Can’t tax, won’t tax The hole in Western finances

HAVE western governments, faced with angry voters, lost the ability to raise taxes? The question is raised by a farcical U-turn by the British government over a budget measure announced a week previously. The government retreated in the face of backbench opposition and the right-wing press. It seems eerily reminiscent of America, where Republicans have an absolute abhorrence of tax-raising measures.

 The planned British increase (aligning the tax rates of the employed and self-employed) was perfectly sensible. Unless closed, this gap will erode the tax base over the long run. Most economists agree that differential tax treatments tend to distort behaviour for no long-term gains. But the government had promised at the 2015 election not to raise income tax, national insurance or VAT—three taxes that raise around two-thirds of revenues—and this (foolish) promise was used against it.

As the graph shows, British tax revenues have struggled to get above 35% of GDP since the late 1980s. That is a problem when spending has consistently been above 35% and often above 40%. The UK is not alone. From 2000 to 2016, the average OECD government spent 40.9% of GDP a year; tax revenues have been 37% of GDP (see the data here). In only two years (2000 and 2015) did tax revenues get to 38% of GDP; since 2008, spending has consistently been above 40% of GDP. As a result, average debt-to-GDP figures have risen from 67.4% in 2000 to 116.3% last year.

In an earlier era, this would surely have caused a crisis. And, of course, it did in countries without a national central bank—Greece and Ireland, for example. Countries that have their own central banks have been able to lower their interest rates (reducing the cost of servicing the debt) and to pursue quantitative easing (QE) programmes that actually buy the debt. As a result, net debt payments are actually lower as a proportion of GDP (1.8% versus 2.6%) than they were in 2000.

Many government have pursued austerity programmes, of course, and these have been highly controversial. First, they have tended to focus on social spending that tends to benefit the poorest in societies. Second, they have also cut capital budgets—spending on infrastructure such as schools, hospitals and roads. This latter category is probably the most useful form of Keynesian stimulus in a downturn. It also looks like a no-brainer given low interest rates; there must be plenty of infrastructure projects with a net positive return if the cost of borrowing is 1-2%. Indeed, the OECD has arguedthat a dose of fiscal stimulus can enable countries to escape the low-growth trap.

While there are very good cyclical arguments for an infrastructure boost in many countries, the question is whether this will generate enough growth to bring the finances back into balance in the long run. The average OECD country hasn’t been in primary surplus (the balance of receipts over payments, before interest payments) since 2001, even though there was a boom in the mid-2000s.  Ann Pettifor, an economist, argued that it is possible.

That certainly would be an outcome everyone would favour but it is not so easily done. Educating the workforce takes time, especially if you have to start at the school level. And it may be that the new industries in technology create a small number of well-paid high-skilled jobs, leaving the rest to low-paid service jobs.

The fundamental problem is that OECD populations are getting older, which implies a steady increase in spending on health and pensions. That will make it very hard to bring overall spending down. Meanwhile the proportion of the population that is of working age is set to decline—not good for tax revenues. Governments could raise taxes but we live in an era of mobile people and companies. Indeed, it is probably no coincidence that British tax receipts started to fall from the 1980s onwards, when capital markets were liberalised. The top 1% of Britons pay 27% of all income tax receipts. Many of these people can go elsewhere—indeed quite a few of them are Europeans escaping high taxes in their own countries. Governments are competing to reduce corporation tax rates to attract multinationals. And as we have seen, there is no political will to raise taxes. This suggests there is a structural problem.

At the moment, the problem is not hitting home because of low rates. But imagine if today’s debt levels were accompanied by 2000’s yield levels; then interest payments would be 4.5% of GDP, more than double today’s levels. And that of course would only make the financing problems even harder.

If as I suspect, government cannot raise the taxes needed to finance the spending their voters want, then we are in for permanent central bank intervention in the economy, with very low real rates. The big test is whether governments with a structural deficit can finance themselves cheaply—even with central bank help—over the long run.