The star turn at the Jackson Hole symposium, the central bankers’ equivalent of Davos, is traditionally the chair of the Federal Reserve, whose speech is widely scrutinised for hints about the direction of US monetary policy.
But the most talked-about session at the gathering in Wyoming this year was not a central banker talking about inflation and interest rates, but an academic discussing debt.
Professor Barry Eichengreen of the University of California at Berkeley bore bleak tidings for his select audience. The huge public debts piled up during the pandemic and the financial crisis “are not going to decline significantly for the foreseeable future”, he warned, citing a paper he and IMF economist Serkan Arslanalp had written.
Economic growth will probably not be strong enough to bring them down and far from cutting spending, many governments are enthusiastically increasing it, he added.
The Return of Big Government
This is the first part of a series on how advanced economies are shifting back to using fiscal policy to drive interventions
Part one: Tax and spend redux
Part two: The new price of peace
Part three: A green Marshall Plan?
Part four: The case for wealth taxes
While making clear he hoped countries would be able to increase tax revenues or improve growth rates to ease public finances, “the challenges are daunting”, he said.
If his prognosis is correct, then an entire consensus around taxing and spending could start to crumble. Since the 1980s ushered in Reaganomics in the US and Thatcherism in the UK, the dominant political idea in many advanced economies has been smaller states that do less and tax less.
But challenges such as the Covid-19 pandemic, the transition to greener energy and rising geopolitical tensions have emboldened governments to be more hands-on. The current US administration is intervening in the economy in a way not seen since the 1930s.
Keith Wade, chief economist and strategist at Schroders, describes this as part of “the return of fiscal activism”, with governments spending more and also taking a more prominent role in managing the economic cycle.
Paying for more interventionist government will require a rethink of fiscal policy. Sharply rising borrowing costs have made it more difficult for countries that are already heavily indebted to use the bond markets to finance yet more spending.
Taxing the incomes of younger workers to pay for healthcare and state benefits for older citizens — who are often asset-rich but economically inactive — is unlikely to be politically sustainable for much longer. New sources of revenue will need to be found.
“The big issue is how do you persuade the voting public in a democracy that tax revenues are going to rise?” says Edward Troup, the former head of the UK’s tax authority.
“That’s the big political economic question of our time.”
Fiscal attraction
The need for greater government spending is focused on three areas: defence, demographics and climate change.
The fall of the Berlin Wall in 1989 and the end of the cold war brought a peace dividend, with defence spending redirected into other uses. By the end of 2021, fewer than half of Nato’s 31 members met its target of spending 2 per cent of gross domestic product on defence.
But Russia’s invasion of Ukraine and rising tensions between the west and China have prompted many governments to expand their military capability.
Three days after the start of the Ukraine war, Olaf Scholz, German chancellor, talked about Zeitenwende — a tectonic shift — pledging to meet the 2 per cent target by 2024. Japan is planning a 57 per cent increase in its defence budget.
But spending on healthcare and pensions will continue to increase sharply. The old age dependency ratio — calculated as the proportion of people over 65 compared with the number aged 20 to 64 — is set to rise across the OECD, from 33 per cent in 2023 to 36 per cent in 2027 before continuing this rough 1 percentage point a year increase to 52 per cent by 2050.
The exact price of achieving net zero carbon emissions will depend not only on technological innovation, but on governments’ willingness to co-operate. Competition between nations to develop or attract green technology is understandable for reasons of national security, but going it alone is likely to raise the cost of greening economies.
The pressing demands of the green transition and increased geopolitical tension are not the only things spurring a renewed focus on fiscal policy.
Governments have been emboldened by their interventions during the pandemic and the recent energy crisis in Europe, when they organised the rollout of mass vaccination programmes and financial support packages to households and businesses.
The revival of big government that is more active in addressing social needs brings the need for higher public expenditure to solve problems.
“Greater reliance on fiscal policy means that macroeconomic policy will become more political,” Wade says. Whereas central banks rely on a limited toolkit to maintain financial stability and control inflation, fiscal policy “presents choices, such as who and what to tax and where to spend”.
A striking example of this is the President Joe Biden’s green subsidy plan, the Inflation Reduction Act (IRA), passed last year. The package is due to hand out hundreds of billions in subsidies and tax credits for green technologies and manufacturing.
The argument for spending for investment has not been advocated so strongly by a US president for decades, according to US tax historian Joseph Thorndike.
“Biden and his people were channelling Franklin Roosevelt in his purest form and unapologetically so,” he says. “No one has made this argument with such freedom and such conviction since Roosevelt.”
The conundrum advanced economies face is that both the desire and need to spend more comes at a time of mediocre economic growth and tighter financial conditions.
Unprecedented government support to businesses and individuals during the pandemic has already pushed up public debt levels in many advanced economies, while a spike in inflation has triggered a surge in interest rates as central banks battle to tame rising prices.
Increased debt levels and higher interest rates will make it harder and more expensive to borrow in the financial markets, especially for day-to-day spending.
“The current need for revenue, particularly for more defence spending, is really big,” says Pascal Saint-Amans, former head of tax at the OECD. “It looks like tax will remain the flavour of the day.”
However, citizens and businesses in advanced economies are already well taxed. OECD figures show that the average tax burden in member states, relative to GDP, rose from 24.9 per cent in 1965 to 32.6 per cent by 1988 as governments expanded social safety nets and healthcare systems.
Levels of taxation then remained fairly flat until this decade, but they have been rising since the pandemic. The average was 34.1 per cent in 2021, according to the OECD.
Historically [in the US] the most powerful way to garner support for tax increases has been during times of war, by appealing to “shared sacrifice and patriotism”, says Thorndike.
‘Fundamental reform’
Telling the public their taxes will need to go up during a cost of living crisis and at a time of higher inflation is a much tougher sell. “We really have no political language to justify raising taxes any more; there’s no way to make the case for it,” he says.
Helen Miller, deputy director and head of tax at the UK’s Institute for Fiscal Studies, points out that cutting public services is the other alternative. But that is also politically difficult. “We’re a long way from a public debate which goes: ‘Here are the challenges that are coming, what do you want as citizens?’” she says.
Given the difficult politics, the most likely outcome is that governments will seek to muddle through, raising taxes here and freezing thresholds there without too many people noticing.
But many experts think a more radical approach is now required to fix the many ills in most countries’ tax systems.
Judith Freedman, emeritus professor of taxation law and policy at the University of Oxford, says we now need “fundamental reform and not fiddling” with the tax system. This should include looking at the balance between tax on capital and income, whether to tax land more, and the way we tax wealth more broadly, she argues.
Anita Monteith, former head of tax policy at the Institute of Chartered Accountants in England and Wales, says necessity has often been the mother of invention when it comes to tax.
She points to the introduction of a coal tax in the 17th century, after the Great Fire of London. This was levied to help with the colossal costs of rebuilding the City and could be thought of as an early energy tax.
“It just goes to show there’s nothing new under the sun when it comes to tax policy,” Monteith says. She predicts that governments will turn to more environmental taxes but warns that they will need to think through any unintended consequences carefully.
Mahmood Pradhan, head of global macro economics at the Amundi Institute, says that “without carbon taxation and that commitment from the public sector, we may not make the green transition”.
Another option would be to revert to the trend seen before the 20th century and tax wealth more. This is something a group of millionaires from around the world are urging leaders meeting at the G20 in India this week to consider.
Their letter to heads of state said an international agreement on wealth taxes “would shrink dangerous levels of inequality” as well as raising funds.
“Up until the first world war Britain primarily taxed wealth — land and inheritance,” explains Norma Cohen, an honorary research fellow at Queen Mary University of London, and a former FT journalist. “Among the reasons for that was that income inequality was so great. There wasn’t enough income to tax.”
As societies age and a rising percentage of the population lives on pensions rather than income from employment, wealth could once again make up a bigger slice of the tax take. “Demographic change alone will force us to tax wealth. Income will just not be enough,” Cohen says.
Others agree. “Political pressure to tax capital will be perennial,” says Pradhan. “Capital gains taxes in a lot of countries are quite low.”
Troup argues governments should make more effort to redistribute wealth from older to younger generations.
“Taxes should be raised on me and my generation of boomers that have become unproductive,” he says. “The boomer generation is undertaxed. The problem is they’re quite vocal and numerous.”
Saint-Amans, meanwhile, points to OECD stats on property which showed the tax take from the asset class is modest across advanced economies. A 2021 report found the revenue from immovable property as a percentage of GDP ranged from 0.1 per cent in Luxembourg, to 3.1 per cent in Canada — with an OECD average of 1.1 per cent.
Property taxes, particularly those based on the underlying land value, should be reviewed, adds Freedman, although governments considering these should look carefully at the history of what has not worked before and learn from it.
The difficulty with wealth or property taxes as a solution is that historically countries have not found levying them to be easy or politically attractive. Any movement towards these taxes is unlikely to be straightforward.
“Attempts to tax development gains in the past have resulted in taxes that inhibited the release of development land, which is obviously undesirable, or very complex schemes giving rise to avoidance,” Freedman warns.
The recent trend of windfall, or excess profit, taxes in Europe could also be a harbinger of things to come. Freedman says Italy’s surprise introduction of a levy on bank profits in August showed what politicians were likely to do when faced with revenue shortfalls.
“They will have a short-term crisis and introduce a short-term tax,” Freedman says. “That is not going to solve problems in the long run.”
Cohen believes governments could learn from the wartime experience of Britain, and others, which introduced an “excess profit duty” on corporate profits in 1917 to help pay for the war. By the last fiscal year of the war, 1918/19, the tax accounted for a third of revenue raised by Britain.
The shift to a carbon neutral economy and the mass adoption of generative AI could also have an impact on how states tax. Treasuries will, for example, have to rely less on fuel duty as drivers shift to electric vehicles.
The 20th-century fixation on income taxes could prove outdated in the 21st as labour becomes increasingly automated. Chris Sanger, global government and risk tax leader at EY, says: “If you think about the increasing use of robots and other items — are we still going to get that high proportion [of tax revenue] from work?”
It is not certain that governments will be able to raise revenues significantly, as Eichengreen warned. Even if this is the case, the greater use of tax and spending policies will lead to increased scrutiny of countries’ financial strength and fiscal credibility.
“Governments . . . have to retain a credible fiscal framework in their budgets where, for example, the debt-to-GDP ratio stabilises over the medium term,” says Wade. “Otherwise, they risk the ire of the so-called bond market vigilantes and seeing extra expenditure eaten up by higher interest costs as markets sell off.”
The fiasco of the UK’s 2022 “mini” Budget — when investors were blindsided by the surprise announcement of £45bn-worth of unfunded tax cuts and reacted by selling UK gilts — is a case study of what not to do.
The consequences for how governments conduct themselves and the need to address long-term issues will have an impact on economies, markets, people’s individual finances and ultimately the planet itself. As always with tax, there will be winners and losers on the way.
“You really need to think through the effects,” Sanger says. “Tax policy is a very powerful tool.”
Data visualisation by Keith Fray
