Economic View: A strike against the Treasury

Tax hikes or tax strikes? Or maybe both?

Tax hikes or tax strikes? Or maybe both?

Throughout the developed world, tax revenues are falling. Some governments, like Germany and now the UK, are responding by increasing tax rates. Others, like the US, are cutting rates in the hope that this will stimulate economic demand. But whatever the response, the fact remains that revenues are under extreme pressure.

Every few days there is further news of some shortfall in the tax take or some economic evidence that points to such a shortfall. Just last week, Italy's was shown to be running more than 3 per cent below last year. In Germany there was news of negative growth in the final quarter of 2002 and predictions of another bad quarter now. A return to recession would further cut revenues that have already been downgraded several times.

In the US there is every prospect that the fiscal deficit will exceed 3 per cent of GDP, while here private sector forecasts suggest that the Chancellor will miss his borrowing requirement of £20bn, revised upwards only last November. The January figures for revenue and spending showed a surplus of £3.1bn but January is always a big month for revenue. Last year the surplus was £7.2bn.

What's up? In any economic downturn you would expect tax revenues to be hit, just as you would equally expect spending to rise. In the left-hand graph above, you can see the impact of the economic cycle on the spending side of the equation for the Group of Seven countries. In general, spending fell as a proportion of GDP during the 1980s boom, rose during the early 1990s recession, fell in the 1990s boom and is now rising again. (Note, incidentally, how the UK briefly had the second-lowest spending in the G7 in 2000, but is now projected by the OECD to become middle of the pack, with three countries having lower spending and three higher.)

A rise in the budget deficit during a downturn is fiscal policy performing its normal function as an automatic stabiliser. There is, further, a perfectly respectable argument for over-adjusting for the downturn – in other words, allowing the fiscal deficit to rise by more than it would do were there no changes in tax rates or discretionary public spending. Here in Britain we are doing just that by increasing spending, while in the US they are over-compensating by cutting taxes.

The issue is not so much whether these policies are right or wrong but whether there is something else happening that the economic ministries around the world have not picked up. We all know our Chancellor has got his sums wrong in that the fiscal deficit is growing faster than the Treasury expected. But so have his counterparts in the US, Japan, Germany, France and Italy. The only G7 country that does not seem to have a worse-than-forecast deficit is Canada, and it has been growing at more than 3 per cent a year, which might explain it.

Why are revenues coming in too low? In so far as growth has been below expectations, you would expect a shortfall, but there seems to be a decline over and above what you might naturally expect.

There are two broad explanations. One is that there is more gearing in the tax system than treasuries around the world realised. Take Britain. Some revenue streams have held up – corporation tax, for example, seems to be doing quite well. Capital gains tax, on the other hand, is down because there are not many gains around these days. Meanwhile, stamp duty will fall as housing turnover at the top end declines.

Even income tax is coming in below projections – despite the fact that the number of people who are employed is at record levels – because many high earners are seeing savage cuts in their pay. The top 1 per cent of income tax payers contribute nearly a quarter of the total, while the top 10 per cent pay more than half. Income tax revenue in January was 6.5 per cent down on last year.

You can see the effect in the second graph. Whereas in past years the public net borrowing requirement was either at break-even or, in the case of 1999-2000, in huge surplus, now it is nearly £17bn in the red. Hitting the £20bn borrowing target for the financial year to the end of March will be dodgy.

This may be the whole story. If so, it does not reflect particularly well on the Treasury not to have fully appreciated the gearing in our tax system. It ought to have spotted that, as revenues during the boom came in well over estimates. But at least there is nothing sinister happening.

There is, however, a second explanation. This is that people – not just here but in many other developed countries – are starting a tax strike.

There is some evidence in the US that tax compliance has declined. This may in part be because of under-funding at the Internal Revenue Service, which seems as a result to have become less good at collecting the money. There may be some reluctance in Germany to pay tax as a result of a sense of outrage that the new government should break tax promises so soon after being re-elected. And here? It is impossible to know, but increased taxation at a time of zero inflation may be increasing people's propensity to try to save tax.

There is an element of consent in many tax payments, together with many perfectly legal ways of cutting the tax bill. Some are simple, like popping over to France to stock up on booze. Most commercial schemes are much more complicated and require months to set up. People did not bother because, well, the gain seemed marginal and governments have to have revenue.

But if people feel their money is being wasted, then they reassess what can be done, and there is no shortage of expensive tax specialists to help them do so. Expect them to be busy in the months ahead.