Taxing question

James Foreman-Peck reflects on the tax row sparked by the Budget last week:

One advantage for the Welsh Assembly Government of their current income source, the block grant, is that it does not fall off in a recession. Instead the central UK government absorbs most of the drop in tax receipts by borrowing. Being able to borrow also allows the UK government, unlike the Assembly Government, to offset some of the impact of the present financial crisis.

During the last world crisis on a comparable scale, policy was to balance the budget at all costs, and the attempt to do so brought down the Labour Government elected in 1929. The conventional wisdom for half a century has been that they should have borrowed rather than balancing the budget. Yet, their successors are now universally berated by the media for doing so. The chattering classes smell electoral blood and the financial industries can divert attention from the sins of the City in causing the crisis.

Certainly the UK Government’s need to borrow nearly 13 percent of GDP this year and the prospect of national debt rising to 80 percent of GDP before adjustment to the world recession is over, are horrendous. But do both these factors really spell disaster? OECD figures suggest that this year’s borrowing would only take the UK up to the debt–GDP ratios of France and the US. After the First World War, Britain managed a debt-GDP ratio greater than 200 percent without default – admittedly with great discomfort. And civilisation has not yet collapsed in Italy with a ratio of well over 100 percent.

Admittedly Gordon Brown’s abandonment of prudence when Chancellor has made matters worse. The European Council of Ministers should not have been obliged to rap Britain’s knuckles over an excessive government budget deficit in 2004-05 when times were relatively prosperous. But this is water under the bridge. The big question now is, how should the public finances be brought back into balance as the economy recovers? To answer this we need to know about the timing and strength of recovery, both of which are still very uncertain. Alistair Darling was unlucky to have announced only two days after his budget GDP figures considerably worse than he projected. This means lower tax receipts than he expected and more borrowing necessary. But the GDP numbers are not his fault, despite the tendency to blame government for everything that goes wrong.

We know that the public spending bonanza under Gordon Brown mark II’s Chancellorship must be over for a decade. Turning to ‘efficiency savings’ and ‘eliminating waste’, opinions differ in practice. There will always be something, if not many things, that some taxpayers think an inappropriate use for their taxes – if they find out. Until recently presumably the Health Commission Wales (HCW) suspected that giving transgender patients in Wales access to funding for gender reassignment therapy would not be popular in Wales – otherwise why pursue a different policy from the rest of the UK?

If defining ‘waste’ and ‘efficiency’ are difficult, how about deciding on tax increases to reduce borrowing? The howls that greeted the prospect of a 50 percent tax rate for those earning over £150,000 a year suggested that the hike presages the end of an era, more than the world crisis itself. Apparently the rich will now leave Britain so we will have no jobs. And, supposedly, they will spend their wealth employing tax advisers to ensure they do not pay the tax, so revenue will actually fall.

A traditional economic argument for not taxing the poor as heavily as the rich was that the more money anybody received, the less wellbeing they would obtain from each pound. So taking £1 in taxes from a rich person caused them less grief than taking £1 from a poor person. Equalising the pain of taxation then means that the rich pay proportionately more. In a world focused on incentives, all this has gone out of the window. If the poor cannot avoid taxes as well as the rich then by this logic presumably the poor should bear most of the burden.

Is this what the present state of economic research tells us about taxation? According to a recent Institute of Fiscal Studies survey, taxes do not affect whether highly educated and wealthy men work or not, or how long they work each week, or even over a year. Not surprisingly, taxes do affect their total earnings as well as their taxable income. So these people react by shifting income and consumption to non-taxable forms, rather than by reducing their work effort. Taxable income of the self-employed is apparently very sensitive to the tax rate and indeed increases in tax rates may lead to reductions in the revenue raised from this group. (Is it an uncharitable thought to wonder if some of this is simply a matter of reduced compliance?)

For ‘low skill’ men the benefit system is likely to affect the chances that they will work at all. Here the Tories’ interest in reducing National Insurance may be relevant to increasing work and ultimately tax receipts. For ‘high skill’ men higher rates of taxes are likely to discourage effort quite substantially. (It is not entirely clear to me how these ‘high skill’ men differ from the highly educated and wealthy mentioned above.) But generally hours of work do not respond much to taxes for men. They are a little more responsive for married women and lone mothers. The critical point is that working at all in the market is quite sensitive to taxation and benefits for women and for ‘low skill’ men.

The conclusion is that we need to worry about the behavioural impact of taxes on everybody if we are concerned about raising extra tax revenue. In a democracy with an election coming up the votes of those directly affected or otherwise by tax increases to cover the budget deficit are likely to be even more fundamental to policy, however.

James Foreman-Peck is Director of the Welsh Institute for Research in Economics and Development.

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