Happy tax year

Today is the start of the new tax year in the UK and to celebrate the Institute for Fiscal Studies recently published a nice little piece outlining the impact of the inflation indexation of tax thresholds (here). As the IFS points out, the UK routinely uprates the cash value of tax thresholds in line with inflation, unlike many other countries. This process dates back to 1977 when two backbench MPs introduced a process forcing the government to automatically uprate thresholds in what became known as the Rooker-Wise Amendment. This makes a lot of sense: Without such indexation as wages rise in line with inflation, so ever more people at the lower end of the income scale would be dragged into higher tax brackets.

But the IFS notes that across many tax categories this automatic uprating has not taken place for a number of years. Two of the most interesting examples are fuel duties which have not increased in cash terms since April 2010 whilst working-age benefits have been frozen since 2015-16. At a time when governments around the world are trying to curb vehicle emissions it does seem rather odd that the UK is not taking the opportunity to take the moral high ground by raising emissions taxes. Consumer prices have risen by 16% since the start of 2011 which would add around 10p to a litre of diesel (7.5%). Obviously, drivers will not complain that the real value of fuel taxes has declined over the last 9 years but it does seem at odds with the government’s self-professed green credentials. We can view this move in one of two ways: It is an overtly political move to curry favour with motorists or it is an attempt to reduce the regressive effect of such taxes.

Being charitable, we should perhaps assume the latter option in an effort to redress the effect of a freeze in the cash value of working age benefits, which obviously means a decline in real terms. But as the IFS put it, “the government might believe that benefits should be more or less generous, but the extent of any change in generosity should be thought through and justified, not the arbitrary and accidental result of what the rate of inflation turns out to be.”

The IFS has also identified a growing trend of instances where thresholds are maintained in cash terms and only uprated when the government believes it to be necessary. Most of these instances really only affect those at the upper end of the income scale and whilst the vast majority of taxpayers will not shed any tears for the better paid members of society, they do illustrate how arbitrary manipulation of tax thresholds can result in some strange outcomes which may impact on work incentives.

One such is the £100k threshold at which the personal tax allowance is progressively withdrawn. Anyone earning below this amount is entitled to a £12.5k tax-free allowance but for every £2 of income above £100k the tax free amount is reduced by £1. One result of this is that those earning between £100k and £123.7k are taxed at a marginal rate of 60% (i.e. they keep just 40p out of every £1 they earn thanks to the allowance taper). Yet more bizarre is that those earning between £123.7k and £150k are once again subject to a lower marginal tax rate of 40% (above £150k the marginal income tax rate rises to 45%). “Oh dear, how sad, never mind” you may say. But there are now 968,000 taxpayers’ earning more than £100k – an increase of more than half since 2007-08, who have been dragged into the net due to the failure to index the threshold.

That said, higher taxes on the better off in society have been used to fund an extension of the zero-tax threshold for the less well paid. In fiscal year 2007-08 (the last year before the financial crisis) those earning £10,000 paid an average tax rate of 13.1% (income tax plus National Insurance Contributions). The government’s stated policy of taking the lower paid out of the tax system altogether means that someone earning this amount today pays an average tax rate of only 1.6%. As the chart suggests, the average tax schedule has clearly shifted to the right compared to 2007-08, illustrating the reduction in tax liability of the less well paid. The curve is also lower than it was in 2007-08 for incomes below £100k, so most people pay less tax, but it rises sharply thereafter, and those earning £120k are paying more.

But the true marginal tax rate is not merely made up of the amount levied on income – we have to account for the withdrawal of social welfare entitlements, and those lower down the income scale are in the line of fire. For example, those earning more than £50k per year have to pay back some of their Child Benefit in the form of extra income tax. If they earn between £50k and £60k and have one child, they face a marginal income tax rate of 51% but if they have three children their marginal income tax rate is 65%. Again, this threshold has remained unchanged for some years which means an increasing number of people are likely to run into this problem.

However, one of the more bizarre quirks is the reduction in the pension annual allowance for high-income individuals. The first £40k of pension contributions is free from income tax but those whose income (excluding pension contributions) exceeds £110k face a tapering in their tax free pension allowance. Without going through the details (they are outlined in the IFS paper), the upshot is that someone earning £150k (including pension contributions) can put £40k into their pension without incurring extra taxation but someone whose total income (including pension contributions) is £210k finds that their tax free allowance is reduced to only £10k. More bizarre still is that the likes of senior doctors, whose generous defined benefit pension schemes result in contributions exceeding £40k, can end up facing marginal tax rates of more than 100%. I was recently made aware of instances where such doctors are not prepared to work beyond a certain point because they pay more tax than they earn (obviously, they could offer their time for free but they could equally well enjoy an evening at home if they are not getting paid for it).

Although some of the examples highlighted here are extreme cases, they illustrate how an ill-designed tax system can result in high marginal tax rates that act as a disincentive to work. And the more people are dragged into the tax net due to the absence of indexation, the greater is this effect. A good tax system should meet five basic conditions: fairness, adequacy, simplicity, transparency, and administrative ease. A lack of inflation indexation undermines all of them.

Sir James Mirrlees and optimal tax systems

To paraphrase the nineteenth century British Prime Minister Lord Palmerston, only two people have ever understood the tax system: One went mad and the other died. Indeed, one of the few people to have properly understood the tax system was the Nobel Prize winning economist Sir James Mirrlees, who died earlier this week. Mirrlees was best known in academic circles for his work on decision making under uncertainty for which he won the Nobel Prize in 1996, and his most insightful work was his 1971 paper on optimal tax systems in which he showed how and why there was a trade-off between equity and efficiency.

The paper is mathematically dense but it had a huge impact on information economics by introducing models with asymmetric information into contract theory. Until the late-1990s the results of these models were not closely connected to empirical tax studies and had little impact on tax policy recommendations. But a number of authors, including Peter Diamond and Thomas Piketty have since connected Mirrlees’ model to practical tax policy.

He was thus the obvious choice to head up a review of the UK tax system commissioned by the Institute for Fiscal Studies almost a decade ago. It was a follow-up to the Meade Committee report of 1978 which was concerned with the question of how the tax system impacted on the wider economy by distorting incentives. Thirty years later, the IFS noted that the tax system had evolved in a piecemeal fashion “rather than by strategic design” and that it had not adapted to changes in the general economic environment in which it applied. Moreover, as the IFS pointed out, “tax design has not benefited as much as it could from advances in theoretical and empirical understanding of the way features of the system influence people’s behaviour.”

Mirrlees and his colleagues took an in-depth look at the state of the UK tax system “to identify reforms that would make the tax system more efficient, while raising roughly the same amount of revenue as the current system and while redistributing resources to those with high needs or low incomes to roughly the same degree.” They noted that the UK system is “unnecessarily complex and distorting” with tax policy “driven more by short-term expedience than by any long-term strategy” in which policymakers did not seem to grasp the extent to which individual agents change their behaviour in response to changes in tax incentives. This was a damning indictment and it is still true today, with a myriad of small changes having come into effect since the report was published which impact on the way people and companies behave.

The report noted in particular that income inequality had widened, particularly during the 1980s, but that merely soaking the rich was not necessarily the way to go. In any case, corporate and capital gains taxes are at least as important as income taxes in terms of their wider impact, and certainly the combination of all three is likely to be more critical than looking at one in isolation. In this sense the Mirrlees Review took a far more wide ranging view of tax issues. Indeed, a key recommendation was that the complex benefits system should be harmonised with income taxation, in order to increase work incentives for the lower paid (something which the government has tried – and failed – to achieve with the Universal Credit System).

The report also noted that the corporate tax system favours debt finance over equity finance which in turn has increased the reliance on debt, and recommended an allowance for corporate equity (ACE) be introduced into the corporate tax system. Taxation of savings is another aspect requiring radical reform. Savings in the UK are subject to double taxation, with income tax levied on the original income from which the saving is generated and again on interest income derived as a result. With the government having for many years exhorted individuals to save more, this is an obvious anomaly. The Mirrlees Review thus recommended that standard bank and building society accounts should be entirely free of tax. Neither of these recommendations has been implemented (though the interest on bank accounts these days is so low that tax is negligible).

I was heartened by the Mirrlees Review when I first looked at it almost a decade ago because it was an accessible review of the state of the tax system, which looked at how the various parts fitted together without delving into the politics of taxation. It is a shame, therefore, that many of its recommendations have not been implemented. Perhaps it was the right report at the wrong time, with governments then too preoccupied with the day-to-day task of reducing deficits to pay much attention to reforming the tax system itself. Perhaps the passing of Sir James Mirrlees offers us another opportunity to revisit what I believe to be an outstanding piece of work, and to think again about some of its conclusions.

Examining the case for a wealth tax

I have pointed out previously that the huge fiscal tightening imposed on the UK over the past eight years has come about through huge cuts in spending and relatively little by way of additional taxation (most recently here). Now that the balance between current spending and revenue has been restored, there is no serious rationale for further swingeing spending cuts. Undoubtedly this was one of the factors supporting the announcement by Theresa May earlier this week that additional funding will be made available for the NHS.

Whilst this is a welcome development, the pressure on public finances has not suddenly gone away now that the deficit on current spending has been eliminated. If anything, as the population ages, the demands on healthcare and social services will continue to rise. It is not just the health system that is struggling to cope: The benefits system is under pressure too, and there is a huge wedge of people at the lower end of the income scale who are struggling to gain access to the benefits to which they are entitled.

What the government has not outlined is how much additional funding will be provided nor where it will come from. After eight years of grinding austerity, raising existing taxes to fund the additional resource requirements will not be acceptable to taxpayers who would regard it as yet another kick in the teeth for the squeezed middle. Indeed, raising income taxes appears to be a non-starter. In any case, efforts to compensate low-paid workers for the curbing of their benefits via an increase in personal income tax allowances is already estimated to have cost a cumulated £12bn in foregone revenue in FY 2017-18. Having raised VAT to an already-lofty 20%, the scope for raising indirect taxes is also limited. It would thus be sensible to look for alternative revenue sources, and two apparently radical fiscal suggestions have been given more prominence in recent weeks. One is the possibility of some form of wealth tax and the other is to introduce a hypothecated tax to fund such items as the NHS.

In this post I will consider only the option of a wealth tax and will come back to hypothecated taxes another time. The rationale for a wealth tax is that incomes, which form the basis of most direct taxes, have remained stable relative to GDP over the past three decades whereas wealth holdings have significantly increased. Thirty years ago, UK household net financial wealth holdings were a multiple of 1.2 times GDP but today the multiple stands at 2.3. The picture looks even more favourable if we add in wealth held in the form of housing. Financial and housing wealth together amount to around 5 times GDP compared to a multiple of 3 in 1988 (chart).

But why should this windfall gain be subject to tax? One strong argument is that taxes on income do not take into account the claim on overall resources that wealth confers. For example, there is a difference in the ability to pay a bill of (say) £1,000 between someone who earns £20,000 from labour income and someone who earns £20,000 as a return on a wealth stock of £1 million. As a result, a wealth tax will raise the overall progressivity of the tax system by taking account of the additional taxable capacity conferred by wealth. But wealth holdings are already subject to tax in some form or another. For example, liquidating wealth holdings subjects individuals to capital gains tax. Moreover, the flow of income accruing to a stock of financial wealth is liable to income tax. In addition, even if the wealth is untouched and generates no direct financial benefit to the individual, if it is passed on as a bequest to future generations it is subject to inheritance tax.

In any case, there are a huge number of practical difficulties associated with introducing a wealth tax. To name just a few: How much should it raise? On which assets should it be levied? At what rate should it be set? Should it be set at a single or graduated rate? Howmuch (if any) of an individual’s wealth should be exempt? Even if we could agree on these issues, once such a tax has been implemented, two of the biggest ongoing problems are disclosure and valuation. The disclosure problem is obvious: It is easy to hide many forms of wealth (think how simple it is to hide small but precious items such as diamonds). As a result, compliance becomes a problem and even honest taxpayers have an incentive to cheat if their fellow citizens are not playing ball. In addition, the valuation problem is often underestimated, particularly if the absence of a market transaction makes it difficult to establish an appropriate valuation metric. It is for all these reasons that the proportion of OECD countries levying a wealth tax has fallen over the last three decades. In 1990, half of them did so (17) but by 2010 only France, Norway and Switzerland levied them on an ongoing basis.

Despite all the practical difficulties, there is a genuine case for some form of wealth tax on grounds of inter-generational fairness. For example, older generations tend to hold the vast bulk of the wealth whilst benefiting from additional public spending on areas such as the NHS. It is for this reason that the Resolution Foundation recently put forward a series of proposals to reform property taxes, including the introduction of a progressive property tax to replace the existing Council Tax and raising taxes on highest-value properties.

Such measures will clearly not be popular with Conservative voters, and is one reason why they will not be implemented any time soon. But as the fiscal debate increasingly switches away from deficit reduction and focuses more on what the state can reasonably be expected to provide, the issue of inter-generational equity will inevitably rise up the list. We may not want to talk about wealth taxes today but it is an issue that is unlikely to go away.

Age concern

Without wishing to trivialise in any way the horrific bombing in Manchester, the suspension of the UK election campaign came at a fortuitous time for the prime minister who was undoubtedly on the ropes on Monday regarding her U-turn on plans to fund care for the elderly. Dealing with old age care is an issue of major economic importance, and I did note last weekend that “tackling the problems of an ageing society will require us to think differently on tax and social insurance issues.” But it is worthwhile digging into some of the economic implications of an issue which not only affects the UK but is a problem for all ageing societies.

To remind you of the story so far, the Conservative manifesto last week suggested that those requiring long-term old age care would be required to run down their assets to “a single capital floor, set at £100,000, more than four times the current means test threshold.” The implication is that households will have to pay a lot less than they do today. Whilst that is true of the current system, it omits the fact that under legislation already on the books “from April 2020, there will be a cap limiting the amount people will have to pay for their care and support”. Moreover, the threshold beyond which people receive no financial support is due to rise from £23,250 to £118,500 (these reforms were originally scheduled for 2016 but local authorities balked at the additional costs this would impose, hence the delay until 2020).

In other words, a significantly more favourable plan is already scheduled to come into play in 2020 than that proposed by the Conservatives. As it currently stands, someone who has lifetime care costs of £150,000 could lose up to 90% of their accumulated wealth. Raising the support threshold and imposing a cap significantly reduces this proportion. By contrast, the Conservatives’ plan placed no such upper limit so that all but the final £100,000 of an individual’s assets could be used to fund their care needs. I am indebted to the FT’s economics correspondent, Chris Giles, for working out the tax rates on assets in different care systems (see chart). What is evident is the magnitude of the costs under the current system (the green area) versus the proposals set out by the Dilnot Commission in 2010 (black line). Last week’s Conservative plans (red line) help those at the lower end of the asset scale but they are far less favourable compared to what was proposed in 2010.

The idea of scrapping the cap caused an outcry for both good and bad reasons. The bad reason is the notion that today’s generation of pensioners be protected so that they can hand over their stock of assets to future generations. Whilst this may reflect an instinctive desire to help one’s offspring, there is no reason why today’s tax revenues should be used to ring-fence bequests to future generations. A better objection is that the absence of a cap promotes unfairness due to the fact that for any given wealth cohort some will be afflicted by illnesses which require extensive old age care whilst others will not. For example, an unfortunate pensioner who suffers from dementia may require many years of care whereas someone with the same assets who dies suddenly at the same age will not face the same care burden. There is no sense of social insurance: people are very much on their own.

Whether the reaction of the public and politicians was motivated more by the latter than the former matters less than the fact that the Conservatives responded to the groundswell of opposition by announcing they would indeed place an “absolute limit” on care costs (without saying what the limit would be). What is absolutely not true is the prime minister’s assertion that “nothing has changed from the principles on social care policy that we set out on our manifesto.” In fact, everything has changed. The principle of a cap means that we have some notion of risk pooling rather than one which forces individuals to bear full personal liability.

A more pertinent question is how this should be funded, which is the bit no-one talks about. The Dilnot Commission pointed out that there are three ways to fund old age care provision. The obvious way is to do what we do now – raise the additional revenue from general taxation, which will mean higher taxes. A second option would be to change the balance of spending away from other items and towards care provision. However, a third option would be to introduce a specific tax increase which should be paid “at least in part by those who are benefitting directly from the reforms. In particular, it would seem sensible for at least a part of the burden to fall on those over state pension age.” Dilnot further suggested that “it would be sensible to do so through an existing tax, rather than creating a new tax” which would most obviously suggest targeting inheritance tax.

I am not even averse to the idea of levying a specific tax in order to build up a social insurance fund, although governments are generally very bad at ring-fencing revenues for specific tasks. Whatever the ultimate outcome, the UK government clearly has to think more carefully about generational outcomes than it has up to now. The current pay-as-you-go option is not fit for purpose. But nor is a system which mitigates against a market for social insurance. There is plenty to ponder but it certainly will not be resolved before the election, and it is increasingly a problem which all industrialised countries have to face up to. Ageing societies don't come cheap.

A partial change of tack from the Conservatives

Having previously looked at the Labour Party manifesto (here), in the interests of balance it is only fair that I take a look at the economic consequences of the Conservatives’ election promises – particularly since they are nailed on favourites to win the election, so what they have to say is probably more relevant. However, since they did not offer any attempt to cost their proposals – unlike Labour or the Lib Dems – it is harder to offer a precise assessment.

What is striking is that last week’s document highlighted “Five giant challenges” in a similar vein to the famous 1979 manifesto which highlighted “Our five tasks.” But there the similarities end. Indeed, the overall tone was widely interpreted as a step back from the Thatcherite policies which have dominated the Conservatives’ agenda for almost 40 years. This view is based on an apparently innocuous couple of sentences tucked away on page 9 which suggested “We do not believe in untrammelled free markets. We reject the cult of selfish individualism.” That is most certainly not the Conservative philosophy which has been presented to me throughout most of my adult life.

So why the change of direction? Perhaps it is because, as John Kay pointed out in an FT column recently (here) , “a great intellectual failure of the past two decades is the inability to offer a more nuanced account of the market economy than that contained in the mantra of ‘greed is good.’” I could not agree more. One of the motivating factors behind this blog in the first place was to point out that systematic indifference to the fate of swathes of the British economy, which had been left to contend with the forces of free market economics, would ultimately weaken, rather than strengthen, it (see my first post from June 2016). Market self-regulation clearly produces outcomes which are damaging both to the company and the consumer (think of the scandals in banking in recent years) and as Kay points out, “the legitimacy of modern business organisation has been further undermined by continuing revelations of corporate wrongdoing … and by the disclosure of the aggressive tax avoidance.”

Does this mean that a Conservative government under Theresa May will take a step to the left (or more accurately, the centre) of the political spectrum on economic matters? Admittedly, one of its consumer protection policies was a rehash of an old Labour policy promising to introduce tariff caps on domestic energy bills. This ironically, was a policy described by David Cameron as “Marxist”. But it is not the whole story.

From a macro perspective, the Conservatives now only “aim for a balanced budget by the middle of the next decade.” At the time of the 2015 election, the budget forecast showed that the UK was on track for a budget surplus by 2018-19. One of the problems which the government has faced since 2010 is that income tax receipts have continued to fall below expectations (chart), which has blown a £30-40bn hole in the budget with the result that filling the fiscal gap has taken far longer than anticipated. At least the Conservatives have dropped the pledge not to raise income taxes or National Insurance Contributions, which caused such a controversy in March. 

All this matters because the government will increasingly have to face up to the problem of rising healthcare costs resulting from an ageing society as baby boomers retire in droves. One of the ways which the Conservatives have tackled this is to propose a reduction in the cap on welfare spending for the elderly, which means that those receiving social care must fund the entire cost until they reach their last £100,000 of assets. This is hugely unpopular amongst traditional Conservative supporters and it also flies in the face of the Dilnot Commission recommendation that a limit be placed on lifetime social care contributions (a review body set up by the coalition government in 2010). Nobody likes the idea of running down their childrens’ inheritance to pay for care costs, hence its unpopularity, but it is a recognition that tackling the problems of an ageing society will require us to think differently on tax and social insurance issues in future.

I have managed to get this far without talking about Brexit, primarily because there is nothing new to say. The Conservatives continue to believe “Britain needs a strong and stable government to get the best Brexit deal … delivered by a smooth, orderly Brexit.” But it also remains committed to reducing annual net migration to ”the tens of thousands, rather than the hundreds of thousands we have seen over the last two decades.” Having failed for the last seven years to deliver this pledge I remain unconvinced that it is achievable any time soon (never mind the fact that the figures are almost certainly wrong, as the UK’s sample based system has huge margins of error). Moreover, it continues to target a net figure whilst only focusing on migration inflows. Even more strange is that whilst the manifesto states a desire to ensure that the flow of skilled migrants continues, in the next paragraph it announces a plan to ”double the Immigration Skills Charge levied on companies employing migrant workers.”

This highlights the lack of joined-up thinking on immigration and highlights why businesses are increasingly expressing disquiet about the costs of immigration curbs.  Moreover, in its Fiscal Sustainability Report, released in January, the OBR assumed long-term net immigration of 185,000 per year. Its low immigration scenario, which assumed a net figure of 105,000 per year, reckons that in 30 years’ time the UK’s net debt to GDP ratio will be 11% higher than in the already unfavourable baseline, rising to 20% and 30% higher on a 40 and 50 year view respectively. Obviously, we should take long-term forecasts with a huge pinch of salt but they should remind us that immigration curbs come at a substantial economic cost.

Quite clearly, Theresa May is banking on the idea that she can win a large enough majority to silence the hardliners within her party who believe in the primacy of free markets and Brexit-at-any-price. She will have to, because there is enough material there to enrage the old-school Thatcherites who have a habit of making life hard for vulnerable prime ministers. As an economic plan, aside from the immigration pledge (and maybe the energy caps), it has its good points. But by pushing out yet again the point at which the UK balances its fiscal budget, I do question whether the last seven years of austerity have been worth the cost.

Labour's fiscal policy: Marks for effort

The UK election campaign, which is being met with indifference at home never mind abroad, took a radical turn today with the publication of the Labour Party’s manifesto. Much of what was leaked last Thursday was included in today’s plan, with one or two additions, and it is very much a series of tax and spend proposals which offers a radical alternative to the economic status quo of market over state. It is, I suspect, the economic plan of a party which does not expect to win an election: Many of the proposals would simply not be acceptable to higher earners or corporates, which will bear the brunt of additional tax rises. At a time when companies have to think about where they want to be located post-Brexit, it is a plan which will encourage footloose capital to move elsewhere. Nonetheless, it does raise very big questions about the nature of the state and the role of fiscal policy, which have been neglected for too long.

The philosophy which the UK electorate has bought into since Thatcher’s time is that a relatively small state is a good thing and that markets provide freedom of choice. But this is not always true. For one thing, private companies are not always as efficient as their proponents claim because they waste resources in the competitive process which could otherwise be used more effectively for service provision – a bit like moving parts which generate heat rather than mechanical energy. Whilst on the whole, they do deliver lower cost services there are real questions as to whether private entities are run for the benefit of shareholders or their customers.

In a competitive market the two sets of interests are aligned, but certain industries are best viewed as natural monopolies. Gas, electricity and water supply all fall into this category and so unpopular is the notion that private sector energy companies are ripping off the consumer, that the Conservatives have stolen one of Labour’s old ideas by planning to impose price caps (what price free markets?). Nor are huge infrastructure projects  necessarily suited to a private sector which does always not have the scale to manage them properly. For example, the UK has outsourced the construction of the Hinkley Point nuclear power station to EDF – a French state-owned company – and a state-backed Chinese entity. The first decade after the privatisation of the UK rail network was characterised by a shambolic series of events which means that today, the Labour Party’s policy of re-nationalising the rail network is actually very popular (it plans to do this as local franchises expire which means that the cost to the Exchequer is limited).

Of course, not all privatised utilities are bad. No-one would seriously advocate renationalising the telecoms network. But it is right to have a debate about which industries require more state involvement, and we should not dismiss the issue as being one for the socialists. Incidentally, the privatisation programme sparked by the Thatcher government in the 1980s was designed to create a nation of small shareholders, in which households held a stake in the nationalised utilities. But that idea faded quickly as shares were snapped up by institutions which in turn sold out to foreign utilities. Whatever the rights and wrongs of today’s energy and water markets in the UK, what we have now is not what was envisaged in the 1980s.

Looking more closely at Labour’s plans, there was more detail on the tax and spending pledges which will result in a tax rise of £48.6bn by the end of the next parliament, or just over 2% of GDP. According to the sober analysis of the Financial Times, this would put taxes relative to GDP at their highest since 1949. But even then, the state will still be significantly smaller than in many other European countries. As I noted last week, a large chunk of the additional taxes will fall on corporates, which are expected to contribute almost £20bn of the £48.6bn increase, and another £6.4bn from higher income taxpayers in what the Daily Mail helpfully described as Corbyn’s class war. What was truly radical was the idea that a Labour government would “consider new options such as a land value tax” which ironically was supported by the likes of Adam Smith, a hero of many on the Conservative right.

It is questionable whether these figures would ever be realised, however. Raising taxes changes the behaviour of those on whom the tax is levied so if tax elasticities are high, revenues may well be far lower than anticipated. Nonetheless, Labour did a good job of allaying fears of an unfunded rise in current spending, even if many people will be less than happy about the prospect of higher taxes. A potential Labour government will, of course, have to borrow to fund its capital spending plans. That is normal. At issue is how much it would need to borrow and what would the market charge. I suspect we will never get the chance to find out.

Even if one does not like the ideas presented today, they represent a rather more grown-up approach to the question of fiscal policy than we have become used to in recent decades. If we want a better healthcare system, we are going to have to pay for it. More policemen? Fine, but the money has to come from somewhere. There is, however, a whiff of the 1970s about the plan. It fails to account for the fact that more money does not necessarily mean better services. It also treats the UK as a small closed economy whereas in reality a globalised environment will pose limits on the government’s ability to operate the fiscal levers. A former Labour prime minister, Jim Callaghan, recognised as such in 1976 when he said “We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists.” Still, I will give Labour marks for trying, and we should not be too surprised if some its ideas ultimately end up being adopted by the Conservatives. It would not be the first time.

Back to fiscal basics

Fiscal rules sound good to economists and are eagerly seized on by politicians as a good way to appear responsible when it comes to matters of public finance. Unfortunately, all too often they fall short of the standards required of them. We all know about the Maastricht fiscal targets which many EMU countries have found difficult to adhere to. Similarly, the UK has experimented with a plethora of rules over the years, beginning with the idea of a ‘golden rule’ designed to ensure that the government only borrows to invest over the cycle with current spending matching current income. When that did not work, the government adopted a policy of reducing the structural deficit – a policy which relies heavily on estimates of the output gap, which in turn is subject to a huge amount of judgement.

But one of the less clever ideas of recent years was the 2015 Conservative manifesto commitment “to no increases in VAT, National Insurance contributions or Income Tax.” It is not a fiscal rule in the sense of those previously outlined but it represents a “promise” to the electorate upon which an election was fought. It is thus not hard to imagine why Chancellor Philip Hammond’s budget announcement that he planned to raise national insurance contributions (NICs) on the self-employed to bring them closer into line with those paid by employees created such a political furore.

The first point to note is that a commitment not to raise taxation is a foolish policy choice: Every government needs some policy flexibility. By closing off this fiscal option, monetary policy has to do more of the heavy lifting and it is thus ironic that the Bank of England has been criticised by politicians for its policy choices when the government has taken a deliberate stance on taxation. Technically, the Chancellor did break an election pledge – though he can justifiably argue that it was made neither by him nor the current prime minister, and that economic circumstances have changed.

There is also a strong economic case for doing so. The Chancellor’s argument is based on the problem that many people change their employment status to self-employed to benefit from lower taxes in order to sell their services back to their former employer which in turn results in a revenue loss for the Exchequer. Under the current system self-employed people pay NICs at 9% versus employee NICs at 12% and a supplementary rate of 2% on higher incomes. The Chancellor argued that “employees and self-employees use public services in the same way but do not pay for it in the same way.” As Paul Johnson of the Institute for Fiscal Studies argued “A tax system which charges thousands of pounds more in tax for employees doing the same job as someone else needs reform.  It distorts decisions, creates complexity and is unfair. The incentives for companies to claim that people who work for them are self employed rather than employees are huge.”

Lest we forget, NICs are supposed to be a tax designed to fund the social welfare safety net. At a time when welfare budgets are under huge pressure the Chancellor is hardly likely to turn down the opportunity to claw back some extra revenue. But one problem, as Ed Conway pointed out in The Times yesterday, is that employee NICs are no longer a hypothecated tax – they are simply seen as a branch of income tax. So why not get rid of them altogether? As the system works at present, those paying the basic rate of income tax face a marginal rate of 32% (20% income tax and 12% NICS) which quickly rises to 42% (40% income tax and 2% NICs) at incomes above £46k per year. A quick set of calculations suggests that assuming tax bands remain as specified for fiscal 2017-18, but abolishing NICs and replacing them with a higher rate of income tax, it is possible to set tax rates which leave most people with a higher post-tax income.

Thus, instead of levying income tax of 20% on the first £33.5k of taxable income (i.e. over and above the £11.5k threshold) plus NICs at 12%, we could replace this with an income tax rate of 33%. The bulk of earners would thus actually receive a post-tax income boost despite the fact that they are actually paying more income tax than they do now. This purely because they are no longer paying NICs which are often viewed as a hidden tax. For upper and higher rate tax payers, it turns out that their incomes are very sensitive to the higher rate (currently 40%). Raising this rate to 41% gives them a bigger income boost (blue line in the chart) than those earning the median wage but increasing it still further, to just 42% means that they suffer modest declines of no more than 0.3% (red line).

These are little more than back-of-the-envelope calculations but they demonstrate how easy it is to play with various tax options to benefit particular income groups. It tells us, too, that much of the current furore over what level to set NICs for different groups is misplaced. Tax simplicity is a critical element of any tax system. And as the influential Meade Committee Report noted in 1978 “the very fact that over recent years there have been so many changes in the tax system suggests that an essential need is to put a stop to this bewildering process of altering each element of the tax system as soon as the taxpayer gets used to it and arranges his affairs appropriately.” What was true almost 40 years ago is still true today.

Paying the price for good health

The Institute for Fiscal Studies released its annual Green Budget publication earlier this week (here). It is intended as a comprehensive assessment of the challenges facing the UK government as it prepares to unveil its official budget (scheduled this year for 8 March). It is certainly comprehensive – the report extends to 312 pages. However, one thing particularly jumped out at me: In the chapter on health and social spending, the authors showed that over the period 1955-56 to 2015-16, real health spending in the UK grew at an average rate of 4.1% per year whereas over the period 2009-10 to 2014-15, real spending increased by just 1.1% per annum (see chart).

We should keep this in perspective: Under the previous Labour government, real spending increased at a rate of 5.9% per year, so some degree of slowdown was required. Indeed, this huge surge in outlays was designed to raise health spending as a proportion of national income towards the average levels of health spending in other western European countries – a target which was not achieved. On a per capita basis real health spending has remained roughly unchanged since 2010 although the ageing of the population, which raises the share of elderly people, means that the per capita numbers are slightly misleading.

Nonetheless, the government can claim that it has abided by its manifesto commitment to protect the National Health Service from the cuts in other public services. But at a time when the strain on the NHS is greater than ever before, the government (irrespective of political persuasion) is going to have to face up to some uncomfortable truths on the provision of health care. Part of the problem stems from the fact that although health spending has been spared the worst of the cuts, the social welfare bill has been slashed, having fallen by 1% in real terms since 2009-10. Faced with a lack of options, people are being forced to turn to the NHS for help which it is not designed to provide, which in turn impairs its ability to meet its other targets.

Professor Sir Bruce Keogh, medical director of NHS England, highlighted in a newspaper interview two years ago (here) that the lack of local services such as district nurses, beds in community hospitals and mental health support were key factors behind the rising strain on front line health services. It is not as though the government is unaware of the problem. The Times reported in December that Chancellor Philip Hammond wanted to raise the funds allocated to social welfare provision but was overruled by the prime minister. It further suggested that the issues facing social welfare are “a political problem exacerbated by political cynicism,” following the stymying of cross-party efforts to find a solution to the problem by former Chancellor George Osborne before the 2010 election.

On the basis that the NHS in England expects to face a cash shortfall of up to £30bn by 2020, what can be done to plug the hole? Unpalatable though it may sound, a simple option would be to raise taxes. A rise of 1% in the basic rate of income tax would provide £4.5bn of additional revenue by 2019-20, according to the Treasury’s ready reckoner. Bearing in mind that the basic rate today, at 20%, is the lowest in decades (40 years ago it stood at 30% and it was last cut in 2008 from 22%), this is not the worst option. A 2% rise in the higher rate of tax would yield a further £2.0bn. The government could also raise national insurance contributions which are, after all, designed to fund social welfare provision. A 1% rise in employee contributions would raise almost £4.3bn and a similar increase in employer contributions would generate £5.1bn. But the real kicker is the government’s planned cuts in corporation tax rates. Each 1% reduction in the standard rate costs £2.4bn in revenue, and with the government planning to cut the standard rate from 20% today to 17% by 2020, this will cost £7.2bn in revenue. If corporate taxes are left unchanged and the other tax hikes are implemented, this would get us two-thirds of the way towards covering the health spending shortfall.

These are, of course, static calculations. Employers will create fewer jobs if payroll taxes rise which will result in less revenue than these numbers suggest. However, they illustrate that UK governments will at some point have to begin squaring the circle.  The 30 year period during which governments have cut taxes whilst promising world class public services are over.

Nobody likes to pay higher taxes of course (least of all me). Thus the other unspoken possibility is to introduce some form of charges in order to encourage rationing. One option might be to introduce an initial charge for doctor’s visits with subsequent visits incurring no such penalty. The British Medical Association reckons that there are around 340 million consultations per year; over 90% of this contact is with local general practitioners and the average member of the public sees a GP six times a year. Running through the maths, GPs see 51 million different people per year. Imagine that the first GP consultation per year was charged at £10 with subsequent ones free (with suitable exemptions for the very young and the very poor) – which is the equivalent of three pints of beer per year or 12 pints of milk – this would yield £0.5bn per year in user charges.

Whilst this is not a huge amount in the grand scheme of things, it might be the direction in which we are forced to travel. As we all know, demand for health care is near-infinite, and unfortunately we need to find ways to fund this demand as our population ages and the pressure on the system mounts. But are our governments brave enough to face up this unpalatable truth? It certainly won’t win votes but it might help to preserve the health services.

The best laid plans ...

Economic plans set out by politicians ahead of an election are probably not worth much more than a cursory analysis, but that does not stop people trying. Ahead of the US presidential election, a lot of ink has been spilled trying to figure out the respective merits of the two candidates' plans. As usual, the candidates talk a lot about taxes and how many jobs they will create. But whilst this may be all well and good in a dictatorship where the election winner has carte blanche to act as they please, it certainly does not wash in western democracies where the head of government is beholden to parliament (or Congress in the US case).

Donald Trump has called for lower taxes and a simplification of the tax code, reducing the number of tax brackets from seven to four, and for the top rate of tax to fall from 39.6% to 33%. In his words, "The rich will pay their fair share, but no one will pay so much that it undermines our ability to compete." Analysis by the Tax Foundation of the Republicans’ tax plan, released in June and which is similar to Trump’s, would disproportionately benefit the rich by raising the post-tax income of the top 1% of earners by 5.3%. But the Republican nominee goes much further, by proposing to completely eliminate estate taxes which would clearly benefit those rich enough to be able to pass on more than $5.45 million of assets to an individual (or $10.9 million to a married couple). This does not sound like a policy aimed at the blue collar workers amongst whom Trump is so popular.

Hillary Clinton, meanwhile, proposes to maintain the existing seven brackets but is also in favour of an additional surcharge on those earning more than $5 million per year which would be used to fund programmes such as free education for the less well off. Both candidates favour limiting tax deductions, with Clinton limiting them to a total of 28%. Analysis of their respective tax plans by the Tax Policy Center suggests that the Clinton plan would raise revenues by $1.2 trillion over the next ten years whilst Trump would cut them by $11.2 trillion. On the spending side, the Committee for a Responsible Federal Budget estimates that Clinton's spending increases would broadly match the higher tax take but Trump makes no effort to close the gap, with the result that his plans will result in much higher deficits. His plans thus sound more suited to Europe, which is crying out for stimulus, rather than the US which no longer is.

Where the Trump plans really start to fall apart is in the area of trade, where there are calls for the renegotiation of trade deals to favour the US and to walk away from those deals which are not viewed as favourable. Meanwhile, Trump has also advocated a 35% tariff on goods imported from Mexico and a 45% tariff on Chinese imports. To put it bluntly, a proportion of the income tax savings which US consumers would derive under President Trump would be clawed back in the form of higher goods prices resulting from higher tariffs. Not that Clinton's trade views are that consistent either. In a bid to tap into the Zeitgeist on trade issues, Clinton now suggests that the Trans-Pacific Partnership is not necessarily the best deal for America, even though she was involved in the negotiations.

John Cochrane argues in a blog post that the Clinton plan is not really a plan at all and that it represents little more than a wish list of ideas. Allowing for the fact that he is not particularly well disposed towards Clintonite policies in the first place, he has hit the nail on the head when it comes to describing candidates' plans (and not just in the US). They can only ever be a wish list. For example, whilst both Trump and Clinton suggest that they will boost the US manufacturing sector, the forces determining its fate lie well outside the control of any US president. For better or worse, we live in a globalised economy and we have to accept that for all the material benefits this has brought, there are costs in terms of a redistribution of jobs. Attempts to reverse the process will also impose major costs – particularly in the case of Trump’s plans.

Often, some of the things which candidates promise on the stump turn out to be things they bitterly regret. Take for instance David Cameron's 2010 promise to reduce annual UK immigration to "the tens of thousands" from levels around 250,000 at the time (it has since risen by a third). It made him a hostage to fortune which he could never deliver upon, and was compounded by the ludicrous decision to hold a simple in-out referendum on EU membership. And we all know where that led.