Raising taxes may not be as effective as you might think

The UK budget deficit will go well over £300bn this year. Government spending as a percentage of GDP will hit around 55%, the highest since 1946. Our debt-to-GDP ratio will end the year above 100% – a peacetime first. That’s not OK. It’s not good for sterling, not good for the bond market and not kind to our kids. Something must be done. But what? We’d like to see more effort put into encouraging growth. As Liam Halligan notes in The Daily Telegraph, the best way to tackle a ratio problem such as this is to “raise the denominator”. But it is hard to imagine there isn’t going to be huge pressure for a few nasty tax rises too.

The problem is that the UK tax take is also near post-war highs – 37%-38% of GDP. To do anything about the deficit, that would have to rise sustainably to above 40%. That may not be possible. The only time the ratio has topped 40% since the war, bar a brief period in 1971, was in the early 1980s (oil helped). UK taxpayers have proved pretty stubborn otherwise. Asked to pay more in one place, they usually find a way to pay less in another.

For a glimpse into the possible struggle ahead, look to the interwar period – one in which our finances were comparably miserable. World War I was expensive. Inflation was discounted as a route out of the debt (the UK was keen to preserve the integrity of its gilt market). There wasn’t any scope for austerity. That left taxation. So the standard rate of income tax rose fivefold in the five years from 1914 – from 5.8% to 30%. According to Peter Scott of the Henley Business School at the University of Reading, this led immediately to a jump in tax evasion (and avoidance).

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Policy was ambiguous (the judicial view tended to be that the protection of civil liberties in the form of property rights had the upper hand in the matter); no one wanted to erode the principle of consent on which tax systems are supposed to be based in a democracy (those were the days!); and even in the worst cases there was little risk for evaders. Until 1942 the “Hansard procedure” “allowed tax fraudsters to simply ‘own up’ and repay the tax, without the matter becoming publicly known”. The avoidance business boomed as much as the evasion business – by the mid-1930s, tax advice was big business and schemes, says Scott, “were being blatantly peddled in newspaper adverts”. People shifted earnings into companies (how times don’t change...); popped them into trusts for their kids; figured out how to turn income into capital gains (private equity companies still devote themselves to this); and sometimes just moved. William Vestey, founder of Union Cold Storage Company, went to Argentina, saying: “The present position of affairs suits me admirably. I am abroad; I pay nothing.” The result? Revenues as a percentage of GDP stayed pretty flat throughout the 1920s and 1930s.

This is all worth paying attention to. Sure, the penalties (legal, reputational and financial) of dodging have gone up. But tax is still very often a choice. You can still move abroad. You can still make capital into income and income into capital. You can still gift to your kids. The evasion of the interwar period dipped going into World War II as collective liberty became more important than private wealth preservation. To believe that our revenue-to-GDP ratio today can go above 40%, you need to believe that sense of cohesive community will return. Any takers?