The political barriers to radical tax reform

 

Want more public services, help with the cost of living, a simplified tax system and a reduction in the public sector deficit? It sounds like a Reform manifesto, but what I’m referring to is a detailed, radical and costed programme published by Prosperity 2030, a research institute at University College London. It got some publicity when its publication was accompanied by an Open Letter signed by, among others. Jim O’Neill, who is advising our new PM.

One of the core aspects of the programme is an extension of Universal Services, involving free local bus travel for all coupled with additional bus services, an end to the BBC TV licence, universal free school meals and much more, designed in part to replace the need for benefits with direct provision. On the tax side Income Tax, employee National Insurance, Capital Gains Tax, Dividend Tax, and Inheritance Tax are rolled into one, with a single schedule applied to all income (including benefit income and gifts), whatever its source. (I like the idea of calling this combined tax ‘national contributions’: see here.) Tax allowances are abolished. This raises around £75 billion a year. Rates run from 22% at the base to 46% at the top, with continuous progression between them and no cliff edges.

A Local Property Tax replaces Council Tax and Stamp Duty, taxing the property rather than the transaction or the occupant's 1991 banding, and contributes an additional £18 billion a year net. Tripled Air Passenger Duty raises around £8 billion in the first year. Overall the tax changes raise around £101 billion a year in new revenue, which fund £65 billion for the new universal services and £14 billion of capital investment in housing, hospices, and care, leaving around £38 billion (1.4% of GDP) spare to reduce borrowing.

Inevitably this involves raising taxes on certain groups by a considerable amount. The details can be found in the reports distributional analysis (see here), which takes account of the benefits of additional universal services as well as all the tax changes The main group to lose out are pensioners, except those in the lowest income quintile. Those in the richest quintile lose nearly £5,000 on average a year. One reason for this is that pensioners don’t pay National Insurance Contributions, so merging this with income taxes hits them. And of course they get no benefit from free bus travel because they already have it (although they will benefit from additional bus services).

Working adults with no children show net gains up to and including the middle quintile, although poorer households benefit the most. However the richest quintile again loses heavily, by on average £4,000 a year, in part because the top limit on national insurance contributions is in effect abolished. This profile is similar for couples with children, but those with children benefit more because of the extension of universal services. Of course all of this is based on quite complex modelling, including assumptions about how many would use free bus services, and how realistic that modelling is I cannot comment on. The distributional results are summarised below.

In essence this programme funds a large increase in public spending, mainly involving new universal services, by raising a very large amount of tax. The latter is achieved by simplifying the tax system, which in itself should be recorded as a significant benefit, although simplification can also produce changes that are seen as unfair [1]. I can see the appeal of a system that involves just one tax on all forms of income with no tax allowances, but also the arguments against. This and other aspects of the project involve issues that we should debate more, but such debates rarely take place in part because those that determine what is debated and what is not would lose out from such a reform, and also because the government has stuck itself with a ‘no additional taxes on working people’ pledge.

While some of the ideas in this proposal are relatively novel (like abolishing tax allowances and merging inheritance tax with income tax), others have been discussed periodically (e.g. universal services), and some much more frequently The idea of combining income tax with employee national insurance contributions has previously received support from many economists (see here), as has the idea of reforming property taxes. But major reform of the tax system has been largely off the radar of politicians for decades.

The reasons why a right wing government would never enact a scheme like this are obvious, and not worth discussing. To say that the reason such reform is off the agenda of Labour governments is because these Labour governments are not left wing enough is too simplistic. The problem is also that reform of this kind helps those that are less inclined to vote for it, while those who would lose out from such a scheme are more likely to vote against it.

This is most obvious with pensioners. As I noted above, pensioners in most income brackets lose out in this scheme, because they pay more in tax and already receive some elements of universal services. The current Labour government very early on tried to do something that hit most pensioners except the poorest, but on a much more minor scale, and the government’s popularity never recovered. The state pension triple lock, although obviously unsustainable in the longer term, seems almost untouchable in political terms. This is simply because pensioners make up a large and growing share of the population, and they are more likely to vote than other age groups. In recent general elections, around 80% of those over 65 voted, compared to around 60% of those aged 35-44 for example.

Exactly the same issue arises if we look at voting by income. Richer voters have always been more likely to vote, but that gap has been growing in recent years. To quote from a recent study written by Ben Ansell and Jane Gingrich that was part of the IFS’s Deaton Review of inequality: “Moving from the poorest to the richest group (up four quintiles) is associated with a 20 percentage point higher probability of turning out in elections since 2010, as compared with a level of under 10% until 2000.” In addition home owners are more likely to vote, and many of them would be hit by higher property taxes. It is no longer safe to assume that wealthier voters are unlikely to vote Labour, particularly if they are university educated.

Add to this the suspicion that those who lose out from tax changes make more noise than those that gain, and it is not hard to understand why our tax system remains complex and is full of inefficiencies. The reaction of those who vote make it much harder for any Prime Minister or Chancellor to enact a major tax reform that helps those who are poorer and simplifies the tax system, whatever their own political inclinations. This suggests that radical tax reform of the kind proposed by Prosperity 2030 will regrettably not be a major part of the UK political debate any time soon.

[1] To take an example that is not in this proposal but which is frequently mentioned by economists, zero-rating of VAT for food costs a great deal, benefits the rich as well as the poor and leads to expensive disputes at the margin. It would be much more efficient for poorer households to receive the equivalent saving in higher benefits, with the additional advantage that these households could choose how to spend the money. However I suspect that, partly for this reason, public support for the fairness of zero-rating food and other essentials is much higher than for higher benefit payments. 

How Right Wing Populism came easily to the Conservative Party

 

All the evidence points to the alarming extent of man made climate change. This isn’t just evidence available to scientists, but the everyday experience of everyone witnessing or experiencing both hotter temperatures and a more extreme climate. Yet Reform in the UK and the Republicans in the US not only deny this reality but propose policies that will end attempts to mitigate climate change, and instead encourage more use of fossil fuels.

It is far from unusual for right wing populist parties to ignore evidence in formulating their policies. They often deride expertise (experts are part of the despised elite, and universities are full of lefties etc), and appeal instead to common sense (the reasoning of the people). In an interesting substack, Joseph Heath relates this to Kahneman’s idea of fast and slow thinking.

While I think there is some truth in this, the example of climate change suggests it is not the full story. It is not obvious what common sense about climate change is, and as I noted above most people can observe (directly or indirectly) the evidence of climate change, if not its man made origins. So climate change denial is hardly common sense.

An alternative to the idea that right wing populists appeal to fast (intuitive) thinking is that they instead appeal to wishful thinking. At the level of right wing populists themselves, it is very convenient for them to deny the implications of climate change because the fossil fuel industry will then become rather generous with donations. At the voter level wishful thinking kicks in when mitigating climate change appears to cost money or involve unwelcome change. [1]

From a UK point of view, an interesting development over the last decade or less has been the attitude of the Conservative party to climate change. There used to be a degree of cross party consensus between Labour and the Conservatives on this issue, even if in reality Conservatives were less keen. (Cameron famously talked in private about ‘Green Crap’.) More recently, however, the Conservatives have explicitly abandoned their commitment to net zero. They want to repeal the 2008 Climate Change Act, get rid of carbon taxes and advocate for more extraction of fossil fuels.

While this change in attitude and policy is very regrettable, it really shouldn’t come as a great surprise. I would argue that the Conservative party has for some time been highly susceptible to wishful thinking and inclined to ignore evidence. In particular on two occasions over the last twenty years they have followed their own wishful thinking rather than evidence with disastrous results for the country.

The first is austerity after the Global Financial Crisis. The wishful thinking involved here had two aspects. The first was the belief that the size of the state could be reduced without cutting the responsibilities of the state. The second was the belief that the biggest recession since WWII was a perfectly good time to embark on a massive programme of fiscal consolidation (aka austerity).

The first aspect of their wishful thinking has been so all-pervasive on the political right that it might seem odd to say that it represents a failure to look at evidence rather than just an opinion, but the evidence is pretty clear. Take the NHS for example. After 2010 spending on the NHS was held flat as a share of GDP. But just a brief look at historic trends and trends in other countries would show that spending on health has tended to rise over time since WWII, in part because of an aging population.

Perhaps talk of ‘protecting’ NHS services was just propaganda, and austerity represented a deliberate attempt to squeeze spending based on a belief that this would force improvements in efficiency. More generally, right wing papers were often full of examples of alleged inefficiencies in state spending. But if this was the belief, then rising waiting lists that emerged pretty soon after austerity began should have led to a rethink. It did not.

The second aspect involved, as best as I can tell, a faith that monetary policy would be able to counteract the impact on aggregate demand of any fiscal consolidation. When interest rates hit their lower bound in 2009 that belief should have been discarded, but it wasn’t because justifying austerity on the basis of scaremongering about the budget deficit was just too attractive politically. Austerity went against what all the economics textbooks said and the majority of economists advised, a majority that became overwhelming within a few years.

The second example of wishful thinking that was disastrous for the UK was Brexit. Here the advice of economics textbooks and academics was even more overwhelming, but those pushing Brexit wished it away as ‘Project Fear’. Now you could argue that I’m being a little unfair here, because the parliamentary Conservative party was split on the issue. I would respond that it is a mistake to see the Conservative party just in terms of the views of its MPs. The party in the media (the right wing press) and at key moments the membership are also very powerful, and both were fully behind Brexit. Of course since the left the EU it has become fatal for a Tory MP to question Brexit, despite all the accumulating evidence of the harm that leaving the EU has done to the UK.

There are many other examples, of course. It would also be silly to argue that wishful thinking didn’t occur on the political centre or left, but it is difficult to think of similar examples where that wishful thinking had such a devastating result for the UK economy. You can blame the Brown/Blair government for deregulating financial services before the Global Financial Crisis, but it is harder to suggest that they did this in the face of the majority of expert opinion advising the contrary. (Expert opinion isn’t always right!)

Why the Conservative party should be so susceptible to wishful thinking is too big a question to answer here, and one I’m not sure I’m qualified to answer. Again, however, it is important to note that the party is more than just its MPs. Those MPs and their leader are at some point chosen by party members and are heavily influenced by a right wing press, a media that has never been known for its objectivity in looking at evidence.

Will Dunn notes the similarities between Trump and Kemi Badenoch here. That piece was written before Badenoch said she would purge Conservative candidates who supported a net zero policy, much like one of her predecessors purged candidates who didn’t support Brexit. It seems that denying bits of reality you don’t like is no longer just a fault, but has become an essential qualification for being involved with the Conservative party.

Among too many of those who comment on politics in the UK, right wing populism is seen as Farage, Reform and those parties and politicians to the right of both. This is a huge mistake. Right wing populism has for some time been integral to the UK’s mainstream right wing party. If support for Reform continues to decline, and the Conservatives overtake it in the polls, the threat of right wing populism in the UK will simply have changed the banner under which it marches. In this sense the UK is very like the US, where right wing populism is now the politics of the right.

[1] A third possibility relates to collective action. Perhaps social conservatives are more inclined to be free-riders, hoping someone, or some other country, will sort the problem out.

The UK’s falling debt to GDP fiscal rule is a rule to suppress public investment

 

Let me start by apologising to any regular readers of this blog. None of the arguments in this post are particularly new. But with a new PM and possibly a new Chancellor, and with Andy Burnham committed to high public investment including many more council houses, it seems appropriate to make this argument once again in as clear a way as I can.

The UK has for some time had two fiscal rules. One targets some measure of the future deficit as a ratio of GDP and the other requires debt to GDP to be falling. The second rule is about the change in debt, but the first rule is about the deficit which is the change in debt. So why do we need two rules which essentially target the same thing? [1]

Here are the variables relevant to the two current fiscal rules since 2000.

The red line, the ‘golden rule’ that targets the current balance, shows the impact of the two recent recessions quite clearly. As I have long argued, fiscal rules should be abandoned during recessions and the subsequent recovery. The blue line, which is the change in the government’s net financial liabilities as a ratio of GDP, is the falling debt to GDP rule. It is much more erratic, which automatically makes it a bad target for any fiscal rule, but it essentially follows the path of the current balance. The main difference is that, for a given deficit, when GDP is falling then debt to GDP will rise sharply, and equally when GDP is growing strongly debt to GDP will tend to fall.

So why two rules? Why not choose the more stable of the two, the golden rule for the current balance? The technical answer, which many of you will have already noted, is that the current balance excludes public investment. Without the second rule, then in theory public investment could be very high leaving debt to GDP rising even if the current balance was zero.

As I have argued many times, the golden rule makes good sense in principle. As long as we measure the current balance some years ahead to strip out erratic elements or the impact of the business cycle, and as long as we have an opt out from the rule in major recessions when interest rates are likely to hit their lower bound, then it makes sense to aim to have a fiscal policy that neither adds to nor subtracts from aggregate demand. A current balance target is a shorthand way of doing that. [2]

Why exclude public investment from the deficit rule? There are many reasons, but one of the more compelling is that politicians will often try to meet any total deficit rule by cutting public investment rather than current spending, because the political cost is less immediately visible. 2010 austerity was a clear example of that, and we are still suffering its effects. Better to target the current balance, which forces politicians to make choices that don’t damage the economy in the longer term. A second, and at least as important, reason is that individual public investment decisions should be based on whether the projects themselves are worthwhile, and not on some aggregate financial number. When a business sees a good investment opportunity it borrows to invest, so why shouldn’t the government do the same?

But that compelling logic means that it makes no sense to have a second fiscal rule, the only purpose of which is to constrain aggregate public investment. The logic that removes public investment from the deficit rule is just overridden by having this second fiscal rule! At best the falling debt to GDP rule just duplicates the golden rule, and at worst it constrains public investment and adds an erratic element to fiscal policy as well.

This case against the falling debt to GDP rule is overwhelming. I have been arguing against this rule for a very long time, and I challenge anyone to come up with a justification for it that I cannot debunk pretty quickly. It is true that a zero current balance rule will not guarantee falling debt to GDP, but if the government really wants to be absolutely sure that debt to GDP falls it can achieve that by targeting a small surplus for the current balance. (See the section headed “Why not focus solely on the current budget balance?” in Ben Zaranko’s discussion.)

I don’t think the reason we have the falling debt to GDP rule is technocratic. Nor do I think it is just because some want low public investment for political reasons. Instead I think it is part of what I call mediamacro. According to too many journalists in the media, government debt is bad, so a good fiscal rule has to ensure that this bad thing is getting smaller. If the rule doesn’t actually specify that directly, then from a mediamacro point of view that is a problem.

I became convinced of that when I was on John McDonnell’s Economic Advisory Council when he was Shadow Chancellor. I wrote a paper for the Council arguing for a form of golden rule and ditching the falling debt to GDP rule, and the only dissent on the Council (chaired by John) was from those against having any rule at all. But later I got a call from John’s team, saying that their political/media advice was that a form of a falling debt rule had to be included as well. (They did, however, try and reduce the eratic nature of that target.) I suspect every Chancellor before or since has been getting that advice, and as ever politics trumps economics.

If we combine the falling debt to GDP rule’s constraint on public investment under a Labour government with the Conservative predisposition to cut this investment anyway, and it becomes much easier to understand why UK public investment is unusually low. There may be occasions where the pressure on real resources is such that the additional domestic demand generated by additional public investment in the short term might lead to unacceptably high interest rates, but that is not always the case and the falling debt to GDP rule applies whatever. This constraint on public investment also means that Labour governments search for other less sensible means to increase public investment that avoid immediate public borrowing, such as PFI for example.

If public perception, which in reality means media perception, is really believed to be a binding constraint, then there is a way around the problem, a route that John McDonnell later took. Rachel Reeves has already redefined the measure of debt in the rule to include financial assets held by the government. The obvious next step would be to include physical assets as well, meaning that public investment would have no long term impact on the measure of debt [3] The disadvantage of taking that route is that it brings the falling debt to GDP rule even closer to the golden rule. but if that hastens the eventual demise of the falling debt to GDP rule so much the better. [4]

So my advice to a new Chancellor, if we have one, is to get the Treasury to write a paper setting out why the falling debt to GDP rule along side the golden rule simply acts as a barrier to public investment, and how under reasonable assumptions the golden rule achieves falling debt to GDP in the medium to long term. [5] At the same time commission an analysis of where the public sector capital stock has declined over the last twenty years, together with a sector by sector analysis of possible supply side constraints on increasing public investment today.  

The argument in this post is not that the government should never try to reduce debt if it can. I think there is a good reason why it might wish to, which is to make room for large increases in debt following a major recession. It can do this by, if necessary, setting a non-zero target for the current balance. Instead my argument here is that public investment should not be the means by which that debt is reduced, which is the inevitable consequence of having falling debt to GDP as our second fiscal rule.

[1] Why not target the level of debt? Targeting debt makes no sense, because debt is the shock absorber that allows governments to avoid erratic movements in spending and taxes following shocks to the economy. But debt (or money creation) has a downside, which is that it allows politicians to avoid tax increases or spending cuts not for the sake of the economy but for the sake of their popularity (‘deficit bias’). That is why it makes sense to target the difference between spending and taxes, which is the deficit.

[2] Why not just look at inflationary pressure directly, as MMT would argue? Well if the central bank is doing its job then it will always ensure inflationary pressure some years ahead is zero.The reason to have a balanced fiscal policy is to avoid our central bank having to raise interest rates just because politicians don’t like making unpopular decisions..

[3] Indeed, if the asset was worth more than than its initial cost, it would increase public wealth

[4] Subtracting physical assets from debt is a logical next step to the change made my Rachel Reeves to subtract public sector financial assets. It transforms debt into a measure of public sector wealth or net worth, that many including another Andy have suggested as a traget in the past. 

[5] While supportive of looking at public sector net worth, a standard line from the IFS among others is that looking at gross debt is still useful because public sector assets don’t necessarily yield a financial return. But this doesn’t matter, because in that case the government can just raise future taxes following the golden rule. Indeed that is the right outcome from an intergenerational point of view, because those who benefit from the investment pay for it.

I think this and similar arguments for retaining a rule involving gross rather than net debt owe something to the concept of ‘fiscal space’, which is the idea that there is some upper limit to what public debt can be, and crucially that we are always close to that limit. There is an upper limit to public debt, which is the level of debt where the government would rather default than raise taxes to service that debt. That level is an order of magnitude above current levels. Other attempts to suggest a much lower limit to the public debt tend to fall apart empirically.