There’s a term in economics called ‘a public good’. The definition is usually if something is non- rivalrous and non-excludable, meaning that nobody can be effectively excluded from using it and one person’s use does not negate the ability of others to use it. These types of goods tend to be underprovided in free markets, for the obvious reason that nobody would be willing to pay if they could free-ride off someone else. Thankfully, however, some tasks – such as the spreading of knowledge – are still often undertaken regardless of the lack of economic incentive to do so. Andrew Lilico’s excellent columns for Conservative Home on economic issues are a case in point. This blog is a shameless attempt to ride the crest of his wave.
I share Andrew’s bug bear that when been debating fiscal policy recently, many of those I speak to assume that all government spending is the same. Now, we can debate whether government investment generates growth in the short-term, medium-term and long-term, the relevant multipliers, the trade-offs and risks of adding more to the debt burden, the longer term ‘balanced budget multiplier’ etc. This is what the whole debate on Keynesianism is all about, and to be fair to most economists who advocate stimulus spending, they do usually focus on government investment spending or tax cuts (which even supply-siders would argue have positive effects on incentives!)
But many non-economist activists and ‘austerity’ bashers make the same arguments for government transfer spending. They say things like ‘cutting benefits will reduce demand’, or ‘cutting public sector wages sucks money out of the economy’. These types of comments are almost always taken as given in television debates. The problem is that the process of reaching the conclusion that government transfer spending increases GDP relies on a range of complex assumptions, which quite frankly are extremely unlikely to hold. So whilst it might be a good idea to increase transfers on other social policy grounds, those who believe taking money from one person and giving it to another will benefit the economy more broadly than the benefit conferred to the individual are usually mistaken. The general result is that redistributive policies don’t tend to generate growth – in fact, they can often retard it.
Let’s see why:
1) First of all, government doesn’t have its own money. It has to tax or borrow to get it. So if I want to increase the benefits given to one group of people, I have to raise tax on another group or else dip into the aggregate savings of the economy to borrow it. If I do it via tax, then the overall effect on the immediate economy is likely to be small or negative, especially when you consider the effect of the tax on incentives, the deadweight costs of the tax. If I do it via dipping into people’s savings, then many think that because the person the government gives the cash to might be more likely to spend than the saver that this will boost GDP.
Right? Well, not so fast. As Andrew Lilico correctly states, most macroeconomic models assume money saved is invested, which also boosts GDP. So transferring money will mean less investment but more consumption, with overall demand unchanged.
2) So, the Keynesian argument relies on other assumption: that there is over-saving in the economy. There is money being saved which is not being invested or consumed, but is just sitting idle. Therefore redistributing it will lead to more demand than there otherwise would be: in this situation we can increase consumption without a corresponding fall in investment, right?
3) Well, it’s not that simple. As Lilico explains:
- Transferring from one group in society to another group, say rich to poor, doesn’t take account of what’s happening to each individual making decisions for themselves. There may be some poor people who currently over-save and some rich people who under-save. Redistributing from rich to poor could therefore increase over-saving. The government simply lacks the means of knowing who’s under or over saving at an individual level.
- Even if you could identify them in this way, their behaviour could change as a result of your transfer in ways in which you might not expect. Taxing a rich person might encourage them to save more, and then giving money to a person who you might think would spend more may in fact lead to them to bank the money and save as well. In that scenario, you can again increase over-saving through redistribution.
- And even if you could get around all of these issues and redistribute to the ‘right people’, the benefit to GDP would have to be greater than the deadweight cost of the transfers and taxation required to redistribute. If you raise transfers without a corresponding work requirement then you can actually discourage work. Raising out of work benefits, for example, make labour more expensive by reducing its supply. The unemployed can also face higher marginal tax rates when deciding whether to work, because of the fact they now would have to pay tax and lose more significant amounts of benefits.
So, in summary: to think that increasing benefits or public sector wages could lead to higher aggregate demand and GDP requires the assumption that there is over-saving in the economy, that the government has the knowledge and ability to redistribute efficiently from over-savers, and that the increase in demand as a result will exceed the deadweight cost of the tax and redistribution.
Now, in a debate that I had on Twitter about this on Saturday morning, Tomas Hirst and Daniel Knowles essentially made the point that ‘ah, so in theory it COULD lead to higher GDP’. Well, yeah, I guess so. But do you think these assumptions are realistic and hold in the real world? The problem that Andrew, I and others have is that reporters, pressure groups and activists just assert that reducing transfers will lower GDP without all of these qualifications which make it extremely unlikely. If you watch carefully what people like Jonathan Portes and other macroeconomists say on television, they never claim directly that increasing transfers would increase GDP, because they are probably well aware of all these qualifications and implicit assumptions. That’s why they tend to focus on investment spending. But others aren’t or don’t.
In fact, I’d go much further than Andrew in dismissing the idea that active redistribution through transfers would increase demand and GDP, or help raise the overall employment level. Too often when we discuss macro issues, we forget many of the basic ideas which make economics interesting, like incentives and trade-offs. So, thinking about the micro there’s a further three reasons why I think Robin Hood policies wouldn’t improve the economy:
- Labour market response: ncreasing benefits and public sector wages bids up wages in the private sector more broadly, squeezes profits and thus lowers investment.
- The idea of trickle-down: redistribution would of course lead to a change in the composition of demand, but this would not necessarily lead to more employment. As Casey Mulligan has pointed out: taking from the rich might lead to a fall in demand for expensive hotels and restaurants, industries which tend to be labour intensive. In contrast, giving to the poor might well actually lead to an increase in demand in industries which are far less labour intensive, meaning that overall employment could fall as a result of redistribution.
- Those advocating redistribution now usually do so by advocating one-off transfers because of the current state of the economy. But economic analysis generally finds that people’s spending decisions tend to be based on permanent income, so this sort of one-time transfer is unlikely to have any significant effect even if you believe all of the assumptions above hold.
Of course, increasing the value of transfers may well be regarded as the right thing to do for other reasons. But from a purely growth perspective, you have to take some huge leaps of faith about over-saving, the ability of government to redistribute efficiently, the effect on incentives, the deadweight costs of redistribution and the composition of demand to assume that Robin Hood policies would improve our growth or employment prospects. Quite simply, they don’t. And more people should call out those who suggest that they do. Thus far the Government's deficit closure has come through tax hikes and capital spending cuts -the implication of this blog is that, from a purely growth perspective, they'd be much better focusing their attention on transfers.