gordon Brown years at the Treasury have returned the UK to where it was before Margaret Thatcher came to power.  Attention is returning to the old battles of the 1970s to see what, if anything, they can contribute to the current debate.

(2) 1970s/1980s Conservatives argued for the reduction of the tax burden on a mixture of grounds:

• moral (people should keep the lion’s share of their own money);
• practical (there is no need for a high tax burden to fund socialism since socialism does not work); and
• commercial (private enterprise is more productive than state control, and lower taxation provides an incentive for private enterprise).

During her time as Leader of the Opposition, and later as Prime Minister, Margaret Thatcher appeared to regard free enterprise and freedom as synonymous (for example, more or less at random: Speech to the Institute of Socio-Economic Studies, 15th September 1975).  This was really a debate about “fairness” and equality versus “efficiency” and growth.

(3) The Conservative pledge of lower income tax was undoubtedly popular and contributed to electoral success.  However, specific pledges were kept to a minimum and each manifesto adopted a very broad-brush approach:

• 1979 Conservative Manifesto: “We shall cut income tax at all levels …and reduce tax bureaucracy.  It is especially important to cut the absurdly high marginal rates of tax both at the bottom and top of the income scale….Raising tax thresholds will let the low-paid out of the tax net altogether…The top rate of income tax should be cut to the European average and the higher tax bands widened.”  It was made quite clear that this would be paid for by an extension to VAT.  More space was devoted to trade union reform.
• 1983 Conservative Manifesto: “Further improvements in allowances and lower rates of income tax remain a high priority, together with measures to reduce the poverty and unemployment traps.”
• 1987 Conservative Manifesto: “In the next Parliament: We aim to reduce the burden of taxation.  In particular, we will cut income tax still further and reduce the basic rate to 25p in the £ as soon as we prudently can.  We will continue the process of tax reform”.
• There was more detail in the 1992 Manifesto, which was only to be expected since the Election immediately followed Norman Lamont’s Budget and it repeated what he had said.  For the longer term it promised: “We will make further progress towards a basic Income Tax rate of 20p.  We will reduce the share of national income taken by the public sector.  We will see the budget return towards balance as the economy recovers.” 

(4) Perhaps more important than specific promises for the future was the continuous and high-profile campaign for lower taxation in principle coupled to a record of delivery in office.  In 1979 Sir Geoffrey Howe inherited income tax rates ranging from 25% to 83%. Kenneth Clarke left office in 1997 with rates ranging from 20% to 40% across fewer, simpler bands and with allowances increased above the rate of inflation (however, VAT went from 8%/12.5% to 8%/17.5% on a wider range of items).  The 1992 Election was fought largely on the threat of Labour’s Tax Bombshell – rather unfortunately, as it turned out.  The fiasco over the departure of sterling from the ERM led directly to increased taxation and destroyed the Tories’ reputation for economic competence.  That was the sort of thing people expected Labour to do, and the fact that Gordon Brown is the first Labour Chancellor to have (so far) avoided financial meltdown has undoubtedly contributed to his over-inflated reputation.

(5) Academic discussion of tax has taken some time to catch-up.  The principal economic debates of the 1970s/80s did not, as such, concentrate on the tax burden.  In very crude terms, Keynesians advocated use of the tax system (in conjunction with public borrowing) to manage economic performance by raising or lowering aggregate expenditure.  There was not a target level for taxation in relation to GDP; it all depended on the state of the economy at any given time. Monetarists argued (again, in simplified terms) that price stability through control of the money supply was more important and the role of fiscal policy was to curb the inflationary nature of a budget deficit when expenditure could not be curtailed.  The growth in semi-independent central banks pursuing monetary targets underlines that the monetarists have, more or less, “won”.  Because of the increasingly globalised capital market, there are now strong if indirect constraints on a government’s freedom of action in setting its tax and spending policies - hence the remark of James Carville, the former Clinton adviser, “I want to come back as the bond market. You can intimidate everybody.”  The international trend in corporate taxes at least is downward.

(6) Standing slightly aside from this debate, supply-side economists argue that the tax burden and the complexities of the tax system should be reduced because they are disincentives to trade, and hence barriers to growth. This is summed up in the Laffer Curve diagram which says that above some optimum rate the incentive to avoid or evade tax will lead to lower revenue, so that receipts can be increased by cutting rates.  This was described by George Bush Senior in 1980 as “voodoo economics” but the evidence does seem to bear it out in practice.  Income tax receipts increased steadily in the US and UK during the 1980s when rates were reduced.  A recent paper for the Centre for Policy Studies by Elphicke & Norton reviewed the experience of Australia, the Czech Republic, Ireland and South Africa and concluded that a reduction in corporate tax rates leads to greater revenues through attracting higher foreign direct investment and boosting economic growth.  There is also evidence that George W Bush’s reduction in capital gains tax has similarly boosted receipts far above expectations. 

(7) There is a developing consensus as to the dynamic effect of tax cuts, whereby a reduction in tax rates stimulates economic growth and that conversely an increase in the tax/GDP ratio dampens growth (see an overview of the evidence here or the theoretical arguments here). Lower rates raise more cash.  This has fuelled calls for a Flat Tax, a single tax band on top of a generous allowance system which, it is said, offers the supply-side advantages of simplicity and the potential for dynamic growth.  This measure has certainly proved successful in Lithuania and Estonia, among others, but some commentators have doubted whether it would be feasible in the UK, one even describing it as political suicide.  The TaxPayers’ Alliance recently called on Gordon Brown to follow the lead of the US Treasury and establish a Dynamic Analysis Division to update his fiscal models to study and include these effects.

(8) There has been vigorous debate, not least on ConservativeHome, as to whether an aggressive commitment to lower taxes would repeat the electoral success of the past (as well as being right in principle).  Critics of such a policy point out that it did not prove to be a winner in 2001 or 2005, and say it would leave the Tories open to the Labour attack that tax cuts flow through directly to cuts in public services.  In part the argument has become wrapped-up in the parallel discussion about the need to demonstrate that the party has changed, with tax cuts being associated with an out-dated 1980s loadsamoney culture which is out-of-touch with the current preference for tax-funded public services.  The counter-argument from groups such as the TaxPayers’ Alliance is that it is not the policies which need to be up-dated, but the language in which they are communicated.

(9) The leadership has sought to maintain a difficult balancing act.  On the one hand, Shadow Chancellor George Osborne has established a commission to study the simplification of the tax system, including a flat tax, and has visited Ireland to see the effects of their low corporate taxes for himself, while David Cameron has attacked Gordon Brown for excessive tax levels, with a notable savaging of the Chancellor over this year’s Budget Statement. John Redwood, joint chairman of the Economic Competitiveness Policy Group, has also signalled the likelihood of his team recommending some form of tax relief.  On the other hand, conscious of the destruction of the Party’s credibility by the ERM fiasco, both David Cameron and George Osborne have stressed “simplification” of the tax system rather than any reduction in rates.  The current position is that stability and responsibility come before any commitment to cut taxes.  This has created the risk of sending out at best mixed messages.  The stability/ tax cuts choice has been queried as a false dichotomy by think tank Reform and has even been condemned by the Daily Telegraph as being economically illiterate.

(10) The preference for stability is not as false or fallacious as might be thought by ardent tax-cutters.  In the past a major source of instability arose from the practice stigmatised as “Stop-Go”: governments would spend to stimulate the economy and reduce unemployment, then seek to contract the economy to rein back inflation.  This undermined any efforts by the private sector to plan for the long term.  More seriously, there is the initial experience of the Thatcher Government, which came to power with a first-term objective of Stabilisation: regaining control of public expenditure. However, it was also saddled with a pre-election pledge to honour the Clegg Commission awards on public sector pay. The 1979 and 1980 Budgets cut taxes as promised, interest rates went to 17% to hold down inflation and the public sector borrowing requirement sky-rocketed: monetary policy was too tight while fiscal policy was too loose.  The solution was the 1981 Budget which raised taxes during a recession (and provoked the infamous letter from 364 economists) but kept the Government’s Medium Term Financial Strategy on track and averted disaster.  This example reminds us that perhaps the most important policy before either stability or tax cuts are sought is to decide how much public spending the country can afford, the items on which you want to spend it, and why.

Comments

[Mike Christie]

A splendid briefing, emphasising why we should be arguing the many benefits of lower taxation.

However I'm afraid the last couple of lines :

This example reminds us that perhaps the most important policy before either stability or tax cuts are sought is to decide how much public spending the country can afford, the items on which you want to spend it, and why.

just left me chuckling in memory of this exchange :

Sir Humphrey: "Taxation isn't about what you need."
Jim Hacker: "Oh, what is it about?"
Sir Humphrey: "Prime Minister, the Treasury doesn't work out what they need to spend and then think how to raise the money."
Jim Hacker: "What does it do?"
Sir Humphrey: "They pitch for as much as they think they can get away with and then think what to spend it on."

It is a very good point on which to finish a discussion on tax. We won't win the argument on lower tax until we win the argument that government bureaucracy has no more place in the actual provision of everyday services like healthcare and education than it does in getting the food on our table.

[Jock Coats]

Some interesting pointers to those of us, not just Tories, who are currently reviewing tax policy.

I wonder at what point the feasibility (everyone's now an expert in whether one plan or another will "add up") became more important?

We seem to tie ourselves up in knots of minutiae of tax policy to please the IFS and the like. No problems of course having to meet some standard of whether a policy is sensible, but we should do so in a broader policy context.

What we all need to persaude the electorate of is whther or not they are overall sensible ideas, not necessarily terribly detailed goals and working of how to achieve them - we are making tax policy hostage to fortune.

I will blog about the lessons from these thoughts later I suspect William, thanks!

[Wat Tyler]

Excellent summary William

Of course, the economic landscape was very different in the 70s and it was easier to sell tax cuts on the basis of the growth/efficiency argument. Today, most people reckon the economy's doing fine, so tax cuts aren't needed.

But people can certainly buy into the waste argument, and can see that all the extra public service dosh hasn't delivered.

The next step is to convince people that there is another way on public services. The Reform agenda that takes government out of the loop and eliminates all that waste, but doesn't mean the end of healthcare etc.

Tax cuts are part of giving people choice over their own health and education provision.

Yes...but you already knew that. The problem is how to convince others.

[Denis Cooper]

The complexities of the tax system don't just affect business, and it could even be argued that they bear most heavily on the individual taxpayer - who of course is also a voter. If we could each bill the Chancellor for the cost of the time we have to waste meeting the requirements of the tax system then he might think twice before making it more and more complex. Too many of us are having to spend too much time and effort dealing with the Inland Revenue, which itself is having to employ too many people for the sake of relatively small sums.

I have a long list of gripes about the inanities of the personal tax system, built up over thirty years, but the one which takes the biscuit for me is the comparatively new child tax credit. The idea was that the limited money available would not be spread thinly as a universal benefit, eg simply increasing child benefit, but would be carefully targetted on those who needed it most. Whether or not that was a good idea in principle, in practice the system is so complicated and administered with such incompetence that the object has been defeated.

It's possible to try to be too clever, and child tax credit is a prime example.

Does George Osborne have any children, by the way?

[Jock Coats]

I have blogged a little about this article. It's very thought-provoking, thanks!

[Eric B-P]

The issues for the local elections are an example of the essential difference of approach between Conservatives and everyone else. Others start by identifying requirements for expenditure, and then decide how to raise the funds to meet them - while we look first at what we have available to spend, and then we try to prioritise where it is most needed.
All of our other principles flow from our fundamental instinct that we should never contemplate further spending until we can be satisfied that we are getting full value for what is currently spent - and also that essential services should be run most efficiently in the interests of the public in priority to the convenience of the departments responsible.
The debate for the voters will always turn on the conflict between the burden of taxation versus inadequate services - and socialism has now proved conclusively that you can spend excessively without solving the problems.
However, promises of tax cuts (equalling less spending obviously) could frighten more voters away from us than we gain from their undoubted popularity amongst those who would probably vote for us anyway.
This should not be dismissed as merely a past failure of presentation that might not fail again next time (a familiar argument as regularly used by the left) but a very real danger of lost support from vast hordes of people whose livelihoods or lifestyles are significantly affected by public expenditure, both directly and indirectly.

[reverse phone lookup]

Τhhis is just the kind off thinng I’ve been hunting foг!
Suρеrb and cheers!