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
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
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.