Repeating old policy mistakes

A reader commenting on my article on economic growth asked, quite reasonably, what my views are on the best way to promote economic growth. My response was that it is easier to highlight what not to do than to make positive recommendations. The reason is that an acceleration in economic growth often results from a random conjunction of favourable external conditions and a willingness by policymakers to keep out the way. Politicians, lobbyists and bureaucrats haven’t any real idea of what works and what does not work. In this article I focus on the systemic policy bias against saving and investment.

The metaphor of ships navigating in thick fog is apposite. Those at the helm just spray money at things that some lobbyist claimed was important. Readers should bear that in mind when assessing the overwhelming flood of guff that accompanied the announcements in the Spending Review published on June 11^th.

I should emphasise that context is extremely important. There is a very large tension between two different ways of viewing tax and spending policies in modern welfare states. The classic view of taxation follows Colbert’s aphorism that the goal is to pluck the goose with the least amount of hissing. The ideal tax system is one with broad-based taxes and low or moderate marginal tax rates. The lower are tax rates, the lower will be pressures to carve out exemptions for all kinds of worthy reasons. Income redistribution is largely achieved by the allocation of public spending rather than via the tax system.

The problem for most developed countries is that a Colbert-type tax system cannot collect sufficient tax revenue to fund the redistributive and other expenditures expected by voters in welfare states. Marginal tax rates of 20% on either or both income and expenditure create substantial incentives for behavioural changes which erode the tax base unless any exemptions are strictly limited and enforced. For example, exempting food from consumption taxes leads to many difficulties.

In any case, most politicians and tax officials do not accept the requirement that broad-based taxes should be neutral. The exemption of food from VAT is only a small example. Whether it is repairs to listed buildings or renewable energy installations, there is an endless list of “good” reasons to exempt individual products or categories from expenditure taxes. The same applies to income taxes. Further, most voters accept the argument that income taxes should be redistributive, even when this is patently self-defeating in the medium or long term.

This kind of approach is reinforced by delusions about so-called windfall taxes, which are presented as once-off imposts that, because they aren’t recurrent, should not affect the behaviour of companies or individuals. Of course, the targets of such taxes don’t buy the logic with the consequence that windfall taxes collect limited revenue after the first year or so but have a hugely damaging impact on economic incentives. The oil and gas sector has been a particular target for such taxes around the world. Inevitably, it has adopted avoidance strategies designed to minimise their impact – at considerable cost to all parties.

The difference between the two approaches is central to any discussion of economic growth because of different views about how savings and income from capital - whether interest, dividends, or capital gains – should be treated. Under a broad income tax system, consumption that is deferred through savings is taxed more heavily than immediate consumption. The returns on savings out of post-tax income are taxed again. Since it is difficult, both practically and politically, to tax the income earned from savings invested in housing, the consequence is a heavy bias to investment in housing rather than other assets. The bias against saving is increased if the income tax system has marginal tax rates which increase significantly with income.

To reduce the impact of the bias against savings, many tax systems allow for privileged savings vehicles by which either (a) savings are made out of pre-tax income with income taxes imposed when the savings are spent (pensions), or (b) savings out of post-tax income are held in special accounts that are exempt from income and similar taxes (ISAs, etc). Tax authorities tend to dislike such arrangements and lobby to reduce the limits on how much can be put into such schemes.

Their reasoning is understandable but short-sighted because they focus on the immediate loss of tax revenue rather than the longer-term impact on savings. Further, the boundary between labour and capital income is quite fuzzy, so that schemes which allow taxes to be deferred can become vehicles for what tax authorities view as tax avoidance, though others may see things differently.

In the case of entrepreneurial activity, the boundary between labour and capital income is entirely absent, so the problem of devising tax arrangements that encourage entrepreneurs to grow their businesses is even more difficult. Tax authorities tend to understand large companies because they are bureaucratic organisations like themselves. They have almost no understanding of small businesses and, especially, entrepreneurs who are seen as being involved in either tax avoidance or potentially fraudulent business practices. Since there is no shortage of examples to sustain such views, sympathy for the issues that affect small but rapidly growing businesses is minimal.

There is a strong structural bias towards large businesses as the primary vehicles for innovation and investment. The tax system allows them to spread the risks of new investment and favours investment via retained profits. Lobbying and visibility means that policymakers see the investment through the prism of corporate interests rather than via the process of competition and creative destruction that sustains productivity growth in truly dynamic economies.

This bias is reinforced by the dominance of financial firms in controlling the flow of household savings via either pension funds or investment vehicles such as unit and investment trusts. There are valid reasons for promoting the pooling of savings to reduce risk and achieve economies of scale in management. Still, we should remember the aphorism that it is investment advisers and managers who own yachts, not their clients. The costs of converting savings into financial assets are high and have resisted compression when dealing with small and medium businesses. The consequence has been to channel most household savings to investments in large companies in either the UK or abroad.

There are tax incentives for investments in start-ups and growing small businesses but anyone who has looked at the rules which govern the schemes will know that the conditions to be met are both cumbersome and onerous. The reason for this, of course, is that the Treasury wants to give the appearance of supporting small businesses while not actually foregoing much tax revenue. Again, the advantages lie with investment via financial sector intermediaries – e.g. Venture Capital Trusts - who impose large costs on the process.

Accelerating economic growth requires an increase in both savings and investment. Funding more investment, especially by the public sector, without additional saving just adds to the level of debt and pushes up the long-term cost of financing that debt. The most important contributor to the low level of national saving is the large deficit run by the public sector. The official dogma that public investment funded by government borrowing can raise per capita incomes assumes a parallel world that bears no resemblance to the UK economy in 2025.[1]

Beyond the big macro issue, what are the old policy mistakes that the current government is repeating? I will highlight two issues but there are many more. I will start with a classic end-run around borrowing rules. In his Substack article on the Public Spending Review, Sam Freedman – both a former Special Adviser and a prominent member of the Institute of Government praises yet another Treasury strategy to pretend that liabilities are not really public debt.

“The new fiscal rules also allow government to use loans and guarantees to attract private capital without it appearing as debt, and the Treasury have set up a number of schemes, particularly around green energy and housing, to make use of that.”

This tells us everything we need to know about both politicians and the bureaucracy. It is a world of pretence in which economic reality has no weight. Fudging debt rules to fund capital spending almost always comes to a bad end – remember the fate of many PFI contracts, even though they achieved genuine reductions in unit capital costs. First, such arrangements push up financing costs relative to public debt because of complexity and uncertainty. Second, they are often used for projects that are poorly conceived and generate low returns. Most are simply public consumption dressed up as investment.

The examples of green energy and social housing are simple examples of those defects. The government is not willing to take the costs onto its balance sheet, since other priorities – e.g. health – rank higher. Nonetheless, politicians who condemn private equity for the detrimental effects of financial engineering rush headlong down the same path. The impact on economic growth will be entirely negative.

What is arguably even worse is that Mr. Freedman, the author of a book about the UK called The Failed State, praises political and fiscal deception because it happens to be applied to causes that he appears to support. Financial institutions and large businesses won’t turn down the opportunity to make money by taking advantage of such arrangements. However, nothing changes the reality that this is just crony capitalism in a thin disguise.

Financial manipulation is being used to underwrite the luxury beliefs of the Westminster elite. Looking at such behaviour, no investor or innovator can have any confidence that they will be permitted to earn a return that will compensate them for their investments and the risks that they bear. If the game is crony capitalism, it might as well be played in places that are both operate competently and are growing rapidly.

The second, and related issue, concerns what return savers/investors can expect to earn and how it will be received. Much attention has been focused on the current government’s change to capital gains and inheritance tax, especially they affect family businesses and agriculture. Sadly, that is only the visible part of what is a huge bite that taxes take out of the returns on savings and entrepreneurial income, so we should consider the numbers.[2]

Suppose that over a period of years an individual sets aside £200,000 of pre-tax income to invest in a small business. With a marginal income tax rate of 40% the actual investment would be £120,000. There is a 50:50 chance that the small business will succeed. If it does it will earn 10% real return on the investment with an inflation rate of 2%. That return will be subject to corporation tax of 25%, leaving £10,800 per year available for dividends or reinvestment. Paid out as dividends subject to 40% income tax, the business investment has a 50% chance of earning a net income of £6,480 per year. Depending on how risk averse the investor is, that is worth a maximum of £3,240 per year or a real return of -0.4% on the original pre-tax income that was saved.

As an alternative, the same individual could put the £200,000 pre-tax sum into a pension fund and might earn a real return of, perhaps, 4% in the pension fund.[3] Since the return on the pension funded is taxed as income when the pension is taken but with a 25% tax-free allowance, the net benefit to the investor is £8,400 per year or a real return of 2.1%. The post-tax nominal return on savings via a pension fund is nearly three time the nominal return on a small business investment, and that assumes minimal compensation for the risks involved in investing in a small business.

That is only part of the story, because we should allow for the valuation of the assets on exit or retirement allowing for capital gains tax. The price-earnings ratio for small businesses is rarely greater than 5.[4] If we assume that the savings are held for 10 years, the post-tax nominal value of the pension fund is about £250,000 incorporating the 25% tax-free allowance. To match that risk-adjusted post-tax valuation the small business investment must earn a gross real return of 51%.

The numbers – a 4% net real return on a pension vs a 51% net real return on a small business investment – highlight the extreme bias against small and start-up businesses built into the UK tax system.[5] This is not new, but it is greatly exacerbated by increases in the marginal income and capital gains tax rates for potential investors in small businesses. If the marginal income tax rate were to increase to 45%, the gross real return on a small business investment would have to exceed 58% to match the return on saving via a pension fund.

The most important single measure to reduce the bias against small business investment would be to ensure that all investments in small businesses are made from savings out of pre-tax rather than post-tax income. This will be fiercely resisted by the Treasury, partly because it reduces immediate tax revenues and partly because they believe this would open the door to potential tax avoidance schemes.

So, we go round in circles. If any government is serious about economic growth, it must correct the bias against saving and, especially, the bias against saving in small and growing businesses. To do that means accepting a reduction in tax revenues and public consumption. There is no sign that the current government even understands the problem, let alone that it is willing to address it. Hence, the rhetoric about the importance of economic growth is vacuous. It is without meaning because there is no willingness to adopt the policies required to accelerate growth. We are truly back to the 1970s.

[1] For the avoidance of doubt, this is not a general proposition along the lines “public bad, private good”. It is merely an observation that, given the current government’s preferences and the competence of the bureaucracy, investment in the next five years controlled by central government will contribute less to economic growth than any plausible outcome when an equivalent amount of investment is made by private businesses responding to market incentives. This assessment is valid even though the current government remains determined to mess up large parts of the economy.

[2] The numbers shown are purely illustrative and are not intended to reflect the tax circumstances of any individual or business.

[3] The net return earned by the pension fund is after payment of corporation tax on profits, so the pre-tax return on its investments might be 5% in real terms, since large companies rarely pay the nominal corporation tax rate on their profits.

[4] Calculated using earnings after corporation tax.

[5] My calculations are, in practice, generous to existing tax system if inflation is more than the 2% per year assumed. Both income and capital gains taxes are based on nominal rather than real returns. This exacerbates the bias against business investments.