Prepare for tax hikes

Britain is growing but the tax take isn't. Why not?And what does it portend? James Ferguson reports.

UK economists face an enigma several, in fact. Britain has strong GDP growth and low unemployment. But we also have zero growth in productivity, or real (after-inflation) wages, or growth per person. And how can the government spend the equivalent of 43% of GDP (high by historical standards), yet food banks still exist?

And why, when we have one of the lowest relative poverty readings in the OECD group of wealthy nations, do we suffer from extreme perceived inequality?

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I've taken a look at the latest OECD survey of the UK. The 2015 edition notes that central-bank money printing, and high government spending, have revived employment and growth. But if you look at growth per person, rather than for the UK as a whole, then we haven't seen much at all since the crisis, and it's still some way below the pre-crisis peak. Weak labour productivity also below pre-crisis levels is holding back real wages, which are 3.6% down on their pre-crisis peak.

Our apparently sound headline "growth" has been driven by two things. The first is growth in relatively low-paid, unproductive jobs. The second is immigration (so GDP as a whole has risen along with the population, but on a per-head basis, growth has been poor).

This rise in low-paid work has made the UK less "tax-rich" and so less able to close the £100bn deficit (the annual gap between what the state takes in taxes, and what it spends). It also explains why many people don't feel better off. Here's a detailed look at the state we're in, and what it implies for the future.

A look at the data

So what's going on? A look at the data (courtesy of the Office for National Statistics) shows that real wages have actually risen at a steady rate for those in continuous employment. So if you haven't lost your job during or after the crisis, you've enjoyed fairly regular pay rises. Real wages have been held back on a national basis because we're seeing a compositional shift people are doing different types of jobs.

Since the crisis, over a million people have moved out of unproductive, full-time public-sector jobs. But they've then moved into equally unproductive, part-time, private-sector jobs. Private-sector jobs should, by rights, be more productive than public-sector ones (this isn't so much an ideological point, it's just that if firms don't make profits, they go bust). But that's not happening right now.

We'll get to why this is the case in a moment. But there's another, connected point. As the political debate deteriorates into pre-election fervour, anyone living in Britain could be forgiven for thinking we are enduring almost Dickensian levels of income distribution.

This simply isn't true. The main measure of inequality, the Gini coefficient, sits at 34%. That's a little higher than the G7 average, which is 33%. But it hasn't changed since 2007.

Meanwhile, relative poverty (which measures the proportion of the population which has an income of less than half the national median) is 9.5%. That's not only significantly below the 12% OECD norm, but it's also several percentage points lower than it was before the crisis. Why? The UK's average household disposable income barely changed during the Great Recession and its aftermath but for the bottom 10%, disposable income has actually risen.

The benefits bill

So people are doing less productive jobs, and income inequality is flat to falling yet perceived inequality is high and rising. Why? The key reason is that benefit spending per person in the UK has soared by 60% in real terms over the last 15 years. That's a huge and perhaps unsustainable shift (given our chronic deficit). And why is food bank use rising, even as unemployment falls? Because these new benefits are largely going to workers, rather than job seekers.

The majority of the £215bn (12.5% of GDP) welfare spending bill goes to the retired (£87bn). But the next largest chunk goes not to the unemployed (who receive just £8bn), but to the employed (£76bn). Supplementary payments to boost earned income include tax credits, income support, housing benefit and other allowances. If you qualify for any of these benefits, it doesn't influence your entitlement to any others, which has led to some huge payouts.

The new Universal Credit is intended to cap recipients' total benefits, but the government website still lists over £56bn of such benefits (including tax credits) as outside of the welfare cap.

It must have seemed like a good idea at the time to top up the earnings of the politicians' favourite group, "hard-working families". But the structure of these in-work benefits creates economically destructive incentives.

To qualify for tax credits, a couple must work at least 24 hours a week between them. So the cynics among you won't be surprised to learn that not only does a third of the working population work part-time (nine million people in total) but that the average hours worked per person is just over 12 hours a week ie, 24 hours per couple.

Part-time work pays £11.24 an hour on average. That's an annual post-tax income of £14,250 for a couple. At this level, tax credits alone would boost household disposable income for those with three children and childcare costs to £35,203 before any other welfare entitlements, including housing benefit. For a full-time, salaried worker to earn the same disposable income, they'd have to be on £48,500 almost double the average.

When the financial crisis forced cutbacks in the number of full-time public-sector jobs, economic theory suggests that these laid-off workers should have found more productive work in the private sector. But the distorted incentives created by our in-work benefit regime instead resulted in laid-off workers and new immigrants opting for part-time work supplemented by welfare.

The data back this up the OECD notes that one million full-time jobs were lost since 2008, half of those in the public sector. Those have been regained since, but the 1.2 million net new jobs on top of that have largely been part-time ones.

Iain Duncan Smith, architect of Universal Credit, gave the example of immigrant Big Issue sellers immediately qualifying for tax credits and housing benefit due to being self-employed part-timers even if they didn't sell a single copy.

Where will the pain come?

The UK unemployment rate is 5.7%. But the UK has achieved this by hiding under-employment under the in-work benefits umbrella. That's why our productivity is so poor. The generous terms have arguably also attracted more migrants than we otherwise would have, who are not necessarily being that productive either.

This is how the UK has squared the circle between low unemployment, productivity and real wage growth. And we're having to borrow almost £100bn a year to pay for it.

Encouraging people to work just 12 hours a week so that their household can qualify for benefits worth four times the poverty line is desperately inefficient. Part-time work, with its discontinuities and excessive travel time is always going to be less productive than full-time work.

Financial transfers from productive, full-time workers to unproductive part-time ones taxes productivity and is also unfair, further distorting the incentives to work. Why put in a six-day week in a semi-skilled job when you could do a couple of hours a day on an easier job and potentially earn almost twice as much?

The OECD and others argue that Britain's deficit comes from weak tax revenues rather than surging spending but this is wrong. Since 1970, the UK tax burden has remained within a fairly tight band (32.5%-37.5% of GDP) it's only been outside of that band twice, both times during oil crises. Today it stands pretty much in the middle of the long-run range at 34%. So our tax revenue is not the issue.

Instead government spending has soared. It rose from 38% of GDP in 2000 to 42.5% under Gordon Brown and then almost 50% at the peak of the crisis. Despite talk of "austerity", spending hasn't actually fallen in any single year. So government spending relative to GDP has only dropped to 42% and is forecast to come in at 41% this fiscal year.

At this rate, it'll take another six to seven years to close the deficit (assuming the interest burden doesn't shoot up in the meantime).

It would be possible to knock a couple of years off that timeframe by raising the tax burden to the upper end of the historic range (any higher than that and the tax take has historically fallen remember the "brain drain"?). But where will the pain come?

Indirect taxes are already shouldering a record amount of the burden, whereas direct taxation has fallen by 2.5 percentage points as a proportion of GDP since the crisis. So the clear target now must be direct taxation. But that's exactly the source of taxation that's been hardest hit by our poor productivity.

Between a rock and a hard place

So to sum up, in 2013-2014, six years after the crisis struck, government revenues totalled £622bn (36% of GDP) but spending was £720bn (42%). This deficit was supposed to be a short-term emergency measure to get us back to recovery.

And right now, headline GDP is back to a record high and our growth is the best in the developed world yet this success story is predicated on unsustainable government spending. Entitlements are hard to scale back. But the in-work benefits system gives an incentive for unproductive behaviour.

There's nowhere else to cut. The coalition government has ring-fenced pensioners under the "triple lock" and other commitments (including to the EU and local government) can't be touched,while the deficit means our interest payments (at £50bn) can only increase. That just leaves departmental budgets to take the hit. But no one dares touch the NHS (£115bn) or schools (£55bn).

This means the burden of cuts is falling disproportionately (and potentially dangerously) on the remaining 25% of discretionary spending: areas like policing and the armed forces. So in the end, if we're to have any hope of getting the deficit down, expect higher taxes or perhaps higher rates will force us to act.

James Ferguson is a founding partner of the MacroStrategy Partnership LLP (macrostrategy.co.uk).