UK: SMITH ON ECONOMICS - BUDGET TEST FOR TORY TAX TOTEMS. - The Tories' belief that lower taxes are an incentive to growth should not be challenged. But, says David Smith, there is little scope for them to do much about it in the last Budget of the term.

Last Updated: 31 Aug 2010

The Tories' belief that lower taxes are an incentive to growth should not be challenged. But, says David Smith, there is little scope for them to do much about it in the last Budget of the term.

If it is November, it must be Budget month. And this Budget carries, of course, its own special significance. It is the last before the general election, perhaps the Conservatives' last serious throw of the economic dice.

This, undoubtedly, will be how the Budget is analysed, followed closely by a second strand of punditry on whether the economy in general, and the consumer in particular, 'needs' tax cuts, or is doing very nicely anyway.

This is all well and good but it is not what the real tax debate should be all about. More than 10 years ago, Nigel (now Lord) Lawson introduced the separation between the different aspects of economic policy when delivering the Mais lecture in the City of London. Macroeconomic policy, and in particular monetary policy, was to be aimed at controlling inflation, while micro-economic policy, including the setting of tax rates, was the key to the economy's growth performance over the medium term.

Tax changes, in other words, should not be thought of as nudging the economy up a gear, or slowing it down; such fine-tuning is essentially the task of interest rates. Tax rates are about incentives.

Lower taxes persuade people to do certain things, including making them work harder. Higher taxes provide disincentives to work, as well as discouragement to spend on heavily-taxed products such as tobacco.

The perverse incentive theory

Some economists, bizarrely in my view, argue that perverse incentive effects operate in the tax system. Lower income tax rates, they say, will not lead to additional work because people target a certain level of take-home pay. If that target level can be achieved by working fewer hours, because taxes have come down, then tax cuts, paradoxically, could diminish work effort.

But consider what that means. A cut in income tax is equivalent to a rise in take-home pay. Is it credible that raising people's take-home pay will make them work less, and vice versa? I think not. The economic impact of a change in tax rates is to alter relative prices. Only those who do not believe in the price mechanism should argue against normal incentive effects.

Beyond the basic rate

The question is how far we have moved away from the 1980s Conservative vision of the role of tax changes and whether it is possible to get back to it. This has been a tax-raising parliament and as the chart shows, the rebuilding of tax revenues as a share of gross domestic product is targeted to continue for some time yet.

Kenneth Clarke would claim that, in spite of the need to raise taxes to rein back a ruinous budget deficit, he and his predecessor, Norman Lamont, remained true to Tory tax principles, by not increasing the basic rate of income tax, indeed by reducing it from 25% to 24%last year.

The basic rate is a tax totem, and an important one, but it is far from the whole story. Direct taxation on individuals has gone up in this parliament even though the basic rate has come down, because the rate of employee National Insurance contributions has increased from 9% to 10%, personal allowances were frozen for two years, people enter the top rate bracket at a relatively lower level of income, and some allowances, such as those for married couples, have been cut.

It would be a mistake, however, to think of incentive effects as only arising from changes in direct taxation. Increases in indirect taxes plainly have an impact as Britain's alcohol and tobacco industries, suffering from the form of foreign competition known as the Calais run, will testify.

The increase in VAT from 15% to 17.5% in 1991 has probably been the single biggest contributor to the growth of the black economy in recent years, and helps explain why Treasury officials are scratching their heads over a continued shortfall in VAT revenues.

Maintaining a low corporation tax rate has been another important Conservative totem during this parliament. A low corporation tax rate does not, however, mean that all company taxes are low. Think of the uniform business rate.

And the argument about the effectiveness of capital allowances has not gone away. The Government appears happy to operate a double standard on investment incentives: it is willing to offer them to foreign companies locating or expanding here, or to others expanding in assisted areas, but argues that they would distort investment decisions if provided as a normal part of the corporate tax system.

How, then, should we judge the 26 November Budget? It is a fair bet that any Budget which is deemed to be a political triumph will almost certainly be bad for the economy. The tough 1981 Budget was a political disaster, but it was right for its time, just as Lawson's 1988 tax-cutting spectacular earned him good headlines but was just what the economy did not need at the time.

Hot favourite, cold comfort

But beware, too, the pundits who say that this year's Budget could repeat the 1988 error. When the public sector borrowing requirement, measured in billions of pounds, is in the mid-20s, the scope for huge mistakes is strictly limited. A tax cut of £3 billion represents under 0.5% of GDP.

The more important question is whether the Budget will leave the tax system, in terms of incentives, in a better state than it found it. A penny off the basic rate of income tax, which must be the hot favourite, helps repair a little of the earlier damage, but the real incentive problems are at the bottom of the income scale, among people to whom a small reduction in the basic rate makes scarcely any difference.

Consider too, the sheer size of the Budget which now contains decisions on both tax and public spending. One of the features of recent years has been the growth in tax legislation and the increasing complexity of the system. In the absence of eye-catching tax cuts, successive chancellors have allowed officials to go to town with technical tax changes. A complex tax system makes work for accountants but rarely provides the right kind of incentive signals. A complex system is what we already have, and we may, sadly, be due for more of it.

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