IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
WP 2016-02. Executive Summary
Most of the literature on rent-seeking and the size of government expenditure has focused on the mechanisms through which policy-makers gather the necessary majorities to justify and expand the role of the state, and thus increase tax pressure.
By contrast, the authors of this paper examine a situation in which tax pressure has been reduced and, more generally, how rent-destruction can be obtained. Researchers have usually analysed this phenomenon from two different standpoints. One theory argues that the main driver of policy action are ideas and that, therefore, government intervention can be reined in only if the ideological climate characterising public opinion turns hostile to populist socialism and comes closer to the classical-liberal vision. On the other hand, a second theory maintains that ideologies play a secondary role, and that the chances to reduce tax pressure depend on the existence of large-enough interest groups that stand to gain from a reduction of government expenditure and what it takes to finance it.
Booth and Meadowcroft study the UK tax policy between 1979 and 1997, the period during which Conservative governments successfully cut the tax burden. In particular, the authors suggest that if the first theory mentioned above applies, then the distribution of the benefits from lower taxation should be relatively evenly dispersed across all taxpayers. By contrast, the presence of concentrated benefits would make a strong case in favour of the second hypothesis.
The authors develop their analysis by considering that the policy-maker can reduce tax pressure in three different ways. He can increase the tax allowance (i.e. the amount of income considered non-taxable); he can reduce the tax rates; and he can widen the lower tax brackets by raising the threshold beyond which taxpayers are required to pay higher tax rates. Of course, all income-earners benefit from an increase in the tax allowance, a measure which can thus be considered “neutral”. By contrast, a reduction in the tax rates and an increase in the threshold favour the high-income taxpayers.
The British Conservative experience during the 1979-1997 period suggests that
(1) The tax allowance measured in earning-adjusted terms was actually reduced. In other words, the ratio between the tax allowance and the average earnings dropped.
(2) Tax rates were reduced, especially for high income earners
(3) The high-tax threshold fell, which meant that the middle-income earners saw a larger portion of their income fall victim to the high tax rates, compared with the pre 1979-years.
To summarise, it seems that the governments led by Margaret Thatcher and John Major tended to pursue a non-neutral tax policy by concentrating the tax cuts on the relatively high-income earners. As a matter of fact, by reducing the progressive feature of the British tax structure, the Conservative Party succeeded in strengthening consensus from its traditional electorate. Moreover, it showed that in the end the interest of selected coalitions prevailed upon the possibility of distributing the benefits of lower taxation equally among British taxpayers, not all of them – presumably – were affected by a revival of the classical-liberal ideas. While a strong rhetorical case was made by the Conservative governments in favour of reducing government spending, the evidence suggests that the tax cutting policy of this time was the result of a confluence of ideas and interests, not simply the triumph of free market ideas alone.
The full version of the paper can be accessed clicking on the following link: