In the aftermath of Rachel Reeves’ Budget, there was much talk of how the increase in taxes will damage growth. Indeed, the OBR’s forecasts for growth are pretty feeble. But, Paul Whiteley argues, the data doesn’t support any direct relationship between levels of taxation and economic growth, and the OBR’s economic forecasts ignores how improved consumer and investor psychology as a result of improved public services could drive growth much further.

The central objective of the Labour government announced in the party’s election manifesto is to raise economic growth. This objective has been repeated by Keir Starmer and others, and it is a response to the fact that growth has been flatlining for many years. Critics of Rachel Reeves’s budget have argued that the large increases in taxes will undermine this objective.

In the general election campaign earlier this year, the strongest attack line against Labour from the Conservatives was on the issue of taxes. Robert Jenrick in his unsuccessful campaign for the leadership of the Conservative party forcefully repeated this attack, indicating that his party is still committed to the idea that tax cuts promote growth.

In a landmark paper, Nobel prize winning economist, Robert Solow, showed that over 80 per cent of growth can be attributable to technological innovation rather than capital investment or increased employment.

The criticisms of the tax increases, particularly when they fall heavily on small businesses, is that they reduce work incentives, increase unemployment, and cause bankruptcies. If true, then all of these are likely to stymie economic growth. This argument has been voiced by business leaders as well.

The Relationship between Tax and Growth in the UK 1965 to 2019

There are two problems with this argument. One is that there is no relationship between taxation and economic growth, as the chart demonstrates. It uses OECD data to compare growth and tax rates in the UK over a period of more than sixty years. The correlation between the two is negligible (-0.04), indicating that they are unrelated.

The second problem is that in a landmark paper, Nobel prize winning economist, Robert Solow, showed that over 80 per cent of growth can be attributable to technological innovation rather than capital investment or increased employment. This means that the predictions about the effects of the tax changes on growth are not supported by the evidence.

Interestingly enough this is apparent if one looks closely at the Office of Budget Responsibility’s macroeconomic model, which is the basis of the economic forecasts used by Rachel Reeves in her Budget. The OBR model has become the yardstick used by commentators as well as by the government to forecast the effects of the budget.

The Office of Budget Responsibility – Taxation and Growth

Growth is measured in the model by changes in a variable called the “Gross Domestic Product at Market Prices”. This captures the entire output of the economy and is influenced by consumer expenditure, investment by the private and public sectors, the rate of inflation as well as exports and imports, among other measures. It is notable that taxation does not figure in this list.

The same point can be made about employment in the model specification. This is of course closely related to economic growth. There are relationships between different types of employment such as private and public sector employment, but no effect of taxation on employment.

In their report the OBR suggests that after a year of stagnation, the economy will grow by just over 1 per cent this year, rising to 2 per cent in 2025, before falling to around 1½ per cent per year, over the remainder of the Parliament. In other words, their predictions about growth are rather pessimistic.

There is a lot of “wiggle” room in economic forecasting.

However, commentators may be a bit too willing to accept these growth forecasts at face value. The authors of the model point out that the numbers emerging from their analysis can be changed by additional contextual judgements made by them and other modellers. They write: “two forecasters using exactly the same model could end up with very different forecasts because the judgements underpinning them differ”. There is a lot of “wiggle” room in economic forecasting.

“Animal Spirits” and Growth

The OBR model ignores “animal spirits”, to use a term first coined by John Maynard Keynes. This refers to the psychology of consumers and entrepreneurs, particularly the latter, who are thinking about starting up a new business or expanding their existing businesses. If they are optimistic about the future, they are more likely to do this, and this will stimulate employment and growth. Pessimism has the opposite effect.

Commentators should stop worrying about the non-existent effects of taxes on growth and focus instead on the general climate of optimism and above all on research and development and innovation in the economy.

The OBR model ignores any measures of consumer psychology, although its authors say they take this into account by looking at surveys of business confidence and other data when they are making the contextual judgements about the forecasts.

However, this may not be enough to forecast growth accurately, since the correlation between economic growth and consumer confidence, something which has been measured continuously in Britain since 1974, is quite strong (+0.49). This means that when consumers and entrepreneurs feel optimistic, we get more growth (and vice versa).

It is a universal law that losers in the budgetary process complain loudly, while winners remain relatively quiet. This was a landmark budget aimed at turning around years of stagnation in the British economy. This means that commentators should stop worrying about the non-existent effects of taxes on growth and focus instead on the general climate of optimism and above all on research and development and innovation in the economy.

Optimism will be stimulated by rebuilding the NHS, investing in education, filling in potholes on the roads and providing fast broadband. If these policies are accompanied by investing in the research infrastructure, growth will follow.

All articles posted on this blog give the views of the author(s), and not the position of LSE British Politics and Policy, nor of the London School of Economics and Political Science.

Image credit: Shutterstock

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