This article is an excerpt from our Growth Bulletin, authored by Ryan Bourne and Tim Knox. To read the full article, click here. To sign up for our mailings, use the form on the left of our newsletter page.
After two and a half years in office, Mrs Thatcher’s government had abolished exchange controls, reduced the top rate of income tax from 83% to 60% (later to 40%) and introduced firm monetary policy which would see inflation fall from 25% to 2.5%. Her critics – such as the 364 economists (including Mervyn King) who wrote to The Times – said that it would not work. But it was done. And the strong medicine prescribed to cure Britain’s economic sickness did work.
After two and half years in office, the Coalition has cut the top rate of income tax from 50% to 45%. But yesterday’s Autumn Statement did not contain any similarly strong cures for our current economic ills. Yes, the Chancellor played a bad hand yesterday relatively well, honestly presenting the growth outlook as awful. But he also sought to triangulate, claiming the Labour Party wanted to increase the debt burden even higher than it is today, while criticising those who advocate deeper cuts for failing to acknowledge the frailty of the economy. In other words, he claimed cuts are good for the economy but cuts are bad for the economy. Sort of. And of course, only the exact path the Chancellor has taken is right.
Many would disagree. Estonia took their medicine in a big one time hit, initiating supply-side reforms at the same time, which kept their deficits low and has now seen the recovery of lost output. But George Osborne instead keeps tinkering away in the hope that growth will pick up and the deficit will prove more cyclical than we thought.
Why has growth been so slow? To answer that question of course requires us to understand the international context, including the on-going Eurozone trauma, and the fall-out from the financial crisis. But we also must acknowledge the structural factors which make a return to growth unlikely in the short-term and on unchanged policies:
- the high level of public debt. Markets aside, there are economic reasons to be concerned with this high debt burden. The important work of Reinhart and Rogoff has shown that gross debt levels over 90% of GDP tend to lead to protracted stagnation. Our official gross debt levels will now almost touch 100% of GDP later this Parliament (excluding all the off-balance sheet liabilities).
- the low level of cuts to government expenditure over this Parliament (about 4% in real terms), particularly given the huge expansion (by 61% in real terms) of the state under New Labour. We’re still borrowing over £100 billion per year and will add well over £600 billion to the national debt in this Parliament.
- Our marginal tax rates are too high, in part because of an unnecessarily complicated tax and benefits system. Significant welfare reform to revive incentives and to reduce state dependency is required: in 2010/11, 53.4% of households received more from the state than they paid in taxes, up from 43.8% in 2000/01.
On top of that, small businesses are overregulated, energy policy has been incoherent for the last 20 years, the banking system is still dysfunctional, our exports are still rebalancing from declining economies towards growth economies and private debt is at historically high levels. We’ve had a perfect slow-growth storm.
Yes, the Coalition is pushing in the right direction on many areas, but it is not going nearly far enough, nor is it going quickly enough. On spending, for example, the Chancellor claimed that the £17 billion in additional consolidation required to meet his debt target would not be undertaken given the apparent cyclical nature of the revisions down of forecasts. But this view is reliant on the OBR being right about its growth forecasts in a few years’ time (anyone care to bet on 2.4% growth in 2014/15?), when thus far it has been consistently over-optimistic.
More, much more, needs to be done to restore health to the government finances. It is fanciful to believe this can be achieved merely by savings in administration, or freezing certain departmental spending limits while ring-fencing vast swathes of the public sector. What is needed is a fundamental re-examination of the scope of government and of the eligibility for government transfers.
If Osborne is still unwilling to face up to the full scale of the challenge, then the opposition party aren’t even in the arena. Their response since 2010 has been an insult to the electorate. Education, health, benefits and debt interest make up 72% of our budget. Yet they’ve opposed any cuts to schools, made a big song-and-dance this week about a tiny real terms cut to the NHS in a year in which they set the budget, and now look set to oppose the restricting of benefit rises. No doubt their politicians will fill our screens chuntering about the unfairness of yesterday’s measures – ably backed up by several think-tanks’ distributional analysis. The problem with this type of work is that it doesn’t define a relevant counterfactual. More debt is no free lunch. Those obsessing over ‘who loses out’ don’t seem to acknowledge this. We are poorer than we thought we were and people are going to be worse off. The analysis therefore isn’t just misguided, but dangerous. Just 6% of the electorate now realise that even the Coalition are raising the debt by over £600 billion. In that context, what hope is there of telling the electorate the problems are going to take a much bigger effort to cut spending?
GROWTH DOWN, BORROWING UP (AGAIN)
“The forecasts were largely as expected – growth revised down, borrowing revised up and the deficit and debt targets pushed back. Rather unhelpfully, the changes to QE cash management, the Royal Mail pension plan and the reclassification of Northern Rock and Bradford & Bingley means there are now many different figures flying around. But when you really strip back and look at the underlying picture you see a worse deficit, a worse structural deficit and higher debt than forecast in March.” – Ryan Bourne, Head of Economic Research
To see how much the Office for Budget Responsibility has revised down our growth forecasts since 2010, consider the chart below. Yesterday saw growth revised down in this and each of the next three years.
Real GDP growth forecast changes by Budget/Autumn Statement
But even these new revised figures still look more optimistic than the average of independent forecasters presented by the Treasury:
| || ||2012/13||2013/14||2014/15||2015/16|
|2012 Budget|| ||1.0%||2.3%||2.8%||3.1%|
|2012 Autumn Statement|| ||0.1%||1.5%||2.1%||2.4%|
|HM Treasury average of independent forecasters||0.1%||1.2%||1.8%||2.2%|
This slower growth has a big effect on tax revenues, with overall cash revenues now £15.4 billion lower in 2014/15 than forecast in March, and £53.4 billion lower than forecast in June 2010. Overall, the real economy is now only forecast to grow by 4.3% over this Parliament, compared to the 6.7% forecast in March and the 11.2% originally forecast in the Emergency Budget of June 2010.
Public sector net borrowing (the overall deficit) and the fiscal rules
The net effect is that borrowing will be higher than first thought. Looking at what has happened to the overall deficit has been complicated by the inclusion of several accounting factors (for example, how to include transferring assets from the Royal Mail pension to the public sector and the Asset Purchase Facility cash management changes for QE). Once these are stripped out, the deficit is going to be significantly higher as a proportion of GDP than forecast in the Budget (compare the bottom and top rows in the table below). By the end of the Parliament in 2014/15, the deficit will be 5.9% of GDP once these items are stripped out, compared to the 4.3% forecast in the Budget.
This higher borrowing meant the Chancellor had to re-assess his two fiscal rules: to eliminate the structural current deficit within five years, and for net debt as a proportion of GDP to be falling by 2015/16. Readers of this bulletin will know that we have said repeatedly the first rule - the fiscal mandate - was meaningless without the supplementary rule because it has been described as a ‘rolling’ target (i.e. you only ever have to promise it will be met in five years time). Though yesterday’s headline numbers suggested that the structural current deficit will be eliminated by 2015/16, once the Asset Purchase Facility change is factored out the Chancellor has once again rolled this mandate forward – this time to 2017/18. In other words, what Osborne promised to do in five years, he now promises to do in seven or eight.
More importantly, George Osborne said in the 2010 Budget: “In order to place our fiscal credibility beyond doubt [we will have] a fixed target for debt” – i.e. that debt would be falling in 2015/16. Yesterday, he admitted that the Coalition is no longer to hit that target. Net debt is now forecast (according to the headline figure) to peak in 2015/16 at 79.9% before falling thereafter. Once the Asset Purchase Facility effect is factored out debt will peak higher at 83.6% in the same year. The Chancellor chose not to adjust spending to meet his debt target.
Here is the Chancellor’s massive gamble: he is staking everything on assuming that constraining public spending will be enough to maintain confidence. But will continued poor performance on growth, with resultingly lower tax revenues and higher deficits, lead to a loss of market confidence in the future? This risk in addition to the potential economic effects of high debt mean that non-adjustment of plans should not be a considered a painless option.
SMALL FRY POLICY CHANGES
The Chancellor chose not to adjust his spending plans, however. We sail on as before.
There were the usual range of micro-initiatives, some welcome, some not so welcome. But we urge you bear in mind that we live in a £1,500 billion economy, which has been propped up with £375 billion of QE, and £500 billion+ of deficits since 2008, and where the government spends over £700 billion (the equivalent of £80 a day for every household). In this sense the measures which grab the headlines can only be considered as pretty small fry. In addition, a concern going forward is that many of the tax revenue hikes used to pay for continued high spending come from largely one-off revenue sources, such as the 4G auction or the raid on Swiss bank accounts.
- The main change in spending was to instigate an extra 1% cut to non-protected departmental budgets in 2013/14 and 2% in 2014/15, in order to fund a capital spending package. As such this will help the Chancellor’s current deficit rule going forward, and the capital spending is easier to withdraw after that. It seems here that the Chancellor has listened to the call of lobby groups for infrastructure investment as a sort of Keynesian stimulus to the economy. But the sums involved are very small (£5.5 billion) and investment should be really judged against the return rather than the sums spent.
- More welcome was the Chancellor’s decision to look at controlling welfare spending by limiting the growth of most working age benefits to rise by 1% (i.e. less than inflation). As George Osborne rightly pointed out, this partly makes up for the 5.2% increase in benefits last year at a time when earnings were only growing by around 2%. Though the Chancellor was wrong to imply all people in receipt of benefits were unemployed or scroungers, all too often people talk of income received by benefits as if it is economically equivalent to earned income. The incentive effects are, however, very different. The large uprating last year saw unearned income increasing much more quickly than earnings, creating perverse incentives for both those out of work and those paying tax to fund benefits.
- It was also good to see that the Chancellor recognised that foreign aid should not increase to exceed the 0.7% of GNI target, given our GNI has not grown as quickly as expected. Yet surely he should have gone further. To update Peter Bauer, why are poor people (who are today getting poorer) in rich countries being forced to pay money to rich people (who are today getting richer) in poor countries? Given there is little rationale for the target, and widespread concern about how our aid is being spent, there was scope for much larger savings here.
- There was another splurge of “sweeties”. The Regional Growth Fund, for example, was rewarded for its costly failure with another £350m. This, and a range of other measures such as the £1 billion in extra capital for the business bank, would have been better served in being used to avoid some of the tax hikes seen through limiting the uprating of allowances.
- Fundamental reform of our tax system is the dog that hasn’t barked. However, the Government again showed that it has little appetite for it, which is disappointing. Thankfully, the Chancellor avoided the Lib Dems obsession for highly targeted wealth taxes, which would no doubt have quickly established themselves as more widespread features of the tax code. But more could have been done to replicate Nigel Lawson’s success in broadening bases and lowering rates, particularly for Capital Gains Tax. Merging income tax and national insurance is also long overdue.
- Another cut to the main rate of corporation tax by 1% to 21% from April 2014 was welcome, as most economic evidence suggests this is the tax that can have the most powerful long-run growth effects. Likewise, pushing ahead with the increase of the income tax personal allowance to £9,440 next year, £235 more than planned, and cancelling the fuel duty hike will help most working people around the country.
- The pensions tax relief system doesn’t work effectively at the moment, but rather than undertake more fundamental reform, the Chancellor merely trimmed the cap on tax relief for upper rate taxpayers from £50,000 to £40,000.
- It is disappointing to see another 400,000 earners drawn into the 40p higher rate tax band. And while politically popular (but economically foolish), the moralising on legal tax avoidance rather than reforming the law risks deterring inward investment to the UK and with it the benefit of job creation and the payment of many other taxes.
…on supply-side reforms…
- There was welcome news with the setting up of the Office for Unconventional Gas. Given the shale gas revolution taking grip in the US, we should do everything to replicate its success here. A big concern for energy policy, however, is the failure to abandon next year’s Carbon Price Support, which will push up bills and the costs of manufacturers.
- On deregulation, it is welcome to see the Government announce a ‘One-in, Two-out’ rule for domestic regulation from January 2013, but the fact that its scope does not include much EU regulation means it will be difficult to quantify any material benefits. We’d also have liked to have seen a framework for effective sunset clauses unveiled, a potential model for new garden cities examined and more in the way of exclusions from regulation and employment legislation for very small businesses.
- Though there were multitude of new infrastructure announcements, the key decision on a hub airport has now been ducked again.
- Finally, the Government appears to have buckled to public opposition and decided against making public sector pay more market driven (except in schools). This is disappointing, as the elimination of national pay bargaining could have done much to help private sector competitiveness in some of our poorest regions. Well done to the unions for running an effective campaign spreading misinformation about how it might work.
CONCLUSION: THIS IS MORE ABOUT WHAT WAS NOT ADDRESSED
This mini-Budget was a microcosm of the Coalition so far. In many ways it is pushing in the right direction, but the measures are not nearly confident or radical enough. Having laid out the predicament of low growth, high debts and the need to be competitive so clearly, the Chancellor’s solutions seem weak in response.
This Autumn Statement was more about what was not said.
- First, having given up the net debt rule, the Chancellor needs to display through action his determination to get debt under control. It seems probable government spending assumptions will have to be fundamentally revisited at some stage due to persistent low growth. This should put everything back on the table.
- Second, fundamental reforms of our tax code (including for pension relief) and government transfers are still necessary and desirable.
- Third, the Government must improve the supply-side of the economy, by removing burdens from business rather than through wasteful interventions.
Finally, the Coalition must stop fighting on New Labour’s terms. Ultimately it is innovation and improvements in productivity which increase prosperity. Yet terms like ‘entrepreneurship’ and ‘innovation’ were notably absent from the Chancellor’s speech. Instead the Government renewed its narrative of fairness. But ‘fairness’ is usually interpreted as ‘never taking away or scaling down government transfers to the relatively poor’ by their opponents. This means Ministers will never win the debate against those who compare outcomes against a world where no cuts are made.
It is time for Ministers to treat us as grown-ups. Too many people have been left in the dark about how bad the nation’s finances actually are. Cutting government spending to the extent necessary will inevitably mean many are made ‘worse off’. In the medium term, there really is no alternative. What would be really unfair would be to leave an unreformed low growth economy and even higher debts to future generations.