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.

The case for normative economics

The epithet dismal science is often used to dismiss economics and its practitioners. This is unfair in many respects. Those who think economics is dismal are advised to have a look at Kilkenomics, the world’s first economics and comedy festival which celebrated its tenth anniversary in 2019. As for whether it’s a science, the jury is still out.

If we define science as what Ernest Nagel called the search for “repeatable patterns of dependence”, (here, p4) then economics could indeed be classed as a science. But if we define it as a reliance on experimental method, Robert Heilbroner suggests that this “throws into limbo certain central ideas of economics, such as value or utility, for which no experiments seem to be possible”.  Since Heilbroner wrote these words almost 50 years ago, there has been a considerable amount of progress in experimentally testing some of these central economic hypotheses, thanks to the work of people like Daniel Kahneman, who has applied psychological techniques to key economic concepts. But still the debate rages.

The moral dimension

I raise this question because it throws up an important issue: that of value judgement in economics. A discipline which pursues the cold hard logic of the physical sciences has no room to make moral judgements. But one of the pioneers in the field of economics was Adam Smith, who in 1759 wrote a book titled The Theory of Moral Sentiments. As titles go, that is as far away from value free economics as you can imagine. More importantly, it provided the ethical, philosophical, psychological, and methodological underpinnings for Smith's later work such as The Wealth of Nations which is now regarded as the first great work in western economics.

Over time, economics moved away from its philosophical roots and by the 1930s, neoclassical economists argued that since the notions of utility and culture which underpin economics are difficult to measure, we should simply avoid them. Rational choice theory, pioneered by Lionel Robbins, postulated that individuals perform a cost-benefit analysis to determine whether to pursue a particular course of action – a way of thinking that quickly came to dominate mainstream thinking. However, rational choice theory could never explain why individuals undertake actions that appeared not to yield any direct benefit to them, such as charitable giving. But by the time economists began to understand that a whole range of cultural factors determined why individuals took a particular course of action, so entrenched was the culture of positivism that it became increasingly difficult to challenge the status quo.

Whilst economics has gone to great lengths to sidestep the moral issues which its analysis throws up, as Timothy Taylor put it “moral judgments aren’t willing to sidestep economics.” As he points out, economics starts to get into difficulties when it becomes subject to “mission creep”. At the heart of the problem is the reliance on the price mechanism to assign value to a particular activity. But this quickly falls down when valuing an activity which is deemed ethically dubious or where the price mechanism is simply not the appropriate tool.

I have often thought that this reliance represents a form of economic singularity – the point at which conventional laws break down. Indeed, my own reservations stem back to my undergraduate days when I was taught that the cost benefit analysis of health programmes was based upon the value of human capital defined on the basis of lifetime earnings. This never struck me as sensible. I later came to realise that the relevant metric is willingness to pay to avoid particular outcomes – a cost that could potentially become infinite in order to avoid the worst-case outcomes. It is precisely because of such calculations that I have been rather scathing over the years about the field of health economics which takes a very narrow cost-benefit approach to one of the most fundamental issues we face – the matter of life and death itself (in fairness, it has moved in the direction of willingness to pay analysis in recent years, thus mitigating part of my criticism).

Why this matters

The issue of ethics in economics is an important one. Policy cannot be framed without some reference to what society deems morally acceptable. It is simply not enough to adopt a positivist approach. In macro terms we can debate the righteousness of the guiding principles followed by the Reagan and Thatcher governments of the 1980s but they were at least coherent: They were designed to reduce the role of state interference in the lives of ordinary citizens and empower the individual. In other words, there was a normative element to the policy. As it happens, they focused on a very narrow set of criteria which boosted short-term material prosperity but failed to take account of the wider long-term costs (rising inequality and the hollowing out of the industrial base to name but two). Nonetheless, the ideas were so electorally popular that subsequent generations of politicians on the other side of the political divide (Clinton/Obama and Blair/Brown) did not try to reverse the tide and instead tried to marry it with the idea of promoting social justice.

In recent years neither the US nor UK policy agenda appear to have been guided by any form of coherent economic thinking. Starting in 2010, the British government adopted a positivist approach based around deficit reduction but this had significant adverse consequences for the less well-off members of society and played a big role in whipping up the discontent which ultimately led to the Brexit vote. The populist governments which emerged post-2016, notably those led by Trump and Johnson, do not appear to offer any coherent economic vision at all.

Trump’s economic policy was based around an America first philosophy which served only to trash the global rules-based order and lit the touchpaper for the disaster which has unfolded in Afghanistan in recent days. Even leaving this catastrophe aside, pursuing what amounts to an isolationist stance in an increasingly interconnected world makes little sense as an economic strategy. The Johnson government has followed a similar stance in that it has trashed the UK’s relationships with its erstwhile European partners. But the criticism most frequently levelled at the Johnson government is that its policies are opportunistic rather than aimed at a coherent set of normative goals. There are some elements of a moral economic policy – notably the promise to “level up” regional inequalities – but over the last year its actions have created an impression that it is out to secure the interests of its members rather than the electorate it is meant to serve. Moreover, in areas such as NHS reform and defence spending – both of which are driven by economic considerations – there is no sense of a coherent, principled approach.

All this gives economics a bad rap, partly because politicians tend to blur the lines between complex economic issues and simple budgetary concerns. Economic policy should concern itself with the wider implications of its actions rather than focusing merely on the monetary aspects. Whether or not people think of economics as a science matters less than the fact that it has roots which emerge from its philosophical traditions, and we would do well to remember that sometimes we have to think in terms of more than assigning monetary values to policy objectives. Adam Smith would undoubtedly have approved.