This week economists at the National Institute of Economic and Social Research (NIESR) said Britain’s difficult financial situation, with high debt levels and no ability to cut public spending, meant taxes would have to rise no matter who wins after the election. – or alternatively Jeremy Hunt’s financial rules will have to be abandoned.
Total government revenues from taxes and other sources are planned to reach 41 percent of GDP this year. This compares with 37 percent as recently as 2019-2020 and 32 percent going back to the mid-1990s.
The last time government revenues rose above 41 percent was 1969-70, for just one year. The last time it rose above 41 percent for several consecutive years was in the late 1940s and early 1950s.
Could taxes be raised significantly higher than currently planned?
I don’t think so. In fact, I suspect even Hunt’s plans will not be realized.
The main reason why taxes have not been kept at these levels, or even raised above, for several years in a row since the late 1940s and early 1950s is that the UK economy has not been able to generate that much revenue.
And it won’t be able to produce it anytime soon.
It is often stated that tax levels in the UK have become several percentage points lower over time than those in some continental European counterparts.
Less well known is that there is an important relationship between tax levels and the structure of a country’s economy and society.
Partly because our tax rates have been historically lower, but also because of things like our robust rule of law tradition; confidence that UK governments (regardless of political hue) will not engage in arbitrary wealth confiscation; our tolerant attitude towards foreign immigrants and foreign investments; The UK tends to attract a disproportionate share of the world’s most mobile capital and high-income labour.
Think financial professionals, lawyers, highly skilled management consultants, highly trained design professionals, and those in similar professions.
The UK creates and trains its citizens for these roles at a rate disproportionate to our share of the global population; We also attract this type of foreign workers.
We also attract the attention of foreign investors and manage the assets of wealthy individuals and institutions.
This ability to attract globally moving capital and high-value labor is called “competitiveness.” Other economies envy our ability to do this.
But a side effect of having a high share of such mobile factors is that if we try to raise taxes, they tend to diverge.
Any attempt to raise taxes above a certain point in any country runs the risk of failure because the attempt to raise taxes does enough damage to the economy that taxes actually fall rather than rise.
But in the UK, the problem is much more serious than elsewhere, as a large part of our economy involves globally mobile capital and labour.
In our current situation, rather than further tax increases bringing the tax share of GDP closer to normal levels among our continental rivals, an attempt to raise taxes is more likely to fail because it would firstly lead to a recession, causing tax receipts to fall; second, it reduces the tax base, causing capital flight; and third, it leads to the migration of high-income and wealthy individuals, again reducing the tax base.
Perhaps after decades of adjustments, our economy will adjust and we will settle into higher percentages of GDP than we are accustomed to.
However, this will involve significant structural changes in our economy. Losing our unusually high share of internationally mobile capital and high-income and wealthy individuals could change our economy in ways that are difficult to predict with certainty, but we can get an idea.
This will likely mean that a lower share of GDP will be taken up by financial and legal professionals, business consultants, software developers and production design experts than today.
House prices may be lower in London, which is no longer a safe haven for international assets. There will be less risk capital for start-ups and fewer of our businesses will be in the hands of foreign firms and individuals.
“Sounds good!” I hear some readers crying. Maybe. But the point for now is that it will take decades to get to that point, and for much of that time our economy will produce less taxes as a percentage of GDP than it currently does.
Therefore, whether or not it is desirable to bring about such structural change in the medium term, it will be of no use in finding a solution to the looming financial crisis that will greet the party that wins the election.
So taxes are unlikely to increase. What else is there? Spending needs to be cut, but that means cutting NHS spending and no government will do that unless forced to do so by international lenders. The last time this actually happened was under the IMF’s austerity program in the 1970s.
We can try structural reforms to make the economy grow faster so that debts decrease relative to GDP.
Both sides say they want to do this; Labor in particular says it wants to “Get Britain Rebuilt”. So will it work, and if it does, will it be fast enough? I doubt it.
All that remains is to inflate the debt, possibly by allowing inflation in the UK to be consistently higher for several years (though the 10-20 per cent inflation trajectory of a few years in the 1970s would also work). I estimate that the inflation target will rise to 3 percent in the near future. But even this may not be enough.
We will soon face a financial reckoning.