Why the government shouldn't raise taxes

Not long after the 1992 election, I heard Michael Portillo speak at an investment conference in the City. Britain was then emerging from a recession, but the finances of John Major’s government were in massive deficit. Portillo’s message was clear. As Labour retreated from its capture by the Left in the early 1980s, the policy differences between Labour and the Conservatives, he predicted, would steadily narrow. But on one issue, taxation, there would continue to be “clear blue water” between the parties. If, however, the chancellor used tax increases to narrow the fiscal deficit, the Conservatives would be defeated at the next election and remain out of power for a long time.

Whereas Nigel Lawson had taken pride as chancellor in abolishing a tax in every budget, his successors adopted the opposite policy, perhaps egged on by Treasury officials. In 1993, Norman Lamont levied VAT at the rate of 8% on domestic fuel as well as freezing tax allowances and raising excise duties in real terms. Later that year his successor, Ken Clarke, introduced taxes on insurance and air travel and continued to raise inflation-adjusted duties.

Abolishing boom and bust

The combination of tax increases, spending restraint and economic growth eliminated the budget deficit as planned. But, as Portillo had predicted, the government got no thanks from voters at the 1997 election. It remained out of office for 13 years and could only govern in coalition for another five. Labour’s chancellor, Gordon Brown, was initially “prudent for a purpose”, but, believing he had abolished boom and bust, then threw caution to the wind.

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In the 2008 financial bust, the government deficit again went through the roof. All that had been achieved by the fiscal rectitude of the Major government was to enable its successor to be reckless. When Labour lost the 2010 election, Liam Byrne, Brown’s number two at the Treasury, left a note to his successor saying “there is no money left”. It’s not surprising that the initial enthusiasm of the coalition government for cutting the deficit soon wilted or that the subsequent Conservative government was no more keen. The lesson that electorates don’t reward fiscal rectitude – yet it is a gift to the opposition – seemed to have been learned.

But has it really? The pandemic has seen government revenues plunge and expenditure soar so that public-sector debt is now over 100% of GDP. With public transport and many local councils bankrupt without bailouts and monthly deficits continuing, Treasury officials, egged on by the media, the opposition and, surprisingly, many Conservative backbenchers with impaired memories, are again calling for tax increases. The focus is on “the rich”, by which most people mean “someone other than me”, but taxes on the rich or well-paid never generate as much revenue as expected, if any. Such tax increases would inevitably be extended to everyone.

The obvious problem with this strategy is that it would impair economic growth and growth is always the principal driver of deficit reduction. The second problem is that taxes are already high; for example, the top marginal rate of tax, applied to annual earnings between £100,000 and £125,000, is 62%. The third problem is that it would be electoral suicide for the government.

Buying time

There are no good answers, but with the cost of government borrowing down to derisory levels, there is no urgent need to take action on the deficit. It may seem to us that the government is spending like a drunken sailor and that a good part of the money has been wasted, but governments in the EU, Japan and the US have been far more extravagant. In time, economic recovery will increase revenues, limit spending and reduce the ratio of debt to GDP, provided that the rebound is encouraged.

There is action the government could take to reduce the current and future deficits. The collapse in rail traffic shows HS2 to be a grotesque waste of money and replacing student loans with a graduate tax would increase revenues, reduce the debt burden on graduates and be fairer. A trick was missed when some of the benefit to petrol prices from the fall in the oil price was not absorbed in petrol duty. Unfortunately, though, there are also taxes that need cutting: the rate of national insurance should be cut from 12% to 10% and levied above £12,500 (the income tax allowance) rather than £7,500. The top marginal rate of income tax is too high.

With such a strategy, the government might have nine years to get its finances in order, rather than four and a half. If only Portillo could take some time off his rail travels to repeat the powerfully vindicated warning he gave nearly 30 years ago.