Hamish McRae: Growth and taxes aren't always linked

We ought to look at practical evidence rather than have strong ideological opinions on ta

Stephen Byers called for the end of inheritance tax, provoking squawks from the Labour faithful. Now a policy review set up by David Cameron is said to call for an unambiguous commitment to increase public spending, provoking squawks from the Tory faithful - or at least from John Redwood.

What gives the current debate a certain spice is its unpredictability. Inheritance tax brings in relatively little money, is expensive to administer and seems to be particularly unpopular. However for the attack on it to come from a former Labour cabinet minister is undoubtedly interesting. Similarly for a Tory policy group to commit to more state spending on public services not only cuts across previous Tory rhetoric but seems to run counter to the downward trend in Europe on tax levels. Things may become interesting again.

Or at least they will if people are prepared to have a rational discussion rather than fight from political stockades built half a century or more ago. That is why the Byers/Cameron initiatives are encouraging: they should make us dump preconceptions. The trouble is that there is no clear and accepted framework for thinking about taxation, or more broadly about the role of government, either here in Britain or anywhere else.

So governments flounder around, launching tax policies that are utterly under-engineered for the tasks in hand. Here we have had endless experimentation with new tax incentives that are subsequently modified or abandoned.

In Germany they are about to increase VAT to try to raise more revenue, when actually revenue has been coming up nicely and a hike in tax may so clobber Germany's modest recovery that they may end up with less revenue, not more. In the US they have had a programme of tax cuts that, on paper, will end after a 10-year life with tax rates going back to where they were at the beginning. Everyone knows this will not happen but the legal form of the cuts says it will.

Now help may be at hand. The Institute for Fiscal Studies is starting a comprehensive review of tax under Professor Sir Jim Mirrlees, the Nobel Prize-winning economist. But meanwhile we need a framework to think about tax. It is such a huge subject that we need to be able to break it into bite-sized chunks. Some thoughts.

First there are the arguments about the efficiency of individual taxes: do they distort the economy, are they socially just, can they be avoided, etc? The most important question of this clutch seems to me to be: do they raise much money?

There are some taxes thatare and will remain absolutely essential for the rest of our days. These include income tax, some form of VAT or consumption tax, and some form of national insurance. But there are also lots of small taxes that don't raise much and need therefore to be questioned. Inheritance tax comes into that category, because, even after substantial rises in house prices, it only raises £3.5bn a year, about 0.75 per cent of total revenues.

There is a further element to this debate. That is how taxes interact with each other in a dynamic economy. For example, were IHT abolished there would be some increase in other revenues simply because some Britons would not move abroad when they retire. But what we don't know is whether those offsetting additional revenues in income tax and VAT, etc, would be £50m, £500m or £5bn.

That is kind of important. The notion that you get more overall revenue by abolishing a tax might seem counter-intuitive, but there are plenty of examples of increased revenue coming from cutting tax rates. Irish corporation tax, now down to 12.5 per cent, is perhaps the best recent example.

At the next level of generality there are a series of arguments about the wider economic impact of taxation on economic growth. In small economies there are certainly good examples of tax cuts stimulating growth, with again Ireland being an obvious case.

At a corporate level tax is clearly very important an element in deciding where to locate investment though it is by no means the only one. The UK is projected to be the second largest recipient of inward foreign direct investment, after the US and ahead of China, in the years to 2010 - this in a new survey by the Economist Intelligence Unit out today. Yet Britain is now no longer a particularly low tax country for companies: the average tax rate for the EU new members is 20 per cent, against our 30 per cent.

If you look more generally at overall tax levels there seems to be some evidence that lower-tax economies grow faster. The UK, with still somewhat lower taxation than other large European countries, has tended to grow faster. We certainly spend a higher proportion of our income on consumption. But you have to be careful about assuming causal relationships. To some extent low tax countries are able to drop tax rates because - for whatever reason - they are growing quickly: growth provides the revenues.

I think we ought to admit that there are great uncertainties over the relationship between tax and growth. We ought to look at practical evidence - for example, where do companies and indeed people move to? - rather than have strong ideological opinions about the matter.

Then there is a third, still wider, level of debate. This is about the nature of government itself. What is government for? What should be within its scope to handle and what should be outside?

Look back 30 years and it is extraordinary how much has changed. I saw a photo the other day of the heads of the nationalised industries, all standing in line at a meeting of "Neddy", the National Economic Development Council. Those jobs no longer exist. Even the idea of a joint industry/government/trade union economic planning body seems strange. The idea that the Chancellor of the Exchequer should set short-term interest rates also seems archaic, and that after less than 10 years.

On the other hand, some of the present concerns would have seemed very odd to an earlier generation. All the targets for education and other functions would seem extraordinarily detailed. I am waiting for a new set of targets for obesity among MPs and the Cabinet: all MPs must have target weights and no deputy prime minister should weigh more than 13 stone.

Looking ahead, we can be pretty sure that similar changes will take place in government and governance: what we regard as normal now will seem very odd in 2030. One particular issue is whether fiscal policy should be taken out of political control in much the same way as monetary policy has been.

The key point is that government this century will be utterly different from government now. There is no road map for what it will be. So we had better start thinking about this in an innovative and apolitical way. And it is more interesting than death and taxes.