By Martin Wolf
Does the financial crisis change anything fundamental in the age-old debate about public expenditure and taxation? I would argue that it does not do so.
What the crisis means in the UK is that the public finances are now on an unsustainable path: national income is substantially and, quite probably, permanently lower than people used to think; the amount of revenue taken by the existing tax system out of any given national income is lower than expected; and public spending is permanently higher than people thought, largely because the stock of debt will be bigger.
How should policymakers respond to this unpleasant discovery? If overall public spending commitments on goods and services were about right before the crisis hit, then some part of the adjustment now must be a permanent reduction in the level of public spending.
If people are in aggregate poorer, they must reduce their aggregate spending. It seems almost inconceivable that they will only want to cut their private expenditures. Public spending will need to be cut, too. It will hurt, but it will have to be done.
More difficult is deciding whether public spending should be cut in proportion to the reduction in national income, by more than that or by less. The right answer is probably roughly in proportion, on the assumption that at the margins we value public and private spending equally.
Of course, this judgement can only be made by democratic choice. Elections will provide a way for people to decide. Equally, they will offer the only answer we can find to the question of how much additional redistribution, over and above that inherent in existing commitments, is needed to cushion the most hard-hit.
If the long-run proportion of public spending in national income is to stay much the same as planned prior to the crisis, the long-run proportion of receipts should remain the same, as well. But, given the structural shifts in economies, this will now require a different structure of taxation. We have to tax what exists, not what has disappeared.
Many would argue that this is also a good time to reform the tax system. But it is easier to reform taxation when there is money to be given away. It is then far easier to make almost everybody a bit better off. So, in practice, this is not going to be a time for radical reform. What is needed is simply to raise new tax revenue as painlessly as possible.
This is not an argument in principle against radical restructuring of the tax system. The general rules are well known: tax “bads”; then tax rent; and then tax the rest in as neutral a manner as possible. A carbon tax is a good example of the former. A tax on land rent is a superb example of the latter. Finally, make income, capital gains and sales taxes as comprehensive as possible, with the minimum exemptions and exceptions.
Progressivity should be achieved in the overall structure of tax and spending. Highly progressive income taxes are a folly, particularly for a country dependent on internationally mobile people and companies. For this reason, the recent introduction of a 50 per cent income tax in the UK will almost certainly prove a mistake.