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Why fiscal health depends on fairer taxation

Stewart Lansley argues that a shift to a more progressive system would have a number of wider economic benefits, most importantly on the health of public finances.

Interviewed recently in the Observer, Labour’s opposition business secretary, Chuka Umunna, argued that the ‘traditional totems for the centre-left’ – progressive taxation, redistribution – are harder to maintain in straitened times.

‘If we had a more progressive tax system’, he added, ‘that would not necessarily address the living standards crisis that millions of people are facing.’

A similar argument was used by successive Labour administrations from 1997. During their 13 years in power, despite being a time of relative economic prosperity, little was done to reverse the regressive structure of the British tax system, one which takes proportionately more from those on low than those on high incomes. Although Labour eventually introduced a top income tax rate of 50p, this alone would have had a limited impact in making the tax system fairer.

Yet, apart from the question of fairness - Adam Smith argued in favour of progressive taxes – a shift to a more progressive system would have a number of wider economic benefits, most importantly on the health of public finances.

Over the last 30 years an increasing number of rich countries have been hitting an apparent limit on their ability to raise revenue through taxation. While demands on the state for improved services have been upwards, the ‘tax-take’ has been largely static or downwards.

Take the UK.

Between 2001 and 2007, spending as a share of GDP rose by four percentage points from 36.8 per cent to 40.9 per cent, largely as a result of improved health, education and welfare programmes. Tax revenue, in contrast, remained static at 38.6 per cent of the economy over the period. As a result of this rising fiscal gap, the
national debt rose from 30 to 37 per cent as a percentage of GDP.

The share of tax revenue in the economy peaked in the UK in the early 1980s at over 45%. It then fell sharply over the next decade and since the early 1990s has settled at the much lower average of 37-38%.

This has meant that tax revenue has fallen short of public spending for most of the last 20 years. Though some of this shortfall is explained by the use of borrowing to fund capital spending, Britain’s deficit is as much a problem of under-taxation as over-spending.

Ultimately, of course, such shortfalls are unsustainable. Either governments need to moderate spending, or increase the tax base.

The long term stagnation in revenue stems from two key economic trends. First, the tax policies of the 1980s that shifted the tax system from progressive to regressive. In 1979, the top fifth paid 37.6% of their incomes in tax and the poorest fifth paid only 30.5 per cent. By the end of the 1980s, these shares had been almost reversed.

Second, by the rising share of the national cake in the hands of the rich. The share of net income held by the top 1% has nearly tripled in the UK, standing at over 15.4% in 2009 compared with a low point of 5.6% in 1978.

The combined effect of these two changes has been that since 1979 the share of earnings paid in tax by those in the top one per cent has fallen from over a half to around a third, while the average tax rate on most of the rest of the population has risen to over 35%.

Supporters of the 1980s reforms have long argued that by boosting economies, lowering tax rates on high earners would actually increase revenue – the so-called Laffer curve.

This is the argument used by the Republicans in the United States to cut taxes on the rich and by George Osborne to cut the 50 p tax rate in the last budget. But the evidence has long been clear. Cutting tax rates does not increase revenue. Along with many contentions of market advocates, the ‘dynamic effect` from lowered taxes at the top is a myth.

The policy strategy of the last 30 years - making economies more unequal while cutting tax rates on the rich - neither leads to a larger economic cake nor to boosted tax revenue. It simply shrinks the tax base. The latest evidence for this comes from a significant paper from Thomas Piketty and colleagues.

They show that the optimal rate of tax on the rich – the rate which maximizes revenue – is well above current rates. Indeed, it has recently been disclosed by the former cabinet secretary, Lord O’Donnell, that George Osborne was advised that the optimal top tax rate is 48p, contradicting the Chancellor’s argument for the proposed cut to 45p. Piketty suggests it is a good deal higher than this.

The lesson is clear. Maintaining fiscal balance requires more progressive tax systems with a much larger contribution from the very rich. This seems to be accepted by the Secretary-General of the OECD, Angel Gurrí, in his recent call on rich nations to reform ‘their tax systems to ensure that wealthier individuals contribute their fair share of the tax burden.’

Stewart Lansley is the author of The Cost of Inequality: Why Economic Equality is Essential for Recovery, Gibson Square, 2012

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