Wall Street Journal: Is Britain Finished?

Slug path
Old Teaser

The country's only chance is a leaner, sounder and less indebted government.

Hope springs eternal in the breasts of politicians. None more so than in Alastair Darling, Britain's chancellor of the exchequer, as he delivered his annual budget speech to Parliament last week.

He conceded that Britain's economy was in a bad way. It would shrink by 3.5% this year, rather more than the 1% dip he forecast only in November. But hey, every country is in a bad way right now, and by 2011-12 the U.K. will be growing again at a record, rip-roaring rate of 3.5%. Crisis? What crisis?

Unfortunately, British budgets tend to unravel pretty quickly. Ever since the £5billion "stealth tax" on pension funds that Gordon Brown somehow forgot to highlight in his 1997 budget speech and which helped to kill half of Britain's workplace pension plans, people listen to the chancellor with more than the usual skepticism, waiting until the number-crunchers expose the real figures a few days later.

We only had to wait a couple of days before the Office for National Statistics punched a hole in the chancellor's optimism. It reckoned that the U.K. economy shrank 1.6% in the last quarter of 2008, and another 1.9% in the first quarter of 2009 -- the biggest six-month fall since records began in 1948 and much more than the government had assumed. The International Monetary Fund piled on even more gloom by predicting that this year's drop in British growth would actually be 4.1%, and that the economy would also shrink next year, when the chancellor had counted on a turnaround. It is all bad news for a government desperately trying to borrow its way out of the crisis while soaking the "rich" by raising the top tax rate to a confiscatory 51.5%.

Another popular British sport is watching the government default on its borrowing estimates. The last time the government managed to stay within its own budget deficit forecast was in 2000. Recently, the difference between planned and actual borrowing has become spectacular. In his 2008 budget, the chancellor figured he might have to borrow £70 billion between now and 2011. Last week, his estimate was five times that -- £348 billion. By 2013-14 he will need £703 billion of debt finance, twice as much as he forecast just five months ago. Britain would be borrowing for the next 22 years -- and that's on Mr. Darling's heroic economic assumptions, which can't possibly be met.

* * *

Britain's Labour leaders have been keen to blame bankers, particularly American ones, for the country's woes. To some extent, though, Labour leaders have brought this crisis on themselves. They saw financial services, not manufacturing, as Britain's future and encouraged it. Financial wizards left Manhattan for London, attracted by the lower taxes and easier regulatory environment. The City's financial market boomed, contributing 8% of GDP and 15% of all corporate taxes. But Britain's heavy reliance on financial services left it seriously exposed when the banking crisis finally hit.

Add to this the imprudence of the public sector and private households. Over the past 10 years, Britain has grown on the back of government and consumer spending, both fuelled by debt. But while households are now cutting back and paying down their debt, the government is spending and borrowing even more.

There comes a time when short-term borrowing turns into a long-term problem. Britain's government debt is still triple-A rated, but a recent auction of U.K. government paper failed to sell in full and some traders already price it lower than some commercial companies' debt. Britain's government could find it harder and more expensive to borrow the huge amounts it seeks.

Already, the government is beginning to look desperate. Mr. Darling plans to hike the top income tax rate from 40% to 50% (plus 1.5% compulsory National Insurance contributions) on people earning more than £150,000. By scrapping certain tax deductions, those making more than £100,000 would also have to pay higher taxes.

This is all eerily reminiscent of Denis Healey, the Labour chancellor of the late 1970s, who promised to "tax the rich until the pips squeak" with rates as high as 83% on income from work and 98% on investment income. In the end, he had to ask the IMF for an embarrassing bailout.

The trouble with taxes is that above a certain level, raising them is counterproductive. People will find it economical to hire expensive accountants to avoid paying the full amount. If everything else fails, they may take themselves and their money abroad to gentler tax jurisdictions, as the actor Michael Caine just threatened to do.

The Treasury claims that the new 50% rate will bring in £1.3 billion next year, but the Institute for Fiscal Studies says it might not raise anything at all, since perhaps 70% of top earners will either evade or avoid it. The Center for Economic and Business Research thinks that as many as 25,000 top earners may leave the country, costing the government -- and the London financial market -- hundreds of millions of pounds in lost tax revenues and investments.

Taking 51.5% of people's earnings sends all the wrong signals. It absurdly suggests that the government is better at spending our money than we are. Higher taxes will simply induce people to spend less and leave entrepreneurs with less for investment, neither of which will help Britain recover.

When Margaret Thatcher's government slashed the top rate to 40%, high income earners actually paid more, and contributed a far bigger proportion of total revenues, than they had before. Even former Labour Prime Minister Tony Blair denounced the 50% tax rate as "wrong, seriously wrong."

Interestingly, while higher income earners are supposed to bleed for the nation and businesses have been hit by the full force of the recession, government workers and their generous index-linked pensions have been left largely unscathed.

And what of the Conservatives? There has to be a general election in Britain before June 2010, and with an 18-point lead in the polls, they are the clear favorites. It would then fall to party leader David Cameron and his colleagues to sort out Britain's debt mountain. Will he have the steel to bring the public finances back into order?

He has spent much of the last few years trying to make the Tories look kinder, gentler -- majoring on social justice rather than tax cuts. He's even said that, although the new 50% rate was a "pathetic piece of class war posturing" rather than sound economics, removing it would "not be a high priority" for any future Conservative government.

But that's because although Mr. Cameron may have tried to rebrand the Conservatives, he still shares one of Mrs. Thatcher's core principles -- that a nation, like a family business, has to balance its books. Already he is calling for a "government of thrift" where civil servants get paid for "producing more with less, not less with more." Like the Iron Lady, he warns of the evils of debt and inflation.

He must know that if he becomes prime minister and fails to deliver a leaner, sounder, less indebted government, his party will be finished. Even worse, so will be Britain.

Mr. Butler is director of the Adam Smith Institute and author of "The Rotten State of Britain: Who Is Causing the Crisis and How to Solve It" (Gibson Square Books), published last month.

Published in the Wall Street Journal here