Having a Laffer: the strange new world of Conservative economic policy

The race to become the next Conservative party leader (and Britain’s next prime minister) has turned into a debate about how much and how quickly the various candidates will cut taxes. It is yet another illustration of how the Conservatives are becoming more like America’s Republicans.

It represents a change in approach. Margaret Thatcher, the notional heroine of many of these candidates, did believe in cutting taxes but she also believed in balancing the budget. The UK budget deficit is set to be around 5.8% of GDP, which Mrs Thatcher would have regarded as too high. Her chancellor Sir Geoffrey Howe famously raised taxes in the teeth of a recession in 1981 because he was determined to get the deficit down. It was only in the late 1980s, when the government’s finances had been repaired, that taxes were cut significantly.

The tax burden is set to rise in the coming years but that is because the government took on a lot of commitments during the pandemic and has committed itself to invest in healthcare and infrastructure. And it is worth putting the projected tax increase in context. In 2020, UK tax revenues were 32.8% of GDP[1], just below the OECD average. But UK public spending has regularly hovered around 40% of GDP in recent decades[2]; higher taxes would seem to be required if we are not to “pass the burden onto future generations” (to use a favourite Conservative phrase).

But the Conservatives seem to have adopted the Republican approach of comppaining about deficits when the opposition is in power but ignoring them when they control the purse strings. The obvious reason is that promising tax cuts seems to offer electoral dividends. But the Conservatives are also pushing the line that tax cuts are good for growth and pay for themselves in terms of extra revenues. And they also make a related point; that high taxes can restrict growth. This idea relates to the “Laffer curve” after the economist who pointed out that taxes would raise nothing if set at 0% of income and 100% of income, and there must be a point at which higher tax rates reduce revenues.

But where is this point? The OECD has data on GDP per capita[3] (and tax revenues as a proportion of GDP[4]) for 35 member countries. I excluded Ireland and Luxembourg whose GDP per capita is greatly inflated by the existence of offshore financial firms (which do little to boost the standard of living of their citizens).

I then ranked the remaining 33 countries by GDP per capita. The richest quartile (top 8) raise 36.4% of their GDP in the form of tax; the poorest quartile (bottom 8) raise just 28%. One can make the calculation the other way by ranking the countries in terms of their tax take. The most heavily taxed quartile have an average GDP per capita of $57,108; the lightest taxed have a GDP per capita of $43,546.

So there is no obvious negative link between the tax level and prosperity. All the data may demonstrate is that rich European nations feel they can afford expansive public services. But they clearly have not crippled their economies by doing so.

What about the idea that tax cuts “pay for themselves”? The idea is that budding entrepreneurs will set up businesses, and existing businesses will invest more, if they can keep a greater proportion of their income. As with many economic propositions, this is hard to prove or refute. It may be that having more income makes you work harder; it may make you relax. If maximising income was the only criterion, no one would ever retire voluntarily. An extra dollar may be worth a lot more to someone on a moderate income than to a prosperous person, who may already be saving a significant proportion of their earnings.

The US provides a useful recent case study. In 2016, under Barack Obama, the US budget deficit was $587bn or 3.2% of GDP. Donald Trump became President in 2017 (despite not winning the popular vote) and duly cut taxes. By 2019, before the pandemic, the deficit had risen to $984bn or 4.6% of GDP. The Trump tax cuts did not pay for themselves.

The tax cuts might well have boosted US economic growth, however. This is not necessarily because they unleashed “entrepreneurial spirits”. It could be down to the writings of an economist who gets little mention in Conservative tax debates: John Maynard Keynes. Keynes suggested that, when demand is deficient, the government can stimulate the economy. The Keynesian approach would normally be to increase public spending, but cutting taxes might work as well (the risk is that cautious consumers will save, rather than spend, the addiitonal income). And demand in 2017 clearly was deficient as the steady increase in demand for labour under Trump and Biden has shown.

Is demand deficient in the UK now? There is a risk that the extra demand created by tax cuts might push up inflation. But that inflation is largely the product of external forces, notably the sharp rise in energy prices. Higher energy prices constrain consumer demand for other goods and services and risk recession. So there is a modest case for fiscal easing to help consumers with the “cost of living crisis” as it has been dubbed. Big tax cuts, as proposed by many candidates, are harder to justify; unemployment is low by historic standards, indicating there is not a lot of slack in the economy.

In the long run, what is needed to boost economic growth is an improvement in Britain’s productivity record, which has been poor in the last decade. That could require changes in regulations but it may also need better infrastructure and a better-educated workforce, both of which require higher public spending.

That leads us to another part of the Conservative debate; the argument that tax cuts would not be fiscally irresponsible since public spending can be cut, preventing the budget deficit from getting out of hand.

Controlling public spending is easier said than done. The UK government is expected to spend £1.1trillion in the current financial year.[5] Of that, nearly a quarter (£250bn) goes on welfare, including £110bn on pensions and £72bn on universal benefit. The NHS spends around £167bn, debt interest £87bn, education £77bn, and defence £32bn. These items add up to well over half the total. In many of these areas, the government is committed to spending more, not less.

Some of the other departments have already suffered plenty of cuts over the last decade. Local authority spending has been slashed for example. Does the government really want to cut sending on police, or prisons, or infrastructure, when it is committed to “levelling up” the regions? In short, there is no way of cutting public spending substantially without damaging services that the public would consider vital.

So the candidates suggest cuts that sound reasonable but won’t actually save that much. Let us take a pledge from the current chancellor (and defeated candidate) Nadim Zahawi. He suggested that he could save money by cutting the headcount in government departments by 20%. Presumably Mr Zahawi didn’t mean he would cut the number of doctors, teachers, policemen or soldiers. He was talking about head office staff. But how much would that save? An Institute for Government study found that, in 2020, there were around 455,000 civil servants with a median salary of £30,000, a total bill of around £14bn a year.[6] So a 20% cut would save £2.8bn. Not bad but a fraction of the lost revenues from the tax cuts being promised by most of the remaining candidates.

It is a golden rule that Tory candidates will declare that vast sums can be saved by cutting “waste” in public spending while Labour candidates will suggest that significant revenue gains can be made solely by taxing the rich. Neither is true.

Most OECD governments spend between 30% and 50% of GDP, and the trend is likely to be up not down, as the population is ageing, something that requires more spending on pensions and health. This means that taxes are also likely to go up. Fiscal deficits have been easy to finance in the last 20 years, at least for the US and the UK, not least because centrak banks have been big buyers of government debt. But higher inflation means central banks are now sellers of bonds, not buyers. And higher inflation means higher bond yields as well, making deficits more expensive to finance. The UK, as a low growth economy that is not part of a big trading bloc, may struggle to attract capital.

So the Tory candidates may talk a lot about tax cuts, but in the end they (or their successors from other parties) are going to have to put them up.

[1] https://www.oecd.org/tax/revenue-statistics-united-kingdom.pdf

[2] https://www.economicshelp.org/blog/5326/economics/government-spending/#:~:text=UK%20government%20spending%20as%20%25%20of,GDP%20has%20stayed%20around%2040%25.

[3] https://stats.oecd.org/index.aspx?queryid=61433

[4] https://data.oecd.org/tax/tax-revenue.htm

[5] https://obr.uk//docs/dlm_uploads/BriefGuide-SS22.pdf

[6] https://www.instituteforgovernment.org.uk/explainers/civil-service-pay