The government cannot raise more in tax

There are a nervous few days ahead for anyone with spare money. You can't open the paper without seeing leaked plans for a new tax.

A mansion tax, perhaps, to be levied on houses worth more than £2m? A revaluation of council tax to take account of the rise in house prices over the last 20 years? A raid on the pension tax relief offered to high earners? Or the tycoon tax suggested by the deputy prime minister, Nick Clegg, which would impose a minimum tax rate of 20% on everyone to ensure the super-rich didn't get away without paying their share?

Some of the ideas are sensible enough. The government is desperate to find a way to cut the deficit, and to free up some money to reform the tax system to make the economy more competitive. As it stands, the coalition has three big priorities.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

One is to get rid of the 50p top rate of income tax, a toxic legacy of Gordon Brown's last days in the Number 10 bunker. It is clearly a deterrent to global business. Chinese and Indian companies might be tempted to invest here, encouraged by a devalued pound, and the fact we are outside of the eurozone. But if their senior executives have to pay 50% taxes one of the highest rates in Europe they won't want to.

Secondly, and in the same vein, the Treasury is making noises about slashing corporation tax. It worked for Ireland and could work for us as well. In the 1980s restructuring of the British economy, low taxes encouraged a wave of inward investment. We aren't seeing that yet and we need to if the economy is to start growing at a decent rate again.

Thirdly, the coalition would like to take low-earners out of the tax system altogether by raising the income-tax threshold to £10,000. That would encourage people off benefits and into work as well as reducing dependency on the state. These are all perfectly sensible aims in themselves. The trouble comes when you try to pay for them by raising taxes elsewhere in the system. All of these proposals miss an important point. The British economy has already reached its limit of taxation.

If you look at the long-term chart below of the percentage of tax taken out of the economy, what is interesting is how stable it is. The most the government has ever managed to squeeze out of us is 38.2% of GDP in 1982 and 1984. Gordon Brown never got the total tax take to rise above the 36.4% of GDP he managed in 2007, despite years of stealth taxes and fiddling around with dozens of revenue-raising measures. The lowest it has been in the last 40 years was 31.8% in 1993, but that was mainly because the economy collapsed. Mostly it is around 36%, pretty much regardless of who is in power.

In fact, around 36%-37% of GDP appears to be Britain's upper limit on tax. It stays at that level whether the prime minister is a Margaret Thatcher doing everything she can to get taxes down, a Gordon Brown doing all he can to get them up, or a David Cameron who doesn't seem bothered either way.

When you look at it like that, one thing becomes clear. It is going to be impossible to get taxes up to the 50% of GDP that the state now spends. You can pass all the new tax laws you like. They won't raise any more revenue. Push taxes any higher, and the economy shrinks and evasion rises, making it self-defeating.

It is the inflection point on the Laffer Curve. Named after the American economist Arthur Laffer, the curve makes the very simple point that at a 0% rate of tax you raise no money, and at a 100% rate, you raise no money either because no one does any work. Somewhere in the middle, there is a point where, as you push taxes up, revenues go down.

Britain is at that point right now. So all this talk of raising more in tax is nonsense. The government can't squeeze any more out of Britain.

A mansion tax? You can impose it if you like, but chances are you will simply start an endless series of court battles over whether a house is worth £1.9m or £2.1m. And you will probably drive another chunk of business out of the City of London, which is the only place a mansion tax would really be levied, and as a result, you would lose all the income taxes those people would be paying.

Another raid on pension funds would simply inflict more damage on a system that is already in bad enough shape. Over the medium-term, it would increase the costs for the government. As for a tycoon tax, how are you meant to get people to pay a general levy rather than a specific tax on their income, spending, or property? It is completely unenforceable.

The real problem for the UK is that public spending is too high for a competitive economy to have room to breathe. The only thing the government can do is cut spending so that it matches revenues with taxes and cuts some of the most damaging taxes at the same time. It may be tough but there is no other option.