15 rounds with reality

Leon Spinks was a former world boxing heavyweight champion who gained the title in 1978 by inflicting only the third ever defeat on an ageing and complacent Muhammad Ali. Ali regained the title later that year and Spinks went on to an undistinguished career which saw him win only 26 of his 46 professional fights. The moral of the story is that it is possible to trigger an upset if the opposition is complacent, as Ali was, but success on that one day will not guarantee future success if you merely got lucky and fail to prepare properly for the challenges which lie ahead.

As queues build up outside filling stations as lorry driver shortages hamper deliveries of fuel, I was reminded of the Spinks effect in a Brexit context. The Remain campaign was clearly complacent in the conduct of its 2016 campaign, allowing Leavers to win a narrow points decision. But the Brexit cheerleaders have clearly failed to prepare for what comes next, and even though it is possible to blame Covid for the magnitude of the problem, it is hard to avoid the view that after going 15 rounds with reality, the economics of Brexit is now getting the pasting that all the knowledgeable pundits said would happen.

Government ministers have been out in force on social media telling us that there is no fuel shortage. The new culture secretary Nadine Dorries reinforced the message in a Tweet in capital letters, thereby convincing people of the exact opposite. There may well not be a fuel shortage, but there is a delivery problem and people increasingly do not take the government on trust. And as I pointed out at the start of the pandemic, “If you believe that a major problem is about to be visited upon you … a sensible forward-looking economic actor will make some sort of contingency rather than trust to luck.” 

But the bigger point is that this is not just about fuel shortages. It primarily concerns the British government’s blithe dismissal of the economic consequences of Brexit that they were warned about. What was dismissed for years as Project Fear has now become reality. And before people get on my case about the fact that Covid is really to blame – as the government is trying to tell us – I invite you to point me in the direction of media stories around the EU of empty supermarket shelves and fuel shortages elsewhere.

What they said

To put some flesh on the bones of what Leavers said, it is worthwhile visiting the BrexitCentral archive of articles written by prominent supporters of the Leave movement to remind us of what they promised, how Brexit could be delivered and why the Remainers were wrong to oppose them. It represents a litany of all that was wrong with the debate – a group of believers preaching a misleading message to those who were already committed to the cause. But it is important to remind ourselves of the economic benefits that Brexiteers promised would flow from leaving the EU, and equally importantly, what would not happen in order that they be held to account. 

In November 2017, for example, David Davis told us to “stand firm in the face of the onslaught of Project Fear propaganda.” The article was a one-sided view of the gains to be derived from a go-it-alone trade policy which dismissed all the evidence on the other side of the ledger. Davis reminded us of the “hysteria over the rationing of food and medicine.” The empty shelves and strains on an underfunded NHS are evidence that Brexit has made a bad situation worse.

The economist Graham Gudgin told us “why a UK-EU customs union remains a terrible idea” arguing amongst other things that “there is not much evidence that a customs union would be more beneficial for UK-EU trade than a standard free trade agreement.” The likes of Gudgin have been less forthcoming on the question of why the UK looks set to drop out of Germany's top 10 trading partners for the first time since 1950. Julian Jessop, another Brexit supporting economist, noted in 2019 that “some have seized on the one-liner that ‘low income groups will be disproportionately affected by any price rises in food and fuel’. Equally, of course, these groups would disproportionately benefit from any reductions in the prices of food and fuel.” Try telling that to poorer households bracing themselves for a double digit rise in domestic fuel bills next month. Peter Lilley argued that “EU economic policy has held the UK back and cost us £82 billion over two decades.” It’s barely worth even responding to such trite nonsense, but suffice to say that my analysis using synthetic control methods pointed to a GDP loss in excess of £100bn in the 3 years following the vote to leave the EU.

One of the central tenets of Brexit economics was that the UK would be free to sign trade deals with third countries which would allow the UK to tap into more rapidly growing markets. Key to this was the prospect of a trade deal with the US. Brexit ultra, Iain Duncan Smith wrote that “achieving a Free Trade deal with the United States alone would be equivalent economically to achieving Free Trade deals with the entire world … This is because the vast US economy could supply virtually every good that the UK currently imports.” Brexiteer economist par excellence, Patrick Minford, wrote in 2019 that “Boris Johnson has already made it clear he will urgently look for a trade deal with President Trump.” This week Johnson visited the US, holding talks with President Biden who played down hopes of a UK-US trade deal, whilst the US Ambassador to Britain recently told Sky News that a comprehensive UK-US free trade deal is “not the be-all and end-all”.

It’s just not happening

The Brexiteers made great play of the fact that forecasts which portrayed a gloomy economic future were made by institutions such as the Treasury whose forecasts, in the words of David Davis, ”have almost never been right and have more often been dramatically wrong.” Words of contrition from those who peddled this view have been conspicuous by their absence. And in one of the great ironies of the current situation, the government is being forced to issue temporary visas to lorry drivers from other EU countries to alleviate domestic shortages. Remember they need us more than we need them? In any case this will not resolve the underlying problems, as the road haulage industry has made clear, and presupposes that they would want to come given that shortages are a Europe-wide problem.

There should be no doubt in anyone’s mind that Brexiteers lied about the economic benefits – their own words provide the most damning evidence. That the opposition Labour Party is unable to hold the government to account, given its preoccupation with internal political battles, is nothing short of a scandal (and the subject of another post). However, not all Brexit supporters were as deluded as the ultras. Gerard Lyons pointed out that “if we left the EU in a stupid way then there would be no dividend.” Well, we did so there isn’t.

Much like the unfortunate Leon Spinks, whose early career represented a triumph of hype over ability, the economics of Brexit is being tested by reality and found wanting. But Spinks was the one who ultimately paid the price. In the case of Brexit there are 67 million of us taking a good beating.

After Angela

The most popular politician in Germany

Three years after she announced that she would not stand again for re-election the moment of truth has finally come for Angela Merkel who will stand down as Chancellor once a government is formed following Sunday’s election (note: past experience suggests it could take a while before this is finally achieved). It is difficult to predict the election outcome: The SPD, which has been languishing in the polls for years, has enjoyed a slight lead over the CDU/CSU in recent weeks but with no party currently polling more than 25% (chart below) many different combinations of government are still possible.

The collapse in support for the CDU/CSU to its lowest recorded level on data back to 1994 is remarkable: Just six weeks ago they enjoyed a six point lead over the SPD. This is at least partly due to the fact that Merkel’s prospective successor, Armin Laschet, is unpopular. Pollsters reckon that around one-third of voters who backed the CDU in the 2017 election did so because of Merkel. Her absence from the ballot paper could cost the party dearly. Whilst Merkel enjoyed a high reputation abroad, her reputation at home looks very solid too. Indeed the latest domestic poll gives her an approval rating of 80% versus only 17% who do not think she is doing a good job. She is also judged to be far and away the most competent of all Germany’s leading political figures, scoring +2.4 on a scale of -5 to +5, compared to Laschet’s dismal showing of -0.4 and some way ahead of the SPD’s candidate for Chancellor, Olaf Scholz, at +1.6.

To some extent this is a reflection of the incumbency effect – Merkel has, after all, occupied the Chancellor’s office since 2005. She took up the post in what are now fondly described as the good old days: before the financial crash; before the euro zone debt crisis; pre-Trump and pre-Brexit. Merkel has subsequently dealt with all of these international crises in a calm, pragmatic fashion, steering Germany through the storms. For that alone, she will be missed at home. But she will also be a big loss on the international stage where leaders with a reassuring presence have been in short supply of late (think Trump or Johnson).

But it has not all been plain sailing. Germany’s role as Europe’s political and economic leader has been reinforced during Merkel’s term, largely by default as traditional international players such as the UK and France became more inward looking. However, she has appeared reluctant to embrace the role. This is in keeping with her natural caution. Merkel has never been one for the grandiose vision and as an apparently keen student of history, she is well aware of the backlash that would emerge in certain quarters if Germany were to start throwing its weight around on the international stage.

... though not necessarily the most economically astute

Her biggest policy error was the handling of the Greek debt crisis. The German government’s insistence that Greece live up to its obligations under EU law may have been in keeping with the letter of the law but was not in keeping with its spirit. Insistence on a punishing austerity programme condemned Greece to an economic depression from which it has yet to recover. For someone with an appreciation of history, this was an uncharacteristic error. As the German economic historian Albrecht Ritschl has pointed out, the cancellation of Germany’s post WW2 debt laid the foundation for the Federal Republic’s modern economy giving rise to the charge of hypocrisy. More seriously, the Greek episode raised many question marks about the future of the euro zone, few of which have been satisfactorily answered. Merkel’s tactics during the debt crisis may yet prove to be very short sighted.

Indeed, Merkel has never shown any great aptitude for economic issues. She came to office in 2005 on the back of the reforms initiated by her predecessor Gerhard Schröder who initiated a programme to boost renewable energy and introduced the painful Hartz IV labour market reforms that did so much to boost German competitiveness. In many ways Merkel reaped the reward of these policies without having to do much herself and she has been far less willing to engage in reform, preferring to maintain the status quo. On energy policy, Merkel’s government did pass legislation in 2010 in support of the Energiewende to continue the process of transforming Germany into a low carbon economy. However, in the wake of the Fukushima nuclear disaster in Japan, Merkel promised to shut Germany's fleet of nuclear reactors by 2022 which resulted in a slower phasing out of coal and fossil gas generation than originally planned. Consequently, the pace of reduction in German CO₂ emissions has slowed over the past decade compared to the previous decade.

Domestic fiscal policy has largely acted with restraint. Germany’s “schwarze Null” budget policy, which aims for balance or a small fiscal surplus, coupled with the debt brake effectively acted as a restrictive financial straitjacket at a time when the economy has tended towards deflation and when infrastructural investment needs have mounted. During a period when Germany has run a significant current account surplus, the government has come under pressure to run a more expansionary fiscal policy but Merkel’s administration has consistently rejected demands to do so. That said, she has proven pragmatic in providing fiscal support when the economy most needed it, particularly in the wake of the 2008 crash and again during the corona pandemic.

Measuring the balance

Although Merkel has not had to be a reforming Chancellor, Germans have little cause for complaint. Indeed, she should be given credit for not derailing the reforms put in place by previous governments. Perhaps one reason for Merkel’s popularity is that she has managed to maintain the status quo by insulating voters from the changes going on around them. For example, Brexit could never happen in today’s Germany whilst Merkel (perhaps reluctantly) made the call to uphold western values at a time when Donald Trump proved unable to do so. The decision in 2015 to open up Germany’s borders to refugees should also be viewed as a great humanitarian gesture. But as The Economist (slightly harshly) put it, “admiration for her steady leadership should be mixed with frustration at the complacency she has bred.”

After 16 years during which Merkel has kept the plates spinning, it will now be up to someone else to tackle the many problems which Germany – in common with all western economies – faces. Whoever the new Chancellor is will not have the personal authority or Merkel’s depth of experience in dealing with crises. They will also have to come to terms with the changed nature of the EU as neighbours such as Poland and Hungary drift away from the EU centre. The new Chancellor will be required to deal with the many issues which are likely to arise in the wake of the pandemic, particularly with regard to the euro zone which has morphed closer to a fiscal union in the last 18 months.

Merkel's successor will do well to be credited with a verb describing their mode of government – to merkeln. It may originally have been coined as a derogatory term to describe one who leads without taking decisions, but there are sometimes worse ways of doing government, as Boris Johnson and Donald Trump have demonstrated.

Supply surprise

Forty years ago most people had never heard of supply side economics. During the 1980s, however, governments in the US and UK promised a supply side revolution by cutting taxes and regulation to allow economies to work more efficiently and thus increase prosperity. Together with the extension of globalisation and advances in technology, this has radically changed the way in which companies operate.  Just-in-time inventory management is now the norm as production chains have grown to encompass the world and the manufacturing process itself is much less vertically integrated than was the case 40 years ago. But whilst the consumer has generally benefited from improved efficiency it has come at the cost of resilience as disruptions in one part of the world quickly ripple out to affect others.

Indeed the problem that supply side proponents never fully addressed was the ability of a deregulated economy to respond to shocks. As the 2008 crisis highlighted, when the deregulated banking sector encountered problems, only governments were able to marshal sufficient resources to ensure rescue packages of the requisite size. In the wake of the crisis, the business community accordingly became much more sensitive to political concerns. As the political climate became increasingly attuned to concerns that local jobs were being shifted to cheaper locations abroad, businesses began to embrace the concept of nearshoring – the process whereby supply chains are shortened to ensure that goods and services are sourced more locally. This was also facilitated by the fact that traditional offshore locations no longer offered such cheap sources of labour as global competition for local resources pushed up wages. This is one of the factors behind the slower pace of globalisation evident in recent years as evidenced by the KOF Globalization Index.

Covid has placed another spanner in the works. Supply chains have been under pressure like never before with the recent surge in global inflation largely attributable to issues arising from supply side disruption. Early on in the pandemic it was realised that Asian based semiconductor manufacturers would face significant disruptions in 2020 which would manifest in 2021, and that is exactly what has happened. This has impacted on industries such as autos, where prices have risen to such an extent that around one-third of the change in the US CPI over the summer could be attributed to second hand vehicles.

No supply network in the world could reasonably hope to escape unscathed in the wake of such a shock. But the nature of the system that has been created across the industrialised world in recent years is particularly vulnerable, and in many cases the problems are compounded by poor policy choices. We can illustrate this by looking at two particular cases.

The lorry driver shortage problem

Over the last few weeks the British media has been reporting on the rising trend of empty supermarket shelves as retailers are unable to secure enough produce to satisfy demand. This in turn is largely due to the fact that there is a shortage of HGV drivers to ensure delivery of the product. It is important to highlight at the start that this is not solely a British problem. According to a survey by Transport Intelligence, it is a Europe-wide problem. In fact, Poland reported the highest number of unfilled vacancies in the logistics sector, estimated at 123,000 with the UK occupying second place with between 60,000 and 76,000 vacancies. Adjusted for population size, there are around 0.33 vacancies per head in Poland compared with 0.09 in the UK and 0.05 in Germany (chart below).

This has arisen for a variety of reasons, not the least of which is that the outflow of older workers from the logistics industry is higher than the number of entrants due in large part to the poor conditions associated with working in the haulage sector. In the UK, however, these underlying structural problems have been compounded by Brexit. According to a survey by the Road Haulage Association, 58% of respondents attributed the shortage of HGV drivers primarily to the UK’s decision to leave the EU. By contrast, only 38% perceived that the problems were mainly due to Covid. That said, Covid is exacerbating the problem because it has significantly slowed the pace at which HGV driving tests can be conducted.

Whilst problems in the logistics sector are long-standing, Brexit has highlighted the lack of resilience in the sector. The UK was heavily dependent on drivers from other EU nations – the RHA estimates that prior to the pandemic around 10% of all drivers employed in the UK were nationals of other EU countries. This was in large part due to the fact that pay and conditions in the sector are perceived as poor and the jobs on offer were unattractive to locals. However, the UK industry was able to pay workers from some of the less wealthy EU countries more than they could have earned in their home market thus alleviating the shortage. But many of them recently appear to have returned home, either because of a perception that they were no longer welcome in the UK or because they feared being stranded on this side of the channel due to Covid. One thing is clear: The UK logistics sector benefited from the freedom of movement enshrined in EU membership and now it must learn to cope without it.

The energy problem

Similar supply problems are looming in the energy sector. Wholesale gas prices have risen by 250% since the start of the year and are up 70% since August alone (chart below). A number of factors are affecting prices: A cold winter in Europe last year had already put pressure on supplies and the amount of stored gas is far below normal levels. We have been warned for some time that there is insufficient storage capacity but this year it really seems to be coming home to roost. There is also increased global competition for liquefied natural gas, particularly from Asian countries. Unfortunately, too, the race to exit fossil fuels has proceeded at a faster pace than investment in alternatives. This was not helped by the collapse in investment activity in 2020 for Covid-related reasons. However as the IEA has pointed out “the USD 750 billion that is expected to be spent on clean energy technologies and efficiency worldwide in 2021 remains far below what is required in climate-driven scenarios.”

This will have a number of knock-on effects. Rising wholesale gas prices have caused producers of carbon dioxide to cease production, which will in turn have a major impact on the food and drink sector (see here for an explainer). Consumers will face a double whammy because they are set to face a huge rise in household energy tariffs which are expected to rise by around 12% next month. They may well rise further later in the winter when Ofgem further lifts the price cap on household bills. For the record, the prime minister did promise in 2016 that “fuel bills will be lower for everyone" when the UK leaves the EU.

As far as the energy industry is concerned, a number of smaller gas suppliers have already gone bust after failing to hedge the big rise in wholesale prices. It is intended that clients of these companies will be supplied by existing companies. However, this will require them to supply gas to customers for whom they have not budgeted in their wholesale market negotiations which in turn is likely to mean they will require government financial support.

What to make of it all?

To the extent that the energy problem is a global one, we cannot lay it at the door of Brexit. To a large extent, it is the result of a state sponsored dash for renewables coupled with a failure of the private sector to make the necessary investment in alternative energy sources. Similarly, the lorry driver shortage issue is not wholly a Brexit related phenomenon although it has exacerbated it. But both are examples of supply chain failures which have been made worse by government policy choices.

Irrespective of the underlying causes, the optics for the UK government are not good. Far from delivering increased prosperity, as Brexit’s proponents promised, consumers face the prospect of empty shelves in the shops and much higher energy bills. Voters may start to draw conclusions about the economic consequences of Brexit and start to ask some awkward questions of government. If and when that happens, Boris Johnson will be in need of some good news to assuage the electorate.

Unpleasant choices redux

As expected, the UK government did indeed announce the widely trailed rise in NICs that I looked at in my previous post. The package of measures represented a budget in all but name and will take the tax burden relative to GDP to its highest since 1950 (chart). If nothing else, this highlights that the era of low taxation is over. This is a reflection of the reality that the UK cannot continue to cut taxes whilst simultaneously meeting the electorate’s demand for better public services. It is also a reflection of demographic reality. The tax cuts of the 1980s were possible because the last of the baby boomers were still entering the workforce. But over the last four decades, the population share of those aged 65-plus has risen by four percentage points to 19% and is set to rise to 25% by 2050. Some thoughts on these issues below.

What was announced?

Dealing first with the package of measures, both employer and employee NIC rates will rise by 1.25 percentage points (a touch more than anticipated) from April 2022 and the rate of dividend taxation will rise by a similar amount. All told, this is expected to generate £12 billion pa of funds for health and social care (0.5% of GDP). From April 2023, underlying NICs rates will return to their previous level and a formal legal surcharge of 1.25% will be levied on wages which will be ringfenced only for health and social care purposes. Another important part of the package is that the government plans to introduce a cap of £86,000 on the amount that households (in England) will need to spend on personal care over their lifetime. This is designed to reduce the problem that individuals will be subject to high and unpredictable long-term care costs (an issue I looked at ahead of the 2017 election).

What is it likely to mean in practice?

The tax hikes come on top of the £25 billion (1.1% of GDP) of medium-term tax raising measures announced in March. It is notable that the UK is the one major developed economy to raise taxes in the wake of the pandemic – which, by the way, is not yet necessarily behind us. It may be that this will prove to be a tax hike too soon. Moreover, contrary to previous expectations, the funds raised by what the government calls a Health and Social Care Levy will be used largely to fund the NHS rather than fix the problems in the social care system. Over the next three years the social care programme will receive just £1.8bn in additional revenues (15% of the total raised by the Levy). The government has taken the (probably well-founded) view that voters are not going to be too exercised by whether the funds are used for the NHS or for social care – at least in the short-term. This might change if the government is forced to come back for more money in a few years’ time.

A deeper dive into the details

Although the government is using the Levy as a way to find sorely needed funds for the health system rather than primarily to fund social care, this is not necessarily unwelcome – after all, many of us have pointed out that the pressures on the NHS arising from demographic change meant that it has been underfunded over the last decade. But those of you with long memories might recall that the Brexit campaign, backed by Boris Johnson, promised that leaving the EU would generate savings of £350 million per week (£18.2 billion per year) which could be used to fund the NHS. That being the case, you may wonder why workers are being hit with additional taxes to do exactly that.

There is also some confusion regarding the impact of the lifetime social care spending cap. The £86,000 lifetime limit refers only to how much individuals pay for care. It does not include daily living costs which are incurred by living in a care home, such as food, energy bills and the accommodation itself. The average costs associated with living in an old age care home are currently £36k per person per year. Daily living costs are estimated to account for one-third of that. It would thus take the average person 3½ years to run up £86k of health costs (3.5*(36-12) = 84) – but 75% of those admitted to care homes do not live longer than three years, suggesting that the £86k limit is (a) not very generous and (b) still leaves residents having to use an additional £40k of their own money to cover daily living costs before they hit the limit.

The macroeconomics of the tax hike

Whilst there was much criticism about the generational aspects of the plan, some of this is to miss the point that there is always a transitional element in tax policy. Admittedly, today’s retirees do benefit at the expense of younger workers but assuming no changes to policy in future, today’s young workers can be expected to benefit from similar funding when they eventually retire. There is no doubt, however, that those in the early stages of their career and those on low to middle incomes will bear a considerable part of the load. At the younger end of the age spectrum graduates already face significant costs as a result of having to pay back their student debt. New graduates with an average debt of £47k and earning an average salary of £30k per year are subject to a debt repayment charge equivalent to 1% of gross income, and are now being asked to contribute an additional 1.25% to fund the health levy. As an inter-generational move, this is not a vote winner.

In any case, many were left wondering why there is any need to raise taxes at all in this fragile stage of the economic cycle. The UK is coming off its biggest peacetime recession in history and is responding by tightening the fiscal stance. It is unlikely that the impact on growth will be significant but on the basis that the government will almost certainly need to tap taxpayers for additional funds for social care, this tax hike may have political repercussions.

Nor has the government had any problem raising funds in the bond market. It could quite easily have kicked this can down the road for a year had it wished in order to assess the longer-term effects of the pandemic. Chancellor Rishi Sunak argued that to continue borrowing would be “irresponsible at a time when our national debt is already the highest it has been in peacetime.” But this is misleading. The BoE owns almost 40% of the debt – a significant proportion is thus held by the one institution that is not about to get cold feet and demand a higher risk premium.

What to make of it all?

We should not be overly critical of efforts to try and secure more funding for the NHS. However, we can be more critical of the way the government has gone about it with too much emphasis on taxing the incomes of working people (not to mention the additional costs to employers) whilst not enough of the burden falls on those who derive income from non-labour sources.

Two final thoughts spring to mind: First, the Chancellor has announced a spending envelope which is unchanged overall. Thus although health spending will rise and some areas of spending will be ringfenced (e.g. schools) this implies real spending cuts for unprotected departments. It also implies that future Covid-related spending will not be funded by borrowing (e.g. to cope with the effects of scarring) but must be met from taxation. This leads us to the second point: Over the past decade, spending on health has risen from 30% of total outlays to 38% today (even after taking out Covid effects). This squeeze is likely to continue as demographic pressures intensify, suggesting that if the state is to remain the primary provider of health and social care, more tax rises are likely before the decade is out. 

And to think that Boris Johnson wrote in the Conservative manifesto in 2019: “the Labour Party … would raise taxes so wantonly.” Life comes at you fast.

Unpleasant choices

Funds are needed to reform the social care system …

Fiscal strategies around the world have been blown off course by the pandemic which has forced governments to reconsider ways to pay for the demands on the public sector. Indeed, one consequence of the pandemic is that it has highlighted the need for a strong public sector to marshal the resources required to meet unprecedented circumstances. It has also highlighted the need to fund areas of public sector engagement which have been neglected for too long.

One such issue in the UK is the provision of social care. Scarcely a week goes by without news that one of yesteryear’s footballers has been diagnosed with some form of dementia – a particularly distressing condition which robs people of their identity – with the latest victim being former Liverpool and England footballer Terry McDermott. Whilst professional footballers appear particularly prone to the disease, due to the repeated application of blows to the head as a result of heading the ball, it affects many hundreds of thousands of people in the UK alone. According to the NHS, there are more than 850,000 sufferers, with 1 in 6 aged over 80 afflicted. Social services struggle to provide the requisite care for this and other conditions, and upon acceding to office in July 2019 Boris Johnson promised to “fix the crisis in social care once and for all with a clear plan we have prepared.”

It turns out that the “clear plan” did not exist. But the Conservatives did promise in their 2019 election manifesto to “build a cross-party consensus to bring forward an answer that solves the problem.” Unfortunately Covid blew the government off course but as we start to cautiously look ahead to the post-pandemic world it appears to be seriously considering how to tackle the issue. Media chatter in recent days has focused on the likelihood that the government will announce a rise in National Insurance Contributions (NICs) – a form of payroll tax – to fund it. It is being suggested that both employers and employees will pay an additional one percentage point, which it is estimated will generate an additional £10bn of revenue (around 0.5% of GDP). One problem with this policy prescription is that it flies in the face of the 2019 manifesto commitment that “we will not raise the rate of income tax, VAT or National Insurance.”

This was, as I noted 2019, “not good policymaking” because “taking these key levers out of the fiscal equation could severely limit the Chancellor’s room for manoeuvre” – a lesson amplified by the unexpected nature of the Covid pandemic. Nonetheless, whilst the plan to raise taxes has been widely criticised as a break with the manifesto commitment, there has been rather less acknowledgement of the fact that it is designed to fulfil another one. That there is a need to provide additional funding for the social care system is undeniable. As the Kings Fund has pointed out, the one percentage point rise in NICs back in 2003 to fund the NHS resulted in “a generational improvement in waiting lists, major investments in key causes of death such as cancer and heart disease, and improvements in mental health.” Providing the funds alone is not enough and significant reforms to the system are also required. Nonetheless it would represent a good start.

… but NICs are not the best way to raise them

The planned tax rise has also come in for significant criticism for a number of economic reasons. For one thing, it is a tax on those in employment whereas those of retirement age are the prime beneficiaries which strikes many people as unfair. It also comes at a time when the government is planning to phase out the temporary increase in Universal Credit to help low paid workers during the pandemic. According to one MP quoted by Sky News, “I'm very concerned about the fact we seem to be protecting the inheritances of those with means at the same time as stripping the £20 uplift [in Universal Credit].”

NICs are also regressive. All employee income between the lower earnings limit (£9,568 per year) and upper earnings limit (£50,270) is taxed at a 12% rate but any income exceeding the UEL is subject only to a 2% rate. This has the effect that the average rate of National Insurance Contributions falls the further incomes are above the UEL. Thus, whilst those earning £50k per annum pay an NIC rate of 9.7%, those earning gross income of £100k pay an average rate of 5.9%. Even more egregious is the fact that those earning half the average wage (around £15k per year) pay a higher NIC rate than those earning £200k. If the government is intent on raising NIC rates, it really ought to review the structure of the tax first. It could, for example, raise the tax rate applied above the UEL so that the average tax rate falls more slowly at higher earnings levels (see chart 1 demonstrating the impact of various options).

Another problem with hiking NICs is that the incidence will also fall on employers. The empirical evidence does not suggest that hikes in employer NICs will have a significant impact on employment but it may at the margin impact on firms’ willingness to create new jobs, particularly in the post-Covid environment where many service sector firms face uncertain revenue prospects.

It is not even clear why we need NICs at all. They were originally intended as a tax to fund the social welfare system but they have long since been subsumed into general taxation (only around 20% goes directly to the NHS). In effect, they are perceived as a form of income tax. Some years ago I performed some calculations which suggested that it would be possible to abolish NICs altogether and set higher rates of income tax whilst still giving a post-tax income boost to the lowest earners. In my view this would not be a bad place to start in order to reform the tax system – a subject to which I will undoubtedly return.

What are the alternatives?

One possibility is a rise in income taxes. As the IFS has pointed out an increase of 1.5 percentage points in the basic and higher rates of tax could generate the same revenue as the proposed rise in NICs. The incidence of the tax is also skewed more to older workers, with 14% of the revenue coming from pensioners versus 1% in the case of NICs – not a huge amount but it is an improvement. However, an increase in income taxes would also violate the manifesto commitment.

Unions have suggested that capital gains taxes be increased although according to the HMRC ready reckoner, each one percentage point increase across the board would only generate around £175 million. A rise in CGT rates would go a long way as a signal of intent to the low paid, but as a practical revenue raising measure it would not deliver much. Increases in stamp duty land taxes by one percentage point could generate around £1 billion. But this is only 10% of the yield generated by higher NICs, so here too, a significant hike would be required to make up the shortfall. It would thus appear that an alternative to hiking NICs would require a combination of tax increases across a variety of areas. For example, a two percentage point rise in stamp duty plus a five percentage point increase in CGT would yield £3 billion. Another £1 billion could be squeezed out of inheritance taxes whilst a 4 percentage point rise in the additional NIC rate (paid by those earning more than £50k) would yield £4.6 billion (chart 2).

However, it is unlikely that a Conservative government would be willing to sanction higher taxes on capital and the well-paid. Ultimately, however, they may have little choice in the long-run and I maintain that a discussion about some form of wealth tax is one which the electorate needs to have. Income taxes exist in part to address the problem of income inequality. But with official statistics suggesting that the richest 10% of UK households hold 44% of all wealth whilst the poorest 50% own just 9% it is a problem that, like it or not, our society needs to address.