Wednesday, September 14, 2005
Has Brown solved his tax problem?
Posted by David Smith at 07:20 PM
Category: David Smith' s magazine articles

Another look at the UK's fiscal situation, written for Professional Investor.

From well before the general election last May until just before the politicians disappeared for their holidays in late July one question dogged Gordon Brown. Would he repeat the tactic he used after Labour’s two previous election victories and raise taxes after a decent interval has elapsed?

Or, as the chancellor insisted repeatedly during the election campaign – and continued to insist after it – would it be different this time? Could the public spending plans really be affordable so the £10 billion of tax hikes long regarded as necessary by the Institute for Fiscal Studies and others will not be needed?

In July we had part of the answer to that question. There had been a big risk that the chancellor would break his own “golden rule” of only borrowing to fund investment. The consensus among analysts was that an economic cycle beginning in 1999-2000 and ending in 2005-6 – the Treasury’s working assumption – would see an overall deficit when it came to the balance between current spending and receipts.

Brown, however, neatly extracted himself from that one, albeit at considerable cost to the credibility of his golden rule. By seizing on revised growth figures from the Office for National Statistics, he was able to put the start of the economic cycle back to 1997-8, add in the healthier public finances for that period, and give himself a margin of error for meeting the rule. At the stroke of a statistician’s pen, his tax dilemma appeared to be solved.

Or was it? The bigger issue has always been not the narrow question of whether the golden rule will be met in the current cycle but whether tax revenues will rise by enough to fund the government’s spending pledges going forward.

The public finances are not obviously getting much worse. But they are not getting better, as the Treasury predicted. Nor has the chancellor had much help from the economy. The sharp slowdown in consumer spending and the housing market is directly reflected in lower indirect tax revenue – VAT, stamp duty and the rest. High oil prices are benefiting the Treasury, by enough for Brown to be able to postpone the excise duty hike on petrol and diesel which had been due on September 1. But the net effect is that revenue growth is weaker than the Treasury was counting on. Meanwhile, there is no let-up in the growth in public spending.

A budget deficit that owes something to weaker economic growth is not in itself a reason to put up taxes. Even so, and after his statistical sleight of hand, Brown faces a predicament. He is the runaway favourite to succeed Tony Blair if the prime minister sticks to his pledge not to fight another election (a pledge it would take a Houdini-like escape to get out of). Would the British public warm to Brown when he has just put up their taxes?

That is why I don’t think we will see another highly visible tax hike like the 1 per cent NI increase, for both employees and employers, announced in 2002, worth an extra £8 billion a year to the Treasury.

Instead we’ll see a lot of reliance by the Treasury on fiscal drag – raising extra tax from people as they move into higher tax brackets. We will also see a huge amount of emphasis on closing tax loopholes, for both individuals and companies, some of which will involve tax hikes in all but name. There will also be an emphasis on value for money throughout government. If public spending does not quite increase in line with plans from now on, that will be attributed to efficiency savings, not going slow on programmes. The next spending review, now postponed until 2007, will be tough. The watchword, I think, will be to avoid a big upfront increase in taxes. Stealth taxation is back – if it ever went away.

Will it work, as both an economic and political strategy? George Osborne, the shadow chancellor, argues that even without further tax increases Britain is losing tax competitiveness. Five years ago only 10 of the 30 advanced industrial countries had corporate tax rates lower than in Britain. Now 20 countries do and others are examining the possibility of reducing their rates.

Osborne has been studying the flat tax revolution sweeping through former parts of the Soviet empire. The flat tax, discussed here in June, is not easily transferable to economies such as Britain’s. But it provides a good indication of the way things are heading. Countries see low taxes as a way of attracting inward investment, and of positioning themselves in the global economy. In Britain, in contrast, tax rates are largely seen as a domestic matter.

The Treasury’s counter to this is that there is no evidence yet that changes in Britain’s tax regime are having an adverse effect. Recent official figures produced by UK Trade and Investment, the body responsible for attracting projects to Britain, show that a record number of new investments came from overseas during 2004-5.

Nearly 40,000 jobs were created from 1,066 projects, an increase from the previous year’s figure of just over 25,000 jobs from 811 projects. Nearly a quarter of the projects, 240, were in IT and software, up 61 per cent on the previous year.

Alan Johnson, the trade and industry secretary, said: “International comparisons continue to show the UK as Europe's top investment destination.” But he warned that the challenges would grow. Britain, he said, had to move forward by “adding value and exploiting technology”.

All this is true. But tax is important too. International firms are increasingly footloose, as they have shown by migrating to countries with low labour costs. They will also move toward countries with the lowest tax rates. It is not, by any stretch, the only factor that drives international investment. But it is an important one. The risk is that, both for the great bulk of firms operating in Britain, and those thinking of coming here, tax will become a significant handicap.

Add to that the risks to the wider economy of higher taxes and the inference is clear. We all have an interest in avoiding another round of tax hikes – and of taxes going up too much by stealth.

From Professional Investor, September 2005