To Arms

by Hew Strachan

  Thus, when Reginald McKenna became chancellor later in the same month he inherited a catalogue of missed opportunities, a Treasury anxious to tax more fiercely, and a parliament predisposed to accept its advice. Moreover, in a memorandum of 9 September 1915 Keynes alerted his political superior to the fact that the issue was not simply that of financing the war but of controlling inflation. The war had diverted ‘a greater part of the income of the nation than ever before into the hands of those classes of the population which are not much affected by direct taxation and are not accustomed, or likely at any time, to subscribe largely to Government loans’. In a crude calculation, Keynes reckoned that half the industrial population was employed directly or indirectly by the state, but much less than half its money income was being appropriated by the government171.

  McKenna raised income tax by 40 per cent in his first budget (the third of the war), in September 1915. He lowered the threshold from £160 per annum to £130. Given the rise in nominal wages, McKenna’s measure was the vital step in expanding the number of taxpayers. At a stroke, their number was all but doubled. Furthermore, inflation made the effect progressive. Two million wage-earners became taxpayers between 1916/17 and 1918/19. Arguably, those on lower incomes were still spared at the expense of those with higher earnings. Farmers were to be assessed on their whole rental, not on one-third as in the past. Rates on incomes over £8,000 were increased to 2s. 8d. in the £, and the scale thereafter rose in three further steps, so that an income of £100,000 or more was taxed at 6s. 10d.

  But McKenna’s approach was two-pronged. He doubled duties on tea, tobacco, coffee, cocoa, chicory, and dried fruits, and increased the levy on sugar from 1s. 10d. per hundredweight to 9s. 4d. Imported luxuries were subject to a tax of one-third of their value. McKenna’s motivations were pragmatic. He wanted to depress consumption, to free shipping space for goods vital to the war effort, and to husband Britain’s foreign exchange. He was not a Liberal betraying the party’s cardinal principle of free trade. But inevitably his critics, and particularly the radical opponents of the war policies of Asquithian Liberalism, saw the new tariffs as a sell-out to the Conservatives and to protectionism. Their fears were justified, not by the principle but by the practice: the universal applicability of free trade had been breached.172

  Import duties may have generated the major controversy, but the real innovation of McKenna’s budget lay elsewhere. A duty of 50 per cent was to be levied on all profits earned during the war which were in excess of peacetime norms. In most cases assessments were based on the best two of the three trading years before 1914. For business as a whole, 1912 and particularly 1913 had been highly successful. Therefore this method, not least because it eliminated from the calculation the effects of low profits in any one pre-war year, mitigated the effects of profits made during the war. Big firms making big profits before the war could continue to make comparable gains during it without showing any growth in profit. McKenna himself made the point that no firm would pay anything unless during the whole of the three years 1914 to 1917 it had made an average profit equal to that of the best two out of the three years preceding the war.173 Those companies which still felt themselves harshly treated because they had suffered a more sustained depression could ask to be assessed on the best four years of the six preceding the war. Firms for whom capital formation was relatively more significant (particularly, therefore, those businesses commencing activity or undergoing expansion just before the war) were permitted to base the calculation on a percentage of capital invested. The norm was 6 per cent on 5 August 1914, but private firms were allowed 7 per cent, and a prima facie case for a greater proportion could be made to the Inland Revenue for arbitration by a board of referees. Allowances under this head were particularly frequent in small businesses where capital was necessarily at stake or in larger concerns where the case for capitalizing the profits was linked to such factors as the rapid depreciation of equipment or the expansion of war production. Under the first head, West End theatres were permitted 15 per cent, and under the second aircraft construction was also granted 15 per cent, mining 14.5 per cent, and the iron and steel industries 8.9 per cent.174

  Ironically, therefore, the initial impact of the excess profits duty was not on firms directly engaged in weapons production, not on the profits arising from warfare itself, but on profits made during the war through unwarlike activities. McKenna himself said that the issue was not that of profits from war production per se, ‘but that during the war persons are enjoying profits more than the average’.175 Indeed, the arms manufacturers were specifically exempted under the terms of the Munitions of War act of June 1915. This act gave the government the power to take over control of the arms firms, fixing their wages and salary scales, and setting their profits at 20 per cent of the average of the last two prewar years. The wartime profits which had drawn the attention of the public and of the Treasury were those generated in grain and food production, in the manufacture of boots and clothes, and in the chemical and soap industries. Profits were generated through the creation of new markets for war services; through the curtailment of supplies from overseas, and particularly from belligerents; through population movements within Britain itself; and through the rapid working up to a proper return on new fixed capital unrelated to the war. The Treasury’s survey showed that those industries which were doing well were doing very well, with profits in excess of 10 per cent of capital.176

  One principal attraction of excess profits duty to the Treasury was its simplicity. In 1916/17 56,430 firms were assessed, and the collection of the tax could have proved extraordinarily complex. But its calculation was based on data which the Inland Revenue already possessed. And it operated through self-assessment, relieving the Revenue of the principal onus at a time when it was short of manpower. But the corollary was the possibility of evasion. In a sense this was recognized in legislation that condoned laxity. The state appropriated no statutory powers to examine the books of companies. Many concerns escaped entirely. Agriculture was exempted—partly because it had already been hit by the new assessment of rentals, partly because of its importance to the war effort, but principally because many farmers failed to keep proper accounts. More controversially, shipping also escaped: the formal explanation was that the Admiralty had already commandeered much British-registered tonnage, and that it was now hard to distinguish between the contributions of British vessels and of neutral ships in the transport of British trade.177 The tax was levied on firms, not individuals: thus, for example, a lawyer whose income increased through war-related business would escape the duty, but a small business which had been struggling to make its way before the war would be hit with disproportionate severity.

  Business critics elevated their opposition to a high moral plane by talk of principles. They objected to the principle of retrospectivity; they pointed out that the first year of assessment included months in 1914 when Britain was not at war. Neither criticism recognized the two fundamental objections to the tax. First, it failed to distinguish between profits derived from speculation and profits generated through hard work and increased productivity (both desirable elements in a war, as in any other, economy). The duty effectively penalized good management; cash was capitalized for the development of production but diverted into direct taxation; wastefulness, in so far as it was reflected in low profit margins, was rewarded. As a corollary, new businesses with low profits before the war but which became established during it were hit harder than pre-existing large and over-capitalized firms178. Secondly, firms were not prevented, particularly in the early stages of the duty’s operation, from setting prices to include the tax element. The government was therefore creating profits through its own contracts which it then clawed back again in taxes. Even one of its principal architects, Josiah Stamp, was tempted to conclude that the whole exercise might have been an illusion.179 In so far as the cash gained represented goods and services, he may have been right. But in the struggle to soak up the liqui
d money supply the excess profits duty became an important, if imperfect, weapon in the government’s armoury.

  McKenna tackled the most obvious anomaly, the simultaneous continuation of both the munitions levy and the excess profits duty, in his second wartime budget of April 1916. The arms firms maintained that their agreement with the Ministry of Munitions exempted them from liability to the new tax. McKenna accepted rates of depreciation which would write off the extra capital invested in new plant within the period of the war. But he insisted that the administration of the munitions levy should be in the hands of the Inland Revenue. The first 20 per cent of the new profit was made liable for excess profits duty; any profit beyond that was forfeited to the munitions levy. The merger of the two taxes was completed in January 1918.

  In other respects the budget of April 1916 contained no major innovations. It was, however, widely seen as an assault on the rich. The rate of excess profits duty was raised to 60 per cent; income tax was increased to 5s. in the £ on earned incomes above £2,500 and on unearned incomes over £2,000. Those liable to excess profits duty, surtax, and income tax could find themselves liable to pay joint rates of 77 per cent. The growth in income tax yield was anticipated to be £43.5 million, roughly double that budgeted for in additional customs and excise180.

  McKenna’s tenure of the chancellorship earned the praise of the Economist: ‘The public credit stands unshaken,’ F. W. Hirst averred on 8 April 1916, ‘thanks to the principle of providing new taxes in advance sufficient to cover both interest and a liberal Sinking Fund on the new debt.’181 Presumably the Gladstonian ring of sound financial management in these precepts compensated for the sin of McKenna’s challenge to free trade. In addition, the chancellor had spurned the apparent attractions of many small taxes, costly to assess and complex to collect. Instead, in embracing the excess profits duty, he had established before any other power one of the principal revenue producers of the war. He anticipated a yield, admittedly highly speculative, of £30 million in its first full year of operation. In practice only £140,000 was netted in the half financial year to March 1916.182 But in 1916/17 the tax totalled £140 million against an expected £86 million.183 By 1918/19 it was budgeted to produce £300 million, putting it on a par with income tax, and thus contributing almost half of Britain’s direct tax and over a third of its total revenue.

  McKenna’s credentials were those of Liberal economic orthodoxy, even if his operation of them was stamped with pragmatism. He stood for a strategy built on sound finance. He was therefore a necessary casualty of Lloyd George’s accession to the premiership in December 1916. Bonar Law, the Conservative leader, succeeded him at the Treasury.

  Law was less bound by the legacy of free trade than McKenna. He was therefore able to introduce an increase in duty from 3.5 per cent to 5 per cent on Lancashire cotton goods imported to India. The package was reciprocal; it included a contribution to the costs of the war of £100 million from the Government of India, to be funded not only by the new import duty but also by a war loan. The Lancashire Liberals saw the tax as a protectionist assault on free trade and expected McKenna and Walter Runciman, the former president of the Board of Trade, to lead the attack from the opposition front bench. They did not do so. For them the issues were not those of Liberalism or of free trade, but of effective government, both in Britain and in India184.

  McKenna’s respect for Law’s position was well founded. His successor added nothing to the principles which he had established, and indeed consulted him regularly on financial issues and retained Keynes as his advisor. Law’s priorities were to manage his party, to deputize for Lloyd George, and to lead the House of Commons. The Treasury spared him the accusation of neglect. But it was surprised that his reputation as a practical businessman did not transform itself into consistency of purpose and firmness of execution.185

  His first budget, the fifth of the war, in May 1917 was widely criticized for its failure to increase income tax. He raised the duties on tobacco and entertainments. But in doing so he netted only £26.1 million, or sufficient to fund five days of the war.186 Even his fierceness over the excess profits duty, boosted to 80 per cent, was moderated by concessions. Assessments on the basis of capital were raised from a profit of 6 per cent to 9 per cent (or from 7 to 11 per cent in the case of private companies).

  Law went some way to meeting his critics in the final budget of the war, that of April 1918. The standard rate of income tax was increased to 6s. in the £. The maximum rate of supertax was raised to 4s. 6d., and the income threshold for the tax was lowered from £3,000 to £2,500. Farmers, whose exemption from the excess profits duty aroused controversy, were assessed on double their annual rental. Indirect taxes targeted luxuries, and the duties on beer and spirits were doubled. In increasing the tax on tobacco to 8s. 2d. in the £, Law justified its use of shipping space by saying that ‘in importing tobacco we are almost importing money’187.

  Law failed to note the implication of his claim. If the consumption of alcohol and cigarettes continued despite high levels of duty, taxation generally was making insufficient inroads into the fiscal base of the country. In each of the previous two financial years, 1916/17 and 1917/18, excess profits duty and income tax had brought in yields over budget. The chancellor’s tax provision was not keeping pace with the growth of the money supply. In 1913/14 the gross income of the nation for tax purposes was estimated at £1,167 million; tax was received on £791 million. In 1917/18 the gross income was put at £1,967 million but tax was received on only £1,083 million.188 Income tax peaked as a percentage of the total tax yield in 1915/16; by 1918/19 it had fallen from 38.10 per cent to 32.75 per cent.189 The government response, that the excess profits duty over the same period climbed from 0.04 per cent of the tax yield to 32.06 per cent, assumed that that tax was a direct tax on income. That was the view of business, and as its consent was central to the tax’s collection the exchequer tended to share its view. But most of the government’s critics argued that it was an indirect tax passed on to the consumer, and that in consequence the increase in direct taxation claimed by the government, as well as the corresponding fall in indirect tax, were exaggerated. On their calculations the excess profits duty increased wages and inflated credit, thus multiplying, rather than reducing, the need for harsher income tax.190

  During the war the income tax yield rose six times. This was the multiple by which a typical supertax payer saw his tax burden grow. Somebody earning £50,000 a year paid tax at 8.4 per cent at the beginning of the war but 50.6 percent at its conclusion. But the numbers earning such large incomes were small, and did not grow as much as war-inflated incomes might have led one to expect. Those in Britain with annual incomes of £75,000 to £100,000 increased from sixty-five to ninety-eight over the whole war. In 1913/1413,664 individuals were assessed for supertax. This total had already jumped to 30,211 in 1914/15, and it actually fell in 1915/16 and 1916/17. It rose to 35,564 in 1917/18 and 46,107 in 1918/19.

  The attention to the affairs of the wealthy led to an underestimation of the tax’s impact on the waged. The government seems to have imagined that it was more lenient than in practice it was with those on lower incomes. A person already paying tax at the bottom end of the scale in 1914 saw his tax burden increase twofold during the war to 9 per cent. However, the more realistic picture was not of somebody on a small fixed salary but somebody on a low but increasing wage. The 2.4 million taxpayers who entered the system during the war constituted two-thirds of all taxpayers by 1918/19. The contributions of a waged member of the working class multiplied 3.7 times. The pre-war system of income tax had been a means by which to bind the working classes to the state; wartime levels threatened to undermine this consent.191 But protests were surprisingly muted. Many Labour leaders felt that direct taxation would inculcate political awareness in the working class, and were, accordingly, not opposed to the trend. A perverse proof of their argument was provided in March 1918 when the desperate situation on the western front prompte
d the Scottish miners to shelve their opposition to income tax on patriotic grounds. But the amenability of the miners also suggests that the collective phenomenon was more significant than the individual burden. In 1919 only 4 per cent of the total revenue from income tax was derived from the direct taxation of wage-earners. The system of allowances removed the liability of many men who were eligible in terms of gross earnings. In 1914 allowances for children were doubled for those on incomes of less than £500, and in 1918 extended to incomes below £800 (and for larger families below £1,000). In the latter year allowances for wives or other adult dependants were introduced. Thus, only 25 per cent of wage-earners earning between £130 and £160 per annum actually paid income tax in 1916/17. Although the reliefs did not keep pace with the money supply, the proportion had only risen to 32 per cent in 1918/19. Of 5.75 million people with incomes in excess of £130 per annum, 2.2 million were exempted by virtue of the system of allowances.192 Not for nothing did the working class dub income tax the bachelor’s or spinster’s tax.

  This did not mean that the breadwinners in working-class families escaped tax; they just paid it indirectly. The 2.6–fold increase in customs and excise and the possible operation of the excess profits duty as an indirect tax hit the low wage-earner with several mouths to feed proportionally harder. In 1919 a married man with three children earning £200 a year was not liable for income tax but still paid 10 per cent or more of his income to the Inland Revenue. Indirect taxes, however, were less visible and caused less grumbling. The fact that different taxes hit the working classes in variable ways fragmented possible opposition. And the net effect was to leave taxation operating rather more as Keynes wished it to: it was reducing the consumptive capacity of the bulk of the population.193