UK economy can aborb higher taxes

The major parties seem to agree that public spending cuts will have to bear the brunt of the effort to reduce the deficit because higher taxes would be worse for the economy than spending cuts. This consensus is based on a view that countries with higher taxes perform less well than countries with lower taxes. In fact, the long-run evidence to support this claim is flimsy.

The debate over the UK’s budget deficit – and how to cut it – is likely to dominate politics in the run-up to the next election. Reform have published Vince Cable’s raft of ideas for public spending cuts, and at the Liberal Democrats conference he has also announced radical plans for changes to the tax system. The other major parties might give us more details of their plans during their own party conferences. All, though, seem to agree that public spending cuts will have to bear the brunt of the effort to reduce the deficit because higher taxes would be worse for the economy than spending cuts.

This consensus is based on a view that countries with higher taxes perform less well than countries with lower taxes. In fact, the long-run evidence to support this claim is flimsy.

Looking at OECD data for 22 developed economies since 1970, two conclusions emerge. First, the UK is not a heavily taxed economy. On average over this period, taxes have accounted for 35 per cent of GDP in the UK – a little above the OECD mean average of 32 per cent. But this is lowered by the two largest economies – the US and Japan – having low tax-to-GDP ratios. When countries are ranked by their tax-to-GDP ratios over the whole of this period, the UK comes 10th out of 22 (i.e. very close to being  the median country). In 2007 – the latest year for which comparable data are available – the UK was 14th out of an expanded group of 30 countries, again just above the median. Any suggestion that the UK is a relatively heavily taxed economy is a myth.

Second, there does not appear to be any relationship between tax take and long-run economic performance. The correlation between average tax revenues as a share of GDP over the period 1970 to 2007 and real GDP per capita growth over the same period is very close to zero for the 22 countries for which the OECD has produced data over the full period. Switzerland, which had the second lowest tax revenue-to-GDP ratio, had the lowest growth rate of GDP per capita. The UK was close to the median for both tax revenues and growth.

Tax take vs. growth in GDP per capitaThis suggests that there is scope for higher taxes to be part of the solution to the UK’s deficit problem (when the economy is strong enough to allow them to rise) and that these higher taxes are no more likely to affect economic performance than cuts in public spending.

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