Tax and cuts: Don’t squeeze the middle
How ‘fair’ can next week’s deficit reduction plan ever actually be? The Institute for Fiscal Studies has shown that in the three recessions of the 1970s, 1980s and 1990s, those on low and moderate incomes, rather than the very poorest, were most exposed. In fact while those in the middle of the income distribution saw their incomes drop in all three recessions, those at the bottom and the very top actually experienced a slight growth in income during these periods.
All the indicators suggest that things have been no different this time around. Echoing TUC findings, our earlier report Closer to Crisis? showed how the ‘squeezed middle’ have suffered more during this recession than other groups – with a greater risk of job loss and drops in income, higher living costs and fewer safety nets such as savings or insurance.
Looking ahead, the question is how this group can avoid bearing the brunt of the fiscal consolidation as the public sector shrinks and as private sector growth remains sluggish. The Resolution Foundation today publishes a report which explores what options the new government has to cut the deficit, and the impact these options might have on the UK’s 7.2 million low earning households.
Our work shows how cuts hurt those on low incomes far more than higher earners. So the deficit reduction plan must exhaust every single potential progressive taxation measure before turning to spending. But what might this mean in practice?
First, the government must be much less timid in taxing unearned wealth. Recent spats about bringing capital gains tax into line with income tax are no more than special pleading and should be ignored. It is simply not fair to choose to raise an additional £3 billion a year from limiting tax credits to middle income families, without also removing the existing distortions in the system that favours those fortunate enough to enjoy capital gains.
Second, the daunting size of the deficit – the largest hole in our balance sheet since the second world war – means that it will be almost impossible to pay it down without making changes to some of the taxes with the highest yields such as income tax and national insurance, which together make up 45% of government revenues.
So while proposals to raise personal income tax thresholds are obviously helpful to the six million low earners who pay tax at the basic rate, higher earners will benefit disproportionately more from an increase in tax-free earnings – unless additional measures are taken to target this change.
Third, even when it comes to regressive taxes such as VAT, there are still some ‘least worst’ options for the working poor. Our report shows that increasing the standard rate of VAT would hurt low earning households less than increasing the reduced rate of VAT that currently applies to domestic fuel and power, for example.
Finally, there is a wide consensus that the scale of the task makes both tax rises and spending cuts inevitable. But it remains the case that there’s no such thing as a good cut for poorer households. On that basis we argue that it would be better to tax universal benefits than increase means-testing. Both achieve similar outcomes, but the former has much less of a negative impact on low earners and is therefore preferable.
Clearly there are no pain-free solutions to cutting the deficit. But if, as Nick Clegg has promised, the coalition government is serious about avoiding a repeat of the misery of the Thatcher years, their plan to reduce spending must put greater emphasis on tax-based options than we have seen thus far.