Manifesto Check: the Lib Dems' tax proposals appeal to the middle ground

The Liberal Democrats' manifesto contained few surprises on tax. It always seemed likely that the Lib Dems would strike a balance between the offerings of the Conservative and Labour parties – one of which may become a coalition partner, if the election proves inconclusive. It turns out that’s exactly what they have done.

The party made five pledges, which would be “non-negotiable demands” in any coalition talks. These include tax cuts and spending increases in areas such as health and education. Overall public sector current expenditure would be covered by revenues by 2017/18. But there is also scope to borrow for “productive investment”, which is also part of Labour’s strategy. So the question is, can the Lib Dems achieve a balanced budget in terms of current spending, as well as offering spending increases?

Balancing act

The first thing to note is that Institute of Fiscal Studies has examined the rival manifestos and concluded that the main parties have not provided anything like the full details on plans to cut the public sector deficit. With this in mind, there are two areas of interest in the Lib Dem’s manifesto. First, there are the proposed changes in the personal tax allowances, which will deliver an increase of £400 in disposable incomes over the next five years for basic rate taxpayers.

In theory, changes in personal taxes will have two opposing effects on the supply of effort by individuals. On one hand, a tax cut will reduce the supply of labour, as better-off workers take more leisure time. But on the other, this will be offset by the “substitution effect”, meaning that people are more likely to work overtime, as they get to keep more of their income when tax rates are cut.

There are a number of studies investigating the extent to which tax cutting policies influence behaviour in the labour market. The evidence suggests that any effects are small. A later IFS study concluded hat the labour supply for men was relatively inelastic with respect to changes in taxation, though the reaction of manual woman to the same stimulus was stronger. Given the size of the proposed increases in personal allowances and the time-scale, it is unlikely that future behaviour will be much different. The IFS observed that the participation of men with low levels of education in the labour market is more responsive to changes in incentives achieved through tax policies, while men with higher levels of education were rather less influenced. The reaction of women to the same stimulus was stronger.

Yet given the size of the proposed increases in personal allowances and the time-scale, it is unlikely that the policies will have much of an impact on future behaviour. This is to be expected, because the effects of increases in personal allowances will have a weaker influence on higher earners. What’s more, the gains from lower personal taxes on the less well-paid are likely to be reduced, as benefits based on post-tax incomes are reduced as the net incomes of welfare recipients rise.

A tricky business

The second interesting element of the manifesto is the pledge to support UK business. There are no specific proposals to change the current regime governing taxation. But the Lib Dems do plan to promote “a high skill, low carbon economy” by such measures as supporting education, infrastructure projects and innovation and technology. These ambitions are laudable, but the available budgets are small, and the Department of Business and Skills is unlikely to escape the cuts in overall government spending (which is part of the Lib Dem strategy to reduce the public sector deficit).

In any case, previous research indicates that state aid is not large enough to have an effect on business and may have a detrimental effect on competition by promoting unfair advantage. However, a government report on industrial strategy painted a more optimistic picture as to the effects of an active industrial policy – perhaps reflecting a need to justify government intervention.

The overall state of the public finances precludes any major developments in terms of taxation and expenditures. The Lib Dems' objective of reducing the national debt as a proportion of GDP after 2017/18, and restricting any growth in public spending to economic growth, will be challenging given political ambitions and the unknowns that blow any plans off course over the period of a parliament. But like most manifesto promises, there is still insufficient detail about the costs of the promises, and how they are to be met.

The Conversation’s Manifesto Check deploys academic expertise to scrutinise the parties' plans.

Kevin Rowles does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.