- An Outline of The Paper
Like most Western governments right now, the British Government is desperate to increase the rate of growth of its economy. Its purpose is not only to raise the living standards of its citizens, which have stagnated for over a decade. It urgently needs to find more tax revenues to pay for a crash programme of rearmament as well as for the spiralling costs of its welfare state.
The best way to raise more tax revenues is by making the economy grow faster, but the rate of economic growth in Britain has languished for almost two decades. The paper suggests that this is because successive governments have persisted in treating the economy as if it were a machine to be controlled from the top down by pulling policy levers. In fact, activity in a market economy is driven from the bottom up, with entrepreneurs being the principal agents of change and growth.
Despite the present Government’s stated intention of trying to increase the overall rate of economic growth, its actions so far have actually inhibited growth by disincentivising entrepreneurs and other working people. If it really wants to attain its declared objective, it needs to significantly reduce the present levels of income tax and capital gains tax, eventually abolishing them.
It should replace the lost revenues with a graduated tax on annual personal consumption expenditures. Such a tax would not only align the incentives of business decision-makers with actions that promote economic growth, but it should also appeal to a shared sense of fairness. Big spenders would pay more than they do now, while those who withdraw least from the common pool of goods and services would pay less. As well as this long term solution, thje paper also proposes a number of ‘quick wins’ for the Government, achievable within the next five years.
- Why Economic Growth Matters
The Government has said that its overriding domestic policy objective is to raise the rate of growth of the British economy. Like the governments of most other Western countries, it is struggling with the inexorably rising costs of health and social care that are driven largely by the needs of an an increasingly ageing population. The British Government has not been able to balance its budget for almost a quarter of a century.
Adding dramatically to these budgetary pressures is the urgent need to rearm to counter Russian expansion in Europe at the same time as the sudden withdrawal of United States protection. At present, the US pays for about two-thirds of all NATO spending. The idea that Britain spending 2.5% o GDP on defence will be sufficient to deter Russia is laughable. Between 1966 and 1990, the comparable figure was 4 to 5%. So where is the additional money to come from?
All governments can borrow, but only the United States Government can count on being able to run budget deficits indefinitely. For most other countries, borrowing significantly more at the present time is simply out of the question, as Liz Truss discovered in 2022.
Raising the rates of individual categories of taxation, for example, “a penny more on the income tax”, or cutting other government spending would be politically damaging as well as counter-productive in terms of incentives to work. Even the modest proposal to means test winter fuel payments provoked a precipitate fall in the Government’s popularity.
But increasing the rate of growth of the whole economy could generate additional tax revenues with fewer painful and unpopular decisions. This is why achieving a faster rate of economic growth of is so high up the political agenda of Western countries today.
- A Market Economy Is a Process, Not a Machine
In the absence of any generally accepted theory of economic growth to guide them, British governments have adopted at different times a variety of ad hoc measures to try to stimulate economic growth. These policies have ranged from cheap money, budget deficits and balanced budgets to indicative planning and public investment. All have failed.
These measures had one thing in common: they were seen by politicians as levers which could be pulled to control the economy from the top down, as if the economy were a machine. Mechanical imagery like ‘kickstarting’ the economy, ‘overheating’ and ‘soft landing’ permeates media discussion. The use of such metaphors in public discourse has even spread to policy makers themselves.
While a mechanical analogy might be an appropriate way to describe a subsistence economy, an advanced market economy does bot behave at all like a machine. It is in fact a process, or rather a collection of processes that together form a self-organising system. Self- organising systems can also be found in the natural world, flocks of birds and colonies of honey bees being examples, although these systems are less complex than human ones. (A Bee he emblem of the Royal Economic Society.)
A characteristic feature of all self-organising systems is that the mutual interactions between individuals at the blower levels of the system give rise to distinctive outcomes at the top or group level. So in a market economy, economic activity is driven from the bottom up, not from the top down. In today’s mixed economy there are of course influences coming from the top as well as from outside the system, but the fundamental drivers are those from the bottom up.
Outcomes at the top level are neither intended nor designed by the individuals themselves. When we go about our daily economic life, buying a pint of milk, looking for a new car, a new job or a new house, we are not moved by any considerations of aggregate national output or GDP. Yet the rate of growth of GDP is the unintended outcome of billions of decisions made by individuals, each of whom is working in an environment largely created by the mutual interaction of other individuals.
When people change their behaviour in response to the behaviour of others with whom they are interacting, we can call this behaviour adaptive, Adaptive behaviour is one of the distinctive features of a market economy as well as of other self-organising systems.
To take a recent example of adaptive behaviour , the Chinese AI company DeepSeek, wanting to develop a Large Language Model to compete with Open AI’s ChatGPT, was faced with a prospective shortage of high-quality chips as a result of US export controls. So it invented some new technologies, a collection of engineering innovations that not only required fewer chips but training its new system required much less energy. By adapting its own behaviour in the face of its changing business environment, the company was able to produce an LLM called DeepSeek R1 with comparable functionality to its rival at a fraction of the cost.
This successful innovation will oblige the company’s competitors to adapt their own behaviour by further innovations . These latter changes will in turn induce still further changes elsewhere in the industry , so that a cascade of adaptive change will ripple through the economy. A market economy is always changing, it is never at rest.
This is another characteristic feature of a market economy, it is a process of incessant change: markets never stand still. (This is one reason why most economic forecasts turn out to be wrong: they are based upon the foundational assumption of neoclassical economic theory, namely that markets are always in equilibrium. It is difficult to imagine a more inappropriate framework for thinking about economic growth.)
- Entrepreneurs and Entrepreneurship
In this process of adaptive behaviour and continuous change that is a market economy, the agents of change are the people who make everyday business decisions. Some of these decisions have greater consequences than others: a decision to build a new data centre is likely to be more important than the daily decisions of a farmer. Although everyone engaged in business life is continuously adapting their behaviour, economists have a special name for those people who take the more consequential decisions, they call them ‘entrepreneurs’. (A horrid word, perhaps attributable to the 18th century Irish economst Richard Cantillon, who wrote in French. Attempted English translations, such as ‘undertaker’, have not caught on).
Like elephants, entrepreneurs are easier to recognise than to define. Although the term can also be applied to movers and shakers in the pubic and voluntary sectors, in economic life entrepreneurs can be identified by their alertness to new profit opportunities, as well as by their ability to exploit these opportunities successfully. The more abundant are the opportunities to make greater profits, the higher will be the level of entrepreneurial activity in a society. If opportunities or profit-making are reduced, so too will be the level of entrepreneurial activity.
If entrepreneurs are the principal agents of change in a market economy, and if the cumulative effect of these changes at the individual level is to bring about more rapid growth of output at the national level, it follows that entrepreneurial behaviour needs to be encouraged if the rate of growth of the whole economy is to be accelerated . And that means that, if the rate of economic growth is to be increased, then government policy measures that tend to increase the prospective profits of entrepreneurs should be adopted while those policy measures that reduce them, such as taxes, should be minimised.
It seems that the present Chancellor of the Exchequer and her team don’t understand this. In last October’s Budget they raised the rates of some of those taxes to which entrepreneurs are particularly responsive, namely employers’ national insurance contributions, capital gains tax and inheritance tax on family businesses. They evidently still think that the economy works like a machine. A possible alternative explanation for their behaviour Is that their priority is not so much raising the rate of economic growth as it is winning the next General Election.
What then are the specific policy measures might actually increase the rate of growth of the British economy at the present time? We propose a solution that is achievable in the longer term . We also offer dome ‘quick wins’ that should provide some more modest results sooner.
5. A Long Term Solution
It is a remarkable fact that Western democracies have tolerated for so long income taxes as one of the principal sources of trevenue to pay for their public services. What is called ‘income tax’ but is really a tax on effort, whether that effort is physical, mental or creative. In other words, we have all along been discouraging people from working, by taxing them on the efforts they put in to the common national pool of economic activity rather than on what they take out , i.e. their personal consumption of goods and services. We can appreciate the argument of administrative convenience in favour of the income tax system when it was originally introduced ,while at the same time recognising its hugely disincentivising effects that inhibit economic growth today.
It would perhaps be better to abolish income tax and capital gains tax, and replace them with a progressive tax on an individual taxpayer’s annual expenditure. This would mean that each individual in the economy would no longer be assessed annually on what income they had earned but on what they had spent during the year. Tax rates would be progressive, so that big spenders would pay higher rates of tax at the top end of their spending while those parsimonious folk who spent less in total each year would pay lower rates of tax . Such a tax system should therefore appeal intuitively to most people’s sense of fairness, while at the same time aligning personal incentives with increasing the rate of growth of the economy rather than discouraging it.
When this type of tax, an ‘expenditure tax’, was first proposed fifty years ago, it would then have been administratively impossible to implement it. But in the intervening decades we have had the digital revolution which has made the collection and processing of the necessary information quite feasible.
- Some Quick Wins
It might take a little while to carry out the administrative changes required to introduce a graduated tax on personal expenditure. Meanwhile, the Government might realise a few quick wins in moving towards its objective of faster economic growth if it adopted some of the following policies:
- Trade
The UK could rejoin the EU’s Customs Union. This would not only provide an immediate boost to growth, but it would also fit in with the need for closer defence co-operation with other European countries.
- Rearmament
This is not so much an option as a necessity. It would do nothing to faise living standards, but the Government could point to a higher GDP statistic.
3) Immigration
Spain has shown how a well-managed programme of
Immigration can raise the rate of national economic growth.
4) Infrastructure
There may be a case for pouring more concrete in areas of existing business success, such as the Oxbridge-0London triangle, but projects with distant benefits that are likely to worsen London’s air quality, such as building a third runway at Heathrow, should be avoided.
5) Make the Whole of Scotland A Freeport
Something needs to be dome to counterbalance the present bias of economic policy towards the South East of England. Making the whle of Scotland a Freeport would be the simplest and most effective way of increasing the rate of economic growth north of the border.
- I would like to thank Brian Arthur, Judy Riley and Fergus Simpson for their comments on an earlier version of this paper.
1.3.25