Payment for goods: Addressing the social democrat's dilemma

If socialism is what socialist parties practise then it has long since ceased to mean common ownership of the means of production. Croslandite revisionism suggested socialism, or social democracy, consisted of maintaining full employment via Keynesian demand management techniques and equalising life chances via high levels of taxation and public expenditure. The supply side of the economy continued to be organised on capitalist principles.

In essence, the programmes of social democratic parties have not got far past the Croslandite programme, though their marketing has changed with electoral exigencies. Demand management for full employment became unfashionable in the era of increasing inflation in the 1970s and early 1980s, to re-emerge briefly in the last financial crisis. The limits of high tax and spend policies, however, are generally thought to have been reached, despite current concerns about growing inequality. Social democratic parties are widely regarded for that reason as having run out of ideas, leaving the neoliberal right with the intellectual upper-hand that it acquired in the reaction of the 1980s to high inflation. The New Labour episode is admired in Europe and elsewhere for its electoral success, but it is seen as brilliant camouflage for intellectual retreat rather than an intellectual advance; to extend the martial metaphor, more Dunkirk than D-Day.

The Croslandite train had to hit the buffers eventually because it faces an essential dilemma. Some would call it an 'internal contradiction'. And that is so even though it was based on a shrewd narrowing of ambition. The left prizes equality; the ideal is complete equality of opportunity and some limits on inequality of outcome. Postwar social democrats crystallised and contracted that ideal to focus on equality of access to certain key things that would promote equal life chances. These key things became known to economists as 'merit goods', things that would be outside the usual market supply-demand system and available to citizens as a right of citizenship. So citizens would have equal access to education to the limit of their ability, to critical healthcare and to criminal justice. Rich people could have better clothes, holidays, even food than their fellow citizens, but before the judge, the matriculation exam and the surgeon's knife, everyone would be equal. Such access does not guarantee complete equality of opportunity but it is surely a necessary condition.

The reality never matched up even to this moderate ideal. Legal aid never gave citizens true equality before the law in civil cases, and even in criminal cases it was partial. Well-resourced private schools have always been a prominent feature of the education scene; the state system never overcame the effect of differences in family circumstances on educational outcomes. Even the achievements have come under pressure. Higher education, for example, has been withdrawn from the social sphere and returned to a quasi-market system. Retreat was inevitable and here's why.

The three horns of a dilemma

The key merit goods identified by the social democrats – health and education – are not things of which people want less as they grow richer. The great error of Beveridge and Bevan was to suppose that health needs would be limited, that as the people got more prosperous they would get more healthy and that the share of GDP going to health services would decline. We now know that the opposite is the case. Technical progress opens up new and expensive opportunities to combat human ailments and extend the healthy lifespan, and the demand is limitless. Similarly in education, more people now want an education previously available only to a minority; the more you know, the more you want to know. And educational qualifications play the role of a positional good; a degree is worth less if everyone has one – then you need a PhD.

Demand for merit goods grows faster than income. The better off we are, the more we want to consume them. In the economists' jargon they are superior, not inferior, goods. The market system forces up the price of such goods to limit access to the available supply, which is itself encouraged by higher prices. But if the aim is to supply these goods free at the point of delivery and finance their provision by general taxation, you hit the essential social democratic dilemma. If demand rises faster than income or GDP, the financing taxes have to do so as well. Taxation has to rise continually as a share of GDP.

It gets worse. While labour productivity in many sectors of the economy rises over time, this has been less true in services like health and education. Therefore the cost of supplying them has risen relative to the price of other goods that have benefited from automation and the scale economies of mass production. Perhaps the information revolution will change things a little, but people resist mass production in health and education, demanding tailored care. Moreover, technical progress frequently serves to open up new treatments or areas of study that benefit recipients but are very expensive to deliver. Not only does demand for merit goods rise faster, their cost rises relatively too. The requirement for an increasing tax share becomes still more onerous.

Don't get depressed just yet because there is worse news still. Taxation tends to fall on labour income because labour is less mobile than capital. High labour taxes seldom lead to mass emigration, despite the French colony in South Kensington, but high capital taxes are either shifted or lead to mobile capital seeking another jurisdiction. In the postwar era of exchange controls and an increasing share of labour income in GDP, taxes could be increased. Today, with free movement of capital backed up by electronic facilitation and a declining wage share, trying to raise taxes indefinitely is a desperate business. Globalisation and the subsequent hollowing-out of the market in well-paid jobs in western countries severely limit the scope for taxes on wage income. Certainly the growing polarisation of incomes that has resulted leads to demands for higher taxes on very high incomes. But while that's an attractive measure to most people, it would not provide all the tax revenues required.

Faced with this triple-whammy, the social democratic programme has suffered serious erosion. Things like dentistry have effectively slipped from universal healthcare. Higher education has become commodified. And still the state budget is in deficit. What is the solution?

The limitations of growth policies

A recurring response on the left is that ways must be found to accelerate growth. If GDP grows faster then tax revenues follow suit, and perhaps they can keep up with the demand for merit goods. This was Harold Wilson's pitch in the 1960s with his 'white heat of the technological revolution'. It was echoed by Gordon Brown in the 1990s as he sought to close the UK's 'productivity gap'.

Let us not denigrate the search – currently fashionable once again on the left – for supply-side policies that will promote prosperity. A sensible active industrial policy would be a good thing. It is important to understand, however, that such a policy is highly unlikely to resolve the social democratic dilemma. It would be folly to base government policy and strategy on the gamble that it might.

UK economic growth over a century or more has averaged roughly 2.5 per cent a year. It has been lower during periods of macroeconomic disturbance, such as in the high-inflation period that followed the first oil shock of 1973, when it fell to 1 per cent for a decade, or in the post-crash period since 2008, when it has been negative. It was higher, at just over 3 per cent, in the 1950s and '60s, during years of postwar recovery. Looking through the cycles, however, it has been remarkably stable. Various ideologies have had their moments in fashion: economic planning and corporatism in the 1960s, free-market liberalism in the 1980s. The growth outcome has been little changed. It has averaged 2.5 per cent in the whole period since 1955; it was 2.6 per cent between 1955 and 1983, and in the period since – which includes the Thatcher 'renaissance' – it has averaged 2.4 per cent.

The international experience is that countries can enjoy periods of fast catch-up growth but eventually, if they are moderately well run, they revert to growth much like the UK long-run average. It is easier to fall short – by screwing up macro stability or allowing vested interests to paralyse the state – than it is to achieve durably faster growth. So try by all means, but recognise that if you raise the long-run growth rate from 2.5 to, say, 2.7 per cent, that will be a massive achievement. If you can do so while cutting carbon emissions then it will be an even bigger achievement, one which will bring blessings over the long run. And the process is slow: it will be 50 years before the economy is 10 per cent bigger than it would have been otherwise.

Building a community fund

A better and complementary answer to the social democratic dilemma sounds remarkably old-fashioned. Profits have been growing faster than GDP since the 1980s. If you can't tax capital in a mobile world you have to own it. Countries with substantial sovereign wealth funds, like Norway and Singapore, that invested in domestic and foreign equities, have far less difficulty in maintaining advanced welfare states. Public ownership of equity frequently arouses howls of protest from those who see it as threatening capitalist free enterprise. Yet the same people fulminate against 'unfunded' public pensions. If it is virtuous for the state to invest for pensions, why not to provide health and education free at the point of care?

The idea has impeccable intellectual credentials too. The Nobel laureate James Meade suggested a community fund to finance a citizens' income in the interests of equality of opportunity. The aim of a community fund for universal healthcare and education is more modest, and necessarily so. This is because of the big question: where will the fund come from? Meade's idea was to build it up by running budget surpluses. That is logical but falls in the same category as supply-side policy: it could make a big difference in 50 years' time. The challenge is to accelerate the process.

It is important to note that the British state has already missed several opportunities to build up a significant wealth fund. North Sea oil produced tax revenues that were used to cut other taxes while the exchange rate was allowed to appreciate. The tax revenues could have been used to buy foreign equities, the outflow holding down the exchange rate while building up the community fund. Indeed, that is where Norway's fund came from. Then the government privatised a range of state enterprises and utilities. The proceeds could have been used to diversify the public portfolio by investing in a range of companies at home and abroad. Most recently, through quantitative easing, the British government has printed some £350 billion, money equal to about one-tenth of the total capitalisation of the London stock market. The money went to buy gilt-edged securities from the banks and has sat idle in their balance sheets, though there is now evidence it may be leaking out to help finance a boom in house prices. Suppose it had been used to buy not gilts but equities. If a third had been invested at home and the rest abroad, the community would own a fund worth more than one-fifth of annual GDP.

Now it is too late, unless another slump and collapse of share prices provides a renewed opportunity. The community fund must now be built by hypothecating certain financial operations and taxes. For example, all future disposals of state assets – whether land sales, privatisations or auctions of the spectrum for telecommunications – should have proceeds hypothecated to the community fund. Capital disposals should not be spent but used to maintain the community's wealth in another form. Existing capital taxes, capital gains and inheritance tax, currently yield little but could be hypothecated. This would legitimise inheritance tax and enable it to be strengthened and have its loopholes closed in order to yield several billion pounds a year. John Major memorably wanted to abolish this tax so wealth could 'cascade down the generations'. That worthy objective could be realised for the community as a whole, not a just a minority of rich families.

Certain capital transactions of companies could also be made subject to scrip taxes – taxes paid with shares not cash. These dilute existing shareholder holdings but result in no cash outflow or liquidity strain on the company. Any one-off taxes on excess profits, like those levied on banks or oil producers from time to time, should be scrip taxes hypothecated to the community fund. There should be a levy on mergers and takeovers to the same end. Most of these have been shown to be not in the interests of the acquirer's shareholders anyway, so making them less attractive offsets a bias in the market and would be good policy. Any merger, acquisition or demutualisation should attract a levy of a small number of percentage points of the equity of the resultant company to be paid in scrip and hypothecated to the community fund. Given that companies are known to overpay for acquisitions by 20 or 30 per cent, a scrip tax of 2 or 3 per cent should not deter them. Stamp duty on share transactions and any future tax on financial market dealings, brought in with international agreement, should also be subject to the same hypothecation.

Securing popular support and political consensus

A practical difficulty with all this is that it is a long-run project that requires a degree of political consensus to be maintained. How is that to be secured?

First, by enlisting a powerful interest group in support. The fund would have to be at arm's length from government, with ministers having no say in investment decisions and no new means of putting pressure on company management. The fund would not be part of the apparatus of industrial policy. An independent entity with its own board would be created and professional fund managers employed. A pot of billions of pounds would present an attractive business opportunity to City fund managers, who would support its continuation.

Second, by explaining the social democratic dilemma to the electorate and cementing the importance of the fund in the public mind. If it acquires by inevitable association the sanctified status of the NHS, no government would abolish it. In any case, once conservatives get used to it, they will see that ensuring some tax revenues are saved, not spent, enhances fiscal discipline. Moreover, the state as a passive rentier would pose no threat to capitalism and, indeed, would have a greater interest in its success.

Gerald Holtham is an adviser to the Welsh finance minister, a visiting professor at Cardiff Business School and managing partner of Cadwyn Capital LLP.