In a major study of public spending and taxation, published by the Institute of Economic Affairs*, David B. Smith** argues that public spending in Britain has seriously overshot its optimal point and is damaging economic growth and national welfare. As a proportion of national income, public spending today is five times the level of 100 years ago (Table 1, page 26). After income tax, national insurance, VAT, council tax and other indirect taxes, a basic rate taxpayer surrenders to the government over 50% of each additional pound earned.
Smith argues that the optimal level of public spending is no more than 30-35% of GDP. This level would allow the government to pay for defence, law and order, redistribution and basic welfare provision. However, he also shows that if public spending had been kept at 30% of GDP over the last 45 years, national income today would be twice current levels because of the faster economic growth that would have occurred in a more lightly taxed economy (pages 77-81 and Table 10).
David Smith comments: This has relevance to the current political debate. In framing their fiscal policy, the Conservative Party is wrong to refuse to take account of the increased revenue that will result from higher growth if taxes are cut. The three parties have come to a consensus on the one issue, namely the size of government, on which they should differ most sharply.
Government and opposition are both misguided in making claims that they can painlessly cut government spending by reducing waste. According to Smith the evidence from around the world demonstrates that governments have to be smaller to be leaner. Only those governments that spend around one third of national income are significantly more efficient than the UK government (pages 39-41).
There are also large regional differences between levels of taxation and government spending. The east and south-east of England and London have levels of public spending of around one third of GDP on a par with the lowest spenders in the OECD, such as South Korea and Australia. The north-east of England, Scotland, Wales and Northern Ireland have spending levels 50% higher than in south-east England, much of it financed by English taxpayers (see Chapter 5 and Tables 16 and 17). This level of public spending is very damaging, because of its perverse microeconomics effects, even if it is financed by transfers from southern England.
There are strong political pressures to maintain the current high levels of public spending. David Smith suggests that a flat tax, without any allowances, would help reduce those political pressures: everybody would contribute to spending in direct proportion to their income. Regional justice also needs to be restored government spending should be lower in cash terms in areas where living costs are lower. Devolved parliaments could be made totally responsible for raising the taxes necessary to finance spending in Scotland and Wales. More generally there should be more local autonomy in fiscal matters to restore the link between taxation and representation that is vital to the functioning of a healthy democracy.
Living with Leviathan: Public Spending, Taxes and Economic Performance  by David B. Smith, Hobart Paper 158, The Institute of Economic Affairs, £12.50. The study can be downloaded free of charge below.
** David B. Smith is currently a Visiting Professor in Business and Economic Forecasting at the University of Derby and chairman of the IEAs Shadow Monetary Policy Committee.
The impact of public sector pensions on future levels of government spending is examined in
Sir Humphrey's Legacy: Facing Up to the Cost of Public Sector Pensions  by Neil Record.
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David B. Smith  Tel: 01923 897885
Philip Booth (IEA)  Tel: 020 7799 8912
Richard Wellings (IEA)  Tel: 020 7799 8919