Raise taxes or cut spending?

NIESR\’s study into the \”generational accounts\”, conducted with the support of the Office for National Statistics, is based on the assumption that \”over time, the Government must balance its books\” and uses current policy and projections.

\”Our basic simulations suggest that taxes need to rise by about 6pc of GDP over and above the changes announced in the June 2010 Budget in order to put the United Kingdom\’s public finances on a sustainable footing,\” the NIESR said. A rise of 6pc of GDP would be £88bn – equivalent to almost two-thirds of the £150bn raised in income tax each year and 16pc of the £548bn of total tax receipts.

The shortfall, it said, is \”mostly driven by the upward pressure on spending, especially pensions and health, resulting from demographic pressures\” and not the recent recession-fuelled rise in debt, which has had a \”relatively modest impact on fiscal sustainability for the long term\”.

This is essentially the cost of what has already been promised to people but for which money has not been put aside.

NIESR estimated the overall cost of \”pay-as you-go benefits which have allowed earlier generations to receive more from the state than they have contributed\” at £6.81 trillion.

It\’s a fair old sum really. No, that £6.8 trillion isn\’t the debt, that\’s the total cost.

Which really leads us to the question of whether we can in fact increase taxes by 6% of GDP?

At which point I\’m going to say that Ritchie is in fact correct in one point that he makes. No, not his blather about pensions, but about how growth is a way out of this sort of problem. If we have trend growth (ie, the long term average around which booms and busts vary) of say 4%, then the economy doubles in size every 18 years or so.

Now doubling the economy does not halve the amount that must be raised as a portion of the economy, for some/many of these promises are linked to living standards, wage growth or even the size of the economy (even if indirectly). But it will shrink it at least a little as a portion of GDP. And further, if GDP is growing strongly then it\’s obviously easier to squeeze a little more tax out as we\’re now talking about the iversion of newly created wealth rather than the reallocation of extant.

So growth is one way out. 4% growth would be better than 2% (a rough and ready idea of what trend growth is currently thought to be) where the economy doubles every 35 years or so.

On the other hand, perhaps we should just whack up xby 6% of GDP? Hmm, well, you might well think that you\’d come up against some Laffer constraints there. Current govt spending is what, 47, 48% of GDP? Yes, some of that is recession related, but raising yet more tax will take us over 50% easy. Even the famed Nordic economies have struggled when their tax shares of GDP rise that high.

So what could we do to get out of this little trap? Raising taxes to handle it, at least handle it all, would seem to land us in a low growth world. Yet growth is the way out in the long term.

Well, actually, what we could do is reform the supply side of the economy. In the long term it\’s that which makes the difference to growth rates: not Keynesian demand management. Even if you accept the short term effects of the latter, all are agreed that that\’s not the long term solution.

So, how can we fiddle with the economy in order to increase the growth rate, that Hail Mary Pass to get us out of what past politicians have promised the future?

Well, actually, we could have a good look at what the Nordics themselves do. They do seem to have high tax rates, a big welfare state and yet they\’ve also got good economic growth. How do they do it?

Firstly, they pay good attention to the basic economics of taxation. BTW, do note that this is neo-classical economics, not that hated neo-liberal stuff. For example, given that various different taxes have different deadweight costs (different taxes cost you more or less in future growth for the revenue raised than others) we would want to be raising our tax revenue from those taxes which give us the most room for growth while still raising the money we want/need.

Do note that this is saying absolutely nothing at all about what should be the proper size of government, nor what should be the role of government in society or the economy. We are simply and purely saying that whatever level of taxation, of State, is desired, there are ways of paying for it that produce more, or produce less, future growth than others.

The general consensus is, in order of greatest room for future growth to least: property taxes, consumption taxes, income taxes then capital and corporate taxes. So, to leave the most room for growth we should lower those taxes to the right end of the list and raise those to the left end.

And yes, this does make the tax system more regressive/less progressive. But it gives us more room for future growth (as ever in economics, there are no solutions, only trade offs).

We could for example  have a land value tax. Although, to be honest, given that the UK already gets more of its tax revenue from property taxation than any other OECD country, this might not be quite the magic bullet some think. But lowering corporate and capital taxation while raising consumption taxes would have a similar effect.

And when we look at the Nordics, this is exactly what we find their system does. The tax system there (although of course not the spending of such taxes) is less progressive/more regressive than our own UK system. Capital and corporate taxes are lower, VAT is higher.

So that\’s one structural or supply side reform that could be done.

Another brake on growth is the level of regulation and red tape. We could cut all of that. Yet another would be free trade. As Patrick Minford has pointed out, leaving the EU and moving to real unilateral free trade would give a 3% boost to the UK\’s GDP (yes, even if the EU still imposed tariffs against us). And we\’d suspect that there would be a long term raise in that level of trend growth as well.

Don\’t forget, even the defenders of protectionism and mercantilism only suppose that it\’s beneficial to protect infant industires, when you\’re behind the technological production boundary. When you\’re right up there against the level of what is possible in terms of production free trade is assumed by all to be beneficial (thus all the complaints about the Empire only having free trade when it was winning).

Finally, there\’s localism. The Nordics really are a great deal more local than we are. My favourite factoid is that the Danish national income ta rate is 3.76%. The top one is 15%. Everything else is taxation raised locally and spent locally. And I\’m damn certain that you get more bang for the tax buck when you know where the bloke who spends all the money has his Friday Night Pint (the FNP measure of the efficiency of government spending).

So, as Polly always says, let\’s go and be more like Sweden. Localism, a more regressive tax system and on top, leave the EU and hang the bureaucrats.

At which point we\’ll be able to pay for what has already been promised but not saved for.

7 thoughts on “Raise taxes or cut spending?”

  1. “let’s go and be more like Sweden. Localism, a more regressive tax system and on top, leave the EU and hang the bureaucrats.”

    Indeed. In other words, Norway (though I didn’t see any bureaucrats strung up from the lampposts when I was there last).

  2. “Another brake on growth is the level of regulation and red tape. We could cut all of that. Yet another would be free trade. As Patrick Minford has pointed out, leaving the EU and moving to real unilateral free trade would give a 3% boost to the UK’s GDP (yes, even if the EU still imposed tariffs against us). ”

    This is illiterate.

    The credit crunch exposed the deep flaws in “de-regulation” strategy (ie. you expose yourself to more risk and that risk when it eventually blows up costs you loads of money).

    Secondly, leaving the EU just won’t produce a 3%GDP bounce.

    As half our exports go there we’d still have to abide by all EU law, present and future. We’d have no say in that future law no matter how onerous it may be.

    Tim adds: Well, you know, Patrick Minford is a Professor of Economics and all and he wrote a great big book on this very subject.

    You are a commenter on the internet.

    Who ya gonna believe?

  3. The credit crunch exposed the deep flaws in “de-regulation” strategy (ie. you expose yourself to more risk and that risk when it eventually blows up costs you loads of money).

    Um, the regulation strategy is also subject to that problem. Regulations don’t prevent risk. For example, as I understand it, part of the problem with the crisis was regulations requiring some institutions, such as pension funds, to only invest in bonds of a certain rating or above. This meant that if a large company was downrated, the holding funds all had to sell their bonds in it at once, in a down market, costing them a lot of money and sending the value of their funds spiralling downwards.

  4. To be honest, I’ve never understood why we don’t just copy the Scandinavians. Yes, we aren’t them so there should be differences, but in general I have no problem with following their lead.

  5. “As half our exports go there we’d still have to abide by all EU law, present and future. We’d have no say in that future law no matter how onerous it may be.”

    BenM,

    Half our exports is only about 10% of our trade, as 80% of our trade is internal. Abiding by EU rules on the 10% of the goods and services we sell to them means not having to on 90%.

    Or would you argue that having to put Chinese characters on a product you sell to China means you may as well put them on the products you sell internally?

  6. BenM,

    De-regulation doesn’t mean no regulation.

    When the unions got out of hand the Tories were needed to control them.

    When the capitalists got put of hand we needed Labour to control them. Instead they went on the prawn cocktail offensive and rolled over to have their tummies tickled, rather than look at effective regulation.

  7. Pingback: Why is Growth Fixed? « Left Outside

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