Stephen King: Don't raise tax, improve efficiency of the public sector

Regional pay bargaining could take some of the burden away from the taxpayer

This week, Henmania, but last week it was more a case of Hainmania. The Leader of the Commons came out with the words that must never be mentioned. No, he didn't talk about Lord Voldemort. Instead, he talked about raising income tax. An interesting idea, perhaps, and one that many Labour politicians would be rather relaxed about. But for the Leadership, this was a definitely a nightmare come true. Mr Blair felt the rush of unhappiness more frequently associated with an attack on Harry Potter by a stray Dementor.

So will Mr Hain's income tax ideas ultimately make much progress? The debate about income tax is really composed of two separate strands. First, there is the issue of redistribution. Is it the case that the tax system takes money from people in a fair way, based on their ability to pay tax? Second, there is the issue of revenue raising. Can the Chancellor deliver his public spending ambitions without raising income tax at some point in the future?

In recent years, these two strands have become increasingly intertwined. In his desire to deliver better and bigger public services, the Chancellor has been more than happy to allow the process of "fiscal drag" to work to his advantage. As incomes rise over time, more and more people will be dragged into the higher rate tax band, unless the band itself is raised sufficiently to prevent this process from happening.

Back in 1997, when Labour came to power, a little over 2 million people were paying the upper rate of income tax. Now, it's more like 3.3 million. Fiscal drag has been a "nice little earner" for the Chancellor. It's contributed to the overall increase in tax revenues as a share of GDP that's been a feature of this Labour administration.

As a result, it's helped limit the overall increase in public borrowing, enabling the Chancellor to stick to his fiscal rules. Yet there are problems with this process. First, as more voters are caught up with fiscal drag, the Labour Party could see some of the "middle-England" support that it gained at the last two elections beginning to fade away. Second, the Chancellor's fiscal position was already looking increasingly vulnerable before Mr Hain decided to raise the spectre of higher income tax.

In the last Budget, Mr Brown swept the problem under the carpet by assuming a strong rebound in economic growth in 2004 and beyond. Yet most independent forecasters have problems with this view: if they're right, the Chancellor will be on the look-out for more revenue-raising wheezes in the years ahead. Mr Hain's solution to these problems is relatively straightforward. "How can we ensure that hard working, middle-income families and the low paid get a better deal, except by those at the very top of the pay scale contributing more?"

In theory, this should be easy enough to do. Raise the starting threshold for the 40 per cent rate or, alternatively, get rid of the 40 per cent rate altogether and introduce higher tax rates that only come into force at significantly higher levels of income. In practice, however, there are some obvious problems. First, the more income you have, the better your access to clever - or devious - accountants, who will work out ways of limiting your tax bill. Second, many people aspire to higher levels of income: there's a danger that higher marginal tax rates will reduce this aspiration and, by implication, reduce the incentive to progress in one's career. Third, and most importantly, Mr Blair simply won't let it happen.

It's for this reason that the majority of the revenue raising that's come from this Government has been in the form of stealth taxes. If Labour has a manifesto commitment not to raise income tax rates yet, at the same time, has ambitions to increase public spending, the money has to come from somewhere. Either the Government has to borrow or, alternatively, it has to be stealthy.

In reality, of course, it's doing both. On HSBC forecasts (see chart), the Government will be borrowing a lot more over the next two or three years. And the increases in National Insurance rates this year are income tax hikes by another name. Should the HSBC forecasts turn out to be right, taxation will become a much bigger issue in the years to come: from that perspective, Mr Hain is simply responding to the inevitable. He is guilty not so much of getting the issues wrong but, rather, not being sufficiently stealthy about them. Mr Blair and Mr Brown prefer to wear their invisibility cloaks to escape detection on this issue.

There are, however, ways that the government could choose to play the fairness card on a broader basis. Over the past two years, there have been sizeable job losses in the financial services and manufacturing industries but, at the same time, sizeable job gains within the public sector. Had jobs not been created in the public sector, income distribution would look a lot worse than it actually does. And, to the extent that the source of growth in the economy has shifted away from the private sector to the public sector, where income levels are, on average, a bit lower, the number of people that get dragged into the upper tax bracket for the first time each year may be a little less than in the recent past.

The tax system itself may not be perfect but it's certainly the case that the Government's overall fiscal stance has led to a better economic outcome over the past two years. As the Chancellor would no doubt be keen to argue, the UK has managed all this because it has not been constrained by the Stability Pact rules that have left, for example, German unemployment at an unacceptably high level.

Nevertheless, the Government is still left with a difficult medium term problem which, so far, it has chosen to avoid. If the HSBC forecasts are correct, Mr Brown appears to be facing one or more of three awkward options in the years ahead. Either he raises taxes more, or he cuts back on spending or he increases borrowing. Whichever way, he faces some tough political choices. There is, however, an alternative approach that might, eventually, come up trumps. If there is a criticism of the Government's plans, it's a lack of focus on reform of the public sector's institutions and, more generally, an inability to do much about productivity. Rather than worrying about the source of revenue for the next public sector scheme, it might be better to consider ways in which the productivity of existing plans could be raised.

The Government has set all sorts of targets for increased output within the public sector but, to date, most of these seem rather unconvincing (not helped by targets gradually evolving into "aspirations"). However, moves towards regional public sector pay bargaining, highlighted by the Chancellor in his review of the five economic tests for entry into the euro, are precisely the kind of thing that could make the public sector a more efficient user of national resources and, by definition, take some of the burden away from the taxpayer. The debate on tax is all very interesting but, ultimately, the true test of this Government will be whether it ever achieves a high quality level of public sector provision that doesn't leave the taxpayer on the receiving end of a Dementor's kiss.

Stephen King is managing director of economics at HSBC.