Tax cuts: one more time

The Tories will try the old strategy again, but will the voters believe them? Stephen Castle and Paul Wallace report

SO NOW we know. If there were any remaining doubts, the promises made by John Major last week and the teasing words of the Chancellor of the Exchequer have dispelled them. The Conservatives will play the tax card in the next budget for all it is worth, hoping as a result to repeat their electoral successes of the 1980s.

Whether they can pull off this trick again is an open question. The Chicago academic Robert Lucas won the Nobel prize for economics last week for his theory of "rational expectations", a mathematical construct that boils down to the idea that you can't fool all of the people all of the time. This theory, as Abraham Lincoln pointed out, is applicable to politics as well as economics.

The Tories may be the party of low taxes, but they have had difficulty delivering them. The tax burden is now higher than in 1979, when the last Labour government left office. Income tax reductions have been accompanied by rises in indirect taxation which cost the average family an extra pounds 800 per year. Labour accuses the Conservatives of increasing taxes by the equivalent of seven pence in the pound.

Against this background, as Professor Lucas might put it, the "rational expectation" of the electorate may well be that, for all the fine words, this government would raise taxes after an election victory rather than cut them.

There are even senior right-wingers who are wondering whether tax-cutting can be made to work again. Michael Brown, a former government whip, said last week: "I am not as certain today as I was 10 years ago that a reduction in taxation will, overnight, transform our fortunes. I am not as certain as I was that the public is as anxious to make the necessary sacrifices in public expenditure to get those cuts. And we are not currently trusted on tax."

Such awkward notions did not worry most representatives at the party conference last week. In the bars and halls of Blackpool, they eagerly debated how much money the Chancellor can afford to give away in his forthcoming budget, and whether or how these tax cuts could be focused on the party's unhappy natural supporters. Nothing, it seemed, not even a declaration of war against Brussels, would revive those withering grass roots so much as a nice shower of money from the Chancellor.

Mr Clarke feels this pressure keenly, for the demands are not new. In the early summer he received a delegation from the right-wing '92 group of Conservative MPs whose recommendations were simple: large tax cuts funded by big cuts in public spending.

In Blackpool last week the same message was most forcibly articulated by John Redwood,the defeated leadership challenger whose battle cry was: "The Conservative Party is the party of low taxation or it is nothing." At Blackpool Mr Redwood produced a menu of proposed spending cuts which, he believed, could yield pounds 5bn.

Yet, in government, taking the axe to spending programmes is much more difficult than it looks, particularly when areas like child benefit are protected by manifesto pledges. Even Peter Lilley, the drier-than-dry Secretary of State for Social Security, has managed only to slow the growth - rather than cut - his pounds 90bn annual budget. He is fond of explaining that a pounds 5bn reduction in his budget means 1 million people losing pounds 5,000 per annum.

And Tories are not above wanting more spending in particular patches of the welfare state: Stephen Dorrell, the Secretary of State for Health, pointed out last week that the same people who demand tax cuts also want increases in spending on residential care for the elderly.

One Cabinet source hinted at the difficulty that spending ministers are having this year: "EDX", the committee that adjudicates on spending, is, he said, "meeting for hours and hours and hours".

The truth is that whatever paring down of public spending was possible has largely been achieved, and only if the Government is prepared to chop off whole functions, abolishing individual benefits in their entirety, can substantial savings be made. Any politician knows how unpopular that would be.

To add to his difficulties, Mr Clarke had some bad news last week on inflation. When he arrived on Wednesday, jet-lagged, from the Group of Seven meeting in Washington, he learned that it had risen to 3.9 per cent last month - when important benefit increases are fixed.

Yet Tories are undeterred, spotting windfalls and hidden reserves of cash all over the place. One senior party figure last week noted rising revenues from corporation tax. Another highlighted a recent report from a City economist saying that the Government could safely raid its pounds 6bn contingency reserve next year. Then there is the possibility that Mr Clarke will steal Labour's idea of levying a windfall tax on the privatised utilities. Their bosses were scarcely more popular in Blackpool last week than at Labour's conference in Brighton the week before. One backbench Tory MP was heard firmly declining an invitation to dinner with Cedric Brown, thechief executive of British Gas who paid a brief visit to Blackpool last week.

The Conservative faithful are confident that the money can be found. What concerns people higher up the ladder, however, in Conservative Central Office, in Downing Street and, for that matter, among Labour Party thinkers, is the question of "rational expectations". Given recent experiences, they wonder, how can you sell tax cuts to voters without it being dismissed as a cynical election bribe?

HISTORY and common sense tell us that no government can cut taxes and guarantee to keep them low. Circumstances change, sometimes for the better and sometimes for the worse, but either way the Treasury always needs money to pay its bills. John Major, then, does not have the option of promising never to increase tax again.

He could tell the electorate that lower taxes are good for the economy, but that, too, would ring hollow. During the 1980s we were always told that cutting income tax was economically good practice because it made it more worthwhile for people to work - thus national productivity would benefit.

Logically, however, tax cuts could just as readily have the reverse effect: encouraging people to work less hard because they could still achieve the same post-tax income. The result could thus be longer hours at the pub or golf club rather than stakhanovite feats of labour on the shop floor.

In reality we know that income tax cuts didn't spur the working population on to greater efficiency in the 1980s any more than the rises in the burden of taxation in the 1990s have caused them to down tools. So that is another argument Mr Major would have difficulty putting forward.

The Government would also have to face up to the political disadvantages of cutting tax, for if the economic merit of cuts is questionable, the social effects are not: put at its crudest, the rich get richer.

Income tax is a great social leveller, and less income tax probably means less levelling. The way cuts were applied in the 1980s meant that the tax system did nothing to mitigate the unprecedented widening in the gap between rich and poor seen in that decade.

By focusing on cutting tax rates rather than increasing tax allowances - the amounts people may earn tax-free - the Conservatives chose a method of reducing income tax that is simply unfair. Last week the Institute for Fiscal Studies showed that if Kenneth Clarke wanted to cut income tax by pounds 3bn, raising personal allowances by pounds 450 rather than cutting the basic rate from 25 to 23.5 pence in the pound would be more equitable.

The chart shows that it is the richest 20 per cent of the population who gain the most from a cut in the basic rate. By contrast, the poorer sections of the population would benefit more from raising allowances. The IFS's suggested increase of pounds 450 in personal allowances would take 750,000 out of the basic rate band of 25 per cent so that they would only pay at the lower rate of 20 per cent, while a further 900,000 people would cease to pay income tax altogether.

Another way in which Conservative policies have favoured the rich is by switching taxation towards indirect taxes such as VAT and excise duties. In 1975, the Treasury's haul from indirect taxes accounted for just under a quarter of total taxation, well below the average in the European Community. By 1993, they raised a third, above the European average. The rise of VAT has been still more striking. In the past 20 years, its share of taxation has more than doubled to 20 per cent, high by EU standards.

Indirect taxes such as VAT are "regressive". They bear down more heavily on the worse off: we all need to heat our homes. Exemptions like those for food and children's clothing help, but the switch to indirect taxation has undoubtedly made the tax system more unfair.

It would be wrong, however, to jump to the conclusion that this has occurred simply because of the particular slant of government policy. The Conservatives have pushed the switch to VAT further than most, but it has happened across the developed world. In 1993, VAT accounted for 17 per cent of taxation in the EU, up from 11 per cent in 1975.

IF MOST Conservatives agree on the desirability of tax reductions, there is some uncertainty over how it should be done. Motions from Conservative constituency associations for this year's economy debate showed that activists were keen to see the restoration of Miras, and an increase in the Married Couples' Allowance. Early results of a policy consultation exercise conducted by Conservative Central Office reveal similar findings. Both those areas have been highlighted by Mr Redwood, who also wants the abolition of VAT on domestic fuel.

There is always a certain amount of tinkering with the system in the budget, but the truth is that Conservatives are looking for serious political impact and traditionally there is only one way to achieve that. As Andrew Dilnot, the IFS director, said last week, it may be more progressive to increase personal allowances, but no one would really remember you have done it, whereas everyone knows what the basic rate is, and will notice a cut.

A senior Conservative source reviewed the options: "The choice is whether to do something which would eventually stimulate the economy, such as abolish capital gains tax, to do something which would benefit our supporters, such as increase the threshold at which higher-rate tax comes in, or whether to do something sexy, like cut the basic rate."

Mr Clarke's instinct has always been to reduce the basic rate - the sexy thing. But there are some signs he might opt for a more extended tax reduction strategy. A three-year programme would allow the Government to increase allowances this year, with the money feeding through to voters' pockets next May, then to cut the politically-symbolic basic rate on the eve of the election. More cuts would then be promised for the first year of another Tory government. The Government plans, as one cabinet minister put it, "a sensible commitment to reduce taxes over a period of time".

Even this, however, would need to be sold, and last week we saw the first signs that a strategy for doing this is taking shape. One senior Tory put it simply: "The Conservative Party won elections when it had a project - to crush the unions, or the miners, or the Argies. Our message now must be that we can save you from the challenges of the East Asian economies."

External competition from the low-wage, high-tech "tiger economies", threatening companies and jobs in Britain with their ferocious brand of capitalism, can be the new bogey. And there are the rising countries of Eastern Europe to be reckoned with.

In this context, tax reduction could be made to appear as an essential part of a political philosophy, rather than a cynical electoral exercise. One senior source said: "There is a clear divide between us and Blair. He has chosen the European social market, complete with minimum wage etc. We have chosen the low-tax, low-cost, low-inflation economy, and that is our selling point within Europe."

This explains why a succession of ministers last week trumpeted the dangers looming from East Asia and Eastern Europe overwhelming Britain in the next millennium. Mr Dorrell warned of Britain being "bowled over by a number of countries which have learned the market system and applied it". The Conservative Party, he said, had to "face up to that juggernaut". The Prime Minister himself spoke of the "millennium challenge".

Tax is central to this argument. In the world of the global market, it is increasingly difficult to tax companies which can hop from one country to the next when they see financial advantage. For the same reasons it is even becoming more difficult to tax individuals, particularly those at the top of the wage scale. Oh yes, as Mr Major might say, we must answer the foreign threat by reducing our domestic tax burden.

As to whether this strategy will be enough to close the gap on the Labour Party, there was less confidence in Blackpool last week. In private, cabinet ministers are gloomy. In public they were reticent.

Introducing a fringe meeting with Mr Redwood and Mr Dorrell last Thursday, Charles Moore, editor of the Sunday Telegraph, told his audience how the title of the debate had been decided: "I gave our two speakers two choices: 'The Future of Conservatism' or 'How to win the Election'. They chose 'The Future of Conservatism'."

Leading article page 20