The fair tax road to fiscal health
In the ongoing debate on how to handle the UK’s public sector deficit, one side of the equation – ‘the tax-take’ – has been mostly ignored. Yet, over the last thirty years an increasing number of rich countries have been hitting an apparent limit on their ability to raise revenue through taxation. While demands on the state for improved services have been upwards, the ‘tax-take’ has been largely static or downwards.
But despite this pressure, tax revenue has often lagged well behind. Take the UK. Between 2001 and 2007, spending as a share of GDP rose by four percentage points from 36.8 per cent to 40.9 per cent, largely as a result of improved health, education and welfare programmes. Although this was quite a jump, it did little more than reverse the fall in spending over the previous two decades. Tax revenue, in contrast, remained static at 38.6 per cent of the economy over the period. As a result of this rising fiscal gap, the national debt rose from 30 to 37 per cent as a percentage of GDP.
Chart: UK tax revenue as a share of GDP, 1976-77 to 2010-11
The share of tax revenue in the economy peaked in the UK in the early 1980s at over 45 per cent. It then fell sharply over the next decade and since the early 1990s has settled at the much lower average of 37-38 per cent. Although cutting tax was a deliberate policy, this has meant that tax revenue has fallen short of public spending for most of the last 20 years (though some of this shortfall is explained by the use of borrowing to fund capital spending).
Ultimately, of course, such shortfalls are unsustainable. Either governments need to moderate their public spending plans, or they must find ways of raising the tax-take. So what explains the apparent long term stagnation in revenue? Three main factors have been at work.
- First, the reforms of the tax system introduced by the Conservatives in the 1980s. The top rate of income tax on the rich was cut from 83 per cent to 40 per cent while the share of taxation taken from indirect taxes like VAT was increased. Up to the mid-1980s, the tax system had been progressive – those on the highest incomes paid a higher proportion of their incomes in tax than those on low incomes. In 1979, the top fifth paid 37.6 per cent of their incomes in tax and the poorest fifth paid only 30.5 per cent. The effect of these reforms was that by the mid-1980s, the tax system had moved from being progressive to regressive – these shares where reversed.
- Second, the rising share of the national cake in the hands of the rich. The share of net income held by the top one per cent has nearly tripled in the UK, standing at over 15.4 per cent in 2009 compared with a low point of 5.6 per cent in 1978.
- Third, the explosion of tax avoidance amongst the highest earners over time.
The combined effect of these three changes has been that since 1979, the share of earnings paid in tax by those in the top one per cent has fallen from over a half to around a third, while the average tax rate on most of the rest of the population has risen to over 35 per cent.
Supporters of the 1980s reforms have long argued that by boosting economies, lowering tax rates would actually increase revenue – the so-called Laffer curve. This is the argument used by the Republicans in the United States to cut taxes on the rich and by George Osborne to cut the 50p tax rate in the last budget. But the evidence has long been clear. Cutting tax rates does not increase revenue. Along with many contentions of market advocates, the ‘’dynamic effect’ from lowered taxes at the top is a myth.
The policy strategy of the last 30 years – making economies more unequal while cutting tax rates on the rich – neither leads to a larger economic cake nor to boosted tax revenue. Instead it simply shrinks the tax base. The latest evidence for this comes from a significant paper from Thomas Piketty , Emmanuel Saez and Stefanie Stantcheva.
They show that the optimal rate of tax on the rich – the rate which maximizes revenue – is well above current rates. Indeed, it has recently been disclosed in an interview with the former cabinet secretary, Lord O’Donnell, that George Osborne was advised by the Treasury that the optimum tax rate is 48p, higher than the 45p rate introduced in the last budget. Piketty and his colleagues suggest it is a good deal higher than this.
The lesson is clear. To maintain high levels of public spending without increasing the level of public debt requires steering economies in the direction of more progressive tax systems with a much larger contribution from the very rich. Although Labour eventually raised the top rate of income tax to 50p, they could and should have done more – and earlier – to increase taxes on the very rich. Even the secretary-general of the OECD, Angel Gurrí, has called on rich nations to reform ‘their tax systems to ensure that wealthier individuals contribute their fair share of the tax burden’.
Stewart Lansley is the author of The Cost of Inequality: Why Economic Equality is Essential for Recovery, Gibson Square, 2012.