Tax policy should be seen within the context of a pro-growth economic strategy. We currently do not have such a strategy, but we need one. In the wake of the 2008 global financial crisis, our growth rate slumped, and there is now a danger we are drifting towards a low growth, low-productivity, low-wage, and high-tax economy. This is a problem confronting Western Europe.
Our pro-growth strategy should be built upon the three arrows of: a sound monetary policy that keeps inflation low; a credible fiscal approach that reduces the ratio of debt to GDP; and a supply-side agenda focused on the four Is: investment, innovation, infrastructure, and incentives – with smart regulation and low taxation.
During the 1960s and the 1970s, the UK was a high-tax economy. That changed in the 1980s, when there was a political desire to not only lower taxes, but to simplify them and improve the economy’s supply side. Recent years have witnessed an upward trend in the UK’s tax take and it is now at a 70-year high.
The Treasury orthodoxy is that the UK is a slow growth economy. Thus, more of the budget deficit is structural, explained by underlying forces, as opposed to cyclical, linked to where we are in the economic cycle. If you believe that more of the deficit is structural, then the solution is to constrain government spending and have higher taxes.
This bleak assessment has led the economic consensus to believe that there is limited scope to cut taxes now, or in the future. Indicative of this was this June’s Office for Budget Responsibility’s annual risk assessment. It assumed that the combination of weak growth and an ageing population meant there would need to be additional tightening ‘of £37bn a year in today’s terms at the beginning of each decade’ in order to stabilise the public finances over the next half-century.
This is far too pessimistic, but is indicative of the challenges faced by those advocating low taxes. The margin of error on only one-year ahead official budget forecasts is large. Thus, projections about what might happen by the middle of this century should not tie policy hands now – especially in the midst of a cost of living crisis.
But it goes to the heart of the current debate. The alternative approach is to raise our growth potential and ask what role taxes can play?
Taxes are frequently viewed primarily as a way to fund government spending. We need world class public services, but taxes should not be on an autopilot to rise in order to fund the state. It highlights the need for public sector reform as well as keeping public spending under control. It should focus attention too on the vital role taxes play in influencing behaviour and determining how our economy works.
It is important to keep in mind some important principles to drive our tax system. Taxes should be neutral, simple, and predictable. They should also be easy to collect and pay. It is notable that the Federation of Small Businesses is calling for tax simplification, to ease the burden on small firms.
Taxes, too, should be efficient in raising the appropriate amount of money. Increasingly, as economic conditions change because of globalisation and technology, taxes also need to evolve.
Taxes should be fair. The UK’s income tax system, for instance, is very progressive, with higher earners paying a significant proportion.
A final principle is that they should send the right incentives, such as rewarding work and encouraging investment. This is critical if we want to boost growth potential.
Since the last general election, there has been little credibility in tax policy. Outcomes have been different to the promises. Admittedly there has been a pandemic, but even allowing for this, a plethora of tax hikes have taken place that were unnecessary. For example: the tax on jobs through the national insurance increase; large numbers have been pulled into higher tax brackets through fiscal drag as tax thresholds have not risen in line with inflation; and next spring the UK will slump in international competitiveness as corporation tax soars.
For a government committed to low taxes, it has not been an impressive performance.
Currently the UK faces the twin problems of rising inflation – which should be addressed through a tighter monetary policy by the Bank of England – and weaker domestic demand. This necessitates an easier fiscal stance focused on targeted tax cuts.
Timely, targeted, and fully costed tax cuts are not inflationary, but are affordable and necessary. At the time of the 2022 Spring Statement, the Treasury had about £30bn of fiscal space that they did not use, and since then higher inflation has swelled the tax revenues.
It is the nature of the inflation shock that explains why tax cuts will not be inflationary. If inflation was caused by an overheating domestic economy, with buoyant demand, then there would be reason to be wary of cutting taxes now. But that is not where we are. Inflation has been triggered by supply-side pressures, and by an inappropriately lax monetary policy last year.
Moreover, tax cuts must be timely and targeted. For instance, taxes on fuel could be reduced, thus easing the cost of living crisis for many, while also lowering costs in the supply chain, keeping prices down. There is scope to help the squeezed middle, too, through raising allowances or cutting income tax.
Some tax cuts could be immediate. Other changes – like revisiting the planned corporation tax hike and recent national insurance increase – may need to wait until the Autumn Budget, to be fully costed and judged alongside other options.
After the Second World War, the UK’s ratio of debt to GDP stood at 250%. Then it fell steadily, driven by stronger economic growth. Now our ratio of debt is around 90%, a peacetime high. As this ratio falls, there will be scope to fund public services and to let taxes fall. Growth is the key, and low taxes are a vital part of this.