As we try to get on top of the impact which the coronavirus has had on our economy, there are two arguments advanced for tax rises. One is that we need to use taxes to start paying off at least some of the huge sums of money borrowed by the government to combat the current crisis. The other is that over the last year there has been a dramatic increase in the scale of government activity which will be hard to rein back, for which we will all need to pay.
The last two times we have had government debt in relation to GDP on the current scale were at the end of World War I and World War II. These debts were reduced, mainly after 1945, by a combination of growth in the economy and inflation. This reduced the ratio between government debt and GDP from 235% at the end of World War II to just under 30% by 2002. During this period the nominal value of total government borrowings hardly changed. This is surely what we need to do again – if we can.
The problem is that we now have both a very low underlying rate of economic growth and inflation at historically low levels. We may start to bounce back with a V shaped recovery, but it is likely, if this happens, that before long we will have both an unmanageably large balance of payments deficit and total demand which will overtax the economy. Investment has been too low to generate the output needed to meet the likely level of demand from both government and private sources. There will then be a sizeable risk that inflation will reappear as a significant problem. The Chancellor’s response may be to increase taxes to stop the economy overheating – but this will slow down the recovery, reduce the growth rate and leave government debt as high as it was before, or greater still if the debt goes on growing because government spending stays higher than its income – as again seems likely to happen.
It is against this background that the second case for tax increases is likely to look stronger and stronger. This is that government expenditure has increased hugely as a result of the current Covid-19 crisis and has to be paid for by higher taxes. In the second quarter of 2020 government spending was 16% higher than it had been in 2019. The government will have difficulties in cutting back on the many spending commitments to which it is already committed and the tax revenues to pay for them may well be well below what they were. The only way then both to stop the government continuing to borrow more and more money and to bring overall demand back in line with available supply will appear to be to raise taxes – perhaps by £50bn or more as the Office for Budget Responsibility has suggested.
Is there a way out of this problem which will both reduce government debt as a percentage of GDP and avoid tax increases climbing to a level which nobody wants? There is – but it will need a major change of strategy. Instead of trying to tax our way out of the problems we face we should trade our way through them. Instead of accepting a future driven by debt and import led stagnation we should go for an investment, manufacturing and export led expansion of the economy to generate the sustainable recovery we need.
To make this happen, we would need to bring down our exchange rate to a level which makes it profitable to invest in the UK in the types of projects – round mechanising, technology and the use of power, all mostly found in manufacturing – which generate much higher rates of economic expansion than we are used to achieving. If we could get our growth rate up by a couple of per cent per year – to say an average of 3% or 3.5% – the economy by 2030 would be at least 20% bigger than it is now. If government debt nominally stays the same as it is at present, it would then fall by 20% as a proportion of GDP. We could easily live with that.
With a more buoyant economy, we ought also to be able both to avoid both more government borrowing over the next few years and taxes rising to deeply unpopular levels. The stronger the economy performs, the higher the tax take would be without the rates going up and the smaller the calls on government to protect those hit by unemployment or low wages.
So, can we avoid tax increases? We don’t need them to pay down government debts. There are much better ways of doing that, by getting the economy to grow faster. As regards the government spending a considerably higher proportioned GDP than it did before, however, if we want this to continue, we will have to pay for it with higher taxes. They should, however, be much easier to shoulder if GDP is growing reasonably fast every year.
The solution to our current economic problems is not, therefore, stifling levels of taxation. It is providing the right incentives to generate investment, a manufacturing revival, exports and growth.
John Mills is Co-Founder and President of the Independent Business Network.