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As the state gets bigger, taxes will rise. It’s time to be honest about that

Published on 28 April 2023

Winston Churchill, a man of famously expensive habits, believed that income should always be adjusted to meet expenses, and never the other way around

In the words of his biographer, Roy Jenkins, “he decided that when the gap between income and expenditure became uncomfortably wide, the spirited solution must always be to increase income rather than to reduce expenditure.”

Government finances are, of course, not equivalent to those of a household. A considerably larger fraction of Churchill’s budget went on champagne, for a start, and the British state is rather more frugal and rather less inclined towards luxury. But there are nonetheless certain parallels to be drawn. For one, it is common for fiscal policymakers to find that the desired level of public expenditure exceeds projected income from tax revenues. The UK government has run an overall budget deficit - with spending in excess of revenues - in all but three of the past 40 years.  

That’s nothing new. More significant is the fact that when those gaps become uncomfortably wide, governments are increasingly taking the Churchillian route and increasing taxes rather than cutting back expenditures. In the UK, tax revenues amounted to 36.8 per cent of national income in 2022-23, versus 32.8 per cent a decade earlier, and they are on track to rise to 37.7 per cent of national income by 2026-27. There seems to be a striking degree of consensus between the main political parties on this move towards a bigger state, and the tax burden is similarly on the rise across many developed countries

Why? In short, because the upwards pressures on public spending are proving too great to contain. 

An ageing population is a key part of the story. The large cohort of baby boomers born just after the Second World War are now receiving state pensions and placing greater demands on health and social care budgets. The Office for National Statistics projects that the number of people aged 85 and over in the UK will increase by 40 per cent over the next 10 years alone. 

Then we have what economists call the Baumol effect, whereby wages in labour-intensive sectors with limited scope for productivity gains, such healthcare or education, rise over time to keep pace with wage rises and productivity growth in the wider economy (notwithstanding the fact that we haven’t experienced much productivity growth of late). In light of demographic trends and the Baumol effect, it’s virtually inconceivable that we’ll spend any less on the NHS in future than we do today. In all likelihood, we’ll spend a great deal more. 

And that’s not all. In response to growing geopolitical instability and the Russian invasion of Ukraine, governments across Europe have announced increases in defence spending. In the UK, the government has stated an “ambition to increase defence spending to 2.5 per cent of GDP in the longer term”, up from around the Nato minimum of 2 per cent now. If delivered, this would mark the end and part-reversal of a decades-long decline in defence spending - a “peace dividend” - which has allowed for ever-higher spending on the health service without any meaningful increase in the size of the state. For the first time in a long time, we might see governments steadily increasing health and defence budgets at the same time. 

On top of that, to make the immediate fiscal picture even worse, rising interest rates mean we’re going to be spending much more on debt interest than we’ve become accustomed to in the recent past. It’s fair to say that the UK public finances need that like a hole in the head. 

The crux of the matter is that structural factors are putting enormous upwards pressure on government spending. Borrowing can take the strain in the short term, but ever-higher borrowing and ever-rising public sector debt is not a sustainable long-term option (from the perspective of both public finance management and inflation control). After the austerity of the 2010s and the disruption of a pandemic, there are few - if any - obvious candidates for “easy” offsetting spending reductions elsewhere. The government has therefore opted for the Churchillian route and is adjusting its income upwards to meet its desired spending, via tax rises. The signs are that the Labour party would do the same, were it in office. 

This isn’t to claim that it would be impossible for the government to instead adjust spending downwards to meet desired tax revenues. But in the face of the pressures described above, doing so would require some quite radical decisions about the scope of the state. 

Health, defence, state pensions and other pensioner benefits, long-term care and debt interest represent around 45 per cent of all government spending. Health alone accounts for more than £1 in every £5 that the government spends. This fiscal circle can’t be squared by squeezing other budgets while expecting them to provide the same range of services and support, or through vague promises of “reform”. 

Instead, the question for advocates of a smaller state has to be: what is it that the state currently does that it would no longer do? Notably, rather than shed state responsibilities, the government has recently chosen to add a new one, by extending free childcare to working families with children aged under three. Liz Truss and Kwasi Kwarteng were very quick off the mark with tax cuts, but far coyer about where the commensurate reductions in spending would come from. It is difficult to detect a desire from the electorate for a government that does less. 

We’re most likely heading, then, for a world with higher taxes and a bigger state. To make the best of this world, three things jump out as being key. First, that we take efforts to promote the economic growth that would make these trade-offs easier. That would be the best way to boost government revenues. It is easier said than done. But infrastructure, planning and trade policy all jump out as obvious areas with room for improvement. Second, and relatedly, that we undertake tax reform to reduce any efficiency costs of higher taxes and make this as (economically) pain-free and growth-friendly as possible. Pretty much every single UK tax could be better designed. And finally, that we recognise the fiscal writing on the wall. The scale of the challenge means we’re all probably going to have to pay a bit more, not just companies or the very richest. The sooner we’re open about that reality, the better.