The tax fallacy
The Boris Project risks unravelling in confusion over how to pay for Covid
Treasury ministers and their officials risk classic “Laffer Curve” injury by talking of plans to raise an additional £30bn a year in taxes to plug the hole in the public finances left by the Covid-19 pandemic. They also risk tearing the Tory Party apart.
It is not just the law of diminishing returns that threatens implementation of such a major tax grab, nor is it even that it runs counter to much Tory positioning as the pro-enterprise, self reliance party of low taxation.
No, there is a more potent reason still – simply that it is economics 101 that you do not impose a fiscal squeeze in the midst of a crisis, nor even in the recovery phase of a bad recession. You wait until the economy is again firing on all cylinders and, even then, governments must tread warily so as to allow growth the room it needs to reestablish itself. To do otherwise risks strangling the recovery at birth.
All this makes the current hysteria around the idea of imminent tax rises faintly puzzling. Of course the Treasury will one day have to take steps to repair the public finances. If it doesn’t, then buyers of government debt will question Britain’s long-term creditworthiness and raise the cost of money accordingly. Higher interest rates would further steepen the challenge of managing the deficit and of economic recovery in the round. But that’s all for the future. For the moment, the Government needs to be focused like a laser on restoring growth, and if anything, that means further cutting the tax burden, not raising it.
This is such standard economics these days that one can only suppose that suggestions of a big tax raising push, to be announced in the autumn Budget and to take effect as early as April next year, must be wide of the mark. The Chancellor will have to engage with fiscal consolidation at some stage, but to do so prematurely would be utter madness.
George Osborne’s fiscal squeeze didn’t begin until nearly two years after the financial crisis, and even that was arguably too early. Growth stalled; it wasn’t until he relaxed the squeeze that things began to revive again.
Arthur Laffer may be the intellectual godfather of supply side economics, but he never actually argued what is often attributed to him – that by cutting taxation you stimulate growth and therefore raise more money, or that higher tax rates necessarily raise less money. Rather his “curve” is classically bell shaped. If your tax rate is zero, you plainly raise no tax; similarly, if it is 100pc, you raise no tax. But at some point in between there is an optimum rate of taxation
‘The Chancellor will have to begin fiscal consolidation, but to do so prematurely would be madness’
which raises the maximum possible amount of tax. If your purpose is maximising the tax take, then striking that happy median is all important.
Raise the rate too high, and it might result in an exodus of talent and investment, a reduction in entrepreneurial drive and an increase in tax avoidance and evasion, thereby reducing the amount of tax paid.
The key question to ask of any tax rise, then, is whether it is going to result in significant behavioural change. When Labour proposed raising the top rate of income tax from 45pc to 50pc, Robert Chote, then head of the Office for Budget Responsibility, described the proposal as “strolling across the summit of the Laffer curve”. It was hard to tell whether it would increase the amount of income tax raised; there was good reason to believe it might actually reduce it.
The same questions can be asked of all the big tax raising proposals said to be currently under consideration at HM Treasury – further erosion in pensions tax relief, aligning capital gains and income tax rates, and raising the rate of corporation tax. Would they actually result in the additional £30bn a year suggested, and even if they did, might the tax take as a whole be damaged by consequent, poorer rates of economic growth?
Eventually, the Government is going to have to confront these questions. If now’s not the moment, the markets do at least need some comfort that it is the Government’s sincere and eventual intention to get the public finances on an even keel again. New fiscal rules will have to be put in place, and some kind of credible plan for meeting them outlined.
According to the famous Juncker curse – after the former European Commission president, Jean-Claude Juncker – “we all know what to do, but we don’t know how to get re-elected once we have done it”. That may not seem particularly relevant to a
Government with an 80 seat majority barely nine months into its term.
Yet already we see the potential for disintegration in an administration which was elected to deliver Brexit but little else. Boris Johnson’s problem is that Brexit was never a cohesive political movement, but a campaigning issue that united multiple different and sometimes conflicting political constituencies. His great talent is his ability to be all things to all men – both a nationalist and a globalist, a libertarian and an NHS worshipping, big state corporatist, low tax and high spend, a high Tory and a Red Wall populist. This is a great formula for winning elections, as we have seen, but a nightmare to manage when it comes to government and delivery.
Even before Covid, the challenge of reconciling the multitude of promises that have been made looked daunting, with Thatcherite, low tax libertarians increasingly at odds with one nation, Nick Timothy type Conservatives, who looked back to an altogether different Tory tradition. The pandemic has put them on collision course.
Those tensions can only grow over the months and years ahead as Johnson and his allies wrestle with whether it is taxes or spending that must do the heavy lifting of fiscal consolidation. One thing is for sure; it is not going to make for cohesive government.
Boris Johnson and his Cabinet team have been in power for nine months and in the run up to the end of the year face tough choices