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Sunak’s toxic tax problem as spending hits wartime levels

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Sunak's toxic tax problem as spending hits wartime levels Posted by David Smith at 09:00 AMCategory: David Smith's other articles My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt. It is easy sometimes to forget what an extraordinary period we are living through. There are many ways to capture it with statistics but let me today provide you with just one. What will public spending be this year as a proportion of the economy? What will the state’s share be? The answer, according to the government’s fiscal watchdog and forecaster, the Office for Budget Responsibility (OBR), is no less than 54% of gross domestic product. That is on the basis of its central scenario. If things turn out worse than it expects, the spending share could be as high

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Sunak's toxic tax problem as spending hits wartime levels

Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is easy sometimes to forget what an extraordinary period we are living through. There are many ways to capture it with statistics but let me today provide you with just one. What will public spending be this year as a proportion of the economy? What will the state’s share be?

The answer, according to the government’s fiscal watchdog and forecaster, the Office for Budget Responsibility (OBR), is no less than 54% of gross domestic product. That is on the basis of its central scenario. If things turn out worse than it expects, the spending share could be as high as 58%. Even in its optimistic take it is 50%

Let me put that in perspective. In 1976, the peak spending share when Britain had to turn to the International Monetary Fund for a humiliating bailout was much lower, 46.4%.

It was also lower in 2009-10, when high levels of spending and borrowing prompted the coalition government’s austerity programme. Then the peak level of spending was 46.3% of GDP.

The level of spending we are seeing this year is normally only witnessed during wartime, when the state mobilises the private sector to pursue the war effort. Indeed, to add to the comparison, this year’s 54% would be the highest since 1946, at the start of post-war demobilisation.

There has been a flavour of wartime mobilisation during the Covid-19 crisis in the quickly negotiated (and in some cases very bad) personal protection equipment contracts, schemes to quickly make ventilators and to buy up future vaccine supplies and, most notably, in policies like the job retention scheme. The government paid people’s wages, not in this case to fight the enemy, but to stay at home on furlough.

This Covid-19 version of the war effort has so far resulted in £178bn of additional public spending this year, out of £192bn of fiscal support, the rest in the form of tax measures. That is unlikely to be the final bill, So, when we are looking at the public spending share of the economy, the numerator has gone up a lot.

At the same time, of course, the denominator, GDP, will show a fall this year of a magnitude that we have not seen for a century. The OBR predicts a 12.4% drop in GDP this year, slightly more than the 10% drop which is the average among independent forecasters. Either way, a large contraction in the economy and a big increase in public spending can only mean one thing: a substantial rise in the state’s share of the economy.

It helps explain why the chancellor’s thoughts are turning to tax increases, as revealed by this newspaper last weekend, and in the speaking notes for a meeting with Tory MPs he inadvertently gave us a glimpse of last Wednesday.

I have argued here before that a one-off increase in the spending share and in public borrowing need not result in tax hikes. Yes, the crisis means more borrowing and higher debt, but if the extra borrowing is short-lived, that need not be a problem.

The context for that view was the OBR’s first look at the impact of the coronavirus, back in April. Then it expected that the impact of Covid-19 on the public finances would be sharp but temporary, with the path of public borrowing quickly returning to what it had expected before the crisis.

Things have changed. The OBR, like other forecasters, no longer expects a short, sharp fiscal shock. The hangover for the public finances will last for some years. Even in 2024-25, it thinks the budget deficit will be nearly 5% of GDP, compared with a pre-crisis prediction of just over 2%. The deficit then is expected to be double in cash terms what was previously expected. That is why, in his own words, Rishi Sunak wants to “correct our public finances” and re-establish the Tory reputation for “sound finance”.

Whichever of the many tax hikes currently doing the rounds makes it into the chancellor’s autumn budget, and when they are introduced, there is something that would worry me if I were him.

This is that it is one thing to announce higher taxes, quite another to actually achieve the higher revenues needed to reduce borrowing. One reason for this is that recessions and their aftermath depress revenues. Typically it takes time. That was a particular issue during the recovery after the recession of the early 1990s.

The other issue is whether it is possible to increase tax revenues to the kind of level that would allow the chancellor to claim that he had brought borrowing under control. The OBR’s Fiscal Sustainability Report, published over the summer, from which my number today are largely taken, projected that after this year’s surge spending will still be 42.5% of GDP by 2024-25, the final year of this Parliament.
That is high for a Tory chancellor, I remember a time when the debate between Tory ministers and would-be ministers was whether spending should be as low as 35% of GDP, or as riskily high as 40%.

Those days are gone but, unless the spending share can be reduced – and in the absence of austerity, faster growth (and thus a higher level of GDP) offers the main hope there – tax revenues would have to be more than 40% of GDP to, say, run a budget deficit of about 2% of GDP.

It is a long time, however, since government receipts have been above 40% of GDP, as long ago as 1982-83 in fact. Then, receipts were boosted by North Sea oil revenues and privatisation proceeds. Income tax rates were far higher, with a basic rate of 30% and a top rate of 60%.

In recent years receipts have typically been between 36% and 37% of GDP. The OBR thinks they will be a little higher by the end of the Parliament, 37.9%, but this still implies a hefty budget deficit, £116bn, or 4.6% of GDP. You can increase tax rates but the behavioural response and other factors may mean that revenues do not respond as expected.

The other thing that would worry me is that 2024-25 is not seen by the OBR as a staging post on the road to ever lower deficits bur, rather, the jumping off point on the road to ever larger deficits, as the ageing population and other factors kick in. Within a couple of decades, without action, the levels of borrowing relative to GDP that we have seen this extraordinary year would become the norm.

As the OBR says: “In reality, no government could attempt to run the public finances along the paths implied by these scenarios for any length of time without running into financing difficulties. At some point, policies would need to change in order to bring the public finances onto a nonexplosive trajectory.”

The chancellor is well aware of this. His dilemma is when to start raising taxes, with every economist saying this is not the year to do it, and whether, when he does, he can make meaningful inroads into the deficit.

Sunak's toxic tax problem as spending hits wartime levels
David Smith
David Smith is economics editor of The Sunday Times. His website is http://economicsuk.com . His latest book is Something Will Turn Up.

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