Direct Taxation and Economic Growth Author(s): Ursula K. Hicks Source: Oxford Economic Papers, New Series, Vol.

8, No. 3 (Sep., 1956), pp. 302-317 Published by: Oxford University Press Stable URL: http://www.jstor.org/stable/2661759 Accessed: 29/07/2010 07:15
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DIRECT

TAXATION

AND ECONOMIC

GROWTH1

By URSULA K. HICKS
the last few years, in countryaftercountry,the burden of direct taxation has become a live issue. In the industrialized countries high rates oftax establishedduringthe war and largelymaintainedafterit (due mainlyto the needs of defence)are a natural cause of this preoccupation. In the less-developed countries interestin the subject has been no less keen, because of the fear that income and profittaxes, whose revenue is so necessaryto financepublic works,will deterthe industrialdevelopment which is so ardentlydesired. In this countrydiscussion has naturally centred round the Reports of the Royal Commission on the Taxation ofProfitsand Income, and matters arisingtherefrom.2 Althoughthe scope of the Royal CommissionReports was wide,subsequent discussionseems verylargelyto have been concerned with questions of equity. Under the circumstancesthis was probably inevitable. Minor and unnoticed inequities tend to become major, and to attract attention,when tax rates are heavily increased. A great part of the Commission'stime was occupied with mattersof this sort. Secondly, inequitable, as between some sorts of income inflation itselfis inherently receiversand consequentlysome sorts of taxpayers, and others. The fact in a period of rapid inflationdoes not, that taxes may have odd effects however, prove that in general and in a more orderlyperiod the taxes themselvesare wrong. This concentration on the equity aspect of income and profits taxes seems to me to have been doubly unfortunate. On the one hand it has emphasized differences which are matters of feeling (or politics) and forwhich there is little if any quantitative support. On the otherit has diverted attention fromthe economicallymuch more important aspect of the effect of currentincome and capital taxes, or of alternative methods, on economic growth. In the present paper I shall consequentlyleave almost whollyon one side questionsof equity, however defined. In the 1930's we regardedourselvesas a 'mature' or 'stagnant' economy unlikely to develop much further,and in fact, in spite of rather high set-up in the unemployment(much of it a legacy froma very different 1920's) we were doing quite well, thanks largely to the very favourable
DURING The gist of a paper read before the Marshall Society at Cambridge, 10 May 1956. Especially the Second Report ofthe Commission(1954), mainly concernedwithpersonal income tax, and the Final Report (1955), mainly concerned with company taxation. Mr. N. Kaldor's 'An Expenditure Tax' is a notable by-productof his work on the Commission. Reference should also be made to Dr. I. M. D. Little's review of this book in Economic Journal,Mar. 1956.
1 2

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termsoftrade whichgave us our essentialimportsoffoodand raw materials at very little cost in termsof our own efforts.'But in the post-warworld we have become an 'underdeveloped country' ourselves, in the strictly parallel sense of countries like India: first,we are in urgent need to develop faster (in terms of increased productivity,real Gross National Product or what you will) than we were, or probably now are doing; secondly, we have got to achieve this against a backgroundof not very good indigenous resources (of which the 1956 plan of the Coal Board is a sad reminder)and with a chronicshortage of the most needed skills.2

Naturally the outlines of a tax structuretailored for developmentwill in a conventional underdeveloped country look substantially different than in a highlysophisticated economy like ours. Particularly relevant differences seem to me to be three: (i) in an underdeveloped country,in the usual sense of a backward country,a good deal more development than is necessary must be undertakenby the government responsibilities whereindustrialskillsare already mature; hence (ii) in backward countries moreespecially as theyhave need tax revenueveryurgently, governments either at home or abroad (although in borrowing, considerable difficulty with higherinterestrates investorsare more forthcoming);(iii) in backward countriesa much greaterburden of achieving the optimum rate of growthfalls on fiscalpolicy than need be the case in the United Kingdom, because in such countries monetary controls are largely unusable or the problemis similarin the two types of ineffective.But fundamentally economy. Mr. Kaldor and the 'functional financiers'3definethe prime objective of taxation as the avoidance of inflation. In a developing countrythis pressure since inflationary considerationis ofprimeimportanceforgrowth, is likely to be very high where the development programme is large relativelyto the size of the economy,and voluntarysaving negligible. As Professor Lewis has shown4 the prime necessity in such an economy is that the tax structureshould be geared so that marginalrates of tax are always higherthan average; if this conditionis realized then government should always be able rathermorethan to containthe inflationary pressure generated by the process of development. In principlethe simplest type of tax which satisfiesthis conditionis a general progressiveincome tax, but in primitiveconditionsthis is not easy to achieve, and recoursemust
2 Since writingthe above the D.S.I.R. Report on Automation has heavily underlined this point. 3Cf. especially A. P. Lerner, The Economics of Control. p. 239. 4W. A. Lewis, The TheoryofEconomic Control,

ch. xxi. 1 Cf. J. R. Hicks, The Social Framework,

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be had to outlay taxes whichhave some ofthe same effects.Thus expendiin primitive; ture taxes have an importantpart to play in curbinginflation they must be assessed on things of which conditions,but to be effective people buy more as they get richer,and must cover the purchases of as large a section of the population as possible. This is of course far from Mr. Kaldor's expendituretax. For a countrylike the United Kingdom I feel we need to definea tax structuregeared to growth more carefully. The basic needs are (i) to secure adequate rewards for enterpriseand initiative, especially in lines which promise a rapid rise in the G.N.P. (the absence of an effective incometax in a backward countryprobably impliesthat this problemwill investment (capital formationand settle itself); (ii) to secure sufficient control in lines; and (iii) to secure sufficient growth-promoting research) both in the public and private sectors,to of consumptionand investment, enable the authorities to pull back into line the inevitable deviations above or below the 'warranted rate of growth' if they show signs of reachingserious dimensions. This calls for somethingmuch more subtle than is possible in a backward country; however, in a countrylike the United Kingdom taxation is not the only, and not always the best, way of achievingthese objects. Neverthelessit must clearlyplay an important part. At the start I want to emphasize a point that sounds obvious, but is oftenoverlooked: that is that we are now in 1956; it can be dangerously misleadingto attempt to solve the problemsof 1956 in termsof the backa war which groundof 1950or even of 1954. Eleven years ago therefinished had a profoundeffect on the world economy,and moreparticularlyon the British economy. Of the changes wroughtby the war and its aftermath those that are most relevant to our discussioncan, I think,usefullybe put into three classes: (a) those which were essentiallytransitoryand which have now passed away-in most countriesin this sense the war may be said to have ended about 1952, being slightly delayed by the Korean episode; (b) those which have proved more enduring and which still in contrastto a generaltendency exercisesome, althougha decliningeffect, to return to the pre-war trend; and (c) those changes which must be expected to be permanent,fromwhich thereis no going back. Naturally these categoriesmergeinto one anotherat the edges, especially (a) and (b). The permanentchanges meritfirstattention,since they are now part of the data. Of these we may single out five: (i) (more or less) halving of the value of money; this is partly,but not wholly,responsiblefor (ii) the increase in the number of income tax payers fromsome 3 millionto over 17 million,togetherwith a tremendousrise in the heightand progression, both ofincometaxes and of death duties; (iii) a fundamentalchange in the

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of industrializedversus non-industrialized -position countries(save perhaps for the two giants of the U.S.A. and U.S.S.R.); the independence of formercolonies has brought about a real loss to most West European industrializedcountries, whileat the same timethe processofindustrialization of the primaryproducingcountriesimplies both a greaterfood consumption at home and a wider spread of manufacturing skills,all adding up to the virtual certaintythat we shall not in this countryenjoy again the favourable termsof trade of the 1930's; (iv) the establishmentof the welfarestate-not indeed implyingthat the percentageof social expenditure to the national income has been drasticallyincreased,but ratherthat there has been a change from negative social services (concerned with moneygrantsto the poor and unemployed),to positive services ofnational health, family allowances, and old-age pensions, all of which greatly decrease the need for building personal reserves against emergencies (a matter of relevance to personal saving). Against these four changes on forgrowthin the British the whole tendingto make thingsmore difficult of the working economy must be set; (v) the much greaterunderstanding of economicprocesses,implicitin the new techniques of social accounting and input/output analysis. It is importantto note that these changes (or the significant part of them) took place rather quickly in what is now a considerably long time ago; hence it must be expected that theirimpact effects, including the short-period adjustments which individuals and firmsmade to the changes,have now been largelyexhausted. They have become part of the data. Turningto the otherextreme,the transitory changes to which we need now not pay too much attentionare (i) rationingand the mass of war-time controls (in other words, by and large, the price mechanism has been restored both internally and internationally): this is of fundamental of taxation; (ii) the exceptionallylow interest importanceforthe effects rates which were established duringthe war and subsequentlyintensified, partly deliberately,partly as a consequence of a long process of the 'gluttingof a closed economywith cash' in a way that could hardly have been avoided. Nevertheless,although it has formallypassed away, the effect of this war-timechange still casts its shadow in the excess liquidity to exert a creditsqueeze. of the national debt, makingit difficult This latter change is thus almost in my (b) category. The most relevant other change in this categoryis concernedwith what has been happening to the distributionof available incomes. Although the latest figures' are only complete up to 1954, it appears that by then the turning-point had already been reached, and the firstsigns of a return towards the
I

Instituteof Statistics,Apr. 1956. Cf. D. Seers in Bulletin of Oxford

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of the war and its themselves. The effect normalpatternwere reasserting aftermathhad been a tremendous levelling up of distributed incomes, and of course still more of available (post tax) incomes. This levelling categories of income, process had proceeded both between the different and in each category between the skilled and the unskilled,the leaders and the followers. Although the available breakdown of income categoriesis not ideal fromthis point of view, the change is obvious. Between 1938 and 1954 propertyincomes had risen 40 per cent., mixed (farmand professional) 140 per cent., wages 220 per cent., salaries and pensions 250 per cent. and social securitybenefits270 per cent. Since farm incomes rose heavily, there was a relative decline in professionalincomes, while salaries are inflated by the inclusion of a number of new firms' pension schemes. By and large a substantial levellingbetween 'rich' and of by the effects 'poor' is implied. These changes were heavily reinforced taxation: propertyand mixed incomes lost 20 per cent. of their pre-tax incomes,wages, salaries, and pensions only 8 per cent. The two most strikingaspects of this levellingprocess have been the decline in the share of income frompropertyon the one hand and the rise of unskilledrelativelyto skilledearningson the other. Propertyincome of course is by no means whollythe perquisiteof a rentierclass; most of the middle and upper incomes are 'mixed' in the sense of being derived partly from present labour, partly from the fruit of past labour, and extent,frominheritedwealth. Further, partly,althoughto a diminishing the wage-earning elementin the economy; his rentieris a very significant quite extensive savings are largely invested in house property,which, due to rent control,has suffered the largest decline of any category. It is more true to say that levellinghas been at the expense of saving than at the expense of a now relativelyunimportantrentier'class'. A change of this type has been experiencedin all Westerncountries; it is an inevitable forBritain is first, accompanimentof war and inflation. The significance that in 1938 post-tax incomes were already more equally distributed than in comparable countries,forexample Canada and the United States; to a greaterextent secondly,that the natural change has been reinforced by deliberate policy. Not less significant than the greaterequality betweendifferent categories of income in the United Kingdom is the greaterequality between different types of income withincategories,especially betweenskilled and unskilled in the weekly wage-earning groups. Here we can draw on Professor Lloyd Reynolds's1 elaborate long-period international comparisons between the wage structure of the United Kingdom, United States, France, Switzerland,and Canada, as well as the moretentativeconclusions
1

Yale UniversityPress. The Evolution of Wage Structure,

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he has reached concerning the U.S.S.R. From a nineteenth-century wage structureof wide disparities,both the United Kingdom and the United States had moved by 1938 to a position of much greaterequality, but the in the United Kingdom than movementhad proceeded very much farther in the United States. This was the position even beforethe war and its aftermathhad made their effect. Of all the countries examined by Dr. Reynolds the United States has a notably greaterdisparitythan the other Western nations; the only exception is the U.S.S.R., where it is still greater. It is hard to believe that thereis not a significance in the factthat the two most rapidly progressingcountries are also the two with the greatest disparitiesin the rewards of labour. It is importantto notice that in respect of these movementsalso, the significantchange had already taken place before 1946, and often considerably beforethat date. Between 1946 and 1950 therewas a moderate but much reduced intensificationof the war-time trend; since 1950 there has been a slightreturnto the pre-warrelation between skilled and unskilled wages-this was a very importantingredientin the printers' strike of early 1956. The reversal has not yet proceeded far enough to restore the 1946 position, let alone that of 1938. If we are to regard in the sense of really attractive rewards for inequality of remuneration, the leaders in all categories-wage-earners, salary-earners,and entrepreneurs-as a necessaryconcomitantof rapidly risingproductivity, then we must conclude that while our 1938 structuremay have been all right for a country which had given up ambitions of rapid development, as further modifiedby the changes which have since taken place, it must be judged to be highlyunsuitable fora countrywhich has an urgentneed of rapid development. Obviously equality of incomes has a strongsocial attraction,especially forEnglishmen,and there is no virtue in inequality as such. We need to distinguishsharplybetween inequalities that are economicallyfunctional and those which are not. Even in respect of earned incomes inequalities may not always be functional, as when entry into an occupation is restrictedby outdated apprenticeshiprules and so on. Again in many backward countrieswhich are just startingto develop, there is often a great concentrationof receipts in the hands of traditional authorities who are unlikelyto be performing any importanteconomic function. I do not contendforinequalityofincomesforits own sake; nor do I thinkthere is much substance in the argumentsometimesput forwardthat we need inequality to restorethe level of personal savings, but I do contend that we need much more functional inequality than we have at present in available incomes, if we are to get sufficient supplies of the skills and for enterprise needed rapid development. In increasing functional

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inequalityand decreasingnon-functional inequalitiesthe tax structure can play an importantpart. II We can divide the objects we wish to furtherby taxation into four categories: (i) optimumworkincentives,especially in the key occupations for development,(ii) optimum investmentincentives,both in respect of (a) portfolioinvestments(lending of savings) and (iii) (b) direct investment, mainly fixed capital formation,and (iv) the reduction of nonfunctionalinequalities. In this you will notice that I have said nothing directlyabout the stimulationof saving, since it seems to me essentially a negative concept,whichwill look afteritselfon the whole,ifthe positive incentivesare correct, and ifeconomicpolicyis sound in general,especially in respectof the preservationof the real value of past saving. At the same time it is of course necessary to see that the tax structuredoes not inadvertently encouragespendingat the expense of saving, especiallyspending derived fromnon-functional inequalities. This it undoubtedlydoes today to some extent,although not nearly to so great an extent as is sometimes claimed,ifwe take into account the additional incentivesto high-spending which were created by economic changes due to the war. The firstquestion then is to consider how the tax structure can be adjusted to improve work incentives. A few years ago economists were all convinced (quite likelycorrectly in the conditionsof the time) that the extensionofincometax in generaland the systemofP.A.Y.E. in particular, were seriously disincentive to effort. At that time war-weariness,the existenceof accumulated balances of war-timeearnings,and the shortages of worthwhilethings to buy, were heavily reinforcing the impact effect ofthe revolutionin incometax. In contrast,over the last eighteenmonths or so the anxiety of both sexes to work, and to take on additional jobs, has been verynoticeable; in particularthe increasein the supplyof women all predictions. workershas falsified Nevertheless the potential disincentive effectsof a big gap between marginal and average tax rates (especially operative below the standard rate range) and of high average rates in the upper income ranges,need to be watched; but they do not seem to call for general action at present. The problem is essentially one of ensuring higher retained incomes for particularcategories. Below the surtax range this is primarilya question of restoringdifferentials for skill, which is mainly a matter for private can help in a numberof ways,by throwing enterprise, althoughgovernment in the rightdirection. Above the surtax exemptionlimit the its influence of any increased differential will since the effect problemis more difficult, tax at presentlargely be lost throughincreased liability. Neverthelessit

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is this group, the managerial class with ?1,000-k3,000 before the war, now ?2,000-95,000, which it is probably more importantto help in the than any other in the country. interestsof increased productivity, It should be rememberedthat the surtax-exemptionlimit has never war; thereis a been raised since it was established at ?2,000 afterthe first strong a prior case for raising it now in some correspondencewith the fall in the value of money.' One of the factorswhich has operated since of assessmenthas been the great increase the war to reduce the efficiency in the number of surtax payers, making it impossible to deal with each assessmentindividuallyin the traditionalpre-warmanner. This failureto adjust to the change in the value of moneyis (or should be) the substance of the annoyance of Dr. Little's academic friendwho complained that surtax was 'never intended forthe likes of him'.2 In a majorityof cases, however, one could retortthat in a developing economy 'unproductive labour' of that sort has no special claim on economic resources,as argued by Adam Smith 170 years ago. Another relevant change (recommended by the Royal Commission)would be the continuationof earned income and familyrebates beyond the surtax-exemptionlimit. Still more important could be the raising of the ceiling for scholarshipsfrompublic authoritiesto the university(or the adoption of a quota systemto include all children),thus discriminating in favour of the more intelligentin all income groups,and not as at present,merelyin the lower income groups. It may be objected that these are small changes; but they would add up quite substantially,and they would almost certainlyimpinge where they were most wanted-in favour of fairly high earners with small propertyendowment. Neverthelesswe should clearly also look at more adventurous alternatives,such as Mr. Kaldor's expendituretax. But here thereis one preliminary point to settle. In orderto make his expenditure tax more palatable Mr. Kaldor introduces 'spreading' of the tax burden in two different senses. First, since (unadjusted) an expenditure tax is much more regressiveon the large familythan an income tax (assuming that there is some marginof saving) the 'quotient'3 systemis introduced, wherebythe incometo be taxed is divided by the numberin the household; this goes far beyond any familyrebates that have ever been suggested, but if it were acceptable it could equally well be applied to an income tax. Secondly, it is of course obvious that an expendituretax discriminates against fluctuating expenditure (just as an income tax discriminates against fluctuating income,a point whichwe shall have to examine later). But fluctuationsin expenditure are likely to be much more widely and
1 The Chancellor has recentlygiven figuresof the estimated cost of raising the surtaxexemption limit. To raise it to ?3,500 would at existingtax rates cost only ?40 million,to ?4,000 would cost ?50 million. Cf. The Economist,12 May 1956. 2 Little, op. cit. 3 Kaldor, op. cit., pp. 208-9. 4520.3 x

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spread than fluctuationsin income; they will always arise fortuitously with the purchase of consumers'durables and are likelyto arise whenever a familyemergencyoccurs. Mr. Kaldor proposes to deal with the first by spreadingliabilityover a numberof years, and the type of fluctuation second by makinginsuranceeasy. If these concessionsare to be assumed practical foran expendituretax they must also be assumed practical for an income tax. The Royal Commissiontried very hard to get the Inland income Revenue to agree that a simple spreadingof liabilityof fluctuating they were persuaded that this was not would be practical,but reluctantly so, at least not in the foreseeablefuture. Hence, if we are comparingthe stimulus for development of the two formsof tax we must treat them which implies, it seems, that we must rule out the benefitsof similarly, both types of spreadingin the expendituretax. Otherwiseit is like cheating in one game of patience and not in another. Even allowing for spreading it is Mr. Kaldor's1 conclusion that, in respect of work incentives,the only superiorityof the expenditure tax over the presentBritishincome tax, assumingthe same ratesof tax, is the stimulus to saving of the expenditure tax. Even this would probably disappear if the same totalrevenuewas to be collected, depending on the taxpayers' outlay habits. Only in the case where saving is forindefinite accumulation (in which case it never bears any expendituretax) is there ask what are a clear superiority over the income tax. We must therefore what the motives which induce people to save, or more fundamentally, are the motiveswhichinduce them to workhard enough to have a surplus over currentconsumption,which is available for saving ? There appear to be three chief motives behind this phenomenon of magnitude. First, extra work; and they are probably of very different thereis the desire to 'save up' forlarge outlays, a process which cannot cost. Secondly, be generally except at prohibitive substitutedby borrowing there is the desire to save for future needs, above all to increase the and finallythere is presumably some amenities available in retirement, with no expectation of spending,unless desireto accumulate indefinitely, by one's heirs. It is this latter type which is especially favoured by the expendituretax; but it can hardly be doubted that social and economic forces,as well as the Health Service and extended pensions,and above all the influence of heavy death duties, have in the presentgenerationmuch reduced the propensityforspontaneous saving on this account. There is to no evidence that the effect of the expendituretax would be sufficient to that the concentraagree overcomethese forces, even ifwe are prepared tion of wealth which it would promote is in itselfa good thing. The work motive of the desire to save for retirementhas also been
1 Kaldor, op. cit., pp. 134 ff.

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substantiallyweakened by the spread ofpensions. Much therefore depends on the revenue to be taken respectivelyby the two alternativetaxes. An unspread expendituretax would be very tough at the moment of retirement when a new mode of life has to be established. Britishincome tax leaves this formof spendingcompletelyuntaxed so far as it is met out of accumulated earnings(or accordingto the mostrecentbudgetconcessions)' out of funds accumulated by insurance. Finally, if saving is mainly ' saving up' an unspread expendituretax would be much tougherthan an income tax, especially if, as seems likely, because of the narrowertax base, its rates and progressionwere higher. That saving up is a very importantelementin extra workingtoday can hardly be doubted in this age of durable consumers' goods. Indeed the dissaving since the credit squeeze was tightenedis a strongindication that consumerswere heavily involved in this process. that on balance an expendiI think,concludefirstly, We musttherefore, ture tax (especially an unspread expendituretax) is less work incentive than British income tax; and secondly, that British income tax is not seriouslydisincentive,and could be made considerablymore incentive if the quite feasible small reforms suggested above were introduced; hence fordevelopmentit would be the superiorinstrument. The main object of an expendituretax, however,is not to make people work more but to make them spend less, especially to stop them spending in excess of their currentincomes. From the point of view of economic growth, or even of stability without growth, such dissaving can be a nuisance since it draws resources away frommore productive uses and may set up an inflationary pressurewhichrequirescorrection. It is therefore desirable to investigate how far British income and capital taxes stimulate formsof dissaving which are undesirablein the sense that they are eitherinconveniently large fromthe point ofview of applyinga corrective, or are related to non-functional receipts. It cannot reasonably be claimed that this is true of dissaving the accumulated savings of a lifetime in retirement, since the anticipation of being able to do this is one of the strongestwork incentivesduringactive life. The two types of dissaving which do seem to fitinto this categoryare (i) the spending of capital gains due to 'speculation' (which,however,is not necessarily devoid of economic function),and methods of avoiding of profitsin a closely controlledfirm,and surtax, such as over-retention (ii) the deliberate dissipation of an estate in anticipation of death duties, on the subject of capital throughriotousliving. Since I have lately written gains taxation at some length2 I only want to emphasize one point here: the opportunitiesfor making capital gains just afterthe war were quite
I

Finance Act, 1956.

Cf. The Banker, Apr. 1956: 'Alternatives to Surtax'.

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abnormally large, and the chances that the methods used would be challenged by the Inland Revenue were quite abnormally small. This must be regardedas a situationof whichthe impact effect has now passed, althoughto be sure some of the gains then made may stillbe being spentthere is little evidence available either for or against. Abnormal opportunitiesof this special nature must be expected to recurfromtime to time; the use which J. M. Keynes put to such an opportunityin the 1930's is well known;1 but the greaterpart of them could and should be brought within the range of surtax. A further strengthening of the hands of the Inland Revenue is by no means impossible, while in normal times at least the ingenuityof the government'sadvisers followsclose on the heels of the lawyerswho advise taxpayers. On the matterof dissaving by the 'new poor' which every inflationary period bringsin its train,two points seem worthmaking: first, the sudden drastic rise in surtax rates in 1940 required in the longerperiod a drastic reshaping of the mode of life of those affected. In the short period the gap could only be bridged by dissaving. It must be presumed that the impact effect of this change has now passed away, and adjustments have been made. They would doubtless have been made more rapidly if low yields on securitieshad not made it especially innocuous in artificially income terms to consume one's capital. Secondly (and this is a more continuing trouble),a much moreseriousincentiveto dissaving is provided by the presentrates and structureof death duties. In the higher ranges of estates it is possible to proceed a long way in consumingone's capital while leaving one's heirs (post tax) hardly any worse offthan they would have been if the estate had been handed down intact. There is a very clear remedyforthis state of affairs, whichwould be rathermore costlyto administerthan the presentsystemof death duties, but which can hardly be said to be impracticable: namely, to assess death duties progressively not on the whole estate but on the main legatees-very small legacies would have to be exempted. This would implyperhaps threeto fivevaluations of capital in place of one at present; but it would be more efficacious than the present systemin redistributing property. On the face of it the change would lose revenue, but this could easily be more than compensated by the reductionof tax avoidance throughdissaving. It is of course a delusion to thinkthat revenue fromdeath duties, comingout of private capital accounts, makes any real contribution to the budget balance in an economic sense.

III

We must now turn fromthe promotion of incentives to work to the promotionof incentivesto venture. We need to consider three different
1

Cf. R. F. Harrod, Life of Keynes.

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aspects; private portfolio investment (purchase of securities), private direct investment(in the personallymanaged firm),and company incentives to ventureand innovate. Space does not allow of morethan a glance at the most salient points. In respect of private portfolio investmentthe exclusion of capital gains and unrealized capital appreciation in British income tax does impart a in favour of buying securitieswith a low presentyield but discrimination good prospects of growth. This no doubt does not always lead to an optimum allocation of resources in the economy (as when the expected takes the formof a fall in the rate of interest,or a beliefby improvement the investor that he is clevererthan the market). There is, however, a definitepresumptionthat the right sort of risk will also be backed, not necessarily indeed in the very small firm(except by those with inside whichtoday are responsible knowledge)but in the medium and large firm, forquantitativelyby far the greaterpart of innovation and experimentation. (The strong backing and rapid expansion experienced by small since the war is a good illustrationof the operation of machine-toolfirms this incentive.) Recent easements in company taxation, especially the more rapid write-off allowed on capital formationand research and the indefinite of losses, reinsurethe lender as well as reducing the risks carry-forward of a company embarkingon untriedinvestments. Further,under British income tax, only stamp duties stand in the way of a free switchingof ifdesired,once the growthstage of a venturehad passed. This investments impartsa very desirableflexibility.The opposite side to these advantages is that thereis nothingin the tax systemto curb a stock exchange boom, and consequent realization of capital gains. Apart fromthe effectof a creditsqueeze, of which under modernconditionswe have as yet too little experience,thereare, however,two possibilitiesof moderatingthe opportunities for stock exchange speculation if it becomes excessive. Stamp duties could be drasticallyincreased,' and on the other hand the powers of the Inland Revenue to charge intended evasion of surtax through capital gains at surtax rates could be extended. Since 1920 therehas been only duringthe exceptional steady progressin this direction,interrupted situation of the war and its immediate aftermath.2 Compared to Britishincome tax an expendituretax (unaccompanied by a capital gains tax) would probably also favour investmentfor appreciation, at least wherevera high value was placed on long-periodaccumulation. Since, however,thereis little evidence that this formof investment
2 Cf. Inland Revenue Memo. on The Taxation of Capital Gains, Final Report of R.C. Appendix.

1 Cf. C. M. Kennedy, 'Stamp Duties as a Capital Gains Tax', R.E.S., June 1956.

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is very common, the stimulatingeffectsof an expenditure tax on riskthan those of British income tax bearing would probably be less definite disincentive to The presence of a capital gains tax would be definitely this type of risk-bearing, since whenevera switch of holdings took place the capital appreciation would be taxed, whetheror not the funds were reinvested. This of courseassumes that the capital gains tax is set at a rate high enough to be deterrent, which is almost certainlynot the case with the Americantax. On the otherhand, when we considerthe effect of British taxes (income tax and death duties) on directinvestment,say in a familybusiness, it is evident that the situation is not so good. If the reformin death duties suggested above were carried out this would be a tremendousimproveof building up reserveswhen they are subject to ment; but the difficulty high rates of profitstax would still remain. In this one case long-period accumulation without the intentionto realize is of real importance,and consequentlythe advantages of an expendituretax would be substantial. This problem,however,needs to be seen against the wide background of the structureof industry,and the contributionto growthwhich can be expected fromthe small firm. This is a matter on which opinions differ very much; on the whole Americans seem to take a more rosy view of the contributionof the small company than is usual in this country. In any case the importanceof the problemhardly seems to warrant a major change in the tax structure.

IV
We come finally to the vexed question of the taxation of company that is mainly of profitsnot intended for distribution. Of all the profits, changes which have taken place in direct taxation since the beginningof than the changed relation the war none is more strikingand significant between personal and impersonal taxation. In spite of the extension of personal incometax from3 to 17 millionpersonsthe revenue derivedfrom profitstaxation has increased by a much higher percentage than that derived frompersonal incomes. This is even more strikingin the U.S.A. and Canada than in this country. The heavy taxation of undistributed profitsstarted with war excess profitstaxes and continued in post-war taxes. Such heavy taxation offundsready and available forgrowth profits has little rationale, except the considerationthat companies do not have votes. This being so, as the Royal Commissionfound to their chagrin, there is little hope of a substantial reductionin company taxation unless economicprospectsturndrasticallyforthe worse,and the aim of a growth tax should rather be to encourage a high rate of investmentin general, with provisionsfor a curb if it should temporarilybecome too high, and

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with especial stimulus to research and innovation. Before discussing measures which mightbe taken along these lines we must glance briefly at the implicationsof the presentformof company taxation. Company directorsall agree in hating profitstax, not deterredby the unwillingnessof chancellors to listen to their plaints. As Mr. Kaldor shows,1they tend to argue somewhat inconsistently (i) on the one hand or at that profitstax tends to raise prices (if so it cannot lower profits, least not proportionately)and thus injures our export position. This of course implies that the tax is shiftedto consumers. (ii) On the other hand they contendthat because ofthe hightaxation ofreserves, insufficient funds are available forexpansion. It could of course be the case that an experienced shortage of funds was the result of personal progressive taxation and not of impersonal taxation, but that is quite another argument. in spite of all the efforts thereis not Unfortunately, by the statisticians,2 sufficient evidence in the post-wardata to draw any conclusionsas to the availability of fundswhich would be valid fora less abnormal period. Mr. Kaldor agrees with most economistsin holding that, save in exceptional circumstances,profitstaxes are not passed on in higherprices, although he claims that in the very long period they probably are in an indirect way (this sounds to me suspiciouslylike the long period in which we are all dead). The distinction,however,is importantfor Mr. Kaldor's argument,because he finds the rationale ofthe taxation ofundistributed profits to be as a means of taxing the capital appreciation of securityholdings. If in fact (even if only after years and years) a rise in prices puts the charge on consumersand not on shareholders,the tax is ineffective for this supposed purpose. I would maintain that the prospect of appreciation is somethingto be encouraged rather than taxed, since it is a powerful stimulus to risk of hard work. If we do want a rationalization taking,and hence indirectly of profitstaxation (other than mere convenience) I would preferto find it in the completion of personal income tax. The undistributedprofits belong to the shareholders; it would be unjust if they were untaxed (incidentally it would also give such a strongstimulusto the over-retention of profitsin the firmthat the Inland Revenue might find it difficult to control). But since non-distributed profitsare more like forced saving than available income,it is only reasonable that the shareholdersshould be taxed on them at less than surtax rates. In this connexionit should be noticed (as oftenseems to be forgotten) that 'ordinary shareholders' are
1 Kaldor, op. cit., p. 146. EspeciallyP. Redfern,'Net Investmentin Fixed Assets in the U.K. 1938-1953 ',J.R.S.S., 1955.
2

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not a class apart (to be identified perhaps with 'stock exchange tycoons' ?). Anyone with a little surplus over currentneeds can buy ordinaryshares; if he buys througha 'unit trust' he enjoys as good a riskspread as a large investor; if he takes out an insurance policy the company gives him the advantage of its accumulated expertise. Hence apart fromthe fact that I regard the presenttaxation of profits as uncomfortably high (and if it could be substantially reduced it might be possible to get rid of that new incubus the separate profits tax), there are in my view two separate, but linked, mistakes about the present treatmentof company profits when consideredin relation to growth. In the firstplace the differential between distributed and undistributed profits is an encumbrancewhich is almost certainlyharmful and should be abolished as fast as can be managed in view of possible hardship on firms whichhave distortedtheirdistribution policy on account of it. This was one of the points on which the whole Royal Commissionwas most emphaticallyunited. Secondly, 'voluntary' dividend restraintshould not be encouraged. If the economicsituation calls fora sudden reductionin investmentlet it be done fairlyand squarely by a temporaryincreased tax on total profits. Reform in this matter would make it easier to control the volume of investmentin three ways. If firmswere never allowed to become very liquid they would have to go to the public for a large expansion of the business; they would then be subject directlyto credit controlsand the market mechanism. Secondly, the abolition of the discriminationin favour of undistributedprofitswould restorethe position in which there is no tax induced distortionof the economic calculus of firms. Finally, in respectof the closely controlledfirm it would make it very much easier forthe Inland Revenue to challenge the over-retention of profitswith a view to avoiding surtax. If, however,we cannot look forwardto a substantial reductionin the total taxation of profits,as seems to be the case, it is of the utmost importanceto see that every means is taken withinthe tax to encourage investment whichpromotesgrowth. In this respectBritishtaxes are now very much more sensible than they were beforethe war. The indefinite of losses makes it almost certain that capital will not carry-forward be lost; the shortening ofthe period ofdepreciationis an imporultimately tant re-insuranceagainst unforeseeableobsolescence, as well as against or price changes. Finally, the tacit permissionto use eitherstraight-line of reducing-balance depreciation(or even a combination both), according to the circumstances and type of the business, gives additional flexibility to investment policy. Thereremainsalso the device ofvaryingthe pace ofinvestment through

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alterations in the allocation of depreciation allowances over time (initial allowances). It is clear that firmsdo not care forthis device, and much preferthe steady 'investment allowance' which also gives them a net loan. The varying reduction in liability and not only an interest-free allowance can obviously be upsettingto business calculations,but it is not clear that it need cause a major upset to plans. The opposite side of this is the flexibility impartedto investmentcontrol(both generaland selective), which is too convenient a weapon to sacrificelightly. A much greater upset to businessprospectscan easilybe caused by carelessover-investment in the public sector,necessitatinga credit contractionlater. All of these growth inducementsto invest (or to undertakeresearch)in lines promoting would naturally operate as well or better with lower taxation of profits in general. On all of this I think Mr. Kaldor is in complete agreement, if we grant (as I thinkhe would) that the completeabolition of the tax on undistributedprofitsand the substitutionof a tax (subsidy) fallingonly on investmentis not practical. If I might now sum up my prioritiesfor gearing British direct taxes more directlyto stimulateeconomic growththan they do at present,they would be these: (i) measures to increase the inequality of incomes functional fordevelopment, ofthe incometax progression especiallya softening in the middle income ranges throughraisingthe ceilingon earned income reliefand familyallowances, includingan abolition of the means test for universityor technical scholarships(if desired above a certain point the scholarshipcould be taxed with the parents' income); (ii) measures within surtax to reduce non-functional inequalities of spendingpower, especially the manomuvring of capital gains to avoid surtax; (iii) the formalincidence of death duties to be transferred to legatees, wherethey would be assessed betweendistributed progressively on theirtotal estates; (iv) the differential and undistributed to be abolished and the full workingof variable profits initial allowances to be restored. These are modest requests, and none of revenue unknowns. The sacrifice would appear to implyadministrative would be small, except perhaps in respect of death duties, and that as we in its presentform. The cumulaknow has no real functionalsignificance tive effect of the reforms could well be decisive.