Higher tax could mean less revenue

People think of politics dividing between rich and poor; increasingly they will divide between working and non-working

The Lib Dem ideas about the future shape of government are fascinating because they draw attention, more sharply than any party conference yet, on the new divide in developed-country politics. This is the clash of interest between people at work on the one hand, and students and the retired on the other. People still think of politics dividing between rich and poor; increasingly it will divide between working and non-working. And the different developed countries will have to figure out ways of managing this tension.

The Lib Dem ideas about the future shape of government are fascinating because they draw attention, more sharply than any party conference yet, on the new divide in developed-country politics. This is the clash of interest between people at work on the one hand, and students and the retired on the other. People still think of politics dividing between rich and poor; increasingly it will divide between working and non-working. And the different developed countries will have to figure out ways of managing this tension.

There is of course an element of rich/poor redistribution in the Liberal Democrat plans: a new top rate of tax of 50 per cent for incomes over £100,000, coupled with higher pensions payments for the over-75s and abolition of student fees. But add in the plan to impose a local income tax to replace council tax and the working/non-working transfer is more significant.

In terms of equity it would be very hard to object to such an idea. Working people, especially the highly paid, can certainly "afford" more. And students and the over-75s could do with more income. The arguments against fall into two groups. One is that increasing taxation on high earners cuts growth potential because it discourages growth industries such as financial services. Lower growth would ultimately cut tax revenues, as is happening in Germany at the moment. The other argument is that increasing tax rates would cut revenue rather than increase it, as more people would take action to avoid the higher tax.

Neither point can be proven either way, though it is true that the proportion of income tax from the top 1 per cent has more than doubled over the past 25 years, as top tax rates have fallen. It is also true that the top 1 per cent of income tax payers pay 23 per cent of the total. So while numerically the Lib Dem plan would not affect many people, it would affect a huge proportion of the revenue base.

I suspect that this second concern is the real reason why Labour has remained so chary about increasing top tax rates: that it might end up with less money, not more. Much better to increase taxes in ways that do not make headlines, though there are some signs that even its "stealth taxes" may be having the same effect: for the last three years revenue has been coming in below estimates. This year, despite very good economic growth, it looks like doing so again. In the five months of the financial year so far, revenues are running 1 per cent below target, which given an expected slow-down next year, is really quite disturbing.

This revenue shortfall is taking place against a background of quite radical tax reform in the rest of the world. In the US there have of course been the tax cuts of President Bush, cuts that would be only partially reversed were Senator Kerry to win in November. But there is a less-noticed revolution taking place in Europe.

Just this week Sweden, social democratic Sweden, has announced overall tax cuts, including the abolition of inheritance tax. It is too early to get any real feel as to why inheritance tax is being abolished but obviously the ageing of the Swedish population must make the political arithmetic attractive. I suspect too that it is at least partly because the tax drives rich Swedes abroad and therefore may cost more in total tax revenues than it brings in.

But tax reform is also happening right across the new EU member states. A few days earlier, Hungary announced a simplified income tax structure, with a top rate of 38 per cent. Meanwhile the Baltic states have all set top rates below 35 per cent, while Slovakia has one of 19 per cent.

One could say that the "old" continental European countries are increasingly finding themselves in a pincer position, being squeezed on the one hand by the US and on the other by the new EU member states. Is their position sustainable?

The reply of the Lib Dems would be that it is. By increasing the top tax rate and coupling this with higher pensions, they are following the established eurozone model. The votes are certainly with the old: soon more than half the electorate will be over 50. And there is a sense in the Government helping to even out people's life-time earnings, so that they - we - get money from the state in the early and late bits of life and then pay in the money during the middle bit when we are at work.

The problem is that while this system has worked very well while the European labour force has grown, it works disastrously as the labour force starts to shrink. Japan has reached this point: its labour force has already begun to fall. Much of Europe now faces the same prospect.

If the number of people of working age is falling, there are only two ways of maintaining the number of people in the workforce. One is immigration, and encouraging that is one of the Lib Dem policies. It will surely happen.

But to maintain the ratio of working people to dependents would require much higher migration than at present and even at present levels there are social strains. The other is to get people into the workforce earlier (for example by getting students to work part time) and encourage them to postpone retirement.

The Lib Dem policies do not really take account of that. Somehow we have to persuade people to work for a higher proportion of their lives but also be prepared to have a considerable proportion of the money they earn taken away from them to pay for people who for whatever reason are not working.

This is the core of the challenge facing all developed countries. It will get more difficult to reconcile the different interest groups with each year that passes. The balance will be determined not by what politicians, or newspaper commentators for that matter, think "ought" to happen but by what does happen. Most politicians inevitably think in terms of their ability to do good by spending money. However, if government revenues fall each year, as is already happening the world's three largest economies (albeit for different reasons), then politicians will have to adopt a different mindset. They will have to find other ways of achieving the objectives the electorates set them.

The Lib Dems don't really take this on board. Instead they believe that by fine tuning the tax and spending system they can improve people's lot. They would adopt elements of the continental European model and believe that this would create an attractive package for voters. In electoral arithmetic it makes a lot of sense.

The trouble is the fiscal arithmetic. By that I don't mean the details of their sums, which has attracted the usual political back-biting. Rather it is the fundamental assumption behind them, an assumption shared with Labour and as far as I can understand the Tories. This is that government revenues will rise in the future. But revenues probably won't, or not by much, because there will not be enough people of working age to pay the taxes.

Lib Dems are thoughtful and decent people and they have the advantage of not having their minds clouded by the experience of office. But we should recognise that their economic policies are tipped towards the growing majority of people who are not at work, rather than the shrinking minority who are. But the latter group has to pay the bills. That is the dilemma of democracy.