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Why politicians are condemned to axe not tax

Updated Wednesday, 5th May 2010

Alan Shipman, lecturer in economics at The Open University, explores why politicians, regardless who's voted in, are condemned to axe not tax

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As Greece, Spain and Portugal adjusted to last week’s credit-rating downgrades, the Institute for Fiscal Studies announced some qualified good news for UK voters worried about their own government’s borrowing. All parties that might take office after the election are committed to tightening the budget, so that public debt peaks around 2015 and then falls steadily back to safe levels.

And the bad news? Debt will peak at well over 70 per cent of national output (GDP), with the public sector borrowing more than four per cent of GDP each year until 2014/15. And to achieve the targeted deficit reduction – equivalent to 4.8 per cent of GDP (£71bn at today’s prices) by 2016/17 – all parties will have to serve up some agonisingly tough public spending reductions. Labour’s and the Liberal Democrats’ cuts would be the deepest since those imposed from 1976-80 after the International Monetary Fund intervened; the Conservatives’ would be the deepest since World War II.

The Conservatives must make heavier cuts partly because they want to reduce public borrowing sooner, but mainly because they don’t want to raise taxes. Shadow chancellor George Osborne has sided with a bevy of business leaders to reject Labour’s proposed National Insurance contribution increase, opting instead for stronger public spending restraint. In branding higher NI as a ‘tax on jobs’, Osborne reflects a widespread belief among economists that, when a budget deficit needs to be closed, it’s better to spend less than to tax more.

Reduce incentive

Lower tax is supposed to be beneficial because almost every tax distorts economic incentives in a way that reduces employment and growth. However, evidence for these negatives is mixed. In theory, taxes on income (and payroll taxes) reduce the incentive to work, because leisure isn’t similarly taxed. Higher marginal tax rates, like Labour’s new 50 per cent top rate, reduce the incentive to work harder, because more of the gain from extra pay is taxed away. In practice, few studies (including one for the IFS’s Mirrlees Review of the UK tax system) find salary-earners working less if they are taxed more. For lower wage-earners, extra tax may in some cases encourage longer or more intensive work to reach a targeted take-home income. In theory, taxes on income from savings and investment reduce the incentive to save, which means less capital for investment and a slower economic growth rate. In practice, such taxes may make people save more if they have a target amount of after-tax saving. And taxes on interest and dividends encourage the re-investment of this income, mobilising more capital for production growth.

Lower public spending is supposed to be beneficial not only because it enables lower tax, but also because private companies and households make better decisions than governments. The efficiency gain from trusting resources to savvy spenders rather than civil servants is at the root of Labour’s preference for public-private partnerships, and the Conservatives’ promise of a quick £12bn of budget savings from eliminating waste without harming service delivery.

Redistributive element

But Wagner’s Law – that as national income grows, governments spend ever more of it – resisted the privatisation drives of Thatcher and Reagan, and will be just as resilient to their successors. By 2017/18, on IFS calculations, a Conservative government will be spending 39.7 per cent of the national income, despite four times as much spending-reduction as tax-raising. Labour, with only twice as much in spending cuts as tax rises, will be spending 40.4 per cent. The Liberal Democrats, with a spending-cut to tax-rise ratio of 2.5, would reach 40.1 per cent. None is very different from the 39.9 per cent share when the Conservatives left office in 1997.

The redistributive element of public spending – tax-financed income transfers – is set to grow as demographic ageing leaves more dependent on state pensions and other benefits, and structural change raises the number needing job-seeker’s allowance. The exhaustive element – spending on state education, healthcare, housing, policing, transport and environmental remedies – is set to grow because these are services of which people want more as their incomes rise. While there’s been privatisation at the edges (especially of capital projects), these services are inescapably public. One person’s purchase yields benefits for others, so they’ll be under-supplied if not funded collectively; and as people’s needs and deserts rarely relate to their ability to contribute, they’d also be inefficiently and unfairly allocated unless publicly financed.   

So the cross-party consensus for lower public spending goes against the tide of the public’s spending preferences – and aversion to higher tax may reflect misguided fears of its incentive effects. But while Scandinavia gives examples of successful higher-tax, higher-spending societies, no-one who proposes bigger government in Britain could hope to form one. Until better public provision of education, healthcare and housing has improved their earning-power, few people will vote for the higher taxes needed to fund them. That’s the Catch 22 that haunts Election 2010.

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