Why tax cuts must remain a priority

With government debt spiralling out of control, politicians of all parties are warning of the need for tax rises.  The ground is being prepared to hit the public with punitive increases in tax as whichever party wins the next election struggles to restore the public finances to some order.  A new 50% top rate of tax is due to be ushered in and David Cameron has refused to commit the Conservatives to repealing it.

After the economic recession and stagnation of the 1970s it was very different.  Advocates of so-called supply-side economics came into prominence arguing for greater flexibility in the economy and lower tax rates.  It started a trend that saw the top rate of tax in the UK come down from 83% to 40%.  In the United States the Kemp-Roth tax cut of 1981 brought the top rate of tax, over a period of time, down from 70% to 50%.

In both cases the aim was to stimulate economic recovery and growth.  Supporters of tax cuts argued that lower taxes helped the economy.  Some went further and suggested that lower taxes actually increased government tax revenues.  The argument was that higher economic growth resulting from the tax cuts, plus the return of high earners to the tax system, would produce increased tax yields.

This argument was based partly on what has come to be known as the Laffer curve, a theoretical model which suggests that raising tax rates beyond a certain point actually decreases revenue.  The assumption behind the Laffer curve is that tax rates at 0% and 100% would raise no revenue at all and therefore there is an optimal point between these two extremes at which tax revenues are maximized.

It is a compelling idea.  The thought that lowering tax rates could actually increase tax revenues should be a gift to aspiring politicians.  It is the modern equivalent of alchemy.

Unfortunately it is not quite as simple as that.  If you look at the curve (see picture), what it actually suggests is that tax revenues go up as taxes increase until an optimum point is reached, after which they go down.  It does not say that cutting taxes always and everywhere increases revenue.

So what is the optimum point, the rate at which tax revenues are maximized?  Surely, it may be said, once we know the optimum rate we can simply implement that and watch the Treasury coffers swell to overflowing!

Unfortunately, again, it is not that simple.

The point at which revenues are maximized is a theoretical concept that in practice is difficult to discern.  Through empirical observation it seems to vary widely from country to country.  We need to add health warnings to how the Laffer curve is used and understood.

First, the Laffer Curve only gives a generalised picture of the relationship between tax rates and tax revenues.  We all know that tax structures are very complex with many different rates and conditions.  This means that we need to look at not just an average tax rate but how it affects different groups in the population.  Higher earners, for example, are likely to be more responsive than average earners to changes in tax rates by engaging in tax evasion, moving abroad or changing their investment plans.  It may also be true that low earners, being taxed on the minimum wage, may calculate that the benefits system is preferable to working for little or no return.

Second, the regulatory environment and the degree of flexibility in the labour market are key factors in understanding how the economy responds to tax cuts (or rises).  In theory, a more flexible economy is likely to benefit more from tax cuts.  Thus tax cuts on their own - in the absence of wider reform - could potentially be costly and wasteful.

Third, there appears to be an historical and social variation, perhaps based upon different expectations in different countries.  The optimal tax rate may therefore be much lower in the United States than in Sweden, the latter having a highly developed public sector.

Fourth, as always in economics we must allow for time lags.  It may, for example, be true that a 10% cut in marginal tax rates would ultimately increase tax revenues in five or ten years, but in the meantime it may lead to much higher deficits.  Small variations in economic growth can make a big difference in tax revenues over time but the lost revenue from a tax cut will be immediate.

Finally, it all depends on the competition.  If one country is raising taxes while a neighbouring country is reducing them, the country with lower tax rates may gain in investment and growth.  Conversely, if all countries are heading in the same direction, the effects of tax cuts (or increases) on growth may be reduced.

Politicians, whether through cynicism or lack of understanding misuse the Laffer curve in order to support tax cuts in any circumstances.  On something as important as restoring the public finances, it is vital that we get it right.  If taxes really needed to be increased, we would not argue against it.  However, there is reason to believe that taxes in the UK have reached a saturation point.  Years of steadily growing taxation in the UK, while some others in the EU have been reducing taxes, has been destroying incentives.  The UK does not look like an attractive place to work or invest in a business.  Somehow we have got to shift the balance in favour of lower taxes.

The average earner in the UK is paying around half of their income in taxation when you take into account income tax, national insurance, council tax, VAT, duties on petrol, alcohol, cigarettes and so on.  The average higher rate taxpayer is paying around 60% of their income to the government.  We would argue that the UK is now on the right-hand side of the Laffer curve, that is, at the point at which higher taxes will - beyond the short-term - lead to lower growth and lower overall tax revenues.

Given the desperate state of the public finances, large tax cuts could certainly not be implemented quickly without creating havoc.  However, a serious and sustained effort to reduce public expenditure and cut taxes accordingly would have massive benefits for the UK in years to come.  The New Party policies on public expenditure and taxation, if they had been implemented several years ago, would have us in a much better fiscal position right now.

As it is, the plans of both Labour and the Conservatives are grim.  The Conservatives have at least started to address the question of public expenditure but they dare not suggest tax cuts.

We do.  The New Party proposal is for a phased move towards a flat rate of tax which would take workers on the minimum wage out of tax and end penal tax rates for higher earners, rates which are ultimately counter-productive.  By implementing a phased programme of tax cuts for all earners over a number of years, dependent upon public expenditure cuts, we would help to restore confidence to investors and return more money to the pockets of hard pressed families on modest incomes.

Taxation is a moral issue as well as an economic one, encompassing the debates about individual freedom and the responsibility of society to care for its most vulnerable citizens.  But moral arguments in favour of taxation count for nothing if the tax policy does not even achieve what it sets out to do.  Tax cuts - implemented responsibly - can be the route to restoring economic confidence and stimulating growth.  It is about time those who govern us got the message.