A piece about last week's symbolic announcement of an increase in the top rate of tax

It was one of the stormiest parliamentary occasions of modern times. Twenty years ago Nigel Lawson, the Tory chancellor, was leading up to his big budget announcement that was to transform Britain from a high-tax to a low-tax economy.

As he began to outline his tax-cutting proposals, Alex Salmond, then a backbench Scottish National party MP, began shouting: “The budget is an obscenity. The chancellor cannot do this.” Salmond was suspended from the house and Lawson continued. He intended to cut the top rate of tax, then 60% and thus higher than in most countries, to 40%, and he was clear about why he was doing so.

“Excessive rates of income tax destroy enterprise, encourage avoidance and drive talent to more hospitable shores overseas,” he said. “As a result, so far from raising additional revenue, over time they actually raise less.”

Labour MPs, taking their cue from Salmond, were incensed and began chanting: “Shame.” The mood became so heated that the sitting was suspended for 10 minutes – unprecedented during a budget speech – because of the “grave disorder” in the Commons.

Lawson was able to continue his budget and deliver the cut in tax, which he later described as an essential component in the “cultural change” that Thatcherism ushered in. Gone was the envy-driven, level-down society of the past. In came a new enterprise-friendly, outward-looking country, ready to take on global challenges and to attract the world’s best to Britain.

The City of London, fresh from the “Big Bang” reforms of 1986, which opened it up to the giant investment banks from America, Japan and Europe, suddenly became the place to be. Bankers had long been deterred from basing themselves in Britain by the high tax regime. The 60% top rate of tax kicked in at the equivalent in today’s money of less than £90,000, and many remembered the 1970s, when the top rate was 83% (and as much as 98% on unearned income).

Now things were different. Britain had become a low-tax country overnight. That same year, work started on the construction of Canary Wharf.

“It added to the powerful sense that London was a welcoming place for the big players from all over the world,” says Michael Cassidy, long-time champion of the City, who has just stepped down as president of the London Chamber of Commerce. “I do think it was very important.”

Lord Young, who took the title of enterprise secretary under Margaret Thatcher, preferring it to secretary of state for trade and industry, suddenly found that the job of selling Britain as a location for international businesses was a lot easier.

The Labour party had a different idea. Neil Kinnock, the party leader, criticised for the ill-disciplined display by his members, advised them: “Don’t get mad; get even.”

Kinnock wanted to get even quickly, fighting the 1992 general election on a programme of a new top tax rate of 50%, with high earners hit by extra National Insurance contributions. He lost, and the 40% top rate stayed.

Last week Labour MPs finally did get even. When Alistair Darling announced in his prebudget report on Monday that he was putting up the top rate of income tax to 45%, along with other measures to squeeze high earners that in effect put up the rate to 60% for some, they cheered him to the rafters.

Britain’s attempt to be a low-tax country had, in truth, perished long ago under the weight of the stealth taxes introduced by Gordon Brown to pay for an eight-year public-spending splurge, but the 40% top tax rate was still an important totem, a sign that there was a settled political consensus on the need to incentivise high earners and entrepreneurs and ensure they did not take their talent elsewhere.

That consensus was not always guaranteed. Until 1997 Labour’s intentions, even under Tony Blair, were far from clear. But he and Gordon Brown knew that if they committed themselves to not raising the top rate of tax, it would also calm public fears that they planned to put up all taxes – which had been one of the Tories’ few remaining election weapons.

Philip Gould, now Lord Gould, new Labour’s strategist, later recalled the effect of the party’s announcement in January 1997. “Brown, in an audacious coup, announced, first on the Today programme and then in a speech to Labour’s Finance and Industry Group, that neither the basic nor the top rate of tax would go up under Labour,” he wrote. “The Tories were poleaxed. It was as though a political mallet had been smashed through their heads.” Three years later Blair, as prime minister, told Jeremy Paxman: “It’s not a burning ambition for me to make sure that David Beckham earns less money.”

The rate of tax was less important than whether people paid tax, he said, and he was right. The cut in the top rate to 40% had been followed by an increase in the proportion of tax coming from high earners, both because there was less incentive to take complex steps to avoid tax and because those at the top of the tree, who had done well under Thatcher, prospered even more under Blair.

So why the announcement now that in three years’ time the top rate will go up to 45%, combined with a squeeze on allowances that will mean some high earners facing a marginal tax rate – the highest rate levied on their income – of 60% or even more?

The Treasury needs the money, though the Institute for Fiscal Studies calculates that, on its own, the new 45% tax rate on incomes above £150,000 will bring in very little, prompting suspicions that this is the tip of a very large tax-raising iceberg.

Politics played a part. Lord Mandelson, the business secretary and joint architect of new Labour, insisted last week that the party had not gone back on its principles. “New Labour is about more than just the top tax rate,” he said. “It is the times that have changed, not new Labour.”

Some detect his hand in the move, designed to force the Conservatives into opposing it so they are seen to be supporting the party’s rich friends and balking at Labour’s “fairness” agenda, which the party thinks will appeal to voters when times are tough.

Underlying it, however, is a straightforward economic calculation. Treasury officials, running through their numbers, have decided that we are in a different world from that of the past two decades. The City, shrunk and chastened, will not be the same for a very long time. Many of the American, Swiss, French and German bankers who helped to fill the government’s coffers with the revenues they generated and the tax on their bonuses have scuttled home with their tails between their legs.

Having them here was great in the good times, and may be again in the future. For the moment, though, the culture of risk-taking and brash wealth creation, so powerful on the way up, has put Britain at risk of a bigger fall on the way down. Suddenly, being Europe’s financial centre is not such a good thing.

“The world has changed,” says Cassidy. “I’m pretty gloomy about it. All those things that I championed and that I thought we were good at – the bonus culture, the risk-taking, the internationalisation – are not looking so good any more. We have to go back to basics.”

Britain, far from being the enterprise capital of Europe, is struggling to stop businesses packing up and heading to Dublin or other centres. And what matters there, the Treasury has decided, is not the top rate of income tax but the deals and concessions that companies can be offered to minimise the amount of tax they pay as businesses.

WHAT does Darling’s move tell us about the kind of economy Britain will have over the next few years? Government borrowing is back to the crisis levels of the 1970s, and taxes are going up after a temporary cut. Is this the new austerity?

Martin Sorrell, chief executive of WPP, one of the world’s biggest advertising agencies, thinks the expansion of the size of the state and higher taxes – plus the huge increase in the amount of red tape imposed by government departments and Brussels over the past decade – mean Britain has taken a huge step backwards. “All the changes Margaret Thatcher made have gone,” he wrote last week. “When I visit Scotland and Wales, and see the extent to which local jobs depend on the public sector, it shows we have lost the progress made under her.

“Governments can invest plenty of money in retraining people but, unless we can change more aggressively, we will be unable to compete. We are back where we were in the 1960s and 1970s.”

Even government is stymied, notwithstanding Darling’s “giveaway” pre-budget report last week. While the political message was that the government was doing everything to help the country through the recession, such is the state of its finances that the public sector will not be a source of job growth in the future.

Over the past eight years, under Brown’s public spending boom, its growth rate has been 4% or 5% a year on top of inflation. In some areas, such as the National Health Service, “real” spending growth was more than 7% a year over the period. Around a third of new jobs in Britain in the past decade have been in the public sector, with plenty of others indirectly dependent on the government’s largesse. In some parts of the country the state has been the only serious source of new work.

Now the outlook is different. Darling, if he stays in the job, will be more like the austerity chancellors of the past, such as Sir Stafford Cripps and Roy Jenkins. Gone is the great expansion of spending, crushed by the sheer weight of borrowing – which will rise to well over £100 billion a year – that has to be reined back.

With the chancellor budgeting for a slowdown in spending growth to little more than 1% a year, and economists warning that even this may be unaffordable, the burden of providing jobs and growth will fall on the hard-pressed private sector.

“There is no magic bullet,” said John Philpott, chief economist at the Chartered Institute of Personnel and Development and one of Britain’s leading experts on the job market. “It’s difficult to identify a major generator of jobs. I can’t see any circumstances in which we are going to go back to high-employment manufacturing.

“Barack Obama and Gordon Brown talk about ‘green’ jobs, but the idea of these has been around for a long time. One area where we might get some jobs growth, paradoxically, is in private health and education, with people choosing to spend their own money as the government cuts back.”

IN one sense, the question of where the future jobs, economic growth and tax revenues will come from is impossible to answer; many will be in skills and sectors we have not yet thought about. Recessions bring about what Joseph Schumpeter called the process of “creative destruction”, an economic version of “out with the old; in with the new”.

Economies change, and they do so rapidly. When Britain emerged from its last recession in the early 1990s, Google was not even a twinkle in the eye of its founders, Larry Page and Sergey Brin. Most people had barely heard of the internet, let alone used it.

There is also a time, in every recession, when it seems impossible to detect even the faintest gleam of light at the end of the tunnel. Gloomy predictions make it onto the bestseller lists.

In 1992, miners marching through London in protest at the Tory government’s pit closures were cheered on the streets of Kensington, an echo of the Jarrow march of the 1930s. In that same year James Davidson’s and Lord Rees-Mogg’s book The Great Reckoning: How the World Will Change in the Depression of the 1990s offered the grimmest vision of what was in store.

According to one summary at the time: “We are heading for an appalling four-year economic depression in which crack-crazed armed gangs will roam the streets, the value of your house will fall to a third of its present level, terrorists will ransom the West with nuclear weapons, anybody worth more than £100,000 will employ an armed bodyguard and everybody else will carry a handgun . . .

“If you are badly in debt, you’re dead; forget it, walk away, sleep in a cardboard box if you can find one. You are about to be totalled by economic history.”

It did not happen. The 1990s, after a sputtering start, turned into what Joe Stiglitz, the Nobel prize-winning US economist, characterised as a “roaring” decade.

Prosperity came back, and it did so quickly. Fears of “jobless” growth in Britain were groundless: the long upturn created 4m new jobs and turned the country into a magnet for migrant workers.

Economies change, but they are more resilient than people think. “You could certainly say that over long periods of time the British economy has gone through many upheavals, but the growth rate doesn’t change very much,” said Nick Crafts, professor of economic history at Warwick University.

That does not mean nothing ever changes. Japan’s long period of stagnation from the late 1980s shows that economies can shift down several gears and not recover. Crafts also points out that in the 1960s and 1970s it was common to predict that Europe would close the economic gap with America. It did not happen, partly because many countries in Europe chose that moment to introduce legislation that cut working hours and increased holiday entitlement.

Perhaps this is the moment when Britain too gives up the fight and embraces the new austerity. Economists think, however, it is too soon to throw in the towel, even for those bits of the economy in the eye of the storm.

“Many people think that business and financial services – the City, banking, advertising, marketing, accountancy, consulting and the legal profession – will never come back,” says Adrian Cooper, managing director of Oxford Economics. “But when we get back to normal conditions we still think these are the areas where Britain has a comparative advantage and where we can still do well, particularly as we benefit from developments like the emergence of China.”

He may be right, but the story of the top rate of tax tells us that the government is looking forward to a very different future. The political consensus about tax has given way to the politics of envy. Rich bankers are to be bashed in any way ministers can think up.

Maybe the result will indeed be a mass exodus of talent if Labour wins the next election, as Lord Young warns. “It is the end of an era,” he says. Last week was a big moment. A totem of the past two decades was demolished in a moment. The consequences of that moment may be felt for a very long time.

From The Sunday Times, November 30 2008