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Taxes which raise the UK's growth rate must be the priority in Budget 2013

    Tim Montgomerie had an interesting post over at Conservative Home yesterday, suggesting that there are three broad strands of Tory demands from the Chancellor ahead of the 2013 Budget – all entailing tax cuts.

    The first are what he calls the competitiveness caucus, who want cuts to business taxation alongside various attempts to institute market reforms in the economy. The second are those who want to focus on the cost of living (things like fuel duty, introducing a 10p income tax rate and council tax). The third want a big bang of deficit-financed tax cuts, mainly, like the competitiveness group, on businesses.

    Tim is right to point out that none of these groups seem to be saying much about spending, which is the key to closing the deficit. In fact, if most Tory MPs were serious about cutting, they would not just have for granted that the recent Dilnot reform to social care, which will open up another ever-widening largely pensioner liability for working age taxpayers to finance, was an unadulterated good.

    My own view is that the next spending review can’t come soon enough, and it must really focus on cutting government current expenditure without any ring-fences or sacred cows and fundamentally re-examine eligibility for government transfers (in which I include public sector pay). Salami slicing budgets which have already seen large reductions whilst protecting the things which will be the key drivers of future spending would just seem bizarre.

    So what about the merits or demerits of the three different groups of ideas?

    The first thing to say is that I don’t find Tim’s distinctions particularly helpful. It sort of implies that these tax cut proposals are a clear choice between helping particular groups – ‘businesses or hard-pressed families’.

    In my view, and Andrew Lilico has written about this extensively recently, the UK has a medium-term growth problem. The squeeze on living standards that lots of the public is facing is a consequence of this slow growth and above target inflation. What is really required then is a dual approach to raise the potential growth rate of the UK economy whilst undertaking supply-side measures to try to cut the cost of things.

    The evidence is crystal clear that business taxation is by far the most damaging type of taxation for a country’s growth rate. Therefore, if the diagnosis is that the UK needs to raise its medium term growth, then the ideas of the first and third Tory groups will be far more economically beneficial than the second. Pro-growth policies are pro-poor in the medium term and help to raise living standards for all.

    Some of the other tax cuts mentioned by the second group, on the other hand, would help hard-pressed families in the short-term by putting cash back into their pockets, but would do nothing to enhance our medium-term growth prospects. They are also incredibly broad-based, meaning a large loss of revenue would be required to produce any significant gain to individual families. And they would be treating the symptoms of slow growth and high inflation rather than addressing the causes.

    The first group’s focus on taking measures to induce market pressure in certain industries, and reduce costs by deregulation and the removal of subsidies to inefficient energy sources (like the measures advocated by Dominic Raab in his recent paper) would do far more to benefit the long-term health of the supply-side and help keep the cost of living lower on an on-going basis.

    So if tax cuts and deregulation for businesses is the way to go, then why not go the whole hog and slash taxes in the way the third group have outlined, borrowing more to do so if necessary. As appealing as that may sound, huge borrowing-financed tax cuts would be a mistake. First, because to work they would need to be permanent, raising the structural deficit without the Government having thought about where the extra spending cuts would eventually come from to finance it. When we are still borrowing over 8% of GDP, this would be a risk that I would not be willing to take as Chancellor. Second, because there are other issues to do with tax simplification which would need to considered before these sorts of large tax cuts could be effectively seen through.

    That said, there are clearly taxes which could be cut now and actually increase revenues. Capital Gains Tax is above the revenue-maximising rate on the Treasury’s own model, and well above the optimum rate for economic efficiency. The recent changes to stamp duty have caused large distortions to high-value property markets for little revenue gain. Research suggests Air Passenger Duty is self-defeating. And announcing a clear, more ambitious path of Corporation Tax cuts could induce firm location decisions today.

    On balance then, I guess Tim would define me as part of the competitiveness caucus. Business taxes should be the priority, because these have the largest effect in raising medium term growth. And while the cost of living is an issue, this can be more effectively tackled by proper supply-side reforms (deregulation of planning, a market based energy policy etc) and growth-inducing tax cuts than by annually manipulating property and consumption taxes to compensate people for the current squeeze.

    If these are really the types of thinking on the table then there is a clear trade off: relatively unpopular tax cuts which will enhance medium term growth, or popular ‘cost of living’ tax cuts which will do little for growth.

    My advice to the Chancellor is: take the long-term view.

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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