Why more tax does not mean better public services

Why more tax does not mean better public services

by Eben Wilson
article from Tuesday 12, January, 2016

THE BBC AIRED a fascinating phone-in the day after John Swinney’s budget. It asked the question “Would you be happy to pay more tax?”

Almost all listeners, with a weighting towards older callers to be fair, said they would - if they could see that the money would go to better public services.  There were, hurrah, a few dissenters, mostly on tweets, texts and emails; perhaps younger people, who felt squeezed by high taxes or thought the money would not be well spent. 

Am I disillusioned by this reaction?  Not really, because the question promotes its own affirmative particularly among a self-selecting cohort who rely on public services. Crucially, it also rests on an assumption that more tax would lead to more and better public services.

If the question instead was “Would you be happy to pay more tax if it meant the state had less money to spend on services in the longer term?” what would people say? I think the answer would be unanimously a negative.  Importantly, that outcome would also be closer to the truth should Scotland’s income tax rates be set higher.

This counter-intuitive conclusion is hugely difficult to explain to those who only consider what is called a static score on taxation changes.  You raise a tax rate, you get more tax revenue, it’s only logical.  Sadly, no.

Static scoring does not reflect change induced by taxes

To get to the truth we must consider the dynamic effects of a tax rate change.  If Mr Swinney raises income tax he transfers money to his coffers from ours. We then spend less, what is called the deadweight loss of a tax and a loss that has consequences.  Here’s a calculation based on a 2p change in income tax.  I've done it in two ways – using both a static and a dynamic score.

Around 2.1m Scottish taxpayers pay the basic rate; with 370,000 others liable at the higher rate; and 18,000 suffering the additional rate. The deadweight static score of a 2p increase in Scottish Rate of Income Tax would be around £1.1 billion.  This assumes the present regime where the power is available to change the basic rate but no other rates or thresholds.  I've also factored in here some static loss of tax revenue from consumption due to the lowering of taxpayers’ disposable incomes.

What about the dynamic score – the changes that take place through time as the effects of a tax change feed through?  This is rather more complex. The best way to illustrate a like for like alternative is to calculate the effect of an identical tax cut of 2p.

To develop a dynamic model is difficult, particularly for Scotland where even our Auditor General is calling for more clarity about our public accounts. However, TaxpayerScotland has access to its own model and here is our conclusion.

  • The additional discretionary income of a 2p tax cut, less savings, would put just over one billion into the Scottish economy.  Mr Swinney would get an immediate gain through indirect taxes of around £200 million based on ONS figures of this tax burden.
     
  • The residual £800 million injection into the private economy would lead to some change in investment and wages. While investment could mean corporate saving, or it could mean capital building, the model is far more sensitive to payroll effects.  We estimate that such an injection could lead to a wage uplift of around one third of this amount in new jobs and/or higher wage payments, The private sector has a lower payroll element in its turnover than the public sector, but a much higher element of labour contract flexibility that gears output uplift into pay packets. Around £260 million of new money therefore enters the pay packets of working families. 
     
  • That in turn would bring in more than £75 million in payroll taxes.  These in turn would add more to Mr Swinney’s piggy back in new VAT payments as these higher wages are spent (less savings held back).  Our model estimates this to be £63 million.
     
  • And, of course, these new wages also incur more income tax.  We calculate £47 million from additional direct tax receipts. This is why our model is so sensitive to wage changes. Working people pay not 20% but 45% on their pay when NIC is taken into account.
     
  • This new income would also add more to Mr Swinney’s swag bag in new VAT payments as these higher wages are spent (less savings held back).  Our model estimates this to be £63 million.

There is one more element we need to obtain a first estimate of dynamic gains to a 2% tax cut. All the above applies to the first shift of money away from the state to ordinary companies and individuals – and then in part back to the state again in new tax collections.  However, the part that does not go back to Mr Swinney of course supports increased production turnover created by the tax cut.

Factoring this in across what Keynes would call his multiplier (correctly, a de-multiplier) involves calculating how much the state hooks out in taxes on spending and wages that grow along with this second level growth in turnover. We find that these increase Mr Swinney’s take by just over half again.

Real economy stimuli repeat year by year

The final outcome of the cascade of spending and wage payments above is an increase in tax revenues of £650 million.

But, there’s more, the stimulus injection is in fact not yet complete.  The turnover increase is not a one off; if the initial tax cut is retained for another year, there is no additional stimulus, but there is a repeat stimulus from the first year turnover which has not been taken away in tax in subsequent years. This also continues to get taxed each year.

Factoring this in increases the total tax take to Mr Swinney of a two pence income tax cut to, would you believe, just over one billion pounds after three years.  This makes statistical sense, and matches the empirical observation that tax cuts take time to take effect.

Now we need to compare like with like.  

A tax rise of two pence gives Mr Swinney an immediate static gain of just over a billion pounds, extracted from the dynamic growth potential outlined above.  Be careful, the state does spend that money which then re-enters the economy, but the net effect of that spend depends on two things, the pattern of spending, and the return to capital of any of that spend which is put into capital projects. No-one actually knows that outcome at any one time but we can surmise its general effect.

Revenue re-distribution spending merely transfers tax revenue to social support and the pay packets of the bureaucracy as, at best, a zero sum game. In reality, due to different tax profiles in the spending patterns of those on social support and the state it’s more than probable that the economy contracts due to these revenue transfers.

Capital spending recently has largely been done through borrowing, and the debt repayments required of the state need to be put against the return to these capital projects.  We think, if we are charitable, Mr Swinney’s spending on capital projects of a two pence tax increase is likely to be at best neutral for growth at worst crushingly wasteful and burdensome.  This is why Keynesian stimuluses do not work.  They can actually shrink economic activity.

What about the 2p tax cut? In this case, Mr Swinney eventually gets his one billion pound loss back in increased tax revenues, although it does take three years.   He also gets, after that time, a larger tax base which allows for more robust public finances, especially if public debt is reduced using his higher revenues.  In the process a lot more people get jobs, and more capital is created with long term sustainable value-adding potential.  It is worth mentioning that here too is a route to alleviating poverty through increased wealth for all. Growth floats all boats.

The perception incentive that builds confidence

In our static calculation, and once again to Mr Swinney’s benefit, we do not consider further shortfalls in revenue that might be induced thorough a 2p tax increase by lower production or sales of higher priced goods through higher payroll taxes.  Similarly, in our dynamic calculation, we do not consider the effect of greater business and consumer confidence if the Scottish economy was seen to be expanding.  There’s nothing like new investment, new products and new marketing initiatives to generate new growth and the tax revenues that go with them.

Note too that the starting point for the deflation of confidence or the inflation of entrepreneurialism start with perceptions. Our numeric calculations which show a £1 billion to £2 billion trade-off between zero growth with a tax rise and some growth with a tax cut ignore additional supply-side effects that are never going to be released for Scotland for as long as the perception exists that the Scottish Government is set on making taxes increasingly progressive in order to spend more money.

The emerging shortfall in collections for the Land and Buildings Transactions Tax, announcements about introducing more local taxes with more progressive tax structures after the 2016 election, the lag in Scotland’s growth and employment outcomes against the UK, and anecdotal reports of business owners covering off against taxation risks, suggest to us that Mr Swinney’s claim to be pro-growth are mere posturing.  Any growth will not be state-induced, ever.

The public sector has a role, but limited

If this supply side argument is true, why don’t we simply cut taxes and cut taxes and cut taxes and increase the total national cake more and more. 

The first answer is that there are some investments that are needed for public gain.  Succour for the vulnerable, public health and security, and transport system organisation are three key infrastructures for any society.  In technical terms, there comes a point, if you shrink the state, where the return to capital of public investment does indeed become higher than the return to capital invested for private purposes.

However, an economy with 45 percent intrusion by the state is nowhere near this point, indeed it is our view that it is far beyond the point where its returns on spending create good value for taxpayers. It certainly curtails growth as many an academic study has shown.

A second answer is that it is not in the interests of politicians to offer such an approach. With a five year horizon, the vote motive overtakes intellectual sense, it is much easier for them to take our money and spend it back on us while applauding how clever they are in stimulating economic activity and helping all.  In this, they are aided and abetted by the mass media who prefer an immediacy of action and an economic “fix”.  That in turn, is supported by radio phone in listeners who buy into this apparently easy solution – just spend a bit more money and it will all be ok.  Sorry, it won’t, the numbers don’t stack up.

There is also a simple observation that all phone-in listeners need to ask of themselves. Why is it that despite years of raising taxes and increasing public spending we always end up with the state needing yet higher taxes, and always claiming a need for more public spending while always piling up higher debt?  Now you know why.  They are shrinking our potential to be wealthy. 

 

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