The welfare state made Britain poor

published 31 October 2005

In this adapted extract from his provocative new book, the journalist James Bartholomew argues that if Britain had never built its welfare state, it would be a much richer country.

It is 1961 in Hong Kong. A balding, bespectacled civil servant has just been promoted. John Cowperthwaite, 46, has been made Financial Secretary, the number three in the official hierarchy. He goes to live in the Government home provided, which is grand by Hong Kong standards. But he lives modestly. Cowperthwaite is Scottish through and through - not Scottish like Rob Roy or Billy Connolly. A flinty kind of Scottish.

The Hong Kong press soon finds he's not media-friendly. He doesn't willingly give interviews or show off his family. His manner is dry almost to the point of rudeness. His only concern is to get on with his job. The Hong Kong whose finances he now manages is an oddity of history - a little bit of the Empire that has not yet been handed over to someone else. It has been flooded with refugees, coming with no more than they can carry. The population has soared, from 600,000 or less in 1945 to 3,200,000. The refugees have built shanty towns or lived in boats or cramped Government-provided units.

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Cowperthwaite is constantly urged to increase taxes and spend the money on supposedly worthy causes. Back in Britain, that is precisely what his boss, the British government, is doing under the premierships of Harold Macmillan and Harold Wilson. But Cowperthwaite is the financial secretary who likes to say "no".

He is urged to extend Government housing to the middle class. He refuses. He says that all public housing involves subsidy. It would be wrong to subsidise the middle-classes, who should pay for their own housing. Some businessmen want the Government to build a tunnel across Hong Kong harbour. He declines again. He says that if they think the project would be so beneficial, they should build it themselves. (In due course, they do.) He is urged to allow mortgage interest to be charged against salaries tax, as in Britain. He says "no". It would only benefit those with substantial incomes. He is urged to tax people on all their incomes, as in Britain, instead of only on their salaries. Yet again, he says "no". Tax on all income is inevitably "inquisitorial", he says, and would discourage investment and enterprise. Although never himself in the top job, John Cowperthwaite dominates policy in Hong Kong. He holds the line, as best he can, against all sorts of tax and spending proposals.

Cowperthwaite's most important reason for playing Scrooge through the 1960s was to keep down taxes. He thought high taxes slowed economic growth. Low taxes would eventually produce more revenue than higher ones, he argued, because of the growth they would encourage. Fast growth would also benefit the poor by boosting demand for labour and pushing up wages. Fast growth produced "a rapid and substantial redistribution of income". Successful capitalism benefited the poor.

Because he kept to his creed, at the end of his time in Hong Kong, the standard rate of tax was 15%. Even the richest were not asked for more than 15% of their gross income. Profits tax was similarly low. There was no tax at all on dividends or foreign income.

Back in Britain, a succession of politicians were building a more all-embracing welfare state. It was, of course, well-intentioned. The early provisions were made by the Liberal government in 1911. The Labour government of 1945-50 took the idea further and so did most of the following administrations of both major parties. By 1971, Government spending had reached 40% of economic activity, a similar level to today. That compares with a mere 10% of economic activity at the start of the 20th century. So there was a big contrast in the policies followed by Britain and Hong Kong. How did the two places do economically?

Britain, in 1945, was one of the most advanced countries in the world. It had hospitals and doctors admired around the globe, some of the finest engineers and scientists, who only recently had developed the Spitfire fighter and penicillin, among other achievements. It was far richer than the vast majority of countries. Conversely, Hong Kong was a Third World country, like Kenya or India, only probably even poorer than either of those. In 1945 it was described as "a barren rock". Immediately after the war, average incomes actually fell because of the influx of penniless people. In 1960, the per capita output of Hong Kong was a mere 21.5% of what advanced Britons produced. Britain was nearly five times more productive per capita and, broadly speaking, correspondingly vastly wealthier. Then, from 1961 - the year John Cowperthwaite became Financial Secretary, as it happens - output per person began to grow very fast. The rate in the 1960s was 6.0%, while Britain was growing at a snail's pace in comparison - only 2.3% a year.

In the 1970s, Hong Kong's output per person grew even faster - at 6.5% a year. Meanwhile, Britain had to go, cap in hand, to the International Monetary Fund because its credit had run out. Its per capita growth slumped to a mere 1.5% a year. By 1992, Hong Kong's growth had been so outstanding - and so vastly better than Britain's - that its output per head overtook that of the "mother country". Hong Kong, under the influence of Cowperthwaite, had transformed itself from being a poor relation - a poverty-stricken colony making cheap plastic toys - to Britain's equal. Hong Kong caught up with Britain in a mere three decades.

The contrasting stories of Hong Kong and Britain are powerful evidence that tax matters' - but one comparison, of course, does not make for proof. What other countries might provide evidence?

Japan, in 1960, had markedly lower government expenditure than elsewhere. In most advanced countries, spending was around 30% of GDP. But in Japan, government expenditure was not much more than half that - only 17.5%. How did its growth compare? Other countries managed an average growth rate of 4.25% between 1950 and 1973, but Japan did nearly twice as well with an average annual growth rate of 8.0%.

At the other end of the spectrum, the Swedish government, in 1980, accounted for 60% of all that country's expenditure. Over the period that most probably reflects such spending (and the correspondingly high taxes), between 1973 and 1999, what was the Swedish growth rate? A mere 1.4%. When Swedish spending and taxing was at its peak, its growth was lower than that of any other leading country in the world.

The OECD has looked at many countries to establish the relationship between tax and growth. It has come to the conclusion that for every one per cent of a country's economic output that is taken by tax, the output per person falls by 0.6% to 0.7%. So, if a country has, like Britain, taxation of approaching 40% of GDP (compared to well under 10% in the late 19th century), it has reduced its GDP by about 20%. To put it another way, if we had not increased taxation, our output - and income - per capita would be a quarter higher.

So let us imagine, for a moment, that Britain had not massively developed its welfare state (which accounts for well over 60% of all British Government spending). Using the OECD estimate, how wealthy might Britain be now? Instead of having output per capita of US$27,650 in 2003, as we did, it would have been US$34,562. We would have ranked as the third-richest country in the world, instead of the 15th. We would have had higher average incomes than the Swiss or the Japanese. The only countries with higher output per person than ourselves would have been America and Norway. And since we would not have been as heavily taxed as these countries, our take-home pay would have been a little higher even than theirs the highest in the world.

It seems reasonable to suppose that there are also cumulative effects to being a low-tax country that are not captured by the OECD analysis. Without the welfare state, and the tax it has made necessary, Britain would now have high rates of saving, investment and research (based on retaining virtually all profits made); it would consequently be a leader in technology and medicine. Instead of the top innovative companies in the world being overwhelmingly American, they would include a large number of British names, as used to be the case.

Britain's welfare state did not achieve what it was set up to achieve. It led to lower standards than would otherwise have been realised in healthcare and education. And in addition to these effects, the tax that the welfare state made necessary stopped Britain from reaching its economic potential. Britain could have been the wealthiest country in the world. But we lost the chance because we created the welfare state.

Adapted from James Bartholomew's book,

The Welfare State We're In