Nobody likes a tough exam question. But over the past year the IEA set itself one. Well, I say one. It is actually a two-parter. But it goes like this: ‘what government size tends to maximise overall prosperity?’ and, second, ‘what would be the most effective tax system to raise revenue for this level of spending in the least distortionary way?’
I know what you are thinking: dream on, IEA. Post-referendum, Philip Hammond is going to open the spending taps. You really think a smaller state is going to happen? You think the Conservatives care about this stuff with Brexit on the agenda? Pah – get with the real world, you crazy libertarians. But the job of a think-tank is to think for the long-term, and our new publication sets out a vision for both the size of the state and the shape of the tax system.
The first question is the toughest. For the true answer is that it depends on the composition of spending. Infrastructure spending can in principle improve productivity growth by facilitating, for example, economic mobility. Yet bad investment in non-economic schemes (cough cough HS2, Hinkley Point) can worsen growth potential relative to alternative or private investments. The provision of the rule of law and a fair judicial system can provide an environment conducive to investment. Some education and R&D spending can have positive spillovers too.
Yet other types of spending and taxation can undermine growth. Badly designed government transfers worsen incentives and reduce saving. High government consumption shifts resources into the less productive non-market sector. Taxation required to finance spending can also reduce the size and growth rate of the economy by reducing incentives to save, invest and innovate, or by distorting economic decisions and deterring transactions.
Putting together both sides of the ledger and reviewing all the literature across countries, we present evidence that develops an illustrative curve with three points: a growth-maximising average level of government spending, an economic welfare maximising sweet-spot that is somewhat higher, and a maximum size of government that can be funded sustainably through taxation.
We show UK government spending is currently beyond the welfare-maximising level (around 30 per cent of GDP), and may even be beyond the sustainable taxable capacity of the economy (between 35 and 38 per cent of GDP). In other words, given we spend considerably more than Switzerland, Australia and Ireland, there is scope for cutting government spending to boost growth.
From where the UK is, a wide body of analysis controlling for other factors suggests that a 10 percentage point cut in the burden of government spending (from UK levels to say Australian levels) is associated with a 1 percentage point increase in the annual growth rate. New sophisticated modelling for our paper, which corrects for some of the problems of previous work, find similar results. This should not surprise us. As the OECD has outlined, only about a fifth of modern day government expenditures tend to be economically productive.
Whilst this would require substantial re-thinking on the scope of the UK state, it’s a good long-term ambition. The second question then is: how to pay for it?
20 current taxes, including corporation tax, national insurance, capital gains tax, inheritance tax, council tax, and a range of duties, could be abolished at this lower level of spending. Drawing on the extensive literature on optimal taxation, we find all taxes could be replaced by just five: a flat-rate income tax at 15 per cent of income above £10,000; VAT at 12.5 per cent; a new housing consumption tax at 12.5 per cent; a new location land value tax; and fuel duty at around half the current rate. On a static basis this would lead to significant income gains across the income distribution, with particularly significant gains for the poorest – particularly since the property taxes would be far more progressive. But the dynamic gains would be greater still.
Radical? Yes. Achievable? Not for a long-time. But the ideals set out in our book should inform the direction of travel for both spending and taxation in the UK. Over to you for the Autumn Statement, Chancellor.
