Neil Record is Chairman of the Institute of Economic Affairs board.
Like many people, I have become increasingly concerned about the long-term consequences of the UK government’s Covid-19-related extraordinary expenditure. Faced with the position the Government’s finances are now in, what would I do if I were Chancellor of the Exchequer?
My first priority, and indeed the core function of any Chancellor, would be to formulate a plan which on reasonable or even conservative estimates of future economic activity would yield enough tax revenue to stop the mountain of public debt growing any larger.
It may be fashionable to argue that with “modern monetary theory” there is a new normal level of fiscal debt which governments can comfortably accommodate that is far higher than, say, the old 60 per cent debt-to-GDP that the EU used to require a country to be under to qualify for membership of the Euro area.
But the UK’s public debt now stands at more than 100 per cent of GDP, and any student of economic history will understand that the higher the national debt level, the more vulnerable a country is to external shocks exactly like the one administered by Covid-19, and indeed to future unknowable shocks.
The consequences of fiscal recklessness can be seen littered not just across the developing world, with serial defaults and bankruptcies, but also in the sophisticated developed world, where the world’s third largest economy, Japan, has been mired in stagnation for 30 years, burdened by enormous public debt which saps confidence and dampens entrepreneurial spirits.
So if the current Chancellor accepts the idea that fiscal prudence is at the heart of his role, then what should he do to combine that constraint with creating the conditions for a vibrant, growing economy providing jobs and opportunities across the board?
Were I Chancellor, my objective would be to initiate policies which have a proven track-record of success on two measures: growth in real Government revenue, and growth in labour productivity. The latter is the heart of the complex modern economic system that delivers real rises in living standards. The former is the measure which, if successful, would minimise the extent to which balancing the fiscal books requires real cuts to public spending. The question of how large a role the State should play in the economy is a bigger question for another day.
Let’s start with government revenue. If we examine the past 40 years of the UK economy, we can search out the best decade for rising government revenue which, as it turns out, is 1993-2003. This decade achieved real growth (i.e. adjusted for inflation) in government revenues of 4.3 per cent per annum – an astonishingly high rate which delivered 51 per cent more real annual government revenue at the end of the period than at the beginning! If the current Chancellor could sow the policy seeds to create another period like that again, he would be rightly acclaimed a hero.
Why was this period so successful for government revenue? The answer is that it was launched on the back of more than a decade of deregulation and reduced marginal tax rates, and that the period itself was one of broad policy stability. This is the more remarkable since it straddled a Conservative government (until 1997), and a Labour one thereafter. It was also a period of strong growth in labour productivity, of which more below.
What were the key tax facts in the successful 1993-2003 period? A top rate of income tax of 40 per cent; corporation tax falling from 33 per cent to 19 per cent; stamp duty top rate of four per cent (after one per cent earlier in the period); VAT at 17.5 per cent; and capital gains tax same rate as income tax, but with taper relief (from 1998-99) reducing the rate on shares by up to 75 per cent (i.e. giving a top rate of 10 per cent).
So here we have a blueprint for a set of tax policies that have been proven to deliver strong rises in Government revenue.
It is always tempting to imagine that as Chancellor you can conjure up any amount of tax revenue by just adjusting tax rates accordingly. The evidence points strongly in the opposite direction. Marginal tax rates send very strong signals to key players in every modern economy, such that economic activity will inevitably shift away from heavily taxed activities or sectors to more lightly taxed (or even, worryingly, to subsided areas).
If you, as a government, want strong economic activity in both the labour market (jobs, productivity) and in the market for capital (infrastructure, homes, machinery, technological change), then each has to be taxed in a balanced way so neither is favoured and neither is avoided.
Which brings me to labour productivity – the engine of living standards. This is a fascinating area – one that, in my opinion, is much under-studied. We had been growing richer and richer in the Post-War period until 2008, when our improvements in living standards came to a juddering halt. There are two “whys” here – why did we grow so consistently for 40 years, and why did we stop growing so suddenly?
On the first question, we had been the beneficiaries of an absolutely remarkable transformation in our technological knowledge, which allowed each worker to enlist more and more power and control over his efforts with the help of increasing amounts of capital equipment. We think recently mainly of the digital revolution, but this comes at the end of a series of revolutions: agricultural, energy, trade and specialisation – all of which have contributed to this quite remarkable success story.
Why did this stop? In 2008, a key specialisation of the UK economy, the financial services sector, had a catastrophic failure. This sector had been an important engine of growth and source of much government revenue. The shorter-term policy response to this crisis protected jobs and the banks.
But the longer-term response to this was to set this sector in a straitjacket of regulation, which has killed its growth, its animal spirits and its tax generation. This enthusiasm for regulation has spread across all sectors, not just financial services, and has had an equivalently dampening effect on growth in those sectors too. Higher tax rates on top incomes have exacerbated this effect.
Governments have choices. This Government may not choose to adopt some or any of the successful policies from the past – and there will be good reasons for those decisions. In the round, however, if the government in general, and the Treasury in particular, is serious about pulling the UK out of the very serious financial and economic position it currently faces, then the arguments presented here should weigh heavily on its thinking.
This article is based on the author’s recent briefing paper, The Chancellor’s Post-Pandemic Choices.