Why tax hikes aren't the answer to our long term fiscal problems

The Office for Budget Responsibility seem to have inherited the unfortunate habit of the Institute for Fiscal Studies, who feel the need to express any fiscal gap in terms of the tax hike that would be needed to fix the situation.  Or at best talk neutrally about the amount that spending needs to be cut or taxes need to be raised.   In reality, as I set out in our response to that report, higher taxes will choke off economic growth and therefore do nothing for the Exchequer in the long run.  The empirical results surveyed and produced by Patrick Minford and Jiang Wang for the IEA report Sharper Axes, Lower Taxes launched yesterday evening reinforce that solid finding from the economic literature.

They report a number of other studies which have come to the same conclusion, and then their own results:

Overall, there is an overwhelmingly strong negative relationship between tax and growth, with some models showing a stronger relationship than others.  Specifically in our preferred model there is an elasticity of growth to tax of approximately -1.4 at the mean of the growth rate (1.6 per cent).  The effects are not expected to be linear in the tax rate but, if they were, then a fall in the tax rate by 25 per cent of its existing value (from 40 to 30 per cent) would lead to a rise in the growth rate to 2.7 per cent if the initial growth rate were 2 per cent.

2 per cent to 2.7 per cent might not sound like a lot but it is.  Over 30 years an economy growing at 2 per cent a year will grow by around 80 per cent, whereas an economy growing at 2.7 per cent a year will grow by more than 122 per cent.  That will erode most of the increase in revenue.  So even if you don't specifically target tax cuts in order to maximise the dynamic returns, just the overall impact on the trend growth rate would almost pay for the tax cut on its own.  And everyone will be far more prosperous.

There are huge problems in the public finances.  Researchers at the Bank for International Settlements (BIS) found in March 2010 that Britain was, in terms of the projected share of GDP that could go on debt interest, facing the worst fiscal position of any of the developed countries they looked at.  The only way we will deal with that problem is by ensuring the Government lives within taxpayers' means.  As the BIS researchers put it:

Taxes distort resource allocation, and can lead to lower levels of growth. Given the level of taxes in some countries, one has to wonder if further increases will actually raise revenue.

While there will be challenges financing substantial tax cuts in the short term, in the long term reforms to deliver lower and simpler taxes will deliver for the Exchequer as well as families and businesses.

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