6 June 2016

The tax paradox

By J.R. Lucas

In order to eliminate a deficit, it is necessary either to cut expenditure or to raise taxes. But cutting expenditure quickly is difficult: public money is highly addictive, and the withdrawal symptoms painful. Additionally, the officials who administer the cuts tend to be to be lenient towards administrative costs, and are inclined to cut nurses, teachers, and others actually providing public services.

(It might seem a good idea to cut the money allocated to the Inspectorate of Quota Compliance, but so doing could alarm many public employees, who will rein in their expenditure and seek more liquidity, in case the axe falls on them too. Plus, it is not obvious that Inspectors of Quota Compliance are well qualified to do other things, and will be able to get another job. Many of them may end up unemployed, drawing unemployment pay which will eat up most of the savings obtained from not paying them a salary. Although it may well be the case that much public money is wasted on paying people to do work that is of little (indeed often of negative) value, cutting out waste is a difficult and slow process, and may be counter-productive because it increases uncertainty.)

So if public expenditure cannot be cut, taxes must go up. Most of the existing taxes are difficult to raise. The top rate of income tax, it seems, brings in less revenue than a lower one would. VAT is about as high as it can be without causing a black market to boom. Although there are calls for taxes on alcohol and tobacco to be raised on ground of health, to do so would greatly increase the quantities brought in from Europe.

The tax on petrol was unpopular. One can understand the political reasoning that led the government to shrink from imposing the increases already scheduled by its predecessor, but from an economic point of view, it was perverse. In fact it ought to be generalised to a carbon tax on fossil fuels, starting at a low level, but increasing every six or twelve months. It would be easy to collect, difficult to evade, widely based, and have benign effects on the world’s climate. It would not create great disruption if it started low, and by increasing only gradually, would give people time to adjust their life-styles and business practices. And it is unlikely that other governments would long forgo the opportunity of raising revenue with the added bonus of its being a positively virtuous imposition.

So in the short term, the only way to cure a big deficit is to raise taxes. But this, it is claimed, will stifle growth, and make the recession worse, since then taxpayers will have less money to spend, which will reduce sales, and cause a double-dip recession. Rather than balance our budget, even in the minimal sense of raising enough money by taxation, we should go on borrowing money, and merely express an intention to reduce the deficit in time to come. Of course it is true that if a taxpayer has to pay more taxes, and is unable to increase his income, he will have less money to spend. But other people will have more. Purchasing power lost on the swings will, by and large, be gained on the roundabouts.

A second objection is more weighty: money repaid to banks may not get lent again, but will simply “disappear”, as bankers reduce the ratio of loans and deposits to a safer level. This has been happening: there is a mortgage famine. But reducing the ratio of loans to deposits is a crucial safeguard against a loss of trust, resulting in a run on the banks and a collapse of the whole banking system.

In calculating the load factor, it is necessary to enter not only the probability of different demands being made at any one time, but also an estimate of how bad it would be if the load were ever too much for the system. If a bank is “too big to fail”, because a failure on its part would cause a collapse of the whole world economy, it needs to be very safe indeed. Various safeguards have been tried, particularly in the United States, such as separating the money-handling business from the risky lending business, or preventing banks from becoming too big, and more precautions have been suggested.

But it may well be the case that in the immediate future, repaying debts may diminish the money supply, as banks draw in their horns instead of lending again what has been repaid. Economic activity will be reduced, but the whole economy will be less precarious. As in many other walks of life, we have to pay in order to gain security. The Thames barrier cost a lot of money. Money spent on the armed forces could have been spent on welfare or the National Health Service. Often in retrospect it seems that insurance premiums were wasted, But with the financial sector, as with the armed forces, the mere fact of being visibly able to deal with an emergency makes the emergency less likely to occur.

The financial crisis is due to a lack of trust, which leads to a loss of liquefiability and hence to a demand for complete liquidity.

The immediate need is to balance the budget, which means increasing tax revenue to pay off creditors. A period of reduced economic activity may be needed in order to consolidate loss of liquidity in the system made up for by restored confidence in government. But in any case it is better a double-dip recession than a full-scale depression and slump.

J.R. Lucas is an academic and author, and Fellow of Merton College, Oxford (http://users.ox.ac.uk/~jrlucas).