Vol 28 No 2 Spring 1999

SECTION 5: PUBLIC FINANCE

Tax policy and the budget

KEITH MARDER

Formerly head of Social and Economic Studies at Langdon School, London 

1 The burden of taxation

Taxation is an area of policy in which the two largest parties are usually thought to be divided by clear blue water. Conservatives have always prided themselves on being, by instinct, the party of low taxation. Labour's social aspirations and attachment to the public sector created the image, partly fostered by its opponents, of a party committed to high levels of public expenditure and taxation. Gordon Brown became Chancellor of the Exchequer in 1997 evidently determined to end that perception.

Contrary to widespread belief, people in Britain are not highly taxed, at least judged by international standards. League tables of national tax burdens, measured by the ratio of total tax revenue to GDP, invariably place Britain below most of its industrial competitors. Nevertheless, the Conservative government elected to power in 1979 considered the level of taxation in general, and income tax in particular, too high for economic health. Tax cutting was thought to be the most potent tool of now fashionable supply-side economics, contributing directly to economic growth by encouraging productive enterprise and effort.

Chancellors of the Exchequer wanting to reduce the tax total must feel like Canute trying to stop a rising tide. Even for a Conservative government ruthlessly bent on cutting back the public sector, the pressures on the public purse proved irresistible. In 1996/97, its last year of office, taxation took 36 per cent of GDP compared with an inheritance of about 34 per cent in 1978/79. Chancellor Gordon Brown's first two budgets raised the ratio to an estimated 37.2 per cent last year. However, this year's tax-cutting budget is calculated to reduce that percentage to 36.6 per cent ­ which is still above the level of 1996/97.

Labour, in opposition, had criticised the government for tax increases in the years preceding the election and said it would reduce the tax burden when in office. However, its only specific electoral pledge on taxation was that, over the five-year term of Parliament, there would be no increase in income tax and no extension of the range of VAT. This put a severe constraint on forthcoming budgets but, of course, did not prevent a resourceful Chancellor from finding alternative sources of revenue. Indeed, the state of the economy and public finances together with Mr Brown's own declared fiscal objectives clearly signalled the need for early tax increases.

The incoming Labour government inherited an expanding economy several years into recovery from the recession of the early 1990s but propelled largely by consumer spending and sending out warning signals of inflationary overheating. Following the example of his recent predecessors, the new Chancellor showed no Keynsian intention of using taxation as an instrument of macroeconomic demand management. Inflation was essentially the concern of monetary policy (delegated to the Bank of England) though higher taxation would help by relieving pressure on the Bank to raise the rate of interest. The decision to raise taxes in his first two budgets really stemmed from the legacy of an unacceptably high public sector borrowing requirement amounting to £23bn (3 per cent of GDP) in 1996/97.

With the economy then still expanding steadily, the borrowing requirement was in fact already on a distinctly downward path. But not fast enough for an 'iron chancellor'. From the outset, it was made clear that financial caution and prudence are to be the watchwords of his exchequer stewardship. Two guiding principles of sound public finance have been proclaimed: that the ratio of public sector debt to GDP should be brought 'and kept' below a ceiling of 40 per cent and ­ resurrecting a Treasury 'golden rule' abandoned under the previous administration ­ that, over the economic cycle, government current spending (consumption) should be fully covered by tax revenue. This year's budget report showed the government on course in both respects.

Mr Brown's insistence on fiscal rectitude has dictated his strategy so far. The budgets of July 1997 and March 1998 together added more than £8bn to annual tax receipts. Public sector net borrowing (PSNB) ­ new terminology for the former PSBR ­ moved into surplus last year at ­£1.5bn. With the public finances thus looking healthy and inflation evidently stable at about the target rate of 2.5 per cent, the Chancellor could begin to distribute some of the fruits of the restraint of the last two years. This year's budget introduced a wide-ranging package of measures calculated to reduce annual net tax receipts by more than £4bn.

2 The structure of taxation

For most taxpayers, the size of the national burden is less important than its distribution between households. Mrs Thatcher's administration, in the 1980s, embarked on a fundamental restructuring of taxation with the effect of eroding its formerly progressive character and so widening the gap between rich and poor ­ a marked reversal of the trend of preceding decades. This was done through a two-pronged policy of radically reforming income tax and sharply tilting the balance of the system towards indirect taxation ­ in effect, from earning to spending.

Over the eighteen years of Conservative government, the basic rate of income tax was reduced from 33 to 23 per cent and, most spectacularly, the top rate on earnings from 83 to 40 per cent, extinguishing a range of intermediate rates. A steeply progressive tax was thus transformed into one that was much more proportional in character. This is demonstrated by Figure 1, which includes both income tax and employees' national insurance contributions (NICs) ­ in effect, NICs are an additional tax on earnings, being deducted from pay packets just like income tax. The result is effectively two marginal rates of tax on earnings: a standard rate of 33 per cent (income tax 23 per cent, NIC 10 per cent) for the majority of taxpayers in the middle and low range of incomes; a top rate of 40 per cent on higher earnings (after an anomalous dip due to the NIC upper earnings limit). Therefore, if we include NICs in the calculation there is very little progression in the UK's tax system.

The loss of revenue to the exchequer from income tax cuts was largely recouped from VAT (more than doubled to 17.5 per cent) and the 'sin taxes' on tobacco, alcohol and motoring, intensifying a move away from progressive direct taxation. Taxes on spending are comparatively regressive since, by necessity, a larger proportion of income is spent (and a smaller proportion saved) by poorer households. Since 1979, the share of income tax in total tax revenue has fallen from about 45 to 25 per cent.

Income tax being the most powerful means of tax progression, Labour's self-imposed strait-jacket severely limited the Chancellor's scope for direct egalitarian redistribution from rich to poor. However, the first two Labour budgets produced an array of measures to relieve poverty by attacking unemployment and low wages. These were financed by a medley of tax changes, mainly on business, from which higher income groups are the main losers -­ a process described as 'redistribution by stealth'. The job-creating New Deal, for example, is financed by the trumpeted windfall tax on utilities. Last year's budget also began a radical overhaul of the tax and benefit system designed to bolster low wages and reduce dependence on welfare. Its centre piece is the replacement of the existing Family Credit by a more generous Working Families Tax Credit channelled through pay packets. (see Section 3, Part 5) As a consequence, from October this year, low-paid households are guaranteed a minimum income of £200 a week and no tax on earnings below £235 a week.

 In his third budget, presented in March, Mr Brown confirmed his redistributive instincts and delighted Labour backbenchers with a further instalment of tax and benefit changes which provided something for almost everyone, but was clearly directed at the most needy, especially poorer pensioners and families

From April 1999 all taxpayers gain from a new 10p starting rate of income tax and will further gain next year from a reduction of the standard rate of income tax from 23p to 22p. The lower starting rate is obviously intended to help low earners though some might have been better served by raising the threshold, taking them out of the tax range altogether. Part of the lost revenue will be retrieved from many taxpayers, particularly the better-off, by the abolition of the married couples tax allowance and mortgage interest tax relief from April 2000 onwards. High income households will also be the chief losers from changes in national insurance leading to the alignment of NICs with income tax rates.

3 Taxation and fiscal policy

To old-fashioned Keynsians, a Micawber-like concern with balancing the budget and reliance on short-term interest rates as the lever of demand management, to the virtual exclusion of fiscal policy, looks like flying a twin-engined plane on one engine. The professed macroeconomic role of fiscal policy is then not to control demand as such but merely to support monetary policy (determined by the Bank of England) by curbing the budget deficit. Deficits are deemed undesirable because the borrowing required to finance them wakens confidence in financial markets and puts upward pressure on interest rates, impinging on monetary policy.

Intentionally or not, in fact, budgets and taxes do affect demand. In setting the base rate of interest, the Bank's Monetary Policy Committee necessarily takes into account the budget impact on aggregate demand and its implications for inflation and growth. Whilst showing no desire to pursue an active fiscal policy, the Chancellor's objective of a budget balance over the economic cycle at least reflects his recognition of so-called automatic stabilisers ­ for instance, a budget deficit induced by falling tax receipts in a recession itself helps to stimulate recovery.

With fiscal policy relegated to a passive macroeconomic role, the economic impact of budgets largely depends on the microeconomic consequences of supply-side tax changes aimed at boosting productivity. The tone and content of this year's budget speech suggests that the government hopes to usurp the traditional role of the Conservative party as the friend of business. A 1p cut in both rates of corporation tax (from 31 per cent to 30 per cent for the main rate of corporation tax and from 21p to 20p for smaller companies) make it, we are told, the lowest among competing industrial countries. A new 10p start-up rate for smaller companies with taxable profits of up to £10,000 will be introduced in April 2000. Improved investment allowances and a new tax credit to reward research and development are intended to further the Chancellor's ambition to create a 'modern knowledge-based economy'.

Questions

1 What determined the size of the tax burden and what are the obstacles to its reduction?

2 If taxation can be reduced, where should the cuts be made?