Why increasing tax bases is the key to fulfilling manifesto pledges

TRL Insight report Tax Receipts and Government Spending, June 2024

“A rising tide lifts all boats”

This phrase was put into common economic and political parlance by John F Kennedy, quoting the slogan of the New England Council, a regional chamber of commerce.

It’s as true for the UK Government as it is for businesses in New England. Yet commentary on UK fiscal events often implies a zero-sum game: that additional spending is only possible with additional borrowing or if policy decisions are taken to increase tax rates.

In the current general election campaign, political parties are keen to make pledges about what they will do to improve the country. Many of these require central government to spend money. Again, there is a narrative in the media – perhaps the dominant one – which demands that they explain which taxes should rise (implying tax rate rises) to pay for these. It then insists that if they don’t, they are not being honest with the public – that tax rises are coming down the line anyway, regardless of what the politicians say publicly.

For example, the BBC reported on Monday that ‘The 'UK's main political parties have “ducked” addressing stark choices over public finances in their manifestos and it will be a "considerable surprise" if taxes are not increased over the next five years’, according to the Institute for Fiscal Studies (IFS). And the Daily Mail also quoted the IFS on 13 June, describing a ‘ “conspiracy of silence” over the true state of the public finances’ and saying ‘Labour had “literally no room” to increase spending without raising taxes further or breaking its own fiscal rules’. These reports – and interviews issuing challenges off the back of them – are being broadcast every day on our radios and TVs.

But an examination of fiscal history shows this is not how things work. Tinkering with tax rates or eligibility can bring in some extra funding – a particularly significant change might bring in a couple of billion pounds. This could allow the Government to boost spending on services and goods in one specific area. But the largest boosts to spending on services and goods are paid for by a mix of increasing tax bases and reductions in the bill for other spending (welfare payments, financing costs and public sector pensions).

My new report, Tax Receipts and Government Spending, looks at spending on services and goods by central government over recent decades.

Given the constraints of available data, it focuses on the years since 1997. Other than the exceptional Covid year of 2020-21, the early 2000s were the only period in which there was particularly strong growth in spending on services and goods.

The report shows that this was mostly affordable because of rising tax bases and shrinking bills for other expenditure. The contribution from rising tax rates was at most a small part of the mix and there wasn’t any net borrowing in real terms over the period 1997-98 to 2005-06.

An examination of fiscal reports and economic data shows that the direct impact of policy changes to tax regimes was relatively limited. The key point here is that there are two factors that determine how much money is collected from a tax – firstly, its profile of rates and allowances, and secondly, the size of the tax base. For example, income tax on earnings has a personal allowance, a basic rate and a higher rate. Above the personal allowance, earners are charged on each pound they earn. Therefore, the more the population is earning above that allowance, the more money the government receives. National insurance (NI) has a similar structure. For Value Added Tax (VAT), most goods are levied at the standard rate – currently 20%. The amount that is raised is determined both by this rate and by the value of goods sold. For corporation tax, limited companies pay the tax on their profits. The yield from the tax therefore depends on both the tax rate and the total profits earned by UK companies.

The amounts raised in 1997-98 to 2005-06 as a direct result of changes to rates and eligibility were dwarfed by the changes due to increasing tax bases, resulting from growing prosperity. The total volume of retail sales rose by 25% in this period, leading to a 35% increase in VAT receipts in current prices. The number of people earning ￡30,000 or more per year rose by nearly 90%; it is therefore no surprise that the income tax liability for higher rate tax payers also rose strongly, increasing by two-thirds and increasing payments due to the Government by ￡31bn in cash terms.

There’s a world of difference for taxpayers between receipts increasing from higher rates and receipts increasing from a growing tax base. So, when we are told that taxes are nearing an all time high and could get higher, this gives a very misleading impression. (Especially when accompanied by the phrase “tax burden”.)

Take, for example, someone earning ￡42,000 a year from their employment. They are currently paying 20% income tax and 8% NI on their earnings above ￡12,570.

Now, say their salary increases by ￡10,000 – maybe they get a new job, get a promotion or start working additional hours. This takes them into the higher rate bands. The total tax and NI on the additional pay is ￡3,042.20. This still leaves them with ￡6,957.80.

Will this feel like they carry a greater “burden”? Only if they’re fixated on seeing the bleak side of things – they’re taking home nearly ￡7k more a year; they’re also sharing their good fortune with the state, where it’s being used to provide hospital services, schools, security from criminals and hostile nations, care homes, road maintenance, rubbish removal and countless other services of value to them, now or in the future.

Prosperity is shared between the individual and the state, paying for services to the community – a rising tide lifts all boats.

Of course, there’s nothing that the government can do to guarantee rising tax bases. But they can certainly create conditions to facilitate them – for example, by carrying out the kind of long-term planning that creates a stable environment in which businesses can make investments. They can also provide both financial and political support to projects which help people overcome barriers to work. For example, diverting young people from crime, reducing reoffending at all ages, supporting people with long-term health conditions (physical and mental), addressing transport and childcare barriers, and equipping people with academic, technical and ‘soft’ employment skills.

For most of these, it will take a few years before the policy measures result in a significant return to the Exchequer. This time lag needs to be factored into planning. But that’s no reason to dismiss growth in tax receipts from such measures as unachievable. It simply makes it important to an incoming government to make a swift start. And some interventions will see a fairly rapid return – either by way of rising receipts or through savings on budgets for service or welfare expenditure.

Even if the Government creates the ideal conditions for tax bases to rise, there is no guarantee that the economy won’t encounter a severe shock. This has happened twice in recent decades: the credit crunch in 2008-09 and the outbreak of Covid-19 in 2020.

However, even in these cases, actions or inactions of the Government had left the UK prone to being hit unnecessarily hard.

In the case of the credit crunch, successive governments had deliberately minimised regulation of the financial services industry, which had encouraged a culture of risk-taking and investment in highly leveraged products without sufficient due diligence. The “prudence” that Brown applied to the public finances was entirely absent in relations with the financial sector. Such moral hazard needs to be avoided in the future.

In the case of Covid, it could be argued that the UK was overdue for a pandemic. Given the increase in international and domestic travel in recent decades, it was only a matter of time before another pandemic arrived, but there seems to have been very little planning for this, particularly in terms of policy/governmental response. And by the time it arrived, the health service had been severely run down by years of budgetary restraint. It was understaffed and the staff were overworked and underpaid. It was barely able to cope with the workload it already had, let alone to take measures to combat a highly infectious new disease.

If anything, the situation was even worse in the care sector. The Government had let a situation develop where it was so far removed from care homes that it had little sense of the conditions under which they were operating. The care sector had been neglected and largely ignored for many years. When deaths started occurring in care homes, they weren’t even included in the published statistics.

So, a lot more can be done to reduce the chance of such shocks occurring than has been the case. But the risks certainly cannot be eliminated.

Faced with these facts, a prudent, responsible government or political party should propose policies to foster prosperity and economic growth, particularly growth of tax bases. They should use available toolkits and expertise to estimate a range of scenarios for the growth in receipts that these policies might lead to. They should also carry out contingency planning as to what would happen were the growth not to be achieved, whether through sudden, severe shocks or otherwise, and work out how their policies would be modified in these situations.