Authors: David Smith
A computer expert employed full-time by the Inland Revenue cannot also be employed by the private sector. The office in which he works cannot also be used for commercial purposes. A pound taken in tax and used to fund the NHS cannot also be spent by the individual for half a pint of beer. It has gone. The government, in carrying out public services, stakes a claim on a substantial slice of the economy’s resources, whether they are people, property, equipment, or the money to pay for all these things. ‘Resource’ crowding out occurs when the government’s claims on these things act to the detriment of the private sector. When might this arise? Suppose there is a limited number of IT experts and the private sector cannot get hold of trained staff because the government is employing most of them. Or Whitehall departments take all the best office locations in the centre of London. More generally, resource crowding out arises when resources are fully used. If the economy is in a situation of full employment, for example, the private sector will be unable to take on extra staff unless it is able to recruit them from the public sector. If the public sector does not want to let them go, or is recruiting too, the effect will be to push up wages, and therefore both private and public sector costs.
There is another type of crowding out. What happens when governments increase spending at a faster rate than tax revenues are flowing in? Governments are required to borrow, to run a budget deficit. All governments borrow, usually from their own citizens and financial institutions, in the form of National Savings or the issue of government bonds (called gilts in the UK because the certificates originally had gold edging). Borrowing by governments is perfectly normal. The problem arises when governments try to borrow too much. Originally people used to think about financial crowding out in the sense that, if there was a limited supply of funds, the more the government claimed for its own purposes the less would be available for companies to raise in order to finance productive investment. In these days of global, free-flowing capital between different countries, it is wrong to think of a narrowly defined pool of money existing only in one country. International investors buy the bonds issued by the governments of other countries. Japanese financial institutions, famously, allowed America to run big budget deficits from the mid-1980s onwards by their willingness to buy US government bonds, so-called treasuries. These days a more subtle form of crowding out can occur. Governments that borrow heavily will be regarded with some suspicion by the financial markets, which will require a higher rate of interest in return for providing funds. The effect of heavy government borrowing is to push up interest rates for all borrowers, which has the effect of crowding out some of them. This is one reason why the euro operates under a ‘Stability and Growth’ Pact, under which member governments are required to restrict their budget deficits to 3 percent of GDP or below. The fear behind it was that heavy borrowing by one member country could have a damaging effect throughout the euro area.
Multiplying government spending
Before moving on to tax, and the ‘Budget judgment’, one quick point. Our next speaker, John Maynard Keynes, will have a little more to say on this, but it is necessary to qualify very slightly the effect of government spending. A pound spent by the government cannot be used by you or me to buy books or groceries but some of that pound may indeed end up being spent on such things. How so? Approximately 70 percent of health service spending goes on wages and salaries. It therefore provides public sector employees with an income, part of which they will use for, yes, books and groceries. Some of the non-wage component of public spending will be used to pay for supplies or services that, again, will provide somebody with an income. An initial increase in government spending flows around the economy for quite a while. Just like with a pebble tossed into a pool, the effects go beyond the initial splash. A pound spent by the government does not, however, produce a pound of spending at the next stage. Some of the income paid out by the health service will be taken by tax, some will be spent on imports, some saved. But the multiplier is a useful idea. Sometimes it is used to justify extra government spending rather than tax cuts, on the ground that cutting taxes for individuals will be subject to quite large leakages because, for example, three-quarters of cars sold in Britain are imported. Government spending, as Americans used to say (some still do), carries ‘more bang for the buck’.
Taxing time – the Budget
Budget day, held in March or April, is one of the great occasions in the British political calendar, and the big date in the UK economic calendar. Many other countries have a single day each year when the finance minister makes his annual Budget statement. In the United States, where the Budget is the product of long and often messy negotiation between the White House and Congress, the process is less clear-cut. Again, though, the principles are similar the world over.
In the UK the days may have gone when MPs would queue for hours to be sure of securing their place in the House of Commons chamber for the Chancellor’s speech, but 3.30 on Budget afternoon, when the speech is delivered, is still guaranteed to be one of the few times when it is full to overflowing. The term ‘budget’ derives from the French ‘
bougette
’, a wallet or pouch, of the kind Robert Walpole used to carry his papers in when he was Chancellor in the 1730s. Nowadays Chancellors carry a more familiar red Budget dispatch box, holding it aloft for photographers outside 11 Downing Street before making the short journey to the Palace of Westminster. Today, too, Chancellors read prepared texts, in the knowledge that a stray word could be misinterpreted in the financial markets. It was not always like this. William Gladstone’s legendary four-hour speeches were made from brief notes, one set of which is on display in the Museum of London. The Budget is preceded by weeks of speculation, some of it informed, some of it leaked, deliberately or otherwise. Only one Chancellor, Hugh Dalton, has resigned for leaking the Budget. In 1947 he inadvertently let slip some of its contents to a reporter from a London evening paper, who was able to get it into the paper and on the streets before Dalton had made his speech to the House of Commons. In 1984 a disgruntled civil servant leaked the entire contents of the Budget to the
Guardian
. A police investigation was launched, but the culprit was never caught. Why the obsession with secrecy? Because some Budget information is market-sensitive and because foreknowledge can allow people to take action. The 1984 leak was important not only because the Budget contained some important changes to corporate taxation, but also because it included, from midnight on the day of the speech, the removal of tax relief on life insurance policies. The leak produced a two-week rush to take out such insurance, and thus to continue to benefit from the tax break, and cost the government tens of millions in lost revenue.
A Budget speech usually consists of a review of the economy’s prospects, including a new forecast from the Treasury (it is required by law, the 1975 Industry Act, to produce two a year). The Chancellor will also run through the state of the public finances and whether the government plans to borrow, in other words run a budget deficit, or repay debt, which would mean a budget surplus. There will also probably be some public spending announcements although since 1998 the main occasion for announcing these has been in the Comprehensive Spending Review (CSR), which concludes in the summer and is held every two years. From 1993 to 1996 the Conservative government broke with tradition and held a ‘unified’ Budget, with both spending and tax announcements, in the autumn. Labour, on taking office in 1997 reverted to spring Budgets. And the main purpose of the spring Budget, as it has been for centuries, is to raise tax.
Taxes and the Budget judgment
In the 2001–2 tax year UK government receipts totalled about £395 billion, a considerable sum. Income tax, introduced 200 years ago by William Pitt the Younger, is easily the most important single tax, bringing in £108 billion. It was followed by National Insurance contributions, at £65 billion. NI contributions, paid by both employers and employees (and the self-employed) are an example of direct taxation. They are levied according to income, as of course is income tax, and have to be paid. Indirect taxation, in contrast, can be avoided, usually by the act of not purchasing the goods on which it is levied. If you do not smoke, drink or drive, you will escape the duties and value-added tax (VAT) levied on these activities. VAT, which brought in £61 billion in 2001–2, is the third biggest tax. It is harder to avoid but not impossible. Food, books, newspapers and children’s clothing and footwear are all zero-rated for VAT purposes. A small person whose only hobby was reading would pay very little VAT. The fourth biggest tax, another direct tax, is corporation tax, levied on the income of companies. It brought in £34 billion. These four taxes together accounted for the lion’s share of the government’s income, £268 billion, or more than two-thirds of the total. Other significant taxes were fuel duties, £22 billion; duties on alcohol and tobacco, £14.5 billion; business rates, £17.5 billion; and council tax, £15 billion.
The ‘Budget judgment’ is, at its simplest, the net amount the Chancellor intends to raise or lower taxation in the coming year. In practice it can get a little more complicated, because Chan- cellors often announce deferred tax changes that will take effect only in future years. The principle is, however, the same. I shall come to what determines that judgment but first a small note of clarification. On the face of it, some taxes always go up in a Budget. Smokers, drinkers and motorists have become used to the idea that duties, and therefore prices, rise after the Budget. But some taxes also usually go down. Most income taxpayers will find, a month or so after the Budget, a small reduction in the amount of tax they pay. There is, fortunately, an easy explanation for this, and it has nothing to do with the Budget judgment. It is conventional for income tax allowances to be lifted each year in line with inflation – to be ‘indexed’ (increased by the rise in the retail prices index). A parliamentary amendment – the Rooker–Wise amendment – introduced during the high inflation of the 1970s, requires Chancellors to do this unless they have got good reason not to. Hence the appearance of an income tax cut – in fact just handing back the extra tax you are paying because of inflation – each year. Chancellors have a way of getting this money back, mainly by indexing petrol, tobacco and alcohol duties. This is why the prices of these tend to rise after Budgets. It is also why these ‘indexation’ effects, which are more or less automatic, should be put aside when we are trying to assess whether taxes are being raised or lowered.
On this basis a typical Budget ‘giveaway’, an expansionary Budget, involves between £2 billion and £3 billion of tax cuts, while a tough Budget might raise them by a similar amount. This is small in relation to government receipts – 0.5 to 0.75 percent – and even smaller in relation to the size of the economy, 0.2 to 0.3 percent. Some Budgets do go further. In 1988 Nigel Lawson cut the top rate of income tax from 60 to 40 percent and the basic rate from 27 to 25 percent. That giveaway was worth, at year 2000 prices, £7–8 billion. A few years earlier, in 1981, his Conservative predecessor Sir Geoffrey Howe had raised taxes by a similar amount. Gordon Brown, in his April 2002 Budget, also increased taxes by £7–8 billion a year, mostly through higher National Insurance contributions for both employers and employees, mainly to fund extra National Health Service spending.
From fine-tuning to no tuning
If the amounts involved in Budget tax changes are generally small in relation to the size of the economy, so too are the ambitions of politicians. From the early 1950s onwards, under the influence of the followers of Keynes – he will be with us in a minute – ‘fine-tuning’ was in vogue. The economy was subject to well-observed cyclical fluctuations, lasting about four years. For a year or two things would be slack then they would pick up, gaining momentum until the point when a boom was under way. These cyclical fluctuations were due to variations in demand, so what better than to try and iron them out by small changes in tax? In a downturn, putting more money into the hands of consumers and businesses by lowering taxes would stimulate spending, thereby lessening the severity of that downswing in activity. Politicians of the day, such as Harold Macmillan, who was both Chancellor and Prime Minister (though not at the same time), used to talk of ‘a dab on the accelerator’. In an upturn, when the need was for consumers and businesses to cool their spending ardour, taxes would be raised slightly, ‘a touch on the brake’. Why? Because otherwise the economy would carry on growing faster than its long-run rate, unemployment would fall to very low levels and the pressures on capacity would push up inflation. There was even a formal mechanism for fine-tuning, the ‘regulator’ introduced in the early 1960s, which allowed the Chancellor to vary most indirect taxes – purchase tax (VAT’s predecessor) and the excise duties on tobacco, alcohol and petrol – by 10 percent in either direction between budgets.
Today, although politicians often talk about tax changes as being timely, fine-tuning through tax is no more. It was killed off by the realization that it was inefficient – tax changes, particularly direct ones, can usually be introduced only slowly and then take time to feed through to pay packets. This is partly because budgets are infrequent, usually only once a year (emergency budgets smack of panic), and take time to pass through the parliamentary process. A tax cut introduced during a downturn may actually have its impact in the subsequent boom, when the opposite is required. Fiscal fine-tuning was also killed off by the boom-and-bust cycles of the 1970s and 1980s. These needed, if it were available, not so much fine-tuning as a major overhaul.