Clarke's complete tax reform

Last week, this column argued that the litmus test for the Budget would be whether it fully addressed Britain's problem of chronic over-consumption in the public and private sectors. In the event, the combination of tax increases climbing to an annual rate of pounds 6bn in 1996/7, along with 'genuine' public spending cuts of pounds 3bn, was about the most that could have been expected in the current political environment. So it would be churlish to complain.

Obviously, Kenneth Clarke's presentational skills were impressive. But the secrets, of course, were to defuse the outrage of the Tory right by springing a surprise package of spending cuts, and to placate the Keynesians by once again back- loading the fiscal medicine.

The table attempts to demonstrate exactly how the two 1993 Budgets have managed to cut the prospective public sector borrowing requirement in 1996/7 from pounds 46bn to pounds 22bn. Norman Lamont's tax increases account for pounds 11bn of the pounds 24bn drop in borrowing. Mr Clarke's fiscal tightening adds a further pounds 9bn, of which two- thirds comes from tax. The remaining pounds 4bn comes from estimating changes such as an assumed decline in debt interest, and in social security payments.

It is therefore immediately obvious that most of the fiscal tightening has come from tax increases, which outweigh genuine spending cuts by a ratio of almost six to one. Furthermore, it is hard not to be sceptical about the spending cuts. This is not because they are all derived from a decline in the contingency reserve - the reserve has dropped by a normal amount, but this year it has been allocated entirely to a cut in spending, instead of being spread (as usual) among the departments.

This seems legitimate. But the overall rise in real public spending in the next three years - an average annual increase of only 0.2 per cent in the control total - seems implausibly small. The Chancellor may have wriggled out of a tight political corner by announcing these tough plans. But he will wriggle into an even tighter corner if he actually implements them in three years - and just before the election at that.

The trouble is that the following two statements are incompatible: 'The Government intends to curtail public spending by controlling public sector pay'; and 'the Government will protect the health and education services'. No one apparently minds if the pay of civil servants is squeezed, except civil servants. But most public employees are not civil servants, they are front-line providers of vital services. Their pay can be screwed down for a year, perhaps two, but not more. Even if it were possible to ride out the inevitable strikes, the services could not survive the exodus of vital workers that would follow any serious pay decline.

Nevertheless, if public spending overshoots targets because of extra pay, more than a third of the cost will automatically flow back to the exchequer in additional tax receipts. And if public spending rises because of a general increase in inflation, then tax revenue is likely to rise at least as fast as spending. The conclusion is that enough has probably now been done to correct excess government borrowing - provided that the economy does, as assumed, grow by around 3 per cent a year up to 1997.

Those who are still inclined to take a pessimistic view of the PSBR should contemplate the following. In just one year, 1993, Mr Lamont and Mr Clarke have announced tax increases that have almost entirely wiped out the huge direct tax cuts of the mid and late 1980s. In today's money, the Lawson tax cuts were worth pounds 20bn a year. This year's tax increases will amount to pounds 17bn. So in the decade from 1985-95, the Government has (unintentionally) introduced a gigantic tax reform package, which in the end has had virtually neutral revenue consequences.

It is fascinating to ask whether this reform has improved or worsened our tax system. The crucial features of the reform have been twofold. First, virtually all of the Lawson tax cuts involved reductions in the marginal rates of taxation - notably a drop in the top rate of income tax from 60p to 40p, and in the basic rate from 30p to 25p.

By contrast, the tax increases of 1993 have generally left marginal tax rates unchanged - the exception has been the rise in employees' National Insurance contributions from 9 to 10 per cent. The increase in revenue has instead come from higher indirect taxes (eg VAT on fuel and many excise duties), and from restrictions in the value of income tax allowances (especially mortgage relief and the married couple's allowance). So over the whole decade, there have been two massive moves - from direct tax towards indirect tax, and simultaneously from allowances towards lower tax rates.

Has this left us with a better tax system? Some may argue that both these shifts are good for 'incentives'. However, the argument that a shift from direct to indirect tax is helpful for work incentives is so much economic gobbledegook. Work incentives depend on the marginal increase in real wages per unit of time worked, and this is not changed by cutting income tax and raising VAT.

Within the direct tax system, however, the Government is on safer territory. The marginal tax rate which most people pay - the basic rate of income tax plus the NIC rate - will have dropped from 39 per cent a decade ago to 35 per cent next year. Top earners, meanwhile, have seen their marginal rate drop from 60 per cent to 40 per cent. True, this has been offset by a large shift of workers out of the basic rate band into the upper rate band as the thresholds have been frozen for long periods, but the main point probably stands. Most workers now face lower marginal tax rates.

Whether a cut in the marginal rate from 39 per cent to 35 per cent is large enough to make any measurable difference to the economy is very dubious, but at least it would seem to be in the right direction. What is less dubious, though, is that the net effect of all these changes has probably been to shift the tax system in a less progressive direction. The really big change has been in the top rate of tax, and this seems almost certain to dominate any other change in post-tax income distribution.

Roy Jenkins once observed that chancellors rarely leave deep footprints in the sands of time. Just as no British parliament can bind its successors, no chancellor can reduce the revenue of future incumbents of No 11.

But the lesson of the past decade is that each tax change needs to be considered on its own merits. Provided that every little change remorselessly grinds the tax system towards a better destination, then the micro-economic objective of a distortion-free tax system need not be sacrificed by the vagaries of macro-economic management.

----------------------------------------------------------------- THE TIGHTENED FISCAL STANCE ----------------------------------------------------------------- (pounds bn) 94-5 95-6 96-7 PSBR before March Budget 51 49.5 46 Lamont tax increases 7 10.5 11 PSBR after March Budget 44 39 35 Clarke new measures Tax increases 2 5 6 'Genuine' spending cuts* 3.5 1.5 3 Total 5.5 6.5 9 Clarke estimating changes Tax increases -1.5 0 1 Spending cuts 2 2 3 PSBR after Nov. Budget 38 30 22 ----------------------------------------------------------------- * These include cuts in the contingency reserve of about pounds 3bn- pounds 3.5bn a year. All numbers are rounded -----------------------------------------------------------------