UK: The pros and cons of the great party taxation divide.

UK: The pros and cons of the great party taxation divide. - David Smith reflects on the economic effects of two different approaches to tax.

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Last Updated: 31 Aug 2010

David Smith reflects on the economic effects of two different approaches to tax.

Will it make any difference to the economy which party wins the general election? There is a view around that because this election is being fought on the common ground of an all-party commitment to sterling's existing European exchange rate mechanism (ERM) parity, the scope for any government to improve or damage the economy is limited.

Readers of this article will already be well aware that Labour wants to redistribute income by taxing the higher paid more heavily and using the proceeds to increase child benefit and state pensions. The mechanism for doing this will be the abolition of the present ceiling for employees' national insurance contributions (currently £20,280) and the introduction of new tax rates of 45% and 50%, significantly above the present top rate of 40%.

At present, the national insurance ceiling means that, while 9% of earnings up to £20,280 are eligible for contributions, those above it are not. Thus, under Labour, every £100 of income above £20,800 would require an extra £9 of NICs. Even without any increase in the higher rate tax rates, therefore, the marginal tax/NIC take on upper income earners will rise form 40% to 49%. The impact of the higher tax rates has to be the subject of guesswork, but my guess is that the new 45% rate (effectively 54% with NICs) would come in at a gross income of about £35,000, and the top 50% rate (59% with NICs) at about £40,000.

The chart illustrates these effects. The higher the income, the bigger the impact of Labour's tax strategy: on £30,000, a married man would pay £870 a year more; on £40,000, £1,979; on £60,000, £5,5778; and on £100,000, a hefty £13,378.

One has to have a certain sympathy with Labour when it points out that prior to Neil Lawson's milestone budget in 1988, a 60% top rate of tax appeared perfectly reasonable. If a left-of-centre party cannot even go back to a situation which prevailed for nine years of Tory rule then, Labour could argue, the opposition parties might as well join the Tories.

Even so, the tax positions of the two parties do bring out the essential economic policy difference that remains - on the supply side. The Tories still believe that low tax rates provide incentives and stimulate risk-taking and initiative. Low tax rates also encourage inward investment. Labour's definition of supply-side policy consists of a more interventionist industrial strategy. It will provide new, or at least revived, incentives for training, investment and R and D. You pay your money, literally for upper income earners, and you take your choice.

My view is that, while the incentive effects of low taxation have generally been overstated, it is difficult to make a case for Britain to move from one of the lowest European tax rates for managers and executives, to one of the highest. That case is even harder to make given the likely fragile condition of the economy immediately after the election, when these changes would be introduced if Labour wins. For the near four million who will be subject to a boost in marginal tax/NIC rates of at least 9%, this will represent probably the biggest single tax increase, to affect so many, since the war.

To return to the question of whether the ERM eliminates differences between the two parties - the shadow chancellor has committed himself to the existing DM 2.95 central rate for sterling. But imagine a situation in which Labour wins the election and is faced with heavy selling pressure on sterling. The choice is between raising interest rates by two or three percentage points to defend the exchange rate, or devaluing. I think that, despite his present whiter-than-white statements, Smith would be sorely tempted to wipe the slate clean by devaluing.

The other essential point to make on this is that not all countries in Europe are the same. Put crudely, you can aim to be an Italy - staying in the system but running a higher inflation rate and budget deficit than the rest. Or, you can aim to be one of the good boys, such as the Netherlands, or France. The Government's aim has been to run with the best. But it is quite easy to foresee a situation where the ambition becomes the more modest one of merely bumping along with the less successful members of the system.

Finally, no one would pretend that the Tories were Machiavellian enough to have arranged the economic circumstances in such a way as to eliminate the big budget surpluses of the late 1980s. but the fact remains that the public sector borrowing requirement is heading for £20 billion or more in 1992-93. There is no pot of gold to draw on to finance additional public spending. At the very least, a Labour chancellor would face a familiar situation - disappointed supporters.

David Smith is economics editor of The Sunday Times.

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