Vince Cable has been out and about this week, burnishing the egalitarian credentials of the Liberal Democrats at their conference, with proposals to limit increases in executive pay coming fast on the heels of the Keynesian stimulus prospectus he set out in a pamphlet last week. The Business Secretary has not yet crossed the Keynesian rubicon on fiscal policy – and could not do so whilst retaining his Cabinet seat – but he is straining at the limits of the Coalition’s economic policy.
Last weekend, Danny Alexander set out some re-profiling of capital spending commitments, in attempt to put some meat on the bones of his talk about economic growth. But what really caught attention was his announcement that the key tax pledge for the next Liberal Democrats’ Manifesto would be to raise the Personal Tax Allowance (PTA) to £12,500. This garnered the headlines the Chief Secretary to the Treasury would have wanted: “zero tax for low earners” and so on. But is it really progressive?
The table below – drawn from an IPPR briefing note by Kayte Lawton – shows the distribution of the gains from this policy across households:
Distributional impact of raising the personal allowance to £12,500 in 2011-12 (IPPR Tax-Benefit Model)
The table shows that the policy is broadly regressive. This seems counter-intuitive, but it’s obvious when you give it a little thought. Raising the tax allowance gives everyone a tax cut, not just low earners, unless it is offset by reductions in the higher rate threshold or other measures. It is particularly valuable to households with two full-time earners who tend to be located higher up the income distribution. It doesn’t help part-time low earners, those earning too little to pay tax, and those in workless households.
There are at least three ways of responding to this charge. First, you could argue that the policy is not about greater equality in household incomes, but simply about cutting taxes for low wage earners. If so, it is an extraordinarily expensive way of doing it. At the last election, the IFS estimated that only 7% of the £17 billion cost of increasing the PTA to £10,000 would go on taking 3.6 million of low earners out of tax altogether.
Second, you might argue that any single tax proposal must be seen alongside other changes to the tax system, particularly those that are more progressive. This is what the Liberal Democrats’ 2010 Manifesto did – setting their proposed increase in the PTA alongside proposals for a Mansion Tax, increased Capital Gains Tax, and the withdrawal of Higher Rate Tax relief for pension contributions. However, most of these were dropped (except an increase in CGT to 28%), leaving the progressivity of the package badly undermined. In coming years, any increase in taxes for the wealthy are likely to be traded off with the cost of cutting the 50p top rate of tax.
The third response might be to accept that an increase in the PTA is not progressive and to use tax credits (or in future the Universal Credit) to sharpen work incentives and reward low earners. This is essentially what Labour negotiators said to their Liberal Democrat counterparts during the abortive negotiations after the 2010 General Election. But the Liberal Democrat Coalition negotiating team was dismissive of this response. They clearly associated tax credits with a whole set of perceptions about Brownite statecraft (i.e. that they were complex to understand and administer, and even illiberal).
So we are left with a very big fiscal commitment that gives much more to better off households in the top half of the income distribution than to those it is intended to help. Thus far, the government has announced that the PTA will reach £8,105 in 2012/13, at a cost of nearly £5 billion. We have some £12 billion still to score to reach £10,000 over the rest of the Parliament – and that’s before we get started on a £12,500 PTA.
In neat piece of symmetry, the FT reported this week that the structural deficit may be £12 billion higher in 2011/12 than previously estimated (using the Office of Budget Responsibility’s own methodology). It’s a debatable claim, since it relies on assumptions about spare capacity in the economy and its growth potential. But if the OBR reaches the same conclusion in November, alongside the Chancellor’s Autumn Statement, it will pose a very stark choice for Ministers: do they cut spending and raise taxes still further, threatening to snuff out what little is left of the recovery, or do they push back their projections for closing the structural deficit?
Osborne has always left himself room for the latter path, since he has projected that he will close the structural deficit in 2014/15, whereas his target is to do so by 2015/16. But he will still face very tough choices on tax and spend, and in these circumstances, we can expect the commitment to increase the PTA to £10,000 to be pushed right back to the start of the 2015 tax year. Anything else will look profligate.
What of the next General Election? After years of austerity, it will be an election fought on living standards, in which the squeezed middle’s concerns will dominate. None of the main parties will want to go into the election raising taxes. But how will they pay for tax cuts and a better offer on public services for key voters?
The Liberal Democrats might cover some of the huge cost of raising the PTA to £12,500 by taking £7 billion from higher rate relief on pension contributions. That would be a progressive move, but it won’t cover the full asking price of their new pledge. Other wealth taxes may have been used up in negotiations with the Conservatives over the 50p rate and they are always more politically fraught than at first sight they appear. So Danny Alexander has his work cut out.
For its part, Labour will need to calibrate any tax and spending commitments very carefully. It will not reverse the building blocks of Coalition tax policy in this Parliament, but it is unlikely to follow the Liberal Democrats in extending the PTA. Some combination of universal childcare, a rising National Minimum Wage, and extra, simple to communicate, rewards for work in the Universal Credit look possible.
The dark horse, as ever, is Osborne. Everyone assumes he is planning tax cuts, and doubtless he is. But he’s also likely to use the 2014 Spending Review to earmark extra spending on the NHS and education, which would be astute but limit his room for manoeuvre elsewhere. He has one great advantage, however: he gets to deliver the pre-election Budget. Conservatives have used that advantage before, to great electoral effect.
This piece was originally published in Nick Pearce's ippr blog.