To Arms

by Hew Strachan

  TAXATION

  The choice between taxation and borrowing as means to finance the war was at bottom a choice between taxation now or taxation in the future. Loans contracted during the war would have to be repaid on maturity through tax receipts. They could, of course, be postponed by contracting fresh debt, but even if the state thereby retained the principal over a longer period taxation would still be required to pay the interest.

  Servicing the debt made loans more expensive than taxation. But it did not follow that the state should therefore tax heavily in order to pay for as much of the war as possible out of current income. Part of the case against such a policy rested on the principle of equity. Those fighting the war were making sufficient sacrifices for the future well-being of their societies for it to be reasonable to expect not them but their successors to meet the financial costs. In addition there was an economic argument. The taxable capacity of a country was a reflection not simply of the money in circulation but also of the goods and services for which the money was the means of exchange. Waging the war depressed both commerce and those industries which were not war-related. Peace would revive normal business. Thus, a higher tax burden would be easier to sustain after the war than during it.

  The problem of post-war reconstruction was therefore a material consideration in the development of intra-war taxation. But it was one which split both ways. The easing of taxation after the war would boost consumer spending and so help reactivate peacetime markets. This, then, was a case for a short, sharp shock—heavy taxation in the war. The opponents of such an approach contended that excessive taxation during hostilities would erode individual savings. Consequently, potential consumers would be too impoverished to be able to buy goods when they were once again available.

  The real difficulty with not taxing heavily during the war was that those whose incomes were left relatively untouched could not be relied upon to save the money they earned. Inflation eroded the real value of capital. Goods seemed a securer investment. But because the state was increasingly taking over the means of production for the needs of the war, goods were in short supply. The consequent monetary overhang—the problem of too much money chasing too few commodities—prompted price inflation. An effective system of wartime taxation which reduced the purchasing power of the consumer was therefore an essential element in the armoury of price control in particular, and of inflation control in general. Because there were few goods to buy, heavy taxation was unlikely to curb actual consumption any more than it was already depressed by the war. And since the war made the state the most important arbiter in the investment of capital (as well as the most significant consumer of its products), there seemed little short-term case for saying that taking such decisions out of private hands restricted industrial growth.

  Government policy, therefore, had to strike a balance between on the one hand actively dampening consumer activity over the short term and on the other securing immediate and, above all, future capital investment. The result was a taxation pattern that in its final form inverted peacetime priorities. Broadly speaking, taxation ceased to be socially progressive. It needed to shore up the wealth of the rich, since this might be invested in goods and services over the long term, and it needed to reduce the disposable income of the less affluent, which would otherwise contribute to price inflation.

  The most striking illustration of this process was the declining significance of inheritance tax. Death duties had generated major constitutional struggles in Britain in 1909–10 and in Germany in 1906–13. In both cases expenditure on armaments had been the prime motor for change. But during the war the egalitarian argument for the direct taxation of large estates was offset by a desire not to penalize patriotism. The deaths of heirs in action threatened families with payments in unexpectedly rapid succession. Britain in 1914 granted relief to those estates where war casualties resulted in the ownership changing more than once. A single transfer caused by a war-related death could be offset by deferring payment until three years after the war’s conclusion.154 Thus, yields rose only marginally and then stabilized. No alternative emerged, despite pressure from the Trades Union Congress in September 1916. Sidney Webb called for a levy on accumulated wealth to reduce government debt and as an alternative to higher rates of income tax. He argued that interest payments would fall, with the result that the profits of rentiers would slump and investment in production rise. But the Treasury rejected the idea for fear that property sales to release cash would cause a slump in values, and that individuals would therefore borrow to pay the levy rather than invest in government bonds155. In France the return on inheritance tax averaged 100 million francs less than the 1913 total in each of 1914, 1915, and 1916. Only in Germany did the annual income on death duties rise progressively—from 47.1 million marks in 1913 to 77.8 million in 1918.156 And even here the increase was not proportional to the growth in direct taxation in general.

  The declining significance of inheritance tax was, above all, relative. In Britain it accounted for 13.8 per cent of all direct taxation at the war’s outset, and 3.4 per cent at its conclusion.157 Other forms of direct taxation, therefore, grew at a much faster rate. In Britain the most important was income tax, which netted £47.2 million in 1913,£205 million in 1916, and £291.1 million in 1918. None of the other major belligerents possessed an effective form of income tax in 1914. Nor did they develop one during the war. Their major revenue producer, a tax also introduced in Britain, was a duty on excess profits arising from or during the war. Delays in its introduction and problems in its assessment meant that the duty varied in its application from country to country, and that it only made an effective contribution in 1917 and 1918. But by the last year of the war it provided France with just under a quarter of its direct taxation, Britain with nearly a half, and Germany with almost all.

  A major question in relation to excess profits duty was the identity of the ultimate payer. Ideally the burden would be shifted onto the consumer. Levies on excess profits would therefore constitute a form of indirect tax, and could depress consumer demand.158 But such theorizing harboured a logical inconsistency. The industries making large profits in wartime were doing so out of the war; their principal client was not the public but the state. But the state’s spending was not easily curbed. Thus, if the war profits tax was borne by the prime consumer it would not inhibit inflation but promote it. The tax would drive up prices which the state could only then pay by further taxation (and a further increase in prices) or by borrowing. The corollary of an excess profits duty, if it was not to stoke credit inflation, was an effective policy of price control.

  The crux of the debate between state and business over war profits was, therefore, the question of what constituted a reasonable return on capital. Firms argued that a radical reduction in their profits would inhibit reinvestment and reduce the plant devoted to war production. Taking the average of pre-war profits as a basis for comparison, which is what most states did, had the disadvantage that firms producing war goods reckoned on a high level of profits during the course of hostilities to sustain them in peacetime when orders were slack. On the other hand, the three years before 1914 were marked by unwonted activity in the armaments industries of Europe. The distinction between war and peace might be less immediate in terms of war profits than it was in many other areas.

  What was clear was that a levy on excess profits could only reduce the demand for goods where peace industries flourished alongside war industries. In these circumstances the duty would act in the same way as indirect taxation. This argument was advanced in the United States. But there, as elsewhere, the nominal returns on indirect taxation fell. In 1916 excise duty accounted for 47.6 per cent of federal revenue; in 1918, 17.9 per cent. Customs receipts declined from 27.2 per cent to 4.4 per cent over the same period159. In Germany indirect taxation fell from 81.3 per cent of ordinary receipts in 1913 to 47.9 per cent in 1918; in Britain from 46 per cent to 21.2 per cent; and in France from 53.5 per cent to 43.1 per
cent.160 The goods were simply not available in sufficient quantity to produce the cash required. Industry’s production for public consumption was pared to essentials. Imports of luxuries and non-essentials were limited in order to maximize shipping space and foreign purchasing power for war goods.

  Much of the increase in direct taxation was therefore no more than relative—a response to a decline in absolute yields elsewhere. Germany between 1913 and 1918 increased its direct tax from 3.5 per cent of its ordinary receipts to 47.9 per cent without establishing a proper Reich income tax. The growth looked so dramatic because, for example, customs, responsible for raising 679.3 million marks in 1913, fell, under the impact of the blockade, to 133 million marks in 1918.161

  Falling real levels of indirect taxation meant that direct taxation was the only effective tool with which to control consumer-led inflation. The major potential change in taxation policy was that which made income tax a burden on all wage-earners and not just on the wealthy. But the belief that the principal aim in war finance should be the securing of cash, not the curbing of consumption, died hard. Even in 1921 a distinguished British economist, A. C. Pigou, observed that a man who paid his income tax by reducing his consumption might manage—because he would avoid indirect taxes on goods— to pay less tax, not more. Pigou’s attention was on the need to raise money to cover the real costs of the war.162 But in practice the function of wartime taxation was less important to this than to the reduction of the monetary overhang created by credit inflation.

  In these terms, no power, not even Britain, taxed as heavily as it needed to or could have done. But, arguably, the possibility of harsher regimes became more evident after the war and with hindsight than it was at the time. Taxation itself was a cumbersome instrument of economic control, in that its burdens were slow to take effect. New areas of liquidity became evident in retrospect; new taxation was applied in future. The time-lag between cause and result was therefore at least a year. The war, however long, presented rapidly changing economic conditions, but conditions whose longevity was of uncertain duration. Pacing the financial effort and retaining a system which would enable a swift change to peace were both factors inhibiting innovation. The taxation systems of most belligerents, therefore, changed little and late. Those states that taxed most efficiently were those that had the appropriate taxes already in place when the war began.

  In Britain income tax was first adopted, in 1799, specifically as a war tax. It was the engine by which the nation harnessed its commercial strength to military applications. But in 1842 Sir Robert Peel employed the tax in peacetime, albeit still on a temporary basis, to enable a reduction in indirect taxes in his bid to stimulate the expansion of commerce and consumption through free trade. So apparently successful was this policy that Gladstone felt consistently able to promise its abolition. But in reality the burdens of colonial defence made the financial distinction between peace and war increasingly irrelevant. Gladstone’s logic, that Britain would be unlikely to go to war if income tax resumed its primary status as a war tax, and if—broadly speaking—liability for the tax correlated with the parliamentary franchise, proved unfounded. The rebuilding of the Royal Navy under the pressure of competition with France raised the basic rate from 5d. to 8d. in the £ in 1885. The Boer War pushed it up to is. 3d. in 1902–3, and in the five years before 1914 it stabilized at is. 2d. In 1900–14 the average tax burden per person per year in the United Kingdom was £3.44, about £1 more than in the other developed countries of the world163. Britons avoided the necessity of conscription by virtue of their dependence on the navy for primary defence. But they paid for the privilege in cash.

  The result was that in 1914 Britain possessed, as no other nation did, the basis for a system of war finance. It had developed the machinery which enabled it to draw on the nation’s liquid assets. The Dreadnought revolution was funded not through loans, as was half of Germany’s spending, but through income. Britain’s lead over Germany was not only naval but also fiscal. Therefore, unlike Germany or France, its stock market was not already encumbered with a superfluity of government stocks. Indeed, in 1914 Britain budgeted for a surplus which was to be applied to the reduction of the national debt.164

  Pre-war opponents of the naval programme argued that the revenue implications were eroding Britain’s fiscal base—that the wealth required in the event of war was being spent before the war broke out.165 In reality income tax, despite its high rate compared with other countries, had plenty of spare capacity. Real earnings per worker rose 36 per cent between 1875/6 and 1889-1900, and yet most did not become liable for direct taxation. In 1913–14 only 1.13 million of the country’s electorate of 8 million were paying direct taxes. The political acceptability of the ‘people’s budget’ of 1909 resided in the fact that its principal burden fell on 11,000 payers of supertax and on the heirs of estates valued at £20,000 or more. With allowances for children and reduced rates on small earned incomes, it exempted most working-class and many married middle-class men. Those taxes which did affect the working class, indirect duties, fell from 70 per cent to 55 per cent of the total tax yield; the cost of customs and excise per head of the population rose a mere 2 per cent. The bulk of the British population, therefore, was encumbered with taxation that was no more than nominal. The country, the supporters of Liberal defence policies contended, was getting financially stronger, not weaker; the total wealth not taken by taxation was put at £1,747 million in 1904–5 and £2,020 million in 1914.166

  The advice of the Treasury to the chancellor of the exchequer on the war’s outbreak, therefore, was that he should increase income tax. By November 1914 Britain’s liquidity was rising as the government spent the money it had borrowed to pay for the war. But Lloyd George’s budget of that month, the first of the war, was, by common consent, not as fierce as the circumstances demanded or as parliament was prepared to accept. On the advice of Austen Chamberlain (speaking for the Conservatives) he did not expand the levying of direct taxation to embrace all income-earners. Liability remained confined to those earning £160 or more per annum, and Lloyd George restricted himself to doubling the basic rate from 9d. in the £ to is. 6d. and to proportional increases in the higher rates. To compensate for his feebleness over direct taxation, the chancellor increased the duty on tea from 5d. to 8d. in the £, and on beer from 7s. 9d. to 25s. per barrel. But as he aimed to reduce consumption of the latter by 35 per cent through restricting the hours of opening of licensees, the total increase from both sources in the first full year of operation, 1915–16, was reckoned to be about £20 million. Lloyd George’s arrangements increased the revenue for the year 1914–15 from its peacetime target of £207 million to an actual figure of £226.7 million. And yet he was anticipating expenditure of £555.4 million, of which £348.5 would be attributable to the war. One of his parliamentary critics, Thomas Lough, pointed out that six-elevenths of the costs of the Crimean War were covered by tax, and two-fifths of those of the Boer War, but on present reckoning only one-seventy-fifth of the current war167.

  The shortfall between Lloyd George’s rhetoric and the financial substance continued into his second war budget, in May 1915. In the first he had warned of a long war. In February 1915 he continued in a similar vein, calling for Britain to be fully mobilized for total war by 1916.168 But in his budget speech he projected two alternatives—a war lasting until the end of September 1915 and one continuing until March 1916. He put the cost of the latter at £1,136.4 million, but then said that most of that sum would be spent on the army and the navy and would be covered by votes of credit. He acknowledged a probable deficit of£800 million without explaining how he would cover it. He observed the growing liquidity of Britain, prompted by government spending; he noted the rise in earnings; he adumbrated the possibility of an excess profits duty. But the budget contained no increases in direct taxation. When tackled on these points, the chancellor replied ‘with a speech full of taxing precepts, but no taxes’.169

  What really concern
ed Lloyd George was his political position—his status as the representative of radical nonconformity and of its preoccupation with temperance. Growing individual incomes were manifesting themselves in the consumption of spirits, which in turn contributed to gains in the yield on customs and excise. In December 1914 beer-drinking fell 38 per cent, in response to the augmentation in duty, but spirit sales increased 3 per cent. In January spirit sales rose 6 per cent, in February 15 per cent, and in March 26 per cent. Lloyd George attributed falling productivity in war industries to drink. At the beginning of April thirty-three Special Branch men in plain clothes investigated the shipyards, and reported that the problem was local and specific: Clydebank was more affected than Plymouth, and riveters were the principal offenders, especially on Mondays. The king, under Lloyd George’s influence, was persuaded to take the pledge for the rest of the war, but the cabinet decided it would be inexpedient to extend prohibition to his subjects. It also rejected, after somewhat greater deliberation, the notion of a national monopoly. Finally, five days before the budget itself, Lloyd George proposed a doubling of the duty on spirits to 29s. 6d. per gallon, and an addition of 12s. per barrel on strong beers and of 15s. per gallon on sparkling wines. Increases in indirect taxation were to substitute for the failure to grasp the nettle of direct taxation.

  The effect was to threaten simultaneously two props of Asquith’s tottering Liberal government. The Conservatives, on whose tacit support the cabinet relied in order to be able to offset its own radicals, were the traditional spokesmen of the drink interest. Even more seriously, the Irish MPs saw the new duties as an attack on the only major manufacture of southern Ireland. Arthur Henderson, for the Labour party, added his voice to the protest: Lloyd George’s assumptions about its drinking habits were a gross calumny on the working class. On 29 April 1915 the government withdrew its proposed increases in duty, and confined itself to a restriction on immature spirits and to local regulation under the Defence of the Realm act. By failing to take the whole matter of excise within the budget proper, it prevented a full discussion of the financial provision for the coming year.170