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Article / 17 May 2017 at 12:18 GMT

Higher taxes and spending will not deliver growth

Managing Partner / Spotlight Group
United Kingdom
  • Labour claim spending will be matched by increased tax revenue 
  • Party platform does not account for behavioural changes in face of higher tax
  • Increased taxation and state spending will fail to deliver economic growth 

By Stephen Pope

Yesterday, the UK general election began to shift into its next gear as the first of the major political parties launched their manifesto.

The Labour Party, led by Jeremy Corbyn, offered a programme they say offers a “stark choice” that will end the economic system being "rigged against" the many and pledged to "build a country where we invest our wealth to give everyone the best chance".

Superficially, that sounds appealing. By now, my followers will know that I am a champion of the free-enterprise market model, but I do oppose large corporations avoiding their fair share of tax. That said, what I oppose even more aggressively is a penal taxation system, state meddling, and endless cash streams being channelled into state-owned enterprises with no accountability.

The programme offered by Labour would, if put into action put the UK under the yoke of the highest level of taxation seen in seven decades. Let me explain why I see this as a sure-fire route to stifle the economy.

What are Labour’s key policies?

• Scrap student tuition fees
• Nationalisation of England's nine water companies.
• Reintroduce the 50p rate of tax on the highest earners (above £123,000)
• Income tax rate 45p on £80,000 and above
• “Robin Hood” transaction tax on a wide basket of financial assets
• More, free childcare, expanding free provisions for two-, three- and four-year-olds
• Guarantee triple lock for pensioner incomes
• End to zero hours’ contracts
• Hire 10,000 new police officers, 3,000 new firefighters
• Moves to charge companies a levy on salaries above £330,000
• Deliver rail electrification

There are elements in this “wish list” that are laudable, but one cannot just wish for things as a potential government. They must be paid for. So, what are the implications for the tax burden the UK would face if Corbyn were to occupy 10 Downing Street?

It has been claimed by Labour that their tax policies will raise an extra £48.6 billion in tax revenue that will match the funding of their pledges. However, such thinking can be described as “comparative statics”. By this I mean that Labour is looking at the state of the UK economy in 2016/17 and assuming that the pattern of behaviour of individuals and corporations will be the same under their proposed taxation programme as it is now. 

This is incorrect. 

Jeremy Corbyn
Labour leader Jeremy Corbyn's plans sound promising, but the economics 
are questionable at best. Photo: Shutterstock 

Often when faced with a change in taxation, individuals may divert more gross income into a pension scheme rather than let it be counted as taxable income. Corporations and extremely wealthy individuals may choose to relocate away from the UK; business investment into new ventures may be delayed or located outside of the nation. 

All these measures are perfectly legal. Of course, not everyone earning a so-called higher income can move away... so Labour would in effect be soaking the middle classes once again.

Financial gap

In fact, the more one drills down into the programme presented yesterday, the more one can see that there will be a disequilibrium between revenue and spending.

Naturally, the governing Conservative Party have poured scorn on the plan and have issued a warning that Labour's manifesto plans would face a shattering £58bn black hole in the public finances by 2021/22 if implemented.

Such a figure would be equivalent to more than £2,000/year for every household in the country. That is the value of extra taxation or spending required to cover the party's colossal spending plans. Of course, it would not be evenly distributed as very low- to low-income households would not be included.

However, they may pay in terms of job security if the increase in corporation tax leads to alterations in business strategy.

Taxation and the effect on the economy

Clearly, one needs to refer to the body of empirical research that evaluates the impact of taxation on economic performance rather than allowing one's political prism to totally fashion the argument.

There are theories about what drives economic growth, the main protagonists being Keynesian, demand-side factors, neoclassical, supply-side factors, or a diluted mixture of the two...  the so-called “third-way”.

Most the academic literature based around empirical analysis of the relationship between taxes and economic growth consistently point to significant negative effects of increased taxes on economic growth even when the economist has accounted for factors such as government spending, business cycle conditions, and monetary policy.

Of the 26 detailed empirical studies going back to 1993 that assessed taxation and growth in western economies (Australia, Canada, Germany, the UK, and the US), 23 of them, or 88%, find a negative effect of taxes on growth. 

Of those studies that distinguish between types of taxes, corporate income taxes are found to be most harmful, followed by personal income taxes, consumption taxes, and property taxes.

These results clearly support the Neoclassical economic view that contends income and wealth must first be produced and then consumed. The implication is that taxes on the factors of production, i.e. capital and labour, are extremely disruptive of wealth creation.

The Joint Economic Committee, cited by the Heritage Foundation stated:

"Through excessive spending, the government negatively affects the long-run economic growth rate of a free economy. Government spending reduces labour force participation, increases unemployment, and reduces productivity..."

It also reduces the incentive to work, raises borrowing costs, and increases wage pressures. There is a well-known tool in the field of the taxation maximisation point conceived under the Laffer Curve, but more important is the economic growth-maximising Armey Curve shown on the right side of the chart below.

Source: Heritage Foundation

The size of government spending is also critical. Theory and empirical evidence show that big government results in lower growth as they crowd out the private sector which equates to a reduction in future living standards for all. This is an area where the Labour plan of a larger welfare state will unravel. Higher taxes will reduce growth and reduce the tax receipts that could feed welfare.

What should be a small system for assisting the most vulnerable people in need will morph into a system that prepares people for little except welfare dependency and long-term unemployment.

In addition, excess welfare spending grows into a self-serving state enterprise with whole government departments, consultants, lobbyists and companies all depending on large numbers of “clients” to justify their existence.

Corporate and shareholder taxes reduce the incentive to invest and to build capital. Therefore, there will be a lower level of investment which means fewer productive workers and correspondingly lower wages.

Progressive taxation reduces investment, risk taking, and entrepreneurial activity since a disproportionately large share of these activities is done by high-income earners. One only has to look at the talent exodus from France in the first years of president Hollande’s administration to appreciate what the effect of such policies would be.

London
Pictured here: France's sixth-largest city. Photo: Shutterstock

Higher levels of income tax reduce the incentive to work and highly progressive income taxes, where higher income is taxed at higher rates, reduce the returns that would feed the items on Labour’s wish list. That in turn means that there is less money available for education and the incentive to seek a higher education is reduced as the higher income one would associate with high levels of education, reduces the incentive to learn... or at least learn and stay in the home market. Therefore, in the medium-term the quality of human capital will decline.

Labour supporters might claim that there will be a reaction in the short-term, however, in the medium- to long-term there will be a readjustment as the economy rebalances. I must say that on this point they are wrong once again as the empirical studies focus on the long-term effects.

They find that over a period of five years or more, i.e. the lifetime of parliament, a programme of higher taxation is detrimental to overall economic performance. What is more, in today’s world of superfast telecommunications and improved transportation links there is mounting evidence that the detrimental effects felt in the long-term are occurring sooner than previously thought, such as within the first few years of a policy change.

Labour’s policies may sound wonderful, but the devil is in the detail. They would have to borrow vast sums of money to finance their plans and as a result UK yields will rise as any sovereign risk assessment is based on an understanding of the politics at play. The credit rating agencies would soon sense that the UK government would have made too many promises that will only be met by borrowing and spending more. 

If they do not deliver then the economy will suffer further as such a government would be held to ransom by the resurgent trade unions.

— Edited by Michael McKenna
Stephen Pope is managing partner at Spotlight Ideas
3y
BuySellBuySell BuySellBuySell
I was going to say it until you did in the last paragraph: 'They would have to borrow vast sums of money to finance their plans' .. One of the golden rules of governments it seems: no matter how much money they have, it will never be enough! Borrow, borrow, borrow and let someone else sort out the problem at later stage when they are long gone.

Nice article Stephen. It is good to hear some facts and research on the issue.
3y
Stephen Pope Stephen Pope
Thank you for your kind words. It all so sounds so easy...and I guess life is when someone else is paying.
3y
BuySellBuySell BuySellBuySell
So true Stephen ..

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