Tax and Fiscal Policy

A quiet revolution in the case for tax cuts

With the ‘stimulus’ versus ‘austerity’ debate having receded, George Osborne likes to talk instead about his ‘long-term economic plan’. This has been dominated by a commitment to deficit reduction and a strong jobs market. But it’s becoming clear that Osborne wants to add a third string to his bow – the intellectual case for low taxes. And about time too.

In opposition, Osborne promised to adopt Adam Smith’s principles of a good tax system – ‘transparent, simple, efficient and fair’. He understood the supply-side argument that tax reform should permanently and predictably lower marginal rates, boosting incentives to work, save, and invest over the long run.

Yet the need to raise revenue in government, given the fiscal calamity, put tax cuts on the back-burner. Worse, noises from the Treasury turned short-termist and Keynesian. ‘It is some of the Tory right’s proposals for growth – such as tax cuts financed by deeper spending cuts, so that there is no actual overall stimulus – that really mystify’, wrote Osborne’s biographer Janan Ganesh.

Thankfully, the Osborne who understands that the case for tax cuts rests on their effects on the supply potential of the economy, not short-term demand, is back. And he has recently been launching a quiet revolution in the intellectual case for low tax rates.

Recognising that the models used by the OBR and the Institute for Fiscal Studies tend to underestimate the full impact of tax rate changes, Osborne has encouraged the use of modelling – dynamic scoring – that accounts for the positive long-term effects on investment and other tax revenues.

The results are significant. Analysis of corporation tax published last year, via a Computable General Equilibrium model, suggested that, over 20 years, the cuts to the main corporation tax rate will increase the long run level of GDP by between 0.6 and 0.8 per cent and increase business investment by between 2.5 to 4.5 per cent of GDP. And a report published yesterday calculated that cutting fuel duty by 1p in 2011, and freezing it for the rest of the Parliament, would lead to a bigger economy by between 0.3 per cent and 0.5 per cent of GDP.

This means that, in the longer term, around half of the revenues that a static model says would be lost are actually recouped in the form of faster growth. Similar work by PwC on Air Passenger Duty (APD) likewise finds that, while static analysis of abolishing APD would find a loss to the Treasury of £3 billion by 2014-15, the growth effects would more than offset this.

Of course, those who like high taxes per se, despite their impact on growth, will object to this type of analysis even being undertaken. They will say that ‘it depends on the assumptions used’. This is true. But it’s up to them to challenge the assumptions and explain why they are wrong. Instead, the reaction of some has been to simply say ‘this is all too difficult, we should carry on measuring tax cuts as we do now’.

This is not good enough. Tax policy is too important to ignore its damaging long-term impacts. Osborne should provide the OBR with the resources necessary to continue and broaden this more complete analysis, and incorporate it into budgetary costings. And he should not allow the OBR to audit general election manifestos when its main models are biased. It’s time to see the revolution through.

This article was originally published by City AM.

Follow @MrRBourne on Twitter.

Head of Public Policy and Director, Paragon Initiative

Ryan Bourne is Head of Public Policy at the IEA and Director of The Paragon Initiative. Ryan was educated at Magdalene College, Cambridge where he achieved a double-first in Economics at undergraduate level and later an MPhil qualification. Prior to joining the IEA, Ryan worked for a year at the economic consultancy firm Frontier Economics on competition and public policy issues. After leaving Frontier in 2010, Ryan joined the Centre for Policy Studies think tank in Westminster, first as an Economics Researcher and subsequently as Head of Economic Research. There, he was responsible for writing, editing and commissioning economic reports across a broad range of areas, as well as organisation of economic-themed events and roundtables. Ryan appears regularly in the national media, including writing for The Times, the Daily Telegraph, ConservativeHome and Spectator Coffee House, and appearing on broadcast, including BBC News, Newsnight, Sky News, Jeff Randall Live, Reuters and LBC radio. He is currently a weekly columnist for CityAM.