This medium-termist government needs to think long-term – now

The UK has been put on a credit-rating downgrade watch. This is not surprising, but one wonders whether Moody’s is focusing on the right issues. In particular, Moody’s cited the lack of growth and the troubles in the eurozone as being the main reasons for its decision. Moody’s fears that the lack of growth could come from further problems in the banking sector, very weak growth in Europe and continued private-sector deleveraging. Leaving aside the fact that it is rather strange to suggest that deleveraging (and the consequent increase in saving) could cause slow growth and a debt crisis in an open economy (a decent third-year undergraduate course on international financial economics would put Moody’s right here) these are relatively short-term issues. What of the long term?

George Osborne’s plan is to bring the government finances back into balance in the medium term and reduce government spending to just below 40% of national income. This is very worrying. By the Chancellor’s own admission, the UK government has never been able to tax its citizens more than 40% of national income. The limit of the ambitions of a Conservative Chancellor of the Exchequer appears to be to tax the British population at the maximum taxable capacity.

If we fast-forward to 2016 and assume that the government has been successful in reducing government spending to its target, then what? The likelihood is that the government will be locked into a 40 year battle just to keep spending at that level. Calculations from IEA authors about the true underlying size of UK debt caused alarm when they were first published four years ago. Now, using somewhat different methods of presentation, the Office for Budget Responsibility produces its own forecasts of the long-term pressure on government spending. They too make depressing reading.

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Academic and Research Director, IEA

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

5 thoughts on “This medium-termist government needs to think long-term – now”

  1. Posted 16/02/2012 at 11:24 | Permalink

    Phillip, you comment that proposals to reduce pension tax relief will target a group who are net savers and imply thus that such measures will lead to reduced private pension savings. True, but surely the restriction of tax relief to this group will be unlikely to have any impact on net savings levels as a whole and will merely see these individuals reassessing their savings options. This must surely be a positive outcome.

    The wider issue is this government’s failure by and large to reform the tax system, broaden the tax base and create a coherent tax environment where tax considerations distort as little as possible decisions to work and save. Instead it has sought to raise revenue wherever its dead hand can whilst increasing the already vast list of tax expenditures. (As we know an economy works best when investment and savings decisions are guided as much as possible by economic considerations and as little as possible by tax considerations).

    I welcome any attempt by the government to close loopholes and remove distortions from the UK tax system, including tax relief for pension contributions, even if such measures remain small. Unfortunately given the shambles that is the UK tax system and evidence to date I’d be surprised if this formed a part of a coherent strategy towards a low rate broad-based system of taxation.

  2. Posted 16/02/2012 at 20:07 | Permalink

    Tony – I have a lot of sympathy with your general approach but, on the details…

    It is possible that it will lead to a reorganisation of the same amount of saving but it would also be surprising if saving in total was not reduced (though, this is an empirical matter which neither of us can fully resolve).

    In general I believe in low and flat taxes. I do think, though, that, if you have pension tax relief at all it should be up front and at the highest marginal rate. There are complicated reasons for this, including the fact that progressive tax systems deal badly with volatile incomes and pension provision is a way in which higher-rate taxpayers can smooth their income. This relates to problem number two, which is that, for the very highly paid, you might end up with a position whereby (unless you abolished all relief and also tax on pensions) they had tax relief at only 20% and then paid tax at 40% in retirement. Also, there is the problem of valuing employers’ contributions to schemes for the purpose of them being a taxable benefit (otherwise, tax would simply be avoided by asking employers to contribute instead of employees).

    I think my first moves with pensions would be to severely restrict the tax-free lump sum and severely restrict the total amount of pension tax relief on contributions (and the salary which can be used to compute a pension in a defined benefit scheme). This revenue could usefully be used to reduce the corporation tax rate to the basic rate of income tax abolishing a chunk of the tax code in the process. I realise that all this is a bit pragmatic and I would hail a chancellor who just through the whole lot in the air to move to a flat tax system with a single rate instead.

  3. Posted 17/02/2012 at 10:16 | Permalink

    Phillip, the primary purpose of the tax system should of course be to raise revenue without distorting the decisions that individuals and firms would otherwise make for purely economic reasons. Ideally all income should be taxed when earned. Pension savings should be put on tax neutral footing; that is taxed, taxed, exempt. All tax-based incentives to save such as ISAs should be removed. These erode the tax base, distort decision making and merely lead to higher rates elsewhere. The evidence presented in a wide range of research suggests that, at the most, only relatively small fractions of earnings going into tax-advantaged savings vehicles should be treated as “new” savings and as such pension tax relief represents an expensive way of encouraging thrift. As for the rate of corporation tax it should ideally align with income tax rates. Lower taxes would do more to encourage private savings than attempts to offset savings disincentives with subsidies administered through the tax system.

    New Zealand in the 1980s took major steps down this path introducing a one rate VaT system which exempted little, removed all tax-based incentives to save and invest and sought to tax all income sources. In doing so it was able to significantly reduce marginal tax rates and the rate of corporation tax (during a period of economic difficulty). Some changes met with considerable opposition from interest groups and, in particular, the pensions industry but nevertheless Douglas et al walked the line. The reform of the tax regime did not result in insurrection and although subsequent governments have moved away slightly from the principles outlined above New Zealand continues to have the most neutral tax system in the OECD.

    Tax leakage is a massive problem in the UK and free market lobbyists should actively encourage the government to plug these gaps whilst also pushing for low income tax rates. The government adopting such a strategy would seem to me to be a coherent and relatively popular.

  4. Posted 17/02/2012 at 12:03 | Permalink

    I agree with all that, but, in the field of pensions, the New Zealand government could only do this by (a) introducing a relatively high level of state pension and (b) a state pension that was given to everybody regardless of contribution record. In the UK, there would be no incentive to save for pensions in the absence of tax relief because of the existence of means-tested benefits. There is a question of the sequencing of reforms and that is what I am really getting at. If we abolished state pension provision (perhaps replaced with some compulsory saving if we maintained means-tested benefits) then that is a different matter.

    Maybe I should blog about this particular issue at a later point but I was making the point in a different context and only a very specific point – everything the government has done recently has involved increasing the burden on future generations. Furthermore, if the government goes down this line, it is not going to reduce tax rates with the money: the 40 per cent rate would stay, the threshold would stay the same and the 50 per cent rate would stay. I was just commenting on Danny Alexander’s particular proposal and what the government was intending to do with the money.

    In an ideal world though, low and flat, yes. But, on consumption or income? That is a moot point amongst most economists, though I prefer the latter.

  5. Posted 17/02/2012 at 14:40 | Permalink

    Philip, yes I’m sorry I didn’t mean to be adversarial. Just as one final point. Whilst I agree state pension provision in NZ has been pretty generous (from 1970s up to late 1980s it was set for a couple at 80% of the average wage) I do not agree that without such the superannuation changes above would have been rendered impossible (but I will need to guage others views on this). Over most of the long history of state pension provision in NZ (going back to Dick Seddon’s Old Age Pension Act in the late 19th century) pensions have been means tested. In 1985 Labour introduced a taxation surcharge on the other income of those claiming the state pension. This in effect was by another route means testing and resulted in approx 10% of claimants receiving no state pension whilst another 15% repaid a partial amount. In 1988 tax concessions on contributions to private and occupational pension or superannuation schemes were abolished. In the late 1980s and early 1990s the government made further changes to the state pension seeking to reduce the level of benefit (reduce benefit levels for a couple to 65% of net average wage).

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