Artillery Row

An economic warning to the curious

There are no good British lessons from higher European taxes

After all that government spending intended at dealing with the fallout from Covid, the uncomfortable question on how to pay for it is slowly coming up. As an estimated £350 billion will have been spent in 2020, Chancellor Rishi Sunak is reportedly looking at the possibility of tax hikes. A political challenge here is that Boris Johnson promised not to raise income tax, VAT or National Insurance. But there are economic challenges as well. As a taxpayer in Belgium, which is the country where a single earner is taxed higher than anywhere else in the world, my advice is: don’t copy this “high-tax” model, given its dire effects on competitiveness and economic growth.

Some argue that Scandinavian countries like Sweden offer a counter-example of how high-tax models do work. Swedish economist Johan Norberg has, however, explained that ‘Sweden got rich when taxes and public spending were lower than in other places, including the U.S. Only then, in the 1970s did we start to tax and spend heavily. And that is when we began to lag behind. Only after reforms since the 1990s did we get back on track.’

Sometimes, tax hikes may result in less government income, regardless of their effect on economic growth. Certain politicians seem to have a hard time understanding this, but it is actually very simple. It’s easy to understand that if a £7 cinema ticket were to be increased to £150, the cinema may see its income drop, as hardly anyone would still turn up to watch a film. In a similar manner, from a certain point, hiking taxes on certain products may result in lower income from these taxes. This effect has been dubbed the “Laffer effect”, after economist Arthur Laffer. In 2017, the Belgian government witnessed its income from taxes on cigarettes and alcohol drop despite a tax hike. Those taxes are lower in Belgium than in the UK, so one can never be sure when the Laffer point is reached in any given society. The ironic thing is that while this was more a public health measure than an economic measure, it resulted in lower government income and therefore less room for publicly-funded health care spending.

Of course, sometimes a tax hike does result in higher tax income. But, as in Belgium or other highly taxed places, the golden goose producing the eggs may be hurt. One should head the lesson of David Ricardo, who always stressed that there is no such thing as a free lunch when it comes to government spending. According to him, if a government engages in deficit spending, private spending will fall by an equivalent amount. This is because people save more when they witness out-of-control government spending, as they expect future tax hikes.

Indeed, that is what we can see in all European countries this year. The amount of money in savings accounts has been skyrocketing across Europe, and also in the UK, as people are too afraid to invest. Some of that is of course not only because of expected tax hikes resulting from Covid spending, but due to the expected negative economic effects of the Covid crisis fall-out.

So does that mean tax hikes will no longer put any extra negative burden on the economy, as they have been largely factored in by private savers?  No, on the contrary. Despite all its spending, the UK government can still avoid damage. Some tax hikes will be more damaging – or unfair – than others. But most importantly, large opportunities remain for the UK government to avoid potential tax hikes and focus on trimming spending inefficiencies.

So which government spending to cut then? The obvious place to start is at anything that is not “investment”, in the sense that it does not deliver a benefit in the future, but merely one in the present. To cut consumption spending should therefore be a priority. Ideally, the government should also only borrow to finance investment spending, which will benefit the children, who shouldn’t be paying off debt used for spending they’ve never profited from.

Second, luxury spending and waste should also obviously be cut. It shouldn’t be hard to find opportunities for that. Last year, Amyas Morse, the outgoing National Audit Office chief, expressed his frustration about the state of UK government spending, referring in his final public speech to a damning list of waste, involving projects like Crossrail, probation, smart meters and of course the Ministry of Defence, a government department notoriously vulnerable to spending inefficiencies in pretty much every country. Despite the fact that his NAO reports identify lots of opportunities for government spending cuts, somehow, at the moment, only tax hikes are at the top of the political agenda.

Any of the options Chancellor Sunak has to increase taxes come with huge drawbacks

The UK government’s two main ideas on how to raise taxes seem to be a new 2% levy on all online sales as well as a change to property taxation; let’s deal with the former first. A Treasury document mentions how an online sales levy could ‘provide a sustainable and meaningful revenue source for the government.’ Some think this may replace business rates, which is the levy on companies based on the premises they occupy, even if there are also ideas floated around to hike these business rates. Taxing online sales more is apparently also meant to protect high street shops from mounting competition.

British retail industry representatives have come out against, rightly warning this would push up prices for consumers. Former MEP Dan Hannan, eloquently pointed out that ‘a windfall tax on online retailers would be a rotten way to thank the firms that kept us going through the lockdown. A country that taxes successful businesses to subsidise failing businesses will end up with fewer of the former and more of the latter.’

The other idea mostly doing the rounds is to hike property taxation. James Kirkup mentions in The Times how according to official statistics, the UK is on course to create, in a generation’s time, a national debt more than twice the size of the entire economy. Generational considerations like these serve to make the case for taxing property harder. The Social Market Foundation has already called for a new “property capital gains tax”, which would raise £421bn over the next 25 years.

It looks like the Chancellor is listening. He has asked the Tax Simplification Office to conduct a review to consider hiking capital gains tax, which may include axing the exemption for those selling their main residence. This would be a damaging hit to middle-class home owners. The objection will naturally be that it is not fair for people selling their family residence in London to no longer be able to afford a new one in the same city, where they live, as a part of the sales price would need to be paid to the government.

David Gauke has made another suggestion: consider a VAT increase. VAT is one of the biggest sources of tax revenue for the government, as it raised £132bn in 2018-19, so any changes there can make a big difference for the Treasury. Labour fiercely opposes this, as it would hit those on lower salaries hard, at least harder than taxing away the gains from higher house prices. More fundamentally, hiking VAT always carries the risk for the government that it will miss out on the expected revenue due to the Laffer effect.

Any of the options Chancellor Sunak has to increase taxes come with huge drawbacks. It will be very hard for him to avoid focusing first on opportunities to trim government spending, before considering higher taxes.

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