The conventional wisdom in both the U.K. and U.S. press is that Maggie Thatcher lost public support in the last two years because of her controversial Community Charge, or "poll tax," which replaced the property tax, more or less, pound for pound. Our belief is that the more fundamental cause of her startling demise after 11 ½ years as prime minister was the elitist and austere fiscal policy her Government introduced in the mid-1980s, particularly the increase in the capital gains tax to 40% from 30% in April 1988. For this reason, her resignation last week has been welcomed in the British financial markets, which expected relief from any of the three potential successors. We expected greatest relief from John Major, the current Chancellor of the Exchequer, who has in fact won the job this afternoon. At 47 he was the youngest of the three contestants, the leader of the growth wing in the Conservative Party. This should make 1991 a very good year on the London stock exchange. With the highest inflation since 1982 and negative growth, the market is justified in believing that political change could not make things any worse.
Ironically, Nigel Lawson, who was Chancellor of the Exchequer in 1988 when the capital gains tax was raised, was, with former deputy prime minister Geoffrey Howe, among the prominent Tories who backed Michael Heseltine, the former defense minister who brought her down. Their reason, though, was Mrs. Thatcher's reluctance to accept Franco-German proposals for a unified European currency. If the British economy were still booming, though, her European position could not have caused the massive Tory defections in last week's voting. The fact is that no Western government has survived stagflation, and the redoubtable Mrs. Thatcher has proved to be no exception. President Bush, who has been placed on exactly this course by his economic team, should take special note. Indeed, Budget Director Richard Darman throughout 1990 has exhibited the same mindset as Nigel Lawson, which is why Darman must soon resign for the good of the President and the GOP.
In the mid-1980s, Mrs. Thatcher adopted the same economic strategy that Darman and Treasury Secretary Nicholas Brady continue to push — a combination of easy money, a weak currency, and a fiscal policy designed to balance the budget. With her characteristic determination, Mrs. Thatcher succeeded in forcing the budget into actual surplus even as inflation was continuing to chew away at the real burden of the U.K.'s national debt. Budget-balancers around the world have trouble explaining the results presented: Growth fell and inflation rose as the U.K. budget deficit shrank and turned into a surplus. The U.K. Treasury's current forecast shows a 1% decline in real GNP during the second half of 1990, the worst result of any of the big industrial economies, while Germany and France next door sail along at 3-4% growth. Consumer price inflation, meanwhile, is at 11% by the British government index (which includes the effect of taxes and interest rates), and more than 8% by a measure comparable to the American CPI -- again, the worst inflation rate by far among the big industrial economies.
It does not occur to the budget-balancers that the same policy combination that caused the "good" budget surplus also caused the combination of recession and inflation. Mrs. Thatcher achieved the budget surplus by transferring the burden of the national debt onto the backs of the British population while smothering the entrepreneurial impulses essential to produce new enterprise and employment. The Bank of England was forced to tighten monetary policy in 1988 to prevent capital flight from interest-bearing sterling assets. This is the same difficulty faced by the Bank of Canada, which also let its capital gains tax shoot up in emulation of the U.S. 1986 tax reform.
Last year's uproar about the proposed poll tax, i.e., a per capita tax to fund local services in place of the existing property tax, represented a warning signal to Mrs. Thatcher by the electorate concerning the entirety of her fiscal program. As such, the poll tax contained no more inequities than the existing "rates," or local taxes, it would have replaced. It became the focal point of a tax rebellion, though, that had been brewing since Lawson's 1988 budget.
The British population was paying down the real national debt at a remarkable pace. Adjusted for inflation, the government's outstanding debt fell by more than a quarter between 1977 and 1990. Meanwhile, the tax burden, measured by government revenues as a share of GNP, rose to 38%, the highest level since Thatcher took office in 1979.
Britain's economic growth during the 1980s outstripped the continent after the Thatcher government brought marginal tax rates down to 40% from the 83% rate in place when Mrs. Thatcher took office. Prior to 1988, a top 60% marginal rate applied to income above $41,200, but capital gains were taxed at 30% after adjustment for inflation since 1965. Indexation left the effective capital gains rate at less than half of the comparable U.S. rate. The Lawson budget of 1988 unified the top tax rates, charging a 40% rate on capital gains since 1982. The effect was to shelter capital gains made before 1982, e.g., in the property market, while subjecting new entrepreneurial investments to the higher rate.
The British business press was flooded with protests by the British Venture Capital Association, Tory backbenchers, and small businessmen warning that the high capital gains rate would erode the entrepreneurial foundations of the Thatcher recovery. And so it has. Financial columnists urged investors to avoid equities and purchase gilts. Unlike the U.S., Japanese, and continental European stock markets, the London market never regained its pre-crash 1987 peak.
While the Lawson tax program choked off the flow of capital to entrepreneurs, the Bank of England eased monetary policy in the fall of 1989, permitting the pound to fall both against the German mark and gold. Long-term government bond yields, which had fallen to 9.4% in 1987 from 11.2% in 1983, rose again to over 11%, the highest long-term rates in the Group of 7. Higher commodity prices (measured in relatively weak sterling) and higher taxes and interest rates forced up costs across the board.
We expect John Major will reconsider these blunders. He's already talking about another round of income tax cuts. And we see a positive sign in the London Economist's editorial last week suggesting that the higher capital gains rate might have been an error. Elimination of the tax altogether would have cost a trivial $3 billion on a static analysis basis, raised several times that amount via rapid economic growth, and avoided the high interest rates and inflation. Younger Tory backbenchers who supported Majors are in fact pushing for a zero rate.
It would be well for the new Tory government to also consider that it is not necessary to hack away at the national debt when the country is starving for a renewal of public infrastructure. Mrs. Thatcher's often laudable stubbornness proved fatal in the case of her fixation with the budget deficit, and her party had to remove her in order to retain some chance in next year's national elections. Indeed, the party leaped from a huge deficit in the polls to a strong lead, even as the stock market rallied as well, indicating increased hopes for a shift to a growth strategy. If so, these events in London could have marvelous ripple effects in the policies of Washington and Ottawa.