John Redwood: There is a magic money tree – the private sector, sensibly taxed

Sir John Redwood is a former MP for Wokingham and a former Secretary of State for Wales.

The UK is riding the doom loop. The state puts up taxes, that hits the economy, growth slows and the deficit increases; the government puts up taxes again to cut the deficit and the same thing happens; we tumble downwards, watching more people and businesses give up on Britain and head abroad.

Most people in the debate acknowledge that current public spending is unaffordable, with various proposals about welfare, migrant hotels and public sector productivity being canvassed to try to tackle the high costs.

All parties agreed to the Covid lockdowns, and the huge spending incurred by the state to subsidise many for not working. It seemed painless at first, as the Treasury and Bank of England had at last found a magic money tree. They literally printed the money and bought bonds to keep interest rates low. The government was able to borrow billions on the cheap to pay the bills.

Some politicians began to ask: why hadn’t we done this before? Didn’t it solve all those old arguments about putting up taxes to pay for the extra spending?

Then inflation hit. People were livid as their pay rises were more than wiped out by higher prices, leading to falling real incomes.

The Bank denied the inflation came from the magic money tree. But its claim that the Russian invasion of Ukraine was the cause driving up energy prices overlooked the uncomfortable fact that inflation was already three times target before Vladimir Putin sent the troops in.

It later decided that it needed to do a huge u-turn, cancelling all further money creation and bond buying and becoming a large and active seller of bonds instead. It hiked the base rate up by 2625 per cent, from 0.1 per cent to 5.25 per cent, showing that in truth the Bank did think it had previous got money, rates and inflation badly wrong.

We should quietly bury the magic money tree that is printing money by the central bank. It is usually inflationary and self defeating. The Bank has done so without attending the funeral.

There is, however, another possible magic money tree made from better stock: lower taxes.

The famous Laffer curve is now accepted by even the sternest Treasury officials. They see that you can get to such a high rate of tax that people no longer stay or work harder to pay more. Treasury officials, however, usually put the inflection point where the tax rate collects less revenue at a very high setting, often well above current tax levels. In that they are wrong.

Of course, far fewer people would stay or would work hard if income tax was set at 100 per cent of income. Before you all say that is a ludicrous extreme, the British marginal rate of income tax on better off people with savings was 98 per cent as recently as 1978. Not surprisingly we had something called the brain drain, where so many talented and higher earning people, or people with accumulated savings, fled the country for more realistic lands.

In 1978 the top one per cent of income tax payers paid just 11 per cent of total income tax. Today with a marginal rate of 45 per cent, under half the 1978 level for savers – but they pay 30 per cent of the total income tax.

The Treasury counters by saying that despite recent increases in income tax charges on the better off and reports of more rich people leaving the country, revenues are up. But this does not prove the point that higher rates make you more money. Higher incomes have been on the rise, so there would have been more revenue if the government had not increased the effective tax rate on the higher earners.

When I worked for Margaret Thatcher, she and the chancellor took bold decisions to slash the 98 per cent tax rate first to 60 per cent then to 40 per cent. I was able to draft her a speech using Treasury numbers after the changes that showed that as a result of big cuts the rich paid more income tax in cash terms, more income tax in real terms after inflation, and paid a higher proportion of all income tax than at the higher rates. What’s not to like?

The reasons were simple. More people stayed as they thought 40 per cent fair and internationally competitive; more people returned to the UK from tax exilel; more people worked harder and longer and more savers took more investment risks, as it was worthwhile to do so. It boosted growth and left the government more money to cover spending.

As a general rule, the easier it is to avoid a tax legally, the lower will be the rate that maximises the revenue. The Government should have found this out recently. Capital gains tax (CGT) is easily avoidable; you do not have to take the gain by selling the second home or the shares you hold that are sitting on decent profits. Many wealthier clients of investment managers tell them, when managing their shares, to use their dwindling tax-free sales allowance but no more.

Over the last two years, with much reduced tax free allowances for capital gains tax, the revenues from it have fallen by a quarter. Think again Treasury.

Business tax is an area where comparisons are made with other countries. Larger companies have freedom where to put their head office, where to base their factories and functions, where to direct their investment. The headline corporation tax rate is often a way of undertaking a first sift to compile a short list of locations for a new plant or office. The overall likely tax bill will weigh on comparative figures between short listed locations for the final decision.

In recent years, Britain and Republic of Ireland have conducted a useful experiment between them to see what rate of corporation tax maximises revenue: Ireland ran at 12.5 per cent whilst the UK took an erratic route to 25 per cent, never falling below 19 per cent. Last year the Republic of Ireland raised almost three times as much corporation tax per head as the UK (£3870 versus £1387).

There should be no surprise, yet most people in Britain ignore this inconvenient truth and still think higher business taxes get you more money. The magic of the Irish low rate was it drew in billions of investment and much activity, particularly from the large and fast-growing US digital giant companies.

More of the investment would have come to the UK if we had the same tax rate as Ireland. Instead we watched as the Irish growth rate soared, their GDP per head took off, and their Treasury had more money than it needed to spend. Why are we in denial about this?

Government does understand that if you want to reduce or stop something you put a tax on it. They use higher taxes to stop people smoking and to deter drinking too much alcohol, to stop people enjoying the wrong types of food, to make flying less attractive, and in a host of other ways. So why impose higher taxes on creating jobs, working harder, saving more and buying a home? These are all good things that should be encouraged, not penalised.

Clearly we all want to live in a good society where the sick and disabled are cared for, and where there are good public services. That requires money, and not all of it can be collected in taxes on things thought to be bad. There needs to be taxation of incomes.

What there should not be is overtaxing to the point where many of the better off and more enterprising simply leave, and where others who could do more are deterred from doing so. It is not a good model to welcome in and support many millions more on benefits, whilst saying good bye to the job creators, the investors and the self helpers with the money.

I am glad the Chancellor has seen the UK cannot afford a wealth tax. She needs to be bolder and see that the right kind of lower taxes will boost growth and revenues. Tax investors less and they will invest more here; tax job creators less, and they will bring more jobs; tax higher earners less, and they will stay, working and paying more. More growth brings more tax revenue.

Great news: there is a magic money tree. It will grow happily in the private sector if you do not try to over tax it. It is better to ride the Laffer curve looking for its peak, than to ride the doom loop, raising taxes at every budget as the economy collapses.