If they can't tax us, they'll boss us around

The War of the tax posters commenced last week - the "red eyes" and the "Tory lies" - as both main parties accused each other of excessive taxation. Given the arguments about tax in recent months and the importance of the issue at the last election this is completely understandable: tax matters. But stand back for a moment and focus on the implications for the size and role of the public sector. The new orthodoxy in Britain, accepted by both parties, is that taxation should not be increased. If taxes should not be increased the size of the public sector cannot increase either.

That is a sea-change from five years ago when Labour did believe that an increase in taxation (and of course spending) would bring economic and social advantages. It is a change which is also taking place in other western European countries - both France and Germany are developing plans for cutting tax levels.

In the US and Japan there is less evidence of change, but then since they have much lower levels of both taxation and public spending than European countries the issue is less immediate. As the graph on the left shows, Britain's idea of the appropriate size of the public sector is a half-way house between France and Germany on the one hand, and the US and Japan on the other.

But Britain is interesting in another way. Most people here are unaware that the peak in the size of the UK's public sector was in 1976, at 48 per cent of GDP, and that the first moves to roll back the state were taken by Denis Healey. Thus Britain, under Labour, was the first country in the developed world to start reducing the size of the state.

The rest of the world has been much slower at doing so. The graph in the middle shows how public spending for the G7 has carried on rising, shooting up at the time of the first oil shock in 1974, then carrying on a rough upward trend through the 1980s and early 1990s. But, as you can see, something else happened around 1974: revenue, which until then had marched up pretty much in line with spending, suddenly started to fall short. Since the middle 1980s it has more or less levelled off, while the gap between spending and revenue has grown.

This is not a sustainable situation. At some stage the two lines will have to be brought back into line, as they were before 1974. Note that this is not particularly a British problem, for we are looking here at the G7 countries as a whole, though the gap in the case of the UK has been associated with (and to some extent masked by) a run-down in capital assets rather than a rise in debt - as discussed in the column below.

But if you are thinking purely about trends in the size of the public sector, Britain is clearly something of a pioneer in redefining the boundaries.

Take another measure of the size of government, the number of people it employs. Some trends are shown in the right-hand graph. Through the 1970s all governments increased their employment. Then in the 1980s in the UK and Japan the number of employees reached a plateau, while the others shot on up. US government employment rose particularly fast during this period despite President Reagan's supposed cutting-back of the state - a good lesson that one should look at what politicians do, not what they say. Finally, in just the last five years or so, UK government employment has started to fall, though this trend has yet to take hold elsewhere,

and even in the UK employment is still higher than it was in 1970.

So what next?

If this argument that the new consensus makes it impossible to increase taxation in the UK - at least to any significant extent - is correct, then the public sector will have to contract. The gap between revenue and spending has to be closed and if you cannot do much on one side you have to work on the other. The only possibility for keeping the public sector at even its present level would be for there to be a significant increase in taxation. But, given the tone of political debate, that cannot happen.

So, on a very long view, the contraction begun by Denis Healey and carried on by successive Tory chancellors, will continue through into the next century. It will happen whoever wins the next election.

This is terribly important, for it means that political debate will not be about taxing and spending decisions but rather about other issues, in particular regulation. If there is not much they can do on taxation and hence no leeway on spending, governments will seek to achieve their aims by other means.

The tradition of exerting political influence by regulation rather than by direct action is more deeply established in the US and in Japan than it is in Europe, but you can see a shift taking place in the UK in the last two or three years. There are several strands to this: one is privatisation.

Privatisation has created a new power barony, the regulators, which has gradually increased in confidence and aggression. Their structure is likely to change, for as their power increases there will be more and more calls for they themselves to be under some kind of democratic control.

Another strand is financial regulation, with successive UK governments reforming the regulation of all three types of financial services - banking, insurance and securities - several times in the last 20 years. Expect further change there too.

But looking forward, there are large areas of human activity which seem ripe for further regulation. For example, expect pressure on people to provide supplementary pensions for themselves. Expect some kind of forced savings scheme (or at least a very strongly encouraged one) for individuals. Expect, should Labour get in, companies to face regulatory demands over and above the minimum wage, itself a very good example of politicians using regulation rather than taxation and spending as a way of influencing social and economic behaviour.

At the same time, however, governments will have to be careful that ill- thought-out or punitive regulation will damage economic performance, or simply fail to achieve the objectives the regulators have in mind. There is a lot of academic literature in the US about the costs of regulation, and it seems that one of the reasons why US living standards have failed to rise much in the last 20 years, even though GDP per head has risen sharply, has to do with the siphoning-off effect of regulation and the legal and other costs this imposes.

In Japan too, there is a regulatory problem, though of a somewhat different order. It is clear that excessive regulation has become a serious barrier to economic recovery. The thrust for deregulation there is driven by economic as much as social forces.

To say that is not to suggest that governments should not regulate; rather it is to point out that quality of regulation is becoming a comparative advantage, something that governments will be judged upon, just as they are now judged on their relative performance as efficient taxers and spenders. Britain is interesting in this regard mainly because of our experience in regulating privatised utilities, but if we perform well in other forms of regulation, then that will attract attention abroad too.

So stand back from the ya-boo element of the posters and think about their common theme: taxes are bad. If taxes are bad, how else will governments try to achieve the objectives which we as voters set them? Prepare for governments to become more bossy.