Public Sector

Should the return of high taxes be a temporary phenomenon or should governments take the opportunity to keep them high for social purposes once budget deficits are under control? Read Martin Sandbu’s take and leave your comments below.

By Martin Sandbu

The financial crisis has left it to the public sector to revive flagging economies around the world. In good Keynesian fashion, governments are becoming spenders and borrowers of last resort, picking up the slack in demand from rapidly deleveraging households and businesses.

In the process, they are driving public finances deep into the red. The budget that the UK government unveiled last week plans for a deficit of 12 per cent of gross domestic product this fiscal year – the largest ever in peacetime. Once the recession abates, deficits will have to be reduced and public debt stopped from spiralling. In many countries – certainly in the US and the UK – it will be impossible to do this without markedly increasing taxes as well as cutting spending. Both right-wing and left-wing political parties, and their constituencies, will have to come to terms with this.

What will be the consequences of this necessary increase in the government’s take of economic surplus – and what should they be? Should tax increases be limited to what is necessary to put public finances back in order, and be cut back once the fiscal hole has been plugged? Or should this be taken as an opportunity to permanently increase the state’s control of the economy?

Some answers to this question must depend on what one thinks is the appropriate role of the state. If one thinks its role in the economy should be minimal, taxes should be reduced as soon as the deficits are eliminated. If one thinks the state should be more actively involved in shaping the economy, one may take the need for higher taxes as an opportunity for permanent reform.

But it seems there is at least one argument for permanent rather than temporary tax increases that can sidestep the old controversy about the right size of the state. It is that in many countries, the current tax systems are hopelessly inefficient. Here are two examples: The US tax system is riddled with complexities that undermine its ability to raise government revenue in as efficient a way as possible. And most tax systems fail pathetically to set taxes so as to adequately alter the inefficient pricing of activities with harmful effects, such as carbon emissions which are still too cheap.

If this crisis brings acceptance of the need for new taxes, those taxes should be designed in a way that brings the overall tax systems closer to efficiency while raising higher revenues. If they are, then they should be permanent – since these are the kinds of taxes we should have. If deficits gradually turn into surpluses, the older, more inefficient bits of the tax system are what should be dismantled.

If, for example, a carbon tax is introduced gets the price of carbon emissions to where it should be – where it internalises the cost to society of emissions – while at the same time raising needed public revenue, then it should not be lowered again even if public finances one day make it possible. Rather, it should be kept in place, and any surpluses should be confined to reducing other taxes, or to financing public goods deemed necessary (that, however, will depend on the appropriate size of the state).

So there is a case for: (a) tax increases in light of the current crisis in public finances, which should be announced now but come into effect once the recession is over; and (b) these tax increases being permanent, but they must be more efficient than the existing system.

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