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Lessons of history lost on ‘big cut’ proponents

The Institute of Directors and the Tax Payers’ Alliance, the free-market lobbying group, have today published their 2020 Tax Commission Report. Its recommendations – as you might expect from its membership – are the fairly standard neoliberal ones of cutting taxes and government spending. The most eye-catching proposals are for a flat tax of 30 per cent on all income and for a limit to public spending at 33 per cent of GDP.

The impact of these proposals would be to cut public spending by a further £121 billion a year by 2020 – which is nearly what we spend as a country on the NHS. The report doesn’t specify where cuts of this magnitude would fall. Nor does it factor in cuts to public spending in its distributional analysis of how its recommendations affect different social classes. Instead, it simply assesses the impact on taxpaying households of the tax cuts. Hence it leaves out what its proposals mean for working and non-working households who are too poor to pay tax, and the regressive consequences of public spending cuts. These are major omissions.

The central claim of the report is that lower taxes lead to higher growth. Unfortunately, the empirical evidence doesn’t support this view. The world’s leading authority on the development of welfare states and public services since the 18th century, Peter Lindert, puts it like this:

‘Across countries and over time, the coefficients linking growth to total government size are not negative, even in sophisticated multivariate analysis. In the global cross section, richer countries do not tax and spend less … The longer sweep of history also refuses to cooperate. Among the advanced OECD countries, the periods with the fastest-growing welfare states – between 1950 and 1980 – included history’s best-ever golden age of growth (1950–1973), even though it included the oil shocks that hit in 1973 and 1979. Whether one looks at levels or rates of change, one cannot show any clear negative relationship between social spending and GDP per capita.’
Growing Public, p30).

To illustrate this conclusion, it is instructive to compare high-tax-and-spend Denmark and Sweden with the low-tax US, as the social theorist Lane Kenworthy has done. In 1960, all three countries had tax takes of around a quarter of GDP. By the mid-1980s, the Nordic countries were taking around 50 per cent of GDP in taxes while the US hovered around the 25–30 per cent mark. Despite this divergence, per capita growth rates have been very similar in the three countries over the last 50 years. Measurements of innovation and competitiveness are comparable, while the employment rate is higher in the Nordic countries. The Nordics are much more equal societies, however, spreading their income and services much more fairly and widely across the population.

The IoD/TPA report retorts that the Nordic and northern European countries may have a history of high tax and spend, but they have been travelling in a free market direction in recent years, cutting taxes and spending. Yet as the table from the OECD reproduced below shows, total tax revenue as a proportion of GDP has remained fairly constant in Denmark since 1995, at around 48 per cent, and in Norway since the mid-1980s, at close to 43 per cent. Tax revenues in Sweden fell from over 51 per cent of GDP at the turn of the century to 45.8 per cent in 2010, but the tax take is still close to the 1985 figure of 47.4 per cent. Finland registered 42.1 per cent of GDP in total tax revenue in 2010 – down from its peak of 47.2 per cent at the turn of the century but still above the 39.8 per cent it scored in 1985. The same broad patterns hold for other northern European countries, such as Germany.

Total tax revenue as percentage of GDP

Total tax revenue as percentage of GDP

Source: OECD

What, then, of the claim that lower taxes and government spending actually increase tax revenues by stimulating economic activity and encouraging tax compliance? On this score, the IoD/TPA report rests heavily on some very suspicious modelling. But we have a real-world example to hand. In 2001, George Bush cut taxes across the board, drawing down the surpluses built up in the Clinton years. The US government’s federal debt rose from 57 per cent in 2001 to 66 per cent in 2008 and 80 per cent at the start of 2009, when Bush left office. Annual growth rates averaged 1.6 per cent in the 2000s, compared to 3.4 per cent in the 1990s. So the tax cuts were associated with higher debt and lower growth.

Interestingly, the UK’s fiscal position has tended to be weakest when spending has been dramatically cut, as shown by this chart from Ann Pettifor and Victoria Chick correlating the relationship between spending cuts and government debt in the UK during the 20th century.

Changes in government expenditure and debt

Changes in government expenditure and debt

Leaving aside the two world wars, we can see that government debt rose sharply during periods of spending cuts, and fell during periods of increased government spending. More specifically:

  • The period of deep spending cuts after the first world war (the ‘Geddes Axe’ era) saw government debt rise from 114 per cent of GDP in 1918 to 180 per cent of GDP in 1923
  • The National government spending cuts of 1931–1933 saw debt rise again from 173 per cent of GDP to 183 per cent
  • After world war two, debt fell in every year between 1947 and 1975 during a period of rising public spending (from 245 per cent of GDP to 45 per cent)
  • From 1976 onwards, the debt ratio has fluctuated with the economic cycle.

None of this means that we can be blasé about the UK’s deficit or its future fiscal sustainability; quite the reverse. Spending cuts will be needed to eradicate the structural deficit, as will tax rises. But this detour into British history should serve as a reminder that when spending cuts produce weaker growth and higher unemployment, they drive up government deficits and debt – they don’t bring them down.

The optimal policy mix is to invest in growth and employment enhancing infrastructure (particularly transport and housing); provide universal services, like childcare, that support full employment; and ensure that the tax base is both broad and resilient, and capable of funding the services and transfers that reduce inequalities. Combine these measures with competitive, open economies and active welfare states, and you have the secret of the northern European experience.

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3 Responses to Lessons of history lost on ‘big cut’ proponents

  1. Matt says:

    I haven’t read the TPA report, I have better ways to spend my time, and I doubt I’d agree with it if I did. I’d say that growth is a) more a product of structural factors that government can’t do much about anyway b) that other factors such as institutional setups and the way in which taxes and spending are conducted matter more to the part they can control than the level of taxation itself.

    Having said that, I find some of your arguments for what is probably a similar position a bit disingenuous. First I find it hard to believe that a group like the TPA would claim that lower taxes lead to higher growth independent of the level of spending. Perhaps they do, as I say I haven’t read the report, but if their claim is that lower taxation and spending leads to higher growth I find your first chart to be a slightly misleading argument to refute this. The UK government actually spent about as much as Sweden and more than Norway and Finland in 2010, the difference in taxation comes about because those countries were running a slight fiscal surplus whilst the UK was running a large deficit. As someone who used to live in the UK and now lives in Sweden I think the Nordics can actually get away with a higher level of taxes and spending than the UK or the US due to higher levels of trust, better institutions and more efficient policy making. The US, who really is the outlier has a higher level of per capita GDP than most European Countries with lower levels of taxes and spending. The Nordics got into some trouble when government started to take up near or above 50% of GDP and they did start to reverse course slightly, this suggests to me that there is a limit on how large the government can be before it starts to become an obstacle. This limit is probably higher in the Nordics than it is in the UK due to issues of trust, institutions and efficiency, and the UK level is probably higher than that in the US. For example the tax code in Sweden is much more efficient than in the UK, whilst the US has a notoriously inefficient tax code. Perhaps higher taxation forces you to make the tax code more efficient, or perhaps a more inefficient tax code forces you into having lower taxes, I don’t know which way the causation runs, but this suggests that since the UK has Swedish levels of spending they either need to cut spending or make the tax code more efficient in order to be able to collect more in tax without it being damaging.

    The second chart, which I realise you didn’t create, I find even more misleading. The three time periods on the upper left are right after WWI, right after WWII and the early part of the Great Depression. The periods after the two world wars are just as much special cases as during the world wars, government spending was falling due to the end of the war effort, but it was still at extremely high levels as the country rebuilt itself and the UK was still incurring debt to pay for this high expenditure. The period at the start of the great depression wasn’t the best time to cut spending, but it’s a special case where the debt/GDP ratio is likely to rise rapidly due to the large exogenous fall in GDP. The 1933-39 period suggests that government spending can be expansionary during a depression whilst you’re on a gold standard which fixes the response of monetary policy, under inflation targeting I don’t see that this would still hold since the central bank should offset increases or decreases in government expenditure in order to keep inflation at the right level. Without either of the two world war or the depression there seems to be very little relationship between spending and debt one way or the other, I imagine the period from 1976-2009 is really the illustrative one – debt tends to fluctuate with the economic cycle.

    Additionally on the George Bush point, George Bush cut taxes considerably and tax receipts actually rose – though probably due to the economic cycle – but he also increased spending by over 70% during his time in office. You could just as easily say that spending increases were associated with higher debt and lower growth.

    • Colin Talbot says:

      Matt,

      By using 2010 as a benchmark for UK spending you miss the long-term picture. UK public spending (as a percentage of GDP) has averaged just under 43% over the past 50 years. At no point during the last Government did it exceed this level until the impact of the Financial Crisis in 2007 crashed the private sector economy into recession. From 1997 to 2007 UK debt never went above 40% and the deficit above 3% of GDP – incidentally the Mastricht criteria for joining the Euro. Over the same period German debt averaged about 60% of GDP, but their growth rate was better. Britain’s debt level was over 100% of GDP from roughly 1750 to 1850, when, as Andrew Dillnot has pointed out, we took over most of the planet and grea like carzy. So none of these ratios are simple predictors or conditions of private sector health and growth, as you acknowledge. Far more complex factors at work. The IoD/TPA stuff is just ideological tosh.