Sunday, June 28, 2015
Cut tax rates at the bottom, not at the top
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

There is more than a touch of déjà vu about George Osborne’s summer budget on July 8. In June 2010, when Osborne presented his first “emergency” budget, Greece dominated the headlines, having agreed to its first bailout package amid deadly riots and a flurry of ratings downgrades.

Then as now, Britain had a substantial budget deficit which had to be tackled. And, while it has fallen by more than half as a percentage of gross domestic product, at 4.9% of GDP or nearly £90bn in 2014-15 (though falling this year) it remains too high for comfort. Hence, one of the sounds you hear from the Treasury is that of knives being sharpened.

True, this is the first budget in a Conservative-only government since Ken Clarke’s last outing nearly two decades ago in November 1996 (at that time the spring budget had been abolished). And true, the fact the chancellor no longer has to get everything past coalition partners will change the character of next month’s budget. In other respects, however, things are rather familiar.

Let me address three aspects of the upcoming budget: the economic backdrop, whether welfare cuts can be achieved and whether in the context of such cuts, the first Tory budget for almost 20 years should include a cut from 45% to 40% in the top rate for very high earners.

The economic backdrop to the budget is one of a strong job market, low inflation and rising real wages. Independent forecasters expect 2.5% growth this year and, in forecasts published since the election, 2.4% next. Though the talk is of tough, front-end loaded austerity, forecasters do not expect this to have a significant impact on growth.

If so, this would follow the pattern of the last parliament. Though there is a view around that growth stopped as soon as Osborne embarked on austerity (in addition to that he inherited from the previous Labour government), and only started when deficit reduction was relaxed or even abandoned, it is a myth.

Growth in 2010-11 was 2.3% and 1.4% in 2011-12, even as austerity was biting hardest (reducing growth by 1.1 percentage points each year according to the Office for Budget Responsibility). Non-oil growth, which adjusts for sharply falling North Sea oil production, and is a fairer measure of underlying economic activity, was 2.7% and 1.9% respectively. Though tax increases and spending cuts hit growth, as did several other factors, low interest rates and quantitative easing by the Bank of England boosted it. With Bank rate at 0.5% for more than six years, monetary policy remains loose now.

What could hit growth is what happens in the eurozone. Growth slowed to 0.7% (1% excluding oil) in 2012-13, when euro break-up fears were at their height and the eurozone was in a full-blown recession, its second in the space of three years. Currently growth in the eurozone is picking up, which is good. The hope has to be that that continues, notwithstanding a Greek saga that has lurched into new uncertainty this weekend, with the Syriza government's decision to call a referendum next Sunday on a deal which may well have evaporated by then.

The two solid elements of the budget are the planned £12bn of welfare cuts and £5bn of savings from curbing tax avoidance. Nobody will argue with the latter. Plenty will criticise the former.

On welfare, as was made clear in the joint piece in this newspaper last Sunday from Osborne and Iain Duncan Smith, the work and pensions secretary, and a speech a few days ago by David Cameron, the aim is not just to cut but to reform, improving incentives to work and ending what the prime minister called the “merry go round”. Essentially, the more that people receive in pay, the less they will need from working-age benefits.

Is this feasible? There is little evidence that employers deliberately play the system of tax credits by paying the minimum they can get away with (usually the minimum wage), knowing that the government will top it up with tax credits.

There is plenty of evidence, however, that benefit and tax credit rules do affect the hours that people are willing to work, and their willingness to receive bonuses. A Low Pay Commission report earlier this year, the Minimum Wage, Taxes and Benefits, found that over half of employers found that employees did not more hours, because it would affect their entitlement to in-work benefits. This was particularly the case among lone parents at 16 hours, and single adults at 30 hours, in each case the threshold for receiving tax credits and other benefits.

This is because of a longstanding flaw in the system, that higher earnings can result in a marginal effective tax rate of more than 100%. Unsurprisingly, people respond to such disincentives. The system can act as a trap. The switch to universal credit will help, though the Low Pay Commission report notes that effective tax rates of over 70% will remain. Osborne, Duncan Smith and Cameron have the right aim, to reduce welfare dependency, and it seems there is demand from employers to increase working hours – shifting the burden from taxpayers to business – but it is ambitious. Taking £12bn out of a £94bn working-age welfare bill means taking some prisoners.

Whatever the chancellor announces on welfare, it will be greeted as draconian by many, the more so if he were to combine it with a cut in the top rate of tax. This was the intriguing possibility raised by the Financial Times a couple of days ago, citing the fact that Lord Lawson, the former Tory chancellor, is urging Osborne to do it.

Lawson, of course, cut the top rate from 60% to 40% in his penultimate budget in 1988. The current chancellor announced a cut in the top rate from 50% to 45% in 2012, a budget that for a variety of reasons was not his finest hour.

Is there a case to go further, taking it back down to the level that prevailed for 22 years after Lawson’s historic announcement? He did it in the first budget of a new parliament, so there is precedent. The closer you get to an election, the harder it is. Combined with a package of measures that hit higher earners – further limiting pension tax relief and abolishing non-dom status for anybody born here – it could be presented as a fiscally neutral. It would delight many Tory backbenchers.

But, while I am normally as much in favour of lower taxes as anybody, it would look terrible. A tax cut for those earning more than £150,000 alongside significant welfare cuts would confirm very stereotype about the Tories. Getting the top rate down to 40% is a laudable aim. It should wait until the public finances are closer to being fixed.