Institute for Research in Economic and Fiscal issues

IREF Europe - Institute for Research in Economic and Fiscal issues

Fiscal competition
and economic freedom

IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom

Phoney fiscal austerity in the United Kingdom

2009/2010 has been a period of phoney fiscalism in the United Kingdom. The period is sandwiched between the economic crisis, which put fiscal policy onto an emergency, macro-economic footing and an election (May 6th 2010). Economic crisis has been marked in the UK as in most other countries by a severe worsening of the fiscal balance which has been supported for now by government borrowing and straightforward money-creation (“quantitative easing”). The political constraint of election has led to a more than usually cosmetic approach to changes in the structure of taxation.

The big tax dates of the calendar---the April 2009 budget, the November 2009 Pre-budget report and the April 2010 budget have thus been dominated by the logics of crisis and of politics, making---with a few exceptions that I shall return to---unusually uninteresting reading for the analyst of the minutiae of tax decisions.

The Labour government responded to the 2008/9 economic crisis with broadly Keynesian accommodation. As reported in this series last year, over and above the automatic stabilisers of higher social security payments and reduced tax revenues, the UK passed an emergency reduction of VAT rates from 17.5% to 15%; introduced a “cash for bangers” car-scrapping incentive to help the car industry; introduced an emergency reduction in sales tax on domestic housing transactions (“stamp duty”) and a number of temporary incentives to help the bloated construction industry.

Falling tax revenues and increasing expenditure has made the state particularly reliant on borrowing. Total government revenues in 2010-11 are forecast to be 37% of GDP (of which 35% come from taxes), while government spending is forecast to be 48% of GDP. 11% of GDP (around £160bn) needs to be borrowed to balance the books in 2010, about the same as was needed in 2009-10.

The borrowing requirement and the election has meant that fiscal policy has been conducted between Scylla and Charybdis: abandonment of Keynesian demand support and recession would have meant giving up all hope of defeating the Conservative opposition in May 2010, while any hint of sovereign default or large-scale currency depreciation would have meant a debt crisis, like the one of 1976 that brought down the last Labour government.

But there is widespread understanding in markets, amongst political parties and in the Treasury that this Scylla and Charybdis are both short-term phenomena. The Keynesian deficit spending cannot last forever, and the electoral constraint will be lifted by the start of May. By necessity, the two legislative periods between 2010 and 2018 will require wholesale fiscal rebalancing and opportunities for fiscal innovation. Whoever wins the election of May 2010 will be in a unique position to redefine the role of the British state. Everyone is expecting hardship; unlike the situation in 1979 or 1983 there is a kind of resignation to it amongst all parts of society that everyone will be hit; the political opportunity for reshaping taxation is therefore unprecedented.

So, just as all the fiscal excitement is ahead of us, most developments in the 16 months since our last UK report have been tactical and constrained–fiscally phoney.

Making future governments responsible for probity

Most, but not quite all. First, the double constraint of borrowing and election has led to one interesting fiscal innovation: the “Fiscal Responsibility Act (2010)”, ( ...) by which the government has tried to persuade lenders in sovereign bond markets that the British state, like St Augustine, is going to be “virtuous, but please, Oh Lord! not yet”.

The Bill, as described by the Treasury, requires that the government:

> ensures that borrowing is 5.5% of GDP or less in 2013-14

> halves public sector net borrowing as a share of GDP over four years from its forecast peak in 2009-10;

> reduces borrowing as a share of GDP in each and every year from 2009-10 to 2015-16;

> ensures that public sector net debt is falling as a share of GDP in 2015-16.

By the principle of Parliamentary sovereignty in the UK system, it is not possible for one Parliament to bind the actions of another. However, if the government fails to deliver on these pledges, then the Treasury is under obligation to report the failure to Parliament and provide an explanation. It increases the political embarrassment and cost of future fiscal irresponsibility. If the UK was indeed facing a Keynesian recession in which intervention is effective as long as interest rates do not rise to crowd out increases in public sector spending, then this fiscal commitment device should be seen as being sensible. In increasing the chance that Keynesian demand support does not extend for too long, it reduces the cost of that support in reduced private sector investment.

Taxing the rich (or trying to)

In 1998, Peter Mandelson, the close ally of Tony Blair (now Lord Mandelson, Secretary of State for Industry), famously set the tone for New Labour’s attitude towards redistribution in tax policy by saying: “we are intensely relaxed about people getting filthy rich as long as they pay their taxes.” New Labour, in other words, was going to adopt a sort of State Rawlsianism: wealth creation was good and justified by its contribution to the income of the state.

This state Rawlsianism is reflected in aggregate measures of earnings distribution on the one hand and taxation receipts on the other through the period from 1997 (when New Labour came into power) until the economic crisis.

Full-Time Weekly Earnings at 2008 Prices, 1968 to 2008, men

Government Revenues since 1948-49

Net tax revenue rose as a proportion of GDP for most of the period under New Labour between 1997 and 2008 (there were falls in the recession of 2001-2) while income inequality rose.

However, the financial crisis proved an embarrassment for the state Rawlsian justification, in that the blame for the crisis was placed with the high income earners while the costs were borne by the whole of society. This was the political difficulty presented by the “privatisation of gains/socialisation of losses” view of the financial crisis.

It is little surprise that the rhetoric of tax policy has therefore shifted from the original stance of “intense relaxation” about wealth. Starting with the April 2009 budget, the following measures have been taken to increase the redistributive impact of the tax system:

1. A new 50% tax rate for incomes above £150,000 (up from 45%)

2. Incomes above £100,000 would no longer benefit from a tax-free allowance of £6,500

3. Tax exemption of pension contributions to be greatly reduced for incomes above £150,000

4. A one-off super-tax of 50% on any financial sector bonus above £25,000

5. A freezing of the zero-rate inheritance tax threshold at £325,000 (against an announced increase in the tax-free amount in 2007 to £350,000)

There are 750,000 people with incomes above £100,000 (2% of adults), 350,000 with incomes above £150,000 (1% of adults). The incidence of these tax changes should be to make the tax system substantially more progressive while affecting a relatively small number of very rich individuals.

Of course, there is nothing to say that these tax changes will be effective, implementable or indeed to say that the high income individuals will not change their behaviour to avoid the incidence of the tax. M. Brewer, E. Saez and A. Shephard, (‘Means-testing and tax rates on earnings’, 2008, ...) have a fascinating analysis that attempts to take into account these factors to compute a “taxable income elasticity” which predicts the fall in taxable income as marginal tax rates rise. Their results are shown for the incomes of £150,000 in the figure below:

The major effects captured in these simulations are:

> the reduction in spending, and therefore VAT receipts resulting from income tax increases;

> the move to work less, retire earlier, emigrate, contribute more to pensions or charity, convert income to capital gains, incorporate, and other investments in tax avoidance.

The fascinating aspect of this “micro-Laffer curve” is the Treasury’s-eye-view of the situation. Think of the Treasury as a tax farmer who understands the response of its herd to different regimes; the optimal tax rate for high income earners may be as low as 40% (on the academic, BSS estimate) or somewhere between 45% and 60% on the Treasury view. The BSS estimate provides some support for the view that the measures to tax the rich introduced since April 2009 have more to do with the politics of the election than with fiscal efficiency.

The one-off tax on banking bonuses appears to have provided a windfall for the Treasury of £ 2.5bn ( ..., Supertax pulls in £2.5bn for UK Treasury, Financial Times, March 4th 2010). At the time it was announced in November 2009, there was much talk of avoidance schemes, of bankers moving offshore, etc. However, as banks showed very healthy end of year profits and as other countries announced similar one-off measures, the large banks all decided to pay bonuses as usual and to pay the 50% supertax. It is hard to avoid the view that this should not be viewed as a rule-based approach to taxation, but rather as a naked piece of bargaining between two powerful actors: the state and a finance sector that knows it is in for a long process of regulatory negotiation and lobbying.

... while being business friendly

New Labour has continued to try to use the tax system to encourage investment. Capital gains tax has been maintained at the very low 18% – very low, that is, compared to corporation and income taxes. Such a large disparity between capital gains taxes and other types of profit tax seems like a gift to accountants and tax-optimisers. Now that we know that a great deal of the financial innovation of the past 15 years has been based on tax and regulatory arbitrage, this disparity seems to be a gift to the kind of creative activity which everyone agrees should be discouraged.

Amongst the “business friendly” measures introduced since April 2009, we have:

> a delay in the rise of small company corporation tax rate from 21% to 22% for at least another year;

> empty business properties are exempt of property tax for another year;

> income from patents is to be reduced to 10% from 2013;

> 100% tax write-down for first £100,000 of investment (up from £25,000) ;

> 40% write-down for plant and machinery investment in the first year above £50,000;

> capital gains tax relief for entrepreneurial activity increased from £1m to £2m;

> a number of temporary micro-measures to help the construction industry;

> Tax relief for investment in the video games industry (see “Video game developers get tax relief”, The Guardian, March 24 2010. ... );

> a new levy on phone lines (£0.5 per line per month) to pay for the next generation of superfast broadband networks.

The last two of these signal a return to a more active “picking-winner” style of industrial policy (and seem to have the support of both Labour and Conservatives). Although small and symbolic, the move is a political response to the perception that the UK economy needs to be rebalanced away from excessive reliance on financial services. There is a wide-spread enduring hope that high technology based growth will save the British economy from the hardship ahead, so we can expect more of this kind of policy over the years to come.

The months and years ahead

The reality of the years to come is that taxes will rise and spending on public services fall. The extent of the problem, little spoken about in the political class because of the election in May 2010, is sure to become the centre of political debate soon afterwards. Borrowing in 2010 will be £167bn, around 11% of GDP. The Fiscal Responsibility Act calls on this to be reduced by a half in 2013-2014. The Conservatives have called for a zero structural budget deficit – the cyclically adjusted, non-investment elements of government expenditure and revenues – over this period, which is a slightly more stringent requirement. So, over the next three years, the government will need to produce a combination of revenue increases and spending cuts amounting to £90bn per year. The current projection is that approximately half of this will come out of automatic factors: a return to economic growth and a reduction in social security payments will still leave approximately £45bn per year of shortfall. Capital spending is set to be cut by 15% per year in the name of protecting “front line services” – in health and education. Both Labour and Conservative parties have conjured rather miraculous “efficiency savings” of £20bn to avoid the charge, before an election, that they will need to bring unpopular cuts to some area of service or other. Expect the gloves to come off in May, whoever it is who wins the election.

The underlying cause of the austerity ahead is not so much the temporary borrowing spike on 2008-2010 but the recognition by the Treasury that its forecasts of the productive capacity of the economy pre-crisis were overly optimistic. Forecasts of non-inflationary GDP potential, used to develop long-term public sector fiscal plans

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