What is the limit on the tax burden?
High taxation does not mix well with political freedom and economic efficiency. Despite this, the second half of the twentieth century – the years when the Institute of Economic Affairs was making its vital contribution to the public debate – was a period of extraordinarily heavy taxation by long-run historical standards. Before World War II it was unusual for taxation to exceed 25 per cent of national output; after the war very few significant industrial countries had a lower tax burden.
Instead the ratio of tax to national output (‘the tax ratio’) varied in the nations of the industrialised West from a low of about 25 per cent to a high of 60 per cent.1 Indeed, a large state sector, and a powerful and omnipresent fisc, are widely regarded as among the defining features of the modern industrial state.
At the start of the post-war period economists raised questions about the viability of the tax burden implied by the welfare state, then at an embryonic stage. In 1945 Professor Colin Clark wrote a paper for the Economic Journal, presenting evidence that a tax take above 25 per cent of net national product would be inflationary. This paper became widely quoted and was still being discussed in an Institute of Economic Affairs pamphlet over thirty years later (Prest et al., 1977: 21–3). In Clark’s view anything above the 25 per cent figure carried such serious inflation risks that it must be an upper bound. Keynes – as editor of the Economic Journal – endorsed his position, opining that 25 per cent was ‘about the limit of what is easily borne’. Given Clark’s and Keynes’ warnings, the surprise must be that economic performance has been so good over the last 60 years. Output growth has been continual, so that living standards today are vastly better than in the late 1940s. It seems that Clark and Keynes were wrong. The facts suggest that considerable economic dynamism can be achieved even with tax levels far above the quarter of national income that they regarded as the maximum.
There is, though, another way of looking at what has been happening across the industrial world since the 1940s. It turns out that tax is subject to a limit, an absolute upper bound, just as Clark and Keynes thought. But the limit is 60 per cent of national output, not 25 per cent. On what evidence is this assertion based? The answer lies in the simple and plain facts of experience: no nation in peacetime has had a tax ratio above the 60 per cent figure. In the post-war period – the period when the state sector has been more extensive than at any other time in history – several nations have had long periods with a tax ratio above 50 per cent and the majority of advanced nations have had at some time or other a tax ratio above 40 per cent. But no nation has exceeded 60 per cent for any noticeable length of time.
Somehow a few nations – virtually all of them in Scandinavia – have coped with a tax ratio of about 60 per cent. But their economic performance has hardly been encouraging and taxpayer resistance has become a major political force. No government in these nations has dared to breach the 60 per cent figure for long. A tax ratio of 50 or 60 per cent may be viable, in the sense that everyday economic life proceeds more or less as normal and national income is stable or even growing slightly. But it is very far from ideal. In fact, an increasing body of evidence argues that the level of and growth rate of national output are inversely related to the tax ratio.
An important study on the subject by Andrea Bassanini and Stefano Scarpetta appeared in the OECD’s Economic Studies in 2001. The numbers depended on the specification adopted, and allowed room for judgement and debate. But in one particularly ambitious formulation, where the tax ratio affected investment and, at a further remove, also influenced the capital stock, a rise in the tax ratio of 1 per cent reduced national output by 0.6–0.7 per cent. In other words, the equilibrium level of output in a nation with a tax ratio of 50 per cent is 12 to 14 per cent lower than in one with a tax ratio of 30 per cent, and the equilibrium level of output in a nation with a tax ratio of 60 per cent is no less 21 to 25 per cent lower than in one with a tax ratio of 25 per cent.
Unsustainability of very high tax rates
The existence of a limit to taxable capacity can hardly be unexpected. If a tax rate of 100 per cent ends voluntary economic activity altogether, a tax rate of 70 per cent or 80 per cent must have drastic adverse effects on incentives. A nation could in theory levy taxes equal to national output without having any tax rate at 100 per cent, because it could combine very high rates of both direct and indirect taxes. This nation might also have a large private sector, with the state handing back enough to the citizens in the form of transfer payments for the bulk of their expenditure still to be on privately produced goods and services. But in practice a nation with a 100 per cent tax ratio – or even a 70 or 80 per cent tax ratio – would be impractical and unsustainable, for three reasons.
Disincentives and labour market participation
First, the nation would suffer from disincentives to work and save, and from discouragement for people to seek employment and for companies to offer it, even on the assumption that collection and compliance costs were nil, and that taxpayers were wholly honest and paid their taxes in full. This statement should hardly need proof, but the admirers of modern European societies with their large state sectors – such as Adair
Turner in his book Just Capital: The Liberal Economy – sometimes appeal to economic theory for a counter-argument. The counter-argument needs to be noted and rebuffed.
A tax change can be regarded as a kind of price change. As is well known, the effect of a price change on the quantity demanded depends on two effects, a ‘substitution effect’ and an ‘income effect’. The substitution effect of an increase in price is always to reduce quantity demanded, but the income effect is ambiguous. If the income effect of an increase in price is significantly to increase quantity demanded, it may – in certain special circumstances – outweigh the negative substitution effect. In such a case an increase in price is followed by an increase in quantity demanded. When applied to the labour market, this argument leads to the claim that an increase in tax rates sometimes causes people to work longer.
But in today’s conditions it is most unlikely that this sort of response would be common or general. In modern industrial societies people are cushioned against the loss of income from not working by social security payments and the apparently ‘free’ supply of certain so-called ‘public services’ (health, education and low-quality housing). The existence of these benefits reinforces the negative substitution effect of high taxation. For many millions of low-skilled or unskilled workers there is no point in working. A prevalent tendency across the industrial world in the last 30 years has been a decline in the proportion of working-age men who actually work. This tendency has been most pronounced in some European countries, such as France and Italy, where the rise in the tax ratio has been greatest.
Fortunately, the decline in male participation in the labour force has been offset by an increase in female participation. Two further prevalent tendencies across the industrial world since the 1960s have been an increase in female participation and a sizeable reduction in the pay differential between men and women. It is clear that without the entry of more female workers into the job market economic growth would have been much lower in recent decades than has actually been the case. But as this mobilisation of the female working-age population can happen only once, the associated output gain will not be repeated. Further, an argument can be made that one of its by-products has been a sharp decline in fertility. Disturbingly, the decline in fertility has reached the point where the populations of nearly all European countries are no longer replacing themselves. The long-term sustainability of the high taxation associated with the welfare state can therefore be questioned from a wider demographic perspective.
Costs of collection and compliance
There can be no doubt that – even in societies where tax payment is frictionless – an increase in the tax ratio reduces the equilibrium level of national income. But tax payment is not frictionless. The second way in which a high tax ratio lowers national output is through the increased costs of collection and compliance. The cost of collection is ostensibly borne by the government, but of course ‘the government’ is a legal fiction. Ultimately the cost has to be borne by the taxpayer.
Further, the compliance costs – of filling in long and difficult forms, of preparing correspondence with accountants, of learning about the tax system and seeking advice on how best to structure one’s affairs – fall directly on the taxpayer. They must rise with the tax ratio, particularly if an increase in the tax burden is associated (as is invariably the case) with a higher number and a greater complexity of taxes. Gordon Brown, the Chancellor of the Exchequer since 1997, has tried to counter the disincentive effects of the UK’s tax and social security arrangements by elaborate ‘tax credit’ schemes, in which tax is reduced as incomes rise. These schemes may have encouraged formerly unemployed workers to take up a job, but they have added to employers’ costs and have been accompanied by large increases in the tax and social security bureaucracy.
Avoidance, evasion and avoision
Finally, the higher the tax rates, the greater the incentives both to avoid tax (i.e. to find legal means not to pay tax) and to evade it (i.e. not to pay tax, regardless of whether the law is being broken). Different people respond to these incentives in different ways. Of course, the dishonest and unpatriotic have less compunction about avoiding or evading tax than the majority of the population. If they ‘get away with it’, citizens with a strong sense of civic responsibility feel cheated and angry. The long-run effect is to undermine respect for law and civic institutions. In these conditions illegal tax evasion may be widely regarded as no more despicable than legal tax avoidance. As Arthur Seldon warned in the 1970s, the resentment caused by excessive taxation led to ‘tax avoision’
in a ‘new twilight of law-breaking’.
Tax ‘avoision’ is often thought to be the preserve of low-income fringe operators, such as building contractors or minicab drivers, in or close to the black economy. But when confronted with true tax rates of possibly as much as 70 or 80 per cent of income even high-income professional people and members of wealthy families structure their assets to escape the attention of national revenue authorities. Favourite strategies are the registration of personal assets in bogus companies to exploit the better tax treatment of corporate entities, the transfer of assets from companies with a transparent pattern of beneficial ownership to nominee companies where beneficial ownership is opaque, the movement of wealth from heavily taxed jurisdictions to tax havens, and the relocation of individuals with the deliberate intention of exploiting tax residence rules (which differ considerably between nations).
All these devices take up an immense amount of time and effort, both for the wealthy people themselves and their armies of professional advisers (lawyers, accountants, brokers of various descriptions). Even so, there is often considerable uncertainty about whether a particular course of action is ‘tax efficient’ or not. Much of the activity is a ridiculous zero sum game, as governments both impose heavy taxation on their own long-standing citizens (in the UK’s case, those deemed to be ‘domiciled’ here) and have advantageous tax arrangements for wealthy people of foreign origin who come to live within their borders. Rich French people live in the UK to take advantage of the low tax on people with foreign domicile and rich Britons live in France to take advantage of the favourable taxation of pension income; rich Americans come to live in the UK and set up artifi cial companies which masquerade as ‘foreign investments’ and rich Britons live in the USA to establish exemption from UK capital gains tax, and so on.
Understandably, the national revenue authorities try to catch up with the fiscally motivated peregrinations of the rich. But decisions by their officials are sometimes arbitrary or downright vindictive, which ends the citizen’s sense of loyalty to the state and utterly destroys taxpayer morality. It is striking in this context that a large chunk of European saving is now held in portfolios of bearer securities (so-called ‘eurobonds’). Because these securities are not registered, it is difficult, or even impossible, for revenue authorities to determine the location and identity of their owners. Regrettably, but unsurprisingly, when the owners receive the income (by handing over a coupon detached from the bond to a paying agent in Luxembourg or New York), they do not report it to their tax inspectors. Most governments in the European Union want a withholding tax to be levied on the income from such securities, but the UK (where most eurobonds are arranged and underwritten) and Luxembourg (because of the importance of paying-agent activity to its economy) have resisted its imposition.
When the IEA was founded, eurobonds had not been invented. At the end of 2003 the value of the outstanding stock of such bonds was about $11,000 billion, up from $2,000 billion a decade earlier. No one knows the proportion of total eurobond issuance owned by citizens of European Union states, but it is almost certainly over half and may be more than two-thirds of the total. This fi gure has become harder to estimate as the concept of ‘the citizen of a nation’ has become increasingly complex: as has already been explained, many wealthy Europeans live in – or, at any rate, have residence status in – tax havens or nations with congenial tax regimes for ‘foreign investors’. If 60 per cent of all eurobonds were owned by citizens of EU countries this would amount to $7,000 billion.
That would imply that the average holding for the citizens of the EU would be almost $20,000 and that it had risen dramatically, by four, five or six times, in the previous decade. There could hardly be a better illustration that high tax, at the levels seen in the modern European state, corrodes taxpayer morality and undermines effi cient tax collection: it is an almost perfect example of Seldon’s tax avoision. To summarise, high taxation reduces economic efficiency, because of the disincentive effects on the amount of work in any particular employment, on the level of employment and on savings; the cost of collecting taxes and of complying with tax codes; the erosion of the citizen’s loyalty to the state and taxpayer morality.
Tax policy over the coming generations
Given the combined power of these three damaging effects of taxes on production and saving, it is hardly surprising that the rise in taxes in the OECD area since the 1960s has been accompanied by a decline in the rate of economic growth. This decline has been particularly marked in Europe, which is also the continent in which countries have a greater tendency to have tax ratios of over 45 per cent. So far economic growth has continued, if at increasingly trivial annual rates of 1 per cent or so.
But the demographic situation is certain to worsen sharply in the 2010s when the working-age population of such nations as Germany and Italy will start to fall. If productivity growth comes to a halt under the weight of further increases in tax and regulation, and if employment contracts in line with the working-age population (typically projected in the nations affected at 0.5 to 1 per cent a year), then significant European nations could experience a trend decline in output. It is not inconceivable that living standards could fall over extended periods, such as five or ten years.
At this point attitudes towards the big-government, high-tax modern European state may change. Leading politicians and high-ranking civil servants may recognise that tax burdens of 40, 50 or 60 per cent of GDP are the main cause of the economic malaise. They may look more favourably on radical proposals for reducing the size of the state and the burden of taxation.
What policies should they consider in order to cut the size of the state? First, they could privatise the supply of health and education, cutting taxes by the full cost of public expenditure on these items and suggesting to their citizens that they use their much enhanced post-tax incomes to pay for them directly. Of course, hospitals and schools would charge for their services, and the market would establish an efficient equilibrium between supply and demand. The privatisation of health and education would reduce the ratio of government spending to GDP by about 12 to 15 per cent of GDP in most advanced countries. That would allow the tax ratio to fall correspondingly.
Income and corporation taxes represent about the same share of GDP as spending on health and education in many countries. Income and corporation taxes could therefore be abolished, ending both their adverse effects on incentives and the destructive nonsense involved in their current methods of collection. The case for market freedom will become more compelling in the early twenty-fi rst century, as the nations of Europe find themselves crippled in an increasingly competitive world by an excessive burden of tax.
Tim Congdon
Copyright © The Institute of Economic Affairs 2005
© Copyright; Foundation for Economic Growth and various authors. Individual authors retain their own copyright.
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