Nick King is Head of Business Policy at the Centre for Policy Studies. He is a former Chief of Staff to Sajid Javid.
As we approach the first Budget of Boris Johnson’s time as Prime Minister, it is being widely reported that he and his new Chancellor are considering changing the current fiscal rules so they can loosen the Government pursestrings.
The argument goes that in order to spend more on day-to-day spending the Government needs to either put up taxes or borrow more. A Government currently riding a wave of popularity is naturally disinclined to do the former. But the latter is difficult within the set of rules created last year – the manifesto was explicit that the Conservatives would ‘not borrow to fund day-to-day spending’.
There are plenty of good reasons not to amend the rules, not least the injustice of passing a higher debt burden on to younger generations. But it is also worth questioning the premise that the only two options available, if the Government wants to spend more on frontline public services, are to increase taxes or borrow more.
A paper published last week by the Centre for Policy Studies, Tax Cuts Don’t Have to be Taxing, shows that cutting taxes doesn’t always have to cost as much as the Treasury might think – and can actually lead to extra revenue being raised.
The phenomenon was most famously – and adeptly – depicted by Art Laffer, a young economist who drew a curve on a napkin to illustrate the revenue-raising potential of different tax rates between 0 and 100 per cent.
Clearly, at either end of the scale no revenue is raised, either because there is no taxation, or because there is no incentive to work. Somewhere in the middle is a revenue-maximising rate – and if rates are too far the other side of that peak point, revenues fall because of the distortions in behaviour the tax rate leads to.
The Laffer Curve, as it has come to be known, shows how cuts in duties can sometimes lead to increased revenues being collected. And this is precisely what has happened in the case of spirits duty, which is looked at in some depth in our paper.
During the final years of Labour Government and the early years of the Coalition, huge annual duty rises became the norm. In the five years to 2013, spirits duty rose by some £6.87 per litre of pure alcohol. Across 2012 and 2013, for example, spirits duty was increased by a total of £2.70 per litre of pure alcohol. But the result was less than £100 million in extra revenue across the following two years.
By contrast, the five years to 2018 saw spirits duty repeatedly frozen – and even cut on one occasion. Overall, spirits duty only rose by 52p per litre of pure alcohol. Yet, in marked contrast to the previous years, this led to bumper returns for the Treasury. Revenues grew by almost a quarter, netting the Government an extra £735 million.
Although full year results for 2019 are not yet available, the 2016 freeze led to the biggest ever increase in Treasury revenues the year after, with a £270 million rise in total revenue raised. And the early signs for 2019 are encouraging: provisional figures for spirits duty receipts show it is the only alcohol category have increased its returns to the Government – providing more than £3 billion to Treasury between February and November.
This enlightened tax policy hasn’t just meant more money for public services, however. It has also had knock-on benefits in terms of export growth, industry investment, and customer satisfaction. A stable duty environment has given spirits producers the incentive and the confidence to invest, with more than half a billion pounds deployed over the last five years, and exports increasing by more than £2 billion since 2015.
Indeed, the huge success of the UK whisky and gin industries mean that spirits are one of the few categories of goods in which the UK can boast a trade surplus, with significant exports to the world’s richest countries, including the USA, China, and Japan.
It’s not just spirits duty. As the CPS has also shown, you could make a similar argument for a very significant cut to stamp duty, whose knock-on effects would compensate the Treasury for much (or even, depending on the modelling you use, almost all) of its cost, while having a transformative effect on Britain’s frozen housing market.
In an age of tight spending constraints, it makes sense for Government to focus on those tax cuts where it gets most bang for its buck – where cutting them will, as per Arthur Laffer, generate enough revenue, both directly and indirectly, to compensate for much of the headline cost, or even cover it completely.
But the underlying problem we identify in our paper is that the Treasury – and, in particular, the Office for Budget Responsibility – don’t always recognise the potential benefits of tax cuts, because they don’t properly factor in behavioural responses and the ‘dynamic’ effects of those tax cuts. If we want to maximise Britain’s economic potential post Brexit, that needs to change. The lesson of our paper is that tax cuts don’t have to be taxing – as long as you pick the right ones.