Higher tax will make us all worse off

Allister Heath
ECONOMICS is not always intuitive – and that is what makes it such a fascinating and important discipline. Take what economists call “incidence” – the study of who actually bears the burden of a particular tax. It is obvious enough that employees pay income tax. But it is much harder to actually work out who really ends up paying for other taxes; voters are often fooled into thinking that somebody else, usually big business, is being hit by higher taxes while in fact it is them who are picking up the tab, albeit in a way that is impossible to detect.

National insurance contributions are a case in point. They are nominally charged on both employees and employers – but in reality employees end up paying the whole thing and employers nothing at all. The reason is that total employee compensation is determined by the value of workers’ output and by supply and demand – and what matters is not merely the wage itself but the entirety of the cost of employing somebody, including benefits such as healthcare and non-wage costs such as employers’ national insurance contributions. Plenty of studies over the years have shown that compulsory, government-mandated increases in on the job training, extra holidays or hikes in employers’ national insurance contributions lead to reduced pay rises in subsequent years. It is a fundamental rule of economics that it is impossible to legislate for higher, economy-wide employee compensation. Only higher productivity can ever achieve that.

So when the Labour party says that it is planning to increase national insurance by one per cent on both employees and on employers, what it will really end up doing is making sure that take home pay will be two per cent less than it would otherwise have been. Corporate profits in the first year may also be hit but it won’t take long for the entirety of the hike to be passed on to employees, via lower pay rises or reductions in other benefits. This always happens and is a very uncontroversial analysis, shared by almost all economists.

The iron law of incidence also applies to the bank tax currently being prepared by the Tories, though in this case it is not as clear-cut. They want the banks to pay about £1bn a year, with the size of the bill dependent on their reliance on wholesale funding, which is deemed to be a bad thing. Some of the money will go towards a £550m tax cut on married couples and civil partners (for those earning under £44,000 a year).

This will have several effects: banks will try and reduce their reliance on wholesale funding and increase their deposits, all other things equal. This ought to be possible over time for large firms such as Lloyds Banking Group but it will also require the public to save more – or trigger lower lending, which could lead to all sorts of other difficulties. Wholesale funding is a must for investment banks, so they won’t be able to avoid the tax.

In practice, therefore, behavioural change won’t be enough and the industry will be hit by most of the tax. Or will it? Commercial and investment banks, which desperately need to increase their return on capital to placate shareholders, will pass on the cost via higher interest rates and lower savings rates to consumers – and in higher fees to businesses that need to raise capital or engage in M&A activity. All of which can mean only one thing: the £1bn tax on banks is really a £1bn tax on users of banks. It’s a shame the public won’t see it that way.