Do tax cuts make us richer?
Tim Congdon
Britain's national economic hypochondria has spawned a proliferation of statistics in recent years. Although they may not have improved the health of the patient, they had made it easier to measure and possibly to diagnose the sickness. Governments have encouraged this tendency, perhaps on the principle that the more numbers there are, the greater the likelihood that one of them will present its policies in a favourable light.
The present Government seems to be no exception and, despite its well-publicised aversion to unnecessary bureaucracy, it has given statisticians at the Department of Employment another function — to compile an inflation index adjusted for changes in the structure of taxation. The argument is that the switch from direct to indirect taxation (which was stich a spectacular element in Sir Geoffrey Howe's first Budget and will no doubt continue in future) leads arithmetically to an increase in the retail price index, but does not contribute to underlying inflationary pressures. Since the jump in VAT to 15 per cent is being compensated by income tax reductions, it is appropriate to develop a new index which takes out the effect of higher indirect taxes. Press reports differ at present on the name of the new index, but one candidate is the Tax and Price Index (TPI). It is to be published for the first time with the July retail price index.
However, as so often, private enterprise has taken the initiative ahead of the Government, The Institute for Fiscal Studies, an independent research organisation, has already brought out a measure of how inflation and tax have affected living standards. The invention of Mr John Kay, the Institute's director of studies, it is termed the 'Gross Earnings Deflator' (GED) and shows the increase in average earnings, before tax, which is required to enable a household to maintain the value of what it can buy. The GED is estimated to have increased by 9.2 per cent in the year to June 1979, compared to a rise in the retail price index (RPI) of11.4 per cent. The Institute will calculate the GED every month and publish it soon after the RPI. This is a valuable watchdog role which should discourage the Government from doctoring the TPI. But it will create headaches for financial journalists who have to explain to their readers what the 'true' inflation rate is. One has to wonder whether the mental and verbal contortions which seem inevitable in comparing the RPI, TPI and GED will really be of much benefit in understanding how the economy is behaving.
Indeed, a good case can be made for saying that, of two central assumptions which lie behind the exercise, both are wrong and one is harmful. The first assumption is that changes in tax rates can alter living standards and the second that the rate of wage increases is related, in a precise and mechanical way, to the rate of price increases.
To suppose that there is a link between tax rates and living standards is conventional in Budget presentations. Thus, Sir Geoffrey Howe claimed that the average family would be better-offas a result of his Budget because the increase in indirect taxes was less than the reduction in direct taxes. It was taken for granted in subsequent comment that it is the Chancellor's power to dole out fiscal largesse in this way — or to cut living standards by raising the net tax burden if he should so choose. The description of Chancellors as 'generous' or 'tough' undoubtedly helps to personalise and dramatise financial news which might otherwise be rather dreary. But it is misleading.
We can see this quite easily if we supposed it were true that tax cuts increased real incomes. Then there would be a simple, popular and painless method of raising living standards by 50 per cent immediately — by abolishing taxes altogether. The 'ordinary man' might, by suspending common sense, accept this conclusion for a few seconds. (In Latin America, politicians seem, in some instances, to have believed it for several months.) But, surely, something has gone wrong. The problem is that the Government is still spendingas much money as before, the difference simply is that it is not being financed properly. As long as public expenditure is absorbing the same proportion of national resources, the extra purchasing power in people's pockets from tax reductions does not increase the quantity of resources available for consumption. If individuals try to spend their additional income the main effect is to raise prices, cancelling the beneficial effect of the tax-cut. No one is better-off than before.
In fact, the repercussions of tax cuts would be rather worse than this. In the extreme case of total abolition of taxes the only way in which the Government could finance its expenditure would be by borrowing from the banks or the public. If the public preserved some vestige of sanity in this extraordinary situation, it would refuse to buy any debt and the Government would have to rely on the printing presses. The eventual outcome would be total financial collapse.
In other words, the level of taxation does not affect living standards only the extent to which public expenditure can be financed without borrowing. It is elementary logic that only what has been produced can be consumed or, in more technical language, that real consumption depends on productivity. The Chancellor of the Exchequer may be a very important person, but he cannot make a nation richer by mere announcement. Indeed, for Government ministers to claim that income tax cuts have 'improved living standards' is the worst kind of political rhetoric. Not only is it crudely materialistic; it is also wrong and dishonest. Equally, trade union leaders who protest that indirect tax increases 'have made our members suffer' are subject to an illusion, as there can be no long-run effect on real incomes from a change in the way public spending is financed. It follows that the publication of a new tax-adjusted inflation index, whether it be the TPI or GED, is a distraction from more genuine economic problems. If VAT had been raised to 20 per cent, rather than 15 per cent, and there had been no income tax offsets whatever, Britain's capacity to provide goods and services would be quite unaffected — and so would living standards.
The idea that there is a connection between tax levels and real incomes has, like many nonsenses in economics, been as influential as it is wrong-headed. In particular, it played a role in the incomes policy bargaining between the Labour Government and the TUC in 1976 and 1977. The aim of inducing the TUC to accept a lower rate of wage increases in exchange for bigger tax cuts was, for a time, the focus of public debate on incomes policy. The tax cut/pay norm trade-off, as it was known, was blessed by both the National Institute of Economic and Social Research and the Cambridge Department of Applied Economics. But, as we have shown, it was based on a fallacy. It also did much harm because the resulting income tax reductions deferred the move towards a lower budget deficit which is an essential component of a meaningful antiinflationary policy. The second assumption behind the compilation of the TPI and the GED — that there is some causal connection between the rate of wage increase and the rate of price increases —is less dangerous, but also unjustified. The theory is that workers set wage claims at whatever the rate of inflation has been in the recent past, plus a few per cent to reflect real, income growth and trade union bravado. If thiswere right, it would be important that the base inflation rate accurately reflect the influences which had actually reduced living standards since the last pay agreement. Hence, the need for the TPI and GED. However, some recent history refutes this notion. In the year to October 1977 prices rose by 14.1 per cent — and earnings by 8.7 percent; in the year to October 1978 prices rose by 7.8 per cent — and earnings by 14.7 per cent. On this evidence, the faster the growth in real incomes, the more aggressive do union leaders become and the higher are wage claims! It is perhaps even more striking that there is a wide dispersion of wage settlements at present — even though all groups of workers face the same inflation and tax rates. The addition of two new indicators to the list of monthly statistics may help take the economy's temperature, but they will do nothing to cure inflation and may also make a rather neurotic patient even more anxious.
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