Be Thankful They Don’t Take It All

Governments will need to find new ways of raising tax.
Economist StaffSeptember 4, 2009

“If you drive a car, I’ll tax the street/ If you try to sit, I’ll tax your seat.” The Beatles may have been joking when they wrote the lyrics of “Taxman”, but the authorities could soon be tempted to use some of their ideas.

The credit crunch has revealed as many holes in government finances as the Fab Four found in Blackburn, Lancashire in “A Day in the Life”. Some nations, including America and Britain, have lurched into budget deficits of more than 10% of GDP, a scale of shortfall not normally seen in peacetime. That may simply be an indication of the depth of the recession. But it may also be a sign that tax revenues have become more volatile, making it much harder for governments to judge the health of their finances.

Instead of storing up surpluses in the fat years so as to cushion their finances in the lean ones, governments were sorely tempted to spend their inflated revenues, in the hope of buying some electoral popularity. A European Commission report published earlier this year concluded that tax-revenue growth was “exceptionally high” in most European Union countries during the period from 2003 to 2007. But even with the money pouring in, Britain actually managed to increase its spending at an even faster rate.

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A bust in tax revenues has swiftly followed the boom. What explains such marked volatility? The property cycle is one possibility. Higher property prices boost tax revenues directly, through levies on capital gains or on transactions (such as stamp duty in Britain). They also have an indirect impact via the wealth effect, as consumers increase their spending in response to improvement in their balance-sheets (see article). Britain and America raise a higher proportion of their revenues from taxes on property than other countries. The commission notes tartly that “revenue windfalls during asset-price boom periods are often misread as durable improvements in the underlying budget position.”

Another explanation is that both Britain and America have been highly dependent on the finance industry. In the good years, bumper bank profits inflated both corporation-tax receipts and the income-tax take from bonuses. The credit crunch has slashed the revenue from both.

The banking boom was also partly responsible for the widening wealth and income inequalities in the Anglo-Saxon world. The result has been a narrowing of the tax base. In 1986 the top 1% of Americans were responsible for 25.4% of all income taxes paid; by 2005 their share had risen to 38.4%. Since the pay of these plutocrats is highly variable, a bad year for them means a bad year for the taxman.

Even though bank bonuses are on the rebound this year, the industry is smaller than it was. Unless the system is changed, tax revenues from the financial system may never reclaim the heights they reached earlier this decade.

As countries try to eliminate the shortfall, it is tempting to hope that they will do so purely by cutting waste in public spending. But they won’t (and probably can’t). So they will find other things to tax.

That task will be made more difficult by the greater mobility of corporations (and high-earning individuals) in the modern world. Competition among EU member nations has forced the top corporate-tax rate down by ten percentage points since the mid-1990s, according to Elga Bartsch of Morgan Stanley. In America, low-tax Nevada is among those trying to lure businesses away from high-tax California (where tax revenues have been extremely volatile).

Competition also explains why governments are unlikely to be tempted by the recent suggestion of “Red Adair” Turner, the head of Britain’s financial services regulator, to impose a levy on capital-market transactions. It would only work if everyone else, including the Swiss and Singaporeans, did the same. Instead their energies will be focused on closing “loopholes”-witness the recent assault on offshore tax havens. That may result in some one-off windfalls, but not enough to plug the revenue gap.

Because governments are limited in their ability to tax the mobile, they will tax the static. As noted above, property is already highly taxed in Britain and America (and may be years away from another boom). So consumption taxes are the more likely answer. They are hard to avoid and fairly stable, since spending patterns do not change sharply from year to year. But they tend to fall more heavily on the poor than the rich. A crisis created by investment bankers will be paid for by shop assistants and office cleaners.