The Cash Nexus: Money and Politics in Modern History, 1700-2000

by Niall Ferguson

  In fact, Pitt’s tax was repealed in 1802; and the modified version introduced by his successor Addington when war resumed the following year was voted out of existence as soon as the war ended in 1815. That naval officer spoke for many who declared in 1799: ‘It is a vile, Jacobin, jumped up Jack-in-Office piece of impertinence – is a true Briton to have no privacy? Are the fruits of his labour and toil to be picked over, farthing by farthing, by the pimply minions of bureaucracy?’108 It was not until 1842, as we have seen, that a peacetime income tax was introduced by Peel, and it was (and, in a spirit of defiant parliamentary hope, remains to this day) formally a temporary measure.109 Despite repeated pledges by both Gladstone and Disraeli to do away with this ‘unjust, unequal and inquisitorial’ measure, it has proved indestructible. Moreover, the years since 1876 have everywhere seen a sustained rise in the rate at which the tax is levied. At its lowest level after 1842 (the mid-1870s), the standard rate of British income tax was less than 1 per cent. By the eve of the First World War, however, it had risen to just under 6 per cent. By the end of the war the figure was 30 per cent. It was only 1 per cent lower on the eve of the next war. By 1945 the figure was 50 per cent. The standard rate fell only slowly in the post-war years: in 1972 it was still just under 39 per cent, and reductions of what became known as the basic rate in the 1970s were compensated for by higher rates for higher incomes (see below). Only with the election of Margaret Thatcher in 1979 was there a real effort to reduce income tax, though the basic rate at the time of writing (23 per cent) is still higher than the average for the First World War years.

  There are a number of ways to refine the income tax. It is possible to exempt poorer taxpayers by setting a threshold below which no tax is payable. In thirteenth-century England, householders with movable property valued below 10 shillings enjoyed such an exemption; after 1334 the proportion of the population which was below the direct tax threshold fluctuated between a tenth and a half.110 Pitt’s tax exempted incomes below £60 a year; while Peel’s income tax, introduced at a rate of 7 pence in the pound (3 per cent), exempted all those whose incomes were below £150 per annum.111 Thereafter, tinkering with the threshold became a favourite occupation of Victorian Chancellors of the Exchequer. In 1853 Gladstone lowered it to £100, which he called ‘the equatorial line of British incomes’. In 1874 Disraeli put it back up to £150.112 Another form of partial exemption is the allowance, which effectively raises the threshold for specific groups by making an additional tranche of their income tax-free. In 1909, for example, Lloyd George introduced an allowance of £10 per child for parents.

  Aristocratic polities, of course, were just as likely to grant exemption from tax to the rich: indeed, for most of the early modern period exemption from tax was as much a privilege of high rank as of low income. This was the principal defect of the French taille, which was unpopular mainly because the large number of exemptions drove up the burden on those who did pay.113 Nor was it easy to get rid of such privileges once they were established. Attempts in Catholic states to increase clerical taxation at the time of the Reformation led to a strike by the clergy of Castile in 1532.114 Between 1561 and 1788 the proportion of total French expenditure paid for by clerical taxation fell from 15 per cent to just 1 per cent.115 Attempts to increase the taxation of the French nobility after 1749 generated loud complaints; and even Calonne assumed in his plans for fiscal reform that the nobility would not have to pay the taille, or indeed the capitation.116 Nor was it only the nobles and clergy who avoided paying the taille: magistrates, royal officials and some urban élites were also exempt. Prussian landowners regarded exemption from taxation as a privilege of their rank, and persisted in evading tax even once it had legally been imposed upon them; something they could easily do in their capacity as local tax-collectors.

  The converse has proved less true: left-wing governments, whatever else they may have achieved, have failed to preserve the Victorian exemption of the working-class from income tax. The main reasons for this have been the huge costs of the world wars, which necessitated a widening of the tax net; the rise of working-class income far above subsistence level; and the effect of inflation, which has lowered the real value of thresholds (the phenomenon of ‘bracket-creep’). In Britain the number of income tax payers more than trebled from 1,130,000 in 1913 to 3,547,000 in 1918, while the proportion of wage-earners paying tax rose from zero to 58 per cent.117 In Germany after 1918 tax deducted from wages at source accounted for a steadily rising share of total direct tax revenue as middle-class taxpayers delayed payment of their tax bills, leaving inflation to reduce them in real terms.118 Lowering allowances, or allowing inflation to lower them, remains the simplest means of increasing income tax. It was one of the ways Britain financed the Second World War, though in this case the additional tax paid as a result of the reduced personal allowances was subsequently repaid (albeit in depreciated pounds). Since the war, the tax threshold has crept relentlessly downward. In 1949 a father of two on average manual earnings paid no income tax; but twenty years later he began paying tax as soon as his earnings exceeded 53 per cent of the average. Conservative rule in the 1980s and 1990s did nothing to halt this trend. In 1979 a father of two had to earn just 35 per cent of average manual income to become liable for income tax. By 1995 the figure had fallen to 30.7 per cent.119

  It is also possible to differentiate between different sources of revenue, so that (for example) income from investments is taxed at a higher rate than income from wages. An early example of differentiation was the subsidy introduced in the reign of Mary I, which was set at 4 shillings in the pound for landed incomes, but just 2 shillings and 8 pence for income from other forms of property.120 When Addington reformed the income tax in 1803, he introduced the five ‘Schedules’ still used by the Inland Revenue today which distinguished the different sources of an individual taxpayer’s income: A (income from land and buildings), B (farming profits), C (public annuities), D (self-employment and other items) and E (salaries, annuities and pensions). Although he made no attempt to tax the schedules differently, a mechanism to do so had been put in place. The introduction of tax deductions for business expenses already implied a discrimination between earned and ‘unearned’ (i.e. investment) income as early as 1853. However, it was not until 1907 that differential rates were introduced by Asquith, who raised the rate on earned income to nine pence in the pound, but the rate on unearned income to a shilling. Lloyd George proposed a further two pence on the unearned rate two years later. Penalizing investment income remained the norm in twentieth-century British budgets until the 1980s.

  An income tax can also be graduated so that the tax rate rises in some kind of (seldom exact) proportion to the size of one’s income. An early example of a progressive income tax was the short-lived French fouage, which was intended to produce an average of three francs per hearth, but rose from one to nine francs depending on the wealth of the household.121 The idea was formalized in the eighteenth century by (among others) Jean-Louis Graslin, who argued for a direct tax scale rising from zero to 20 per cent on the highest incomes.122 During the Revolution Robespierre took up the idea: ‘Those citizens whose incomes do not exceed what is necessary to their subsistence shall be exempted from contributing to public expenditure; the others shall support it progressively, according to their fortune.’123 The association of graduation with Jacobinism took a long time to fade, and not only in France: Gladstone detected in graduation ‘a distinct tendency towards communism’.124 It might, he warned, ‘amount to confiscation’.

  Yet Gladstone himself admitted that ‘the principle of graduated taxation had already been recognized by the income tax exemptions’; and he himself introduced an element of graduation to the income tax in 1853, when a lower rate was introduced for income between £100 and £150; and in 1863, when he introduced a £60 allowance for taxpayers earning less than £200, a device developed further by Disraeli in 1874. The real departure, however, was the introduction of higher rates of tax for h
igher income groups: this came in 1909 with Lloyd George’s ‘People’s Budget’, which introduced three different rates: 3.75 per cent on incomes up to £2,000 a year, 5 per cent on incomes up to £3,000 and 5.83 per cent on incomes above £3,000. In addition a new ‘super-tax’ (‘surtax’ for short) of 2.5 per cent was levied on income above £5,000. Lloyd George’s (defeated) Finance Bill of 1914 envisaged a lower threshold for this higher band and a steeper ‘gradient’, as well as proposing graduation for death duties.125 By 1939 the ‘surtax’ rate was 41 per cent; by 1945 it was 48 per cent (for incomes over £20,000). Again, it was not until the 1980s that these rates were lowered – to 40 per cent in the case of the higher rate.

  Finally, the twentieth century has seen the advent of tax on the incomes of companies as well as individuals. In Britain, the First World War once again was the watershed, with the introduction of the Excess Profits Duty, which taxed the difference between pre-war and wartime profits. The same measure was adopted in the Second World War, when the rate rose to 100 per cent; though there was a 20 per cent rebate after the war. In 1965 the Labour government introduced Corporation Tax on company profits and a Capital Gains Tax on the appreciation of assets.

  The crucial difficulty of income tax remains the method of assessment. Should income be assessed by the state according to ‘objective’ indicators, as was the case in the France until 1914? Or can the state trust citizens to declare their annual income, assuming that the majority will not understate their earnings by too much? If not, how much power of inquisition can the state be allowed? The French preference for assessed taxation – not only of land, but also of businesses, individuals, movable property, doors and windows – proved costly, as the ‘objective’ values in each case tended to lag behind economic growth. The collection of the vingtième, for example, depended heavily on local verification of assessments; but only a fifth of parishes in the pays d’élections co-operated with this in the 1770s.126

  In the United States and in Britain, by contrast, a system of individual declaration evolved. It remains intact in the United States today, where the number of individual tax returns each year now exceeds 120 million. But the enormous financial costs of the Second World War, combined with the rising money incomes of manual workers, brought to an end the purely declaratory system in Britain. Ever since the introduction of Pay As You Earn – PAYE – in 1944, British employers have been required to deduct tax ‘at source’ from the wages and salaries they pay. Even so, income tax is still considerably more expensive to collect than customs and excises. In 1992–3 Customs and Excise collected only 16 per cent less tax than the Inland Revenue, but at roughly half the cost: just over 1 per cent of the total tax collected, compared with a figure of 2 per cent for the Inland Revenue, that employs more than double the number of staff.127At least part of the explanation for this discrepancy lies in the complexity of the system that has developed as one Chancellor after another has tinkered with tax reliefs in the hope of pleasing selected interest groups. In 1989 the Labour MP Frank Field estimated that if all tax allowances and reliefs were abolished, a standard rate of 12–15 pence in the pound would be possible.128

  There is no question that income tax has been the crucial lever of modern fiscal policy. In most states it rose steadily from the 1890s until the 1970s (see Figure 5). However, its importance has varied from place to place. The individual German states followed the British example in the second half of the nineteenth century, but the Reich itself did not secure control of income tax until after the First World War. (‘How jubilant the German people would be’, observed the economist Gustav Schmoller in all seriousness in 1909, ‘had it so adaptable a factor of revenue …’129) During the Civil War, the United States introduced a federal income tax, but it was abolished after the war, and declared unconstitutional by the Supreme Court in 1893.130 The radical principle that the state should not be allowed to probe the individual’s private affairs meant that France did not introduce an income tax until as late as 1914. This difference persists. In Britain and America today income tax accounts for a quarter of total public revenue; in Germany for as much as 36 per cent; in France for a mere 17 per cent.

  Only belatedly (and at much higher rates than Victorian opponents of ‘confiscation’ had expected) did diminishing returns set in. By 1947 the standard rate of income tax in Britain was 45 per cent; that of surtax was 52 per cent. Taking into account the special contribution payable when a person’s total income exceeded £2,000 (50 per cent for investment income over £5,000), the effective rate of tax on investment income above that threshold for a higher-rate taxpayer was 147.5 per cent.131 Twenty years later the situation was little different: by then the effective rate on such income was 136 per cent. Under James Callaghan in the mid-1970s, the top rate of tax was raised to 83 per cent, producing a top marginal tax rate of 98 per cent on investment income.132 It is hard to imagine much stronger economic disincentives than these; though as with indirect taxation, punitively high rates on income are more likely to encourage evasion than abstinence, to say nothing of promoting the art of avoidance. Ultimately, the excessive income tax rates of the post-war period affected enough people directly or indirectly (through their undoubted dampening effect on aggregate growth)133 to generate a political reaction, strongest in Britain and the United States, in the 1980s.

  Figure 5. Income tax as a percentage of taxation, 1866–1999

  Sources: Flora et al., State, Economy and Society, vol. i, pp. 299, 305, 339; Butler and Butler, British Political Facts, pp. 391 f.

  Yet the extent to which the Thatcher and Reagan governments were able to alter their respective fiscal systems should not be exaggerated. The high costs of taming inflation made it difficult to cut taxes across the board; and the net effect of reductions in tax rates was much less than might be expected. True, the marginal rate of taxation in Britain fell between 1978 and 1995 from 53 per cent to 44 per cent. But whereas a married father of two on average earnings paid 20.9 per cent of his gross income in income tax and national insurance contributions in 1978, twelve years later the figure was 20.8 – hardly a huge tax cut. Moreover, the figure rose under the Major government to 22.5 per cent in 1995. On average, those on lower incomes (say three-quarters of average earnings) did slightly worse under the Conservatives than those on higher incomes (50 per cent higher than average). But more striking than this is the general consistency of direct tax rates and indeed the tax burden as a whole.134 It should also be remembered that the proportion of total income tax paid by the top 1 per cent of taxpayers went up from 11 to 15 per cent under Margaret Thatcher: a good example of lower tax rates bringing in higher revenues.135

  THE TWO SISTERS

  The balance between direct and indirect taxation has thus varied a great deal over time and between different states. Indirect taxes accounted for nearly all of the tax revenues of the English crown in the fourteenth and fifteenth centuries, but by the 1550s for little more than a tenth. Throughout the sixteenth century they only exceeded 50 per cent five times; and during the Commonwealth they averaged just 20 per cent. It was not until the 1750s that the share of indirect taxes rose back to between 70 and 80 per cent.136 In the first half of the nineteenth century, despite the sustained reduction of import duties, this did not change much, since the liberal theory that cutting duties would increase revenue proved to be broadly true. However, the introduction of the peacetime income tax confirmed that a liberal trade policy could not be reconciled with continued imperialism without direct tax.137

  In Gladstone’s rather laboured metaphor, direct and indirect tax were like ‘two attractive sisters, who have been introduced into the gay world of London; each with an ample fortune’. Throughout his career, he continued to dream of abolishing income tax, but had to admit that, ‘whether it be due to a lax sense of moral obligation or not … as Chancellor of the Exchequer … I have always thought it not only allowable, but even an act of duty, to pay my addresses to them both’.138 Yet the proportion of tot
al gross revenue coming from direct tax remained remarkably low for much of his career. When he entered parliament in 1832 customs and excise alone accounted for over 70 per cent of gross revenue; in 1875 it was still 64 per cent. Only gradually did the share of direct tax in total taxation rise, from a third in 1868 to 57 per cent in 1910.139 The First World War and its subsequent costs drove the figure up to just under 70 per cent in 1920, a peak not exceeded until 1975, after which the direct tax burden has tended to diminish. At the time of writing, direct taxes account for around half of total UK government revenue.

  France had relatively high direct taxation under the ancien régime –it accounted for some 41 per cent of total revenue – and this remained the case at the end of the First Empire, by which time the figure was 43 per cent.140 But subsequently the balance shifted in the other direction, not least because the various assessed taxes proved to be very inelastic sources of revenue.141 Between 1815 and 1913, direct tax fell steadily as a proportion of total revenue from 34 per cent during the Bourbon Restoration, to 24 per cent under the Second Empire, to just 13 per cent on the eve of the First World War. The proportion coming from indirect tax rose from 22 to 55 per cent.142 Thus, as has rightly been remarked, ‘the principle of justice in the sense of equality of incidence was increasingly infringed de facto though ever more strongly entrenched de jure’.143 The pendulum swung back the other way under the influence of the world wars: between 1920 and 1945 the share of total revenue coming from direct tax rose from 26 per cent to 52 per cent. However, between 1950 and 1975 the proportion averaged just 37 per cent. That was also the figure in 1997.