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By Richard Murphy

7 October 2010

All eyes are on how much the chancellor will cut in his Spending Review. But maximising income from tax revenues is just as important, argues Richard Murphy

If there is one obsession in public finance today, it is the forthcoming cuts. In Whitehall, there is talk of little else. In local authorities, quangos and other agencies, the ramifications are feared and plans are being made for the post-Spending Review world.

Few can be approaching the task with much enthusiasm. If you have chosen to work in the ­public sector, seeing so much of it pulled apart cannot be fun.

But are these cuts needed? It was not expenditure that went out of control when the financial crisis hit in 2008, it was income. The graph opposite compares the income and expenditure forecasts of successive chancellors in their main Budget statement between 2000 and 2010. This is a plot of expectation, not outcome – but that is what is relevant in this context. The forecast for income in 2008/09 was £575bn in the 2008 Budget. In fact, that income was £533bn when the accounting was done a little over a year later, and fell again to £515bn the year after that (slightly ahead of forecast, by then).

This fall in income was the surprise that the recession had sprung on government. In comparison, spending has ­remained remarkably controlled.

So it is a shortage of income and not an excess of spending that caused the crisis – the gap between income and spending in most of the years is explained by net investment spending, which can always, and reasonably, be borrowed. There is no proven need to rebalance the government’s accounts at this time, let alone move to a position of fiscal neutrality so that within a few years we might be ­repaying government debt.

Despite this obvious fact, the Treasury demands that spending should be cut now and the opportunity to increase income should be ignored. Chief Secretary to the Treasury Danny Alexander claimed last month that when the coalition came into office, there was a serious danger that the debt crisis that has affected many eurozone nations could be repeated in the UK. ‘But we have taken the country out of the ­danger zone by acting swiftly,’ he said.

The implication was that but for the cuts the UK would go the way of Greece. This is not true. The UK is nothing like Greece. It has a smaller deficit, a smaller tax gap and its own currency and so technically cannot default. But, most of all, as the International Monetary Fund said recently, Greece, Spain, Italy, Japan and Portugal have little or no room for fiscal manoeuvre. The UK has more than a 75% chance of increasing its debt by another 50% of gross domestic product before getting into a vicious debt spiral.

That means the IMF thinks we could have a debt of 140% of GDP without a bond crisis.

As Nobel ­laureate economist Paul Krugman has put it: ‘Central bankers, finance ministers, politicians who pose as defenders of fiscal virtue – are acting like the priests of some ancient cult, demanding that we engage in human sacrifices to appease the anger of invisible gods.’ And he says that the message from those who promote austerity is that these ‘bond ­vigilantes’ – although invisible – must still be feared.

That message is a myth. As evidence, on the day of writing this article, interest on UK ten-year gilts fell below 3%. When inflation is taken into account, this is close to zero, showing how popular UK government bonds are right now and how confident investors are in them. This means the whole premise for cutting now is flawed.

That is not to say we can borrow ­forever, of course. We cannot. But, as the Treasury has admitted, cutting 600,000 public sector jobs will cost 700,000 ­private sector jobs. The belief that the private sector will then pour into the economy to employ these people is ­another myth, as has been proven in ­Ireland where the cuts have already cut hard and deep.

The private sector cannot step in ­because so much of it is dependent on state sector contracts and the part that is not is dependent on overall demand and rising house prices. Both of these are and will remain depressed as long as the cuts regime stays in place.

In that case, these newly redundant people will remain unemployed unless the state creates work opportunities for them. Doing so might prove cheaper in the long run than leaving them unemployed. If they are in work, they will provide the stimulus to encourage private sector investment and expansion – which in turn will generate tax revenue, which in turn will reduce the deficit and so the cost of borrowing. In other words, ­borrowing now will pay for itself.

This leads on to a related issue about how the deficit should be managed – by reducing the gap between potential and actual tax revenue. In September 2010, Revenue & Customs admitted that their estimate of this gap is £42bn. However, this excludes £26bn in late paid tax. When this figure is taken into account, it increases the gap to at least £68bn.

R&C’s estimate is also wrong for two other reasons. Its definition of ‘tax avoidance’ is far too narrow and its estimate of the gap for direct taxes such as income tax suggests the UK has the smallest shadow economy in the world at 6%–7% of GDP. I would put it at 13%–14% (an estimate the World Bank agrees with), which indicates that tax evasion might be £70bn a year and tax avoidance £25bn a year. Including the £26bn of late paid tax, this would bring the total tax gap to about £120bn.

Of course, this £120bn could not be ­collected at once, instantly closing the gap. But the outstanding tax could be reduced by £5bn. And some £8bn a year – a third of the tax avoidance gap – could be collected by introducing a ­General Anti-avoidance Provision; by removing the domicile rule, tackling residence abuse and income shifting; and by changing the rules on corporate residence. Outright tax evasion could be reduced by at least £7bn a year, more if – and it’s an important if – enough resources were dedicated to the job. Those resources would cost at least £1bn a year. The net gain is obvious, none the less.

The result would provide up to £20bn in additional tax revenue that could be used to prevent swathes of cuts – real cuts that will impose real pain on real people and leave our economy in the doldrums of recession and massive numbers of ­people in the despair of poverty and unemployment.

This might be an unpopular argument and out of tune with the current ­consensus on cuts but it has to be made. If we accept the IMF’s advice that we can still borrow now, we can use this short-term borrowing to create new investment in our economy to drive private sector growth, prevent unemployment and generate new tax revenues. If we then go on to tackle the tax gap, we will avoid recession, create new tax generating and deficit-cutting jobs and generate yet more tax revenues to tackle the core problem in government finances revealed by the ­recession – a weakness in the top line.

This might be considered heretical but what is better – mass unemployment or taking the risk of borrowing at almost zero percent interest rates? I know which I’d choose if I was in Number 11.

Richard Murphy is the director of tax analysts Tax Research
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