What price the welfare state in a brave New Economy world?

'While the fiscal house is still standing, one can visualise fiscal termites gnawing at its foundations'

The Westminster classes are clearly under the impression that decisions made in London SW1 really matter for the future course of fiscal policy and the economy. In truth, there are much stronger forces determining what governments can and should do in future. Fiscal policy in the New Economy is unlikely to take the same shape as in the past.

The tax and spending structure most industrial countries have was put in place between 1960 and 1980. Before 1960, the government share of GDP did not exceed 30 per cent in the OECD economies. By 1980 it had expanded above 40 per cent and today stands at a 43 per cent average. The UK is just a little below this average. Four main categories of spending accounted for the huge 20-year expansion. They are education, health, pensions, and unemployment benefit - the key elements of the welfare state.

The fact that the growth of government levelled off during the 1980s around the world - not just in the UK and US underThatcherite or Reaganite policies - hints that there might be a natural limit that we have already reached. If that is true,future expansion of the welfare state would have to keep pace with the economy's growth.

A provocative working paper from the International Monetary Fund goes further, and argues there are good reasons to suppose government, and the scale of social protection, in the OECD countries is going to have to shrink. Vito Tanzi, its author, notes that with tax burdens at their historical high in many countries, there is no immediate sign of collapse in the tax system. But he adds: "While the fiscal house is still standing and looks solid, one can visualise many fiscal termites busily gnawing its foundations."

The paper identifies several reasons why the tax base is becoming steadily narrower and less reliable. Individual consumers are increasingly able to travel to shop in countries where sales taxes are lower - just think of all the beer and tobacco bought across the Channel for consumption in the UK. More broadly, e-commerce makes shopping mobile on a global scale - "a nightmare for the tax authorities," Mr Tanzi writes.

If it were agreed amongst OECD countries that sales taxes should be levied at the source of origin of the sales, electronic merchants would migrate to low-tax countries. But imposing taxes on customers will be incredibly hard to police and administer. Besides, we are spending a growing amount of money on weightless products such as software, music and videos that can be shipped online and are inherently impossible to monitor. "The meaning of tax jurisdiction becomes vague" in these cases, the paper says.

On top of this, offshore tax havens are becoming ever more important in the global economy. While we are a long way from the dystopian science fiction vision of a parallel offshore pirate economy, there is enough truth in it to give the tax authorities pause for thought. Already, chunks of the financial services industry, including hedge funds, are located offshore. Financial capital, the profits of multinationals and incomes of the highly mobile wealthy are hard to tax now, and it will not get any easier. And, as Mervyn King, deputy governor of the Bank of England, has said, the more money takes electronic shape, the harder it becomes for tax authorities to keep track.

These all add up to a compelling case for the impossibility of raising the tax burden significantly in future. In itself that implies some hard choices in public policy. For three out of the four key components of spending on the welfare state will experience strong expansionary tendencies. Populations in almost all OECD countries are ageing, adding to the state pensions bill. And education and health services are goods for which demand grows faster than incomes, so there will be pressure for spending on them to rise as a share of GDP.

But what if tax revenues do start falling in future, as the ultra-global, ultra-mobile New Economy takes shape? The IMF paper concludes that the modern welfare state will need to rethink its role radically, and in particular that governments will not be able to provide the same social protection in future.

If incomes are generally rising most citizens will be able to pay privately for health and education services, and save for their old age. Yet even for the prosperous majority it would be, in many countries, a real dislocation in the relationship between citizen and government.

Perhaps the IMF study is unduly alarmist, and overstates the threat to the tax base. Yet its list of difficulties makes it plain politicians ought to think about the possibility that existing taxes will deliver less revenue. They could perhaps draw up plans for less easily evaded taxes, as an alternative to planning on downsizing themselves.

Economic theory indicates it is best to tax things that can't move, so perhaps more tax could be raised from things like land or housing, or even cappuccino bars. A debate about the shape of the tax system and the scope of government in the globalised New Economy is one we urgently need, rather than the imbecilic clashes we get in Westminster over who can cut which taxes fastest.

d.coyle@independent.co.uk

"Globalization and the Future of Social Protection", by Vito Tanzi, IMF Working Paper 00/12,