Policy Papers


Equality and incentive: fiscal politics from Gladstone to Brown

Martin Daunton |

Executive Summary

  • In all societies, there is a debate between the social benefits of equality and the need for incentives. Equality might create a sense of fairness and integration - but if it is at the expense of incentives for growth, all members of society might suffer.
  • In the mid-19th century, politicians were wary about the pursuit of equality, fearing it would lead to lower growth and class warfare.Everyone should pay the same proportion of their income in taxes.
  • By the early 20th century, attitudes had shifted and a pursuit of equality was acceptable, either from a sense of fairness or from ideological hostility to the market.
  • With much higher levels of taxation instituted after the Second World War, by the 1980s, the pursuit of incentives moved back into the ascendant and inequality subsequently rose.
  • Is the balance now shifting back, in 2002, to a realisation of the human costs of inequality and the social dangers of incentives? In his paper, Rodney Lowe asks if the time is now right for a paradigm shift in financing the welfare state; the same question may be posed of fiscal policy.

The Gladstonian tradition

The approach adopted by Gladstone in his great budget of 1853, building on the budget of Peel of 1842 which had reintroduced the income tax, was that the fiscal system should not change the existing structure of society: it should follow the principle of proportionality, that is extracting the same proportion of income from all types of wealth and levels of income, by using a range of different taxes. As a result, Gladstone had to contain two arguments for redistribution: one was differentiation and the other graduation.

The first was the more powerful, a claim by radicals that the income tax was unfair because it fell on the income from trade and industry at the same rate as on the income from landed estates or government bonds. The former income was 'industrious' and insecure, for it was lost with ill-health or death; the second was 'spontaneous' for it continued regardless of the circumstances of the individual, and left an asset and income for dependants. The advocates of differentiation argued that industrious incomes should pay a lower rate of tax as compensation, so that money could be saved for retirement and dependents. To Gladstone, the danger was that it would define one economic group against another, stirring up class enmity. He argued that the system was in fact already balanced by the use of death duties and local rates (which were levied on landlords alone), which provided compensation for the differential burden of the income tax: the fiscal system was fair and balanced. The most he was willing to do in 1853 was offer a tax break for life insurance policies.

He also feared that differentiation would open the way for graduation, by extending the argument of what people could afford to pay to the level of income. Again, he felt that this was a threat to social and political stability, opening up jealousy and bitterness. Like John Stuart Mill, Gladstone argued that high incomes were necessary as an incentive and to provide savings. Much of the argument then and later revolved around Adam Smith's first maxim of taxation, of 'equality of sacrifice': taxation 'should be made to bear as nearly as possible with the same pressure upon all'. Mill did not accept that equality of sacrifice implied a graduated income tax. He was only willing to admit that taxes should not affect the income needed for the 'necessaries of life'. Thus a tax of £5 from an income of £50 would affect the ability to buy necessities, whereas a tax of £1,000 on an income of £10,000 might not. This same tax of 10 per cent was not equal in its sacrifice, and the solution was to remove taxes from the basic income 'needful for life, health, and immunity from bodily pain'. Mill was not prepared to go further towards a graduated income tax. He did not accept that the income of £10,000 should bear a higher rate than 10 per cent, for this 'is to lay a tax on industry and economy; to impose a penalty on people for having worked harder and saved more than their neighbours.' A graduated taxation of income would therefore harm growth and enterprise; taxation of inherited wealth was a different matter. As he put it, 'impartiality between competitors would consist in endeavouring that they should all start fair.

The most that could be done by Gladstone was two things. The first was to 'degress' the income tax, that is offer a lower rate of tax for the smallest incomes liable, without a progressive rate which would increase rates on higher incomes. In other words, a compensation to some was seen as a social boon; a higher tax on others would be seen as the pursuit of envy and class enmity. Such a policy was indeed pursued by Gladstone.

The second was to use the duties on estates left at death to strike a balance between passive and active capital. In Mill's view, inherited wealth was not based on individual merit and might therefore be taxed at a high rate; wealth produced by the active enterprising individual was merited and deserved. Again, the complex system of duties on death took account of such arguments, varying the rate according to the degree of relation to the person leaving the estate, and introducing an element of graduation by size of estate. The fiscal politics of Gladstone rested on the pursuit of economic growth by encouraging individuals to act in an enterprising way, which was linked to another point: hostility to corporations.

Large-scale companies (such as railway companies) had, in effect, the ability to tax individuals, much like the old chartered monopolies such as the East India Co. with its ability to impose a high rate of duty on tea. The state swept away the monopolies of the East India Co. and free trade was meant to secure freedom of entry into trade by competitive individuals. Companies would distort such a world of freedom, creating new monopolies to exploit individuals: hence Gladstone's support in his act of 1844 for controlling railways by the threat of nationalization. He was also hostile to the accumulation of assets by trusts and endowed charities which were not liable to the efficiency of the market. The political culture of free trade and of Gladstonian finance rested on growth through free association by small units, guarded against exploitation by monopoly capitalism or passive accumulations of wealth.

The impact of the marginal revolution

Why did this political culture start to change? The position adopted by Mill in his interpretation of Smith's maxim was overturned by the marginal revolution in economics at the end of the nineteenth century. Alfred Marshall's Principles stressed the marginal costs of producing another unit of output, and the marginal satisfaction to be derived from consuming it. In this approach, an additional pound did not produce the same satisfaction for someone in receipt of an income of £1,000 as for someone in receipt of an income of £100. The meaning of equality of sacrifice was more complicated than writers in the past had appreciated. Did equal sacrifice mean each taxpayer should surrender the same proportion of their total utility? That is, the aim should not be to take 10 per cent from all income levels (£5 from an income of £500 and £10 from an income of £1,000), but rather to extract the same proportion of happiness or satisfaction, which varied according to income. Or did it mean an equal marginal sacrifice in order to produce minimum disutility? By this definition, the aim was to calculate the additional satisfaction produced by the final increment of income, and to ensure that the rate of taxation on that income imposed the same loss of utility or satisfaction. Thus the final £10 of income for someone earning £500 might produce three times as much satisfaction as the final £10 for someone earning £1,000, so that the tax rate could be three times as high on the larger income with the same marginal disutility.

F.Y. Edgeworth, the professor of political economy at Oxford, embarked on a complex and even convoluted and elusive project of using marginal theory to create a 'pure theory of taxation'. He started from a 'hedonistic' principle of taxation, that is the sacrifice of happiness by the taxpayer, and he assumed that the test of government action in taxation was the 'greatest-happiness principle'. This approach derived from the utilitarian philosopher Jeremy Bentham and, in a sense, the marginal revolution in economics involved a reworking of Bentham's concern with the means of creating the greatest sum-total of happiness in society. The pursuit of his principle led Bentham to argue for equality; Edgeworth would not go so far but he went beyond Mill to accept a progressive income tax. Edgeworth suggested collecting all taxes from the small number of incomes with the lowest final utility. In other words, there would be less loss of satisfaction to society as a whole by taking all taxes from millionaires with very low marginal utility from their final tranche of income, than by taking money from a larger number of smaller incomes which would impose taxes on people with a higher marginal utility from their final tranche of income. The result would not be complete equality, but a levelling of the higher incomes which would lead to the minimum aggregate sacrifice. As he explained to the Royal Commission on Local Taxation in 1899, in allocating taxation 'the prima facie best distribution is that the whole amount should be paid by the wealthiest citizens. The incomes above a certain level should all be reduced to that level; the incomes below that level should be untaxed, the level being determined by the amount which it is required to raise.' This levelling principle should be moderated by prudence, to avoid driving capital out of the country, or 'awakening the predatory instincts of the poor'.

The importance of Edgeworth (and other economists) was less in initiating change in fiscal policy than in removing the intellectual authority of the opponents of progression. These economists were not arguing for equality of income and wished to contain 'predatory instincts' and socialist ambitions. Their definition of fiscal justice might still assume that the existing distribution of property and income only needed to be changed to a modest extent rather than to alter the structure of society in any fundamental way. Edgeworth's starting point was the amount of revenue needed by the government, which was still around 10 per cent of GNP: he simply wished to allocate this amount with the minimum sacrifice, and did not assume a marked increase in spending and taxation. Indeed, it could be argued that higher marginal tax rates simply removed the distortions created by a single flat rate of tax which imposed an unequal sacrifice on different sources and levels of income.

Nevertheless, the shift in economic theory did alter the terms of debate over taxation, providing intellectual authority for progressive taxation as a prudent measure to increase the sum total of happiness and the size of the 'national dividend'. Economic ideas provided a large part of the meanings and vocabulary of political debate, and limited possible alternatives. The point is apparent in 1909, when opponents of Lloyd George's 'people's budget' turned to Alfred Marshall to supply them with intellectual authority - which was not forthcoming. He refused to denounce the budget as socialist, as a device to remove responsibility from individuals and pass it to the state. Instead, Marshall believed that cautious redistribution from poor to rich would be beneficial. 'For poverty crushes character: and though the earning of great wealth generally strengthens character, the spending of it by those who have not earned it, whether men or women, is not nearly an unmixed good.' In 1902 he asked, 'Is the share of the total price of products which goes to manual labour as large as is compatible with a wholesome and "free" state of society? Could we by taking thought get the work of our great captains of industry and financiers done with rather less of their present huge gains?'

The way Marshall posed these questions indicated that the 'context for refutation' had changed, so that the onus rested on opponents of redistribution to indicate that it would harm freedom and efficiency. Pressures for change could no longer be blocked by an appeal to the intellectual authority of economics. What were these other changes leading to a rephrasing of the case for a shift to a more progressive fiscal regime which might start to change the distribution of income and wealth? By the first decade of the twentieth-century, following the British Army's poor performance in the Boer Wars, and rising economic and imperial rivalry with Germany, most in the nation concurred that increased national resources must be devoted to 'national efficiency', entailing military and social spending. Liberal politicians were willing to move away from Gladstonian hostility to differentiation and graduation for two reasons. One was that they had a still greater loyalty to free trade, and the Conservatives were suggesting that revenue should be increased, and social and defence problems solved, by protective duties. If free trade was to be saved, a graduated income tax was the price. The second reason was the argument that a graduated income tax might well increase economic efficiency. This rested less on Marshall's marginal neo-classical economics than on a revised concept of rent and socially created wealth. Much wealth and income was socially created, not the reward for individual effort and incentive but the unmerited seizure of value created by the activities of society as a whole. In other words, the political culture of free trade was being transformed from the understanding of Gladstone.

The impact of war

By no means all Liberals accepted that radical edge, which might alienate many wealthy voters and drive them into the Conservative party. On the other hand, some such argument might be needed to prevent working men from shifting to the newly emerging Labour party. The Edwardian Liberal party had a delicate balancing act to perform. It could attack socially created wealth in the largest fortunes (especially landed, and the greatest 'unearned' or spontaneous incomes). It could then use some of that revenue to reduce income tax on smaller, earned incomes and to give tax breaks for family responsibilities. As a result, there was a marked 'middle-class dip' in the incidence of taxation (both income tax and indirect taxes): unskilled workers at the bottom and the very rich paid a higher proportion of their income in taxes than the middling income, especially of married men with families in receipt of salaries. The approach was taken further in the interwar period by Winston Churchill, as Conservative Chancellor in the budget of 1925, when he retained high levels of income tax on the very rich and reduced tax rates on the middle of the income distribution. The strategy made electoral sense, for modest middle class incomes of family men and women (who now had the vote and made family issues crucial to Conservative identity) were the central constituency and identity of the party. The strategy was also economic, for he stressed the benefits for incentives: breaking down passive wealth and massive incomes to release enterprise, to protect risk-takers from failure by offering welfare benefits in terms of widows' pensions, and to weaken the attraction of socialist envy and malice (as he saw it.)

Meanwhile, the socialist attack on wealth had a greater resonance at the end of the First World War, not only because of the growing electoral attraction of Labour, with the extension of the franchise to all working men in 1918, but also because of the serious political tensions over the fiscal burdens of the war. The war was financed from loans, and at the end of the war there was a heavy cost of debt service. Income inequality had been reduced in the latter part of the war, and there was a shift from capital to labour, as a result of disproportionate wage increases during World War I for all grades of workers. Many members of the middle class felt aggrieved, and pressed for a reduction in income tax and a cut in government expenditure. But the Labour party and trade unions argued that workers had been conscripted during the war, and that now they returned to an uncertain future - often injured in body or mind. The debt should therefore be paid off by a once-off levy on capital, or a conscription of wealth, which would reduce the burden of parasitical rentiers on producers and earned incomes (both workers and the salaried middle class). But might this be the start of a wider attack on all property, a socialist menace to the free market? Such issues became central to politics in the 1920s, and help to explain Churchill's response in 1925. Labour argued for an attack on socially created wealth, and a positive drive to equality with a rejection of incentives as the motor of economic growth. But there was also an ambiguity: were profits a sign of risk taking which was socially desirable, to be set against socially undesirable rentiers income? There was a degree of confusion.

The matter was clarified after the slump of 1931 and by the Labour government of 1945-51. The policy pursued by Labour now moved away from the political culture of free trade, and redefined attitudes towards profit. The key figure was Hugh Dalton, who had advocated the capital levy after the First World War; he was also a leading advocate of equality. In the interwar period, he advocated the Rignano scheme, by which inherited wealth paid higher and higher duties as it passed from one generation to another, and was more removed from the active creator. This could be linked with the desire to give an incentive to the active creator of prosperity against the passive recipient of assets. After the Second World War, he increased death duties and ensured that the income tax was highly progressive. Indeed, the 'middle-class dip' was removed during the war and was not restored.

Another key feature of his fiscal policy was in the taxation of business profits, reformed so that they differentiated between retained and distributed profits. This was vital to Labour's notion of growth. The motor of growth was not private profit taken by individuals, for distributed profits would increase income inequality and lay the basis for large fortunes. It would also generate inflation, both by giving spending power to the shareholders and inspiring workers to demand high wages. Further, the stock market would allocate resources according to speculative, short term considerations. An active, external capital market was seen as a source of socially created wealth and inefficiency. Rather, profits should be retained in the firm for reinvestment by managers who would have long-time horizons; and dividend restraint could be used to secure wage restraint. Growth would be created by equality, which removed the underspending which marred the 1930s. Equality seemed to create growth, by boosting consumption and creating social harmony and integration. And retained profits in the hands of large firms, run by experts, replaced the waste of competition and the inefficiency of duplication of goods. Of course, some sectors were nationalized - but many of the benefits could be secured by working with large corporate capitalism within a highly regulated market with strict limits on competition. Equality was ethically and economically desirable; personal incentives were unnecessary.

Despite the Conservative's ideological animosity to many aspects of this policy, it survived for most the period from 1951 to 1964 when the party was in power. The key date was 1959, when the Treasury ministers (Thorneycroft, Birch and Powell) favoured a reduction in government spending and a move to incentives. They resigned after the Cabinet feared the political dangers. The government did remove differentiation in the profits tax, but was still wary that higher profits would lead to wage-push inflation. It was cautious about adopting an active policy of incentives by reducing high taxation of incomes, fearing demands from workers for higher wages and expensive welfare benefits.

When Labour returned to power in 1964, it pursued some of the strategies of 1945-51, and added some new policies. The differential profits tax was restored in a slightly different guise, so that suspicion of an active external capital market was reinforced. In addition, the introduction of a capital gains tax in 1965 was a further attack on socially created or unearned income from appreciation of assets, which had not previously been taxed. Further, the Selective Employment Tax imposed a tax on service employment in an attempt to shift labour into industry, which was seen as critical for growth. Again, there was little concern for personal incentives, and a desire to take equality a step further.

The current debate

When Thatcher came to power in 1979 she began to pursue vigorously a policy of incentives to the rich. Income and wealth inequality started to widen. The explanation was not simply that previous strategies had manifestly failed. There was also a change in the relationship between taxation, income, and voting. A strategy of equality had worked since World War II so long as the income of the median voter was below the median income taxpayer. By the 1970s, this was no longer the case. Inflation meant that more people came into the income tax system, and more people moved into higher tax brackets, for there was a failure to adjust thresholds. Indeed, the starting point for the payment of income tax was below the point for the payment of supplementary benefits to poor families. The median voter was now more likely to see the income tax as a threat to their standard of living, rather than a benefit. Further, the Conservatives realized that share-ownership and the ownership of assets was popular. In the 1950s, a few voices in the Labour party - above all W Arthur Lewis - argued that equality could be created by spreading the ownership of capital rather than the expansion of public ownership or high taxation. He was not heeded, and the approach was eventually exploited by the Conservatives in a new strategy of growth.

Are we now at the start of a move to achieve a new balance between equality and incentives? Gordon Brown's budget of 2002 is possibly a sign that we are, and it might be seen as a budget with great historical significance, akin to Gladstone in 1853 or Lloyd George in 1909 or Dalton in 1947. Greed no longer seems so good: do high incomes and profits really lead to efficiency on the railways or in the financial service sector; does inequality lead to growth or to social exclusion? The finance for the NHS will redistribute income from rich to poor more explicitly than any major change in fiscal policy since the 1970s - but should this be done through additional national insurance contributions rather than a more radical shift in the fiscal system? The last occasion on which NHS finance moved from taxes to insurance was in the late 1950s and early 1960s. Does this return to insurance now mark an attempt to converge with the European norm of an insurance based system - and how far will convergence with the European fiscal system be carried in the next few years? One problem is that the increase in insurance contributions for the NHS does not resolve funding for education or transport. It is not linked to a wider debate on the purposes and scope of public versus private consumption. How far does the adoption of an additional insurance contribution for the NHS mark the emergence of hypothecation, which could be extended to other sectors - such as the Liberal Democrat proposal for an income tax for education, or congestion taxes for transport? The task facing Gordon Brown now is to construct a larger vision and to develop a rhetoric to express a new understanding of the benefits of equality and public spending within a market-based and globalised economy. He will not return to the stress on the public sector and hostility to the market found in Labour in the past - but he does need to develop a much clearer rhetoric of a social market and the proper limits of equality and incentives.

Further Reading

A B Atkinson and A J Harrison, The Distribution of Personal Wealth in Britain (Cambridge, 1978)

P Baldwin, The Politics of Social Solidarity: Class Bases of the European Welfare State, 1875-1975 (Cambridge, 1990)

M.J. Daunton, Trusting Leviathan: The Politics of Taxation in Britain, 1799-1914 (Cambridge 2001)

M.J. Daunton, Just Taxes: The Politics of Taxation in Britain, 1914-79 (Cambridge 2002)

J A Kay and M A King, The British Tax System (Oxford, 1980)

R. Whiting, The Labour Party and Taxation (Cambridge, 2000)

About the author

Martin Daunton is Professor of Economic History at the University of Cambridge. He has recently completed a two volume history of taxation policy in Britain since 1799, and edited an urban history of Britain from 1840 to 1950. He has written extensively on economic and social policy in Britain in the 19th and 20th centuries. mjd42@cam.ac.uk

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