Jeremy Warner: Competence, not ideology, is all that matters in economics

Why are we having a national debate over the relative merits of big and small government? Free markets may seem manifestly to have failed us over the last two years, but through the tax revenues they have generated in the past they have also supported a burgeoning public sector which is now looking ever more unaffordable.

Even if "bigger" government were thought desirable after the supposed failings of unfettered capital markets, it would also seem to be unobtainable. It's small government we are heading for, not big government. Without a thriving private and financial sector, it is impossible in today's globalised environment where the taps of international credit can be turned off at the flick of a switch to have a big public sector.

The "New Labour" government which took power in 1997 seemed to recognise this truism better than any of its Labour predecessors. It promised to keep personal tax rates low and deliberately encouraged the City's freewheeling ways with light-touch regulation and highly competitive tax arrangements.

For a while it worked, with the Treasury's coffers filled to overflowing by the money that was pouring in from the City. Now that these revenues have gone – perhaps they were largely illusory in the first place – Labour seems to be reverting to type by imposing a cynically populist but fiscally futile squeeze on the rich.

Even by the capricious standards of the politician, a more cynical reversal in position is hard to imagine. Two years ago, ministers were only too pleased to lap up the tax revenues being generated by the City, whose success they attributed in no small measure to the genius of their own policies. Now that these revenues have proved a windfall, rather than the permanent enlargement of the tax base Gordon Brown once imagined, policy is turning viciously against the hand that once fed it.

I have to confess to a growing sense of bemusement over the big government vs small government debate. On the one hand, the banking and accompanying economic crisis seems to have made the case for more state intervention and regulation, particularly of financial services, but on the other it is brutally apparent that there's no money for a big state sector even if it were thought appropriate.

What's more, by taxing high earners more, the Government seems only to be further undermining any chance of returning to the boom in tax revenues it was enjoying two years ago. According to PricewaterhouseCoopers, the Budget measures will make Britain one of the two least competitive tax regimes for high earners in the G20. In time, this is bound to have its effect on the overall size of the tax base.

Fiscal crises are hardly ever solved by raising tax rates. As tax rates rise, the law of diminishing returns soon sets in as those who have the ability to move to more hospitable climes vote with their feet and those who can't merely work less hard, retire earlier or find ways of avoiding the higher taxes. What's going on is like a 21st-century version of the window tax. People would rather brick up their windows and live in darkness than pay the Revenue's demands.

The only realistic solution to a fiscal crisis is to shrink the size of the public sector. Of course, it is perfectly possible both to downsize the state and have a more politically controlled economy. The state sector can also be expanded substantially through nationalisation, and indeed already has been in Britain through effective public ownership of a number of banks. So there can be more state control even though the economy as a whole may be the poorer for it.

Is this really the way our national politics is shifting? I think not. But it is not just the political left within Labour that thinks greater state activism is the answer to all our problems. Lord Mandelson, who once said he was intensely relaxed about people getting filthy rich, wants a lot more state intervention too.

Lord Turner, chairman of the Financial Services Authority, is not a Labour peer, but he is part of the prevailing political consensus. In a speech yesterday, he repeated claims that the macroeconomic costs of tighter regulation for banks should be set against the benefits of low risk to financial stability. This is the excuse governments always give for meddling in the economy.

It is worth recalling that the first post-war Labour government lost the election of 1951 in part because of electoral aversion to further nationalisation, and then spent 13 years in the political wilderness squabbling about whether and how to jettison its Clause IV socialist traditions.

Circumstances are profoundly different today. Back then, voters were rebelling against years of austerity and experimentation in state control of the economy. Today, it's free market economics and the culture of personal enrichment which are being challenged.

In the final analysis, the British electorate tends to vote not on grounds of economic ideology, but on that of economic competence. On this latter measure, Labour has manifestly failed, just as John Major's government was judged to have failed after Britain's ignominious exit from the ERM.

It doesn't matter how far Labour shifts its ideology to match the assumed public mood. It's too late for that now. What supreme irony that a supposedly centre-left party is about to lose out to one whose roots lie in the ideas of economic liberalism and a small public sector.

Despite its erstwhile acceptance of the importance of free markets, Labour has fallen into the same trap as all its predecessors – spending beyond the country's means and then vainly trying to tax the successful and wealthy to make up the difference. There is an air of fin de siècle about the present wallowing around in the old ideas of big government and state activism.