Martin Daunton, a professor of economic history at the University of Cambridge and Gresham College, explains why the costs of servicing the Covid debt, rising inequality, and concerns about fairness warrant a new fiscal constitution in the UK. He looks at the three major pivots in attitudes to taxation over the past 200 years to explain why and how this redrawing ought to occur.

Changes in the level of taxation and the state’s share of national income has been driven in the past by warfare, but political difficulties and social tensions arise on the return to peace. The surge in the level of debt as a result of Covid creates similar dangers when we emerge from the pandemic.

Line chart of UK national debt (per cent of GDP) showing State spending rockets during wartime

The abolition of the wartime income tax introduced in 1799 by prime minister William Pitt the Younger to fund the French Revolutionary and Napoleonic Wars, for instance, is one example to avoid.

During the wars, government revenue rose to about a quarter of the national income. How the bill was settled was grossly unfair. Not only had revenue from land tax not been increased since the 1690s, landowners also escaped the income tax when it expired after the wars. Instead, most of the revenue came from excise duties and import duties that hit working families and producers. At the same time, revenue was transferred to the passive rentiers who held government bonds or gained from sinecures in the state.

The result was a crisis of legitimacy of the state and the tax regime, of social unrest and political turmoil. Prime ministers Robert Peel and William Gladstone responded in their budgets of 1842 and 1853 by reintroducing the income tax on landowners and rentiers, and reducing duties, lessening the burden on working families. Gladstone’s fiscal constitution was neutral between classes and interests. It rested on shrinking the state, with government spending dropping to around 10 per cent of national income.

The Gladstonian constitution was challenged at the start of the twentieth century. The electorate had become wider and working men no longer saw the state and taxes as a transfer payment from the poor to the rich. It could work the other way round too, with revenues capable of alleviating social ills such as poverty and unemployment. Businesses – facing competition from Germany and the United States, and in shock at the poor health of recruits in the Boer War that in peacetime made up their workforce – also supported spending on social welfare. The solution of Prime Minister David Lloyd George was to raise revenue through a progressive income tax that targeted both higher and unearned incomes from interest or land values.

Gladstonian equity as a balance between interests was replaced by a redefinition of equity as redistribution. Redistribution was not just about social harmony, but growth too – raising spending among the poor and removing some of the impetus to save among richer members of society.

This reformed fiscal constitution helped fund the First World War. After the end of conflict in 1918, the level of state spending remained at around a quarter of national income. However, more revenue was needed to avoid the animosities that had stung British society in the early-nineteenth century.

Column chart of Tax revenue as a portion of GDP (per cent) showing British taxation over the 20th century

The Labour Party demanded a one-off capital levy on those who gained from the war: the idea was wealth should be conscripted, as well as men who lost their lives or limbs. From the right, there were calls for cuts in welfare spending and a focus on government ‘waste’. The government found a balance between these demands. First, a capital levy was avoided by retaining an excess profits duty, introduced during wartime to tax exceptional profits that resulted from conflict. Second, the income tax that rose during the war to fall on modest earnings was removed, but retained on higher incomes. The task was completed by Winston Churchill, then chancellor, in his 1925 budget. The thrust of this approach continued after the Second World War, with greater redistribution and higher levels of spending.

The next pivot came in 1979 with the election of Margaret Thatcher.

High levels of taxation threatened incentives, and not only for the top earners. Society was becoming wealthier, but the tax system failed to adjust, creating a fiscal drag that meant more people were moving into higher bands. In 1945, many voters did not pay income tax and were content to vote for government spending. Now, most did – and, in an economic climate marked by industrial unrest, many doubted their money was being wisely spent.

The result was a shift from equality as the basis of social order to incentives as a source of prosperity, from a sense that wealth was socially created to a belief that it was personal property, and from the interests of the collective to the freedom of the individual.

The level of government spending did not radically change. The structure of the fiscal system did, with a shift to indirect (and regressive) taxes such as VAT, an end to higher rates on unearned income and wealth, and an encouragement of personal ownership of equities. All of which reversed the tide on redistribution.

This fiscal constitution has now reached its limits and should change once more. There is again a wide sense of inequity. Asset prices have continued to rise, while for many employees, especially the low skilled, work has become increasingly precarious. As it stands, the tax regime is unfair in its division between capital and labour income. The impact of inequality apparent in the incidence of deaths from Covid between rich and poor are there for all to see.

Unearned or unmerited income and wealth are again challenged by advocates of a wealth tax or capital levy. More plausibly, a ‘solidarity’ tax on excess profits and on high incomes, the removal of profit shifting to low tax regimes, and the introduction of a digital tax and carbon tax, could do what Peel and Gladstone, Lloyd George and Churchill did in the past. That would recreate a sense of legitimacy in the fiscal constitution and re-establish trust in the rectitude and efficiency of the state. Failure or a return to the austerity experiment of the 2010s will likely threaten social cohesion and economic recovery.Related linksThe century-old tax that could help pay for the pandemic – FT Alphaville