But if the government's future proposals are a rollercoaster ride of spending, economists say that the past few years have also followed a similar course. Initially, Mr Osborne set out on a course of fast-paced austerity designed to eliminate the structural deficit by 2015. But the crisis in the euro zone and a British economic slump led the chancellor to toss out that plan. Slowing down his plans for fiscal adjustment, along with monetary stimulus in the form of funding for lending by the Bank of England, were the policies that underpinned the economic boom that has taken hold since 2013.
Yet this rollercoaster ride may not have simply been due to yo-yo austerity or Europe's economic problems. As we pointed out yesterday, one of the coalition's most important tax reforms has been to shift the burden of taxation away from direct levies on income to indirect ones. Since 2010, the personal allowance, the amount each individual can earn before they start paying tax, has been increased from £6,475 ($9,518) in 2009 to £10,000 last year. This has been partly paid for by raising value-added tax (VAT) from 15% to 20% over the same period.
The last time such a fast-paced shift from direct to indirect taxes occurred was during the government of Margaret Thatcher. In the 1979 budget, for instance, income-tax rates were slashed, paid for by replacing the two rates of VAT, 8% and 12.5% with a unified rate of 15%. A recent book* by Duncan Needham, an economic historian at Cambridge University, suggests that this shift had a devastating impact on the economy:
When treasury officials ran the [1979] Budget forecast, they estimated that the "revenue neutral" tax switch would shrink the economy by 1.7%. This is because of the different behaviourial effects of the changes in direct and indirect taxation. In the short-term, individuals tend to react to an increase in net income by increasing savings to maintain existing levels of consumption. Per contra, an indirect tax rise increases the cost of existing consumption, causing individuals to reduce their purchases of the now more expensive goods and services, thus narrowing the indirect tax base. Also, indirect tax rises increase the general price level. This discounts the stock of real wealth. Since individuals tend to want to hold their wealth fairly constant, they react to higher prices with increased saving. This reduces the overall level of consumption with further negative consequences for overall output.
The result was a rollercoaster ride: a sharp recession in the early 1980s, followed by a recovery when some of the reforms were reversed in the 1981 budget. Similar forces, perhaps, contributed to the slowdown of 2011 and 2012 and the return to rapid growth thereafter. With both the Conservatives and the Liberal Democrats going into the next election promising further income-tax cuts, that is food for thought today.
* D. Needham, "UK monetary policy from devaluation to Thatcher, 1967-82" (Basingstoke, 2014).
