Falling tax receipts show that we’ve forgotten Laffer’s lesson

SOMETHING very worrying is happening to the UK’s public finances. Income tax and capital gains tax receipts fell by 7.3 per cent in May compared with a year ago, according to official figures. Over the first two months of the fiscal year, they are down by 0.5 per cent. This is merely the confirmation of a hugely important but largely overlooked trend: income and capital gains tax (CGT) receipts were stagnant in 2011-12, edging up by just £414m to £151.7bn, from £151.3bn, a rise of under 0.3 per cent. By contrast, overall tax receipts rose 3.9 per cent.

Revenues from income and capital gains tax had previously fallen sharply in both 2008-09 and 2009-10, before recovering somewhat in 2010-11. They remain below their 2007-08 boom time peak.

There are of course some good reasons for this sluggishness in receipts. The personal allowance has gone up. Pay isn’t rising quickly. Bonuses are down. Unemployment is elevated. Asset markets are sluggish. But these factors are insufficient to explain the scale of the problem. Total employment and the economy wide-wage bill are still creeping up. And overall taxes on labour and capital have been hiked: the 50p tax was introduced from April 2010 (and will fall to a still high 45p in April 2013), those earning above £150,000 have lost their personal allowance, CGT has risen to 28 per cent, many workers have been dragged into higher tax thresholds, and so on.

In theory, if one were to believe the traditional static model of tax, beloved of establishment economists, this should have meant higher receipts, not lower revenues. It is also nonsense to claim, as some did yesterday, that the May drop in income and CGT tax receipts was to be expected given the double-dip recession – an economy that is shrinking by a few tenths of a percentage point doesn’t respond in such a drastic manner.

It was apposite, therefore, that Arthur Laffer was in London yesterday. He is the economist who popularised (via a famous curve) the notion that there is a revenue-maximising rate of tax – and that if you set rates too high, you raise less because people work less, find ways of avoiding tax or quit the country. The world isn’t static, it is dynamic; people respond to tax rates, just as they respond to other prices. Laffer told a gathering at the Institute of Economic Affairs that this is definitely true in the UK today – and the struggling tax take revealed in the official numbers suggest that he is right. Tax rates and levels are so high as to be counterproductive: slashing capital gains tax would undoubtedly increase its yield, for example. Many self-employed workers are delaying incomes as much as possible until the new, lower top rate of tax kicks in.

Of course, higher VAT is also damaging growth, though it is still yielding more. Some taxes can still raise more – but try doing that with income tax, CGT or corporation tax and the result is now clearly counter-productive. These taxes are maxed out; they have been pushed beyond their ability to raise revenues. George Osborne’s decision to suspend the August fuel duty hike is welcome, as far as it goes. The problem is that spending is too high – central government current expenditure is up by 3.7 per cent year on year in April-May – not that taxes are too low. The result is that the April-May budget deficit reached £30.7bn, some £6.2bn higher than a year ago. But the chancellor will have to make a much more dramatic U-turn if he wishes to salvage what is left of his crumbling fiscal plans: he needs to accept that only lower taxes on income and capital can boost growth and, eventually, nurse his finances back to health.

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