Eco Today - Mar10:ET Master Page 2007 - ASKnLearn

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Dear Chancellor Institute of Directors Chief Economist and Director of Policy, Graeme Leach, sets out a radical plan to boost long-term economic growth. Snapshot Received wisdom accepts the budget deficit is very large and merely poses the question as to what combination of higher taxes and/or lower spending is required to reduce the deficit? The question on the mind of the Chancellor should be very different. It should be: How should we implement fiscal policy so as to maximise longterm GDP growth? The Chancellor faces a clear choice. Squeeze public spending or tax and spend will squeeze the life out of the economy. The scale of the financial crisis provides a once in a generation opportunity to reduce the size of the state. The Chancellor should set a target of a 35 per cent spending to GDP ratio by 2020 and a 30 per cent share by 2025 – potentially the lowest share in the world by then. W eakened by financial crisis, recession, an exploding budget deficit, stifling regula - tion and a looming 50 per cent top rate of income tax, the UK appears set for economic decline. Thankfully there is an alternative path Reducing public spending down towards 35 per cent of GDP could yet transform the long-term performance of the UK economy. There is a broad acceptance that public spending must be reduced as a proportion of GDP. OECD projections show total public spending 1 in the UK increasing from 37 to 54 per cent of GDP over 2000-10. 2 Between 2000 and 2007, in other words before the current economic crisis began, public spending increased by 7.5 percentage points of GDP, which was by far the fastest increase in the OECD. Net borrowing will approach £185 billion in 2009-10 and worst case but still plausible forecasts suggest total public borrowing over 2009-10 to 2013-14 could even reach £1 trillion. Received wisdom accepts the deficit is very large and merely poses the question as to what combination of higher taxes and/or lower spending is required to reduce the deficit. This is an inappropriate response. The question on the mind of the next Chancellor should be very different. It should be: How should we implement fiscal policy to maximise long-term GDP growth? Focusing on fiscal sustainability is likely to result in a squeeze in public spending together with a higher tax burden. There will be a lot of pain, but little or no gain in long-term economic performance. We will simply return to the position before the financial crisis. Tax and spend policies will have reversed slightly. The alternative approach is to focus on the supply-side of the economy and not just fiscal sustainability. Setting fiscal policy to maximise long-term GDP growth draws on a large economic literature from the OECD, IMF, European Commission, ECB, New Zealand Treasury and individual academics, showing higher taxes reduce long-term growth and lower public spending increases it. The policy conclusion at present is clear. The fiscal adjustment should fall on lower spending and not higher taxation. 3 1. The coverage of this OECD measure differs from HM Treasury estimates for total managed expenditure. The total spending to GDP ratio hides considerable regional variation. Many UK regions have public spending to GDP ratios of 50- 60 per cent plus, whilst the South East is closer to 35 per cent (pre-recession statistics). There is a need for huge structural adjustment to squeeze out the dependency culture. 2. This understates the extension of the state, for example, the effective ‘transfer’ of welfare spending to the private sector through the national minimum wage. The use of alternative denominators can also increase the public spending ratio. 3. Fiscal consolidations comprised largely of lower spending are also more durable than those based on higher taxes. 4. Encouraged also by the development of endogenous growth modelling in the late 1980s. The academic literature in this area has flourished over the past 20 years and now provides an opportunity to quantify the trade-off between taxation and spending on the one hand and GDP growth on the other – an opportunity which wasn’t really available in the 1980s due to the thin literature which existed then. 4 Empirical variation notwithstanding, some estimates suggest that a 10 per - centage point of GDP increase in public spending lowers the GDP growth rate by 1 percentage point. Based on this empirical relationship, reducing the public spending to GDP ratio from 50 per cent to 30 per cent could raise the UK’s long-term GDP growth rate by 2 percentage points – from approximately 2 per cent at present to 4 per cent. Even if the gain was only half this amount, the cumulative impact would still be considerable. Viewed over a 40 year period the difference between just 2 and 3 per cent compound growth is equivalent to cutting away the Scottish, Welsh and Northern Ireland economies! Attitudes need to adjust from the naïve and somewhat tired view which pre - vailed for much of the post war period – that because rising levels of prosperity had run in parallel with the expansion of the state, any relationship was benign at worst. Echoes of this worldview can still be heard. The Scandinavian economies are 18 M ARCH 2010
said to epitomise how big government and economic success can run hand in hand. Closer inspection reveals a somewhat different interpretation. First, there is the counterfactual. These economies could well have achieved even faster growth in the absence of a large state. Second, many of these economies have reduced the size of the state significantly e.g. Sweden where public spending fell from 71 to 51 per cent of GDP over the 1992- 2007 period (before the current financial and economic crisis took hold). The damaging potential impact of higher taxation (to finance higher spend - ing) on economic activity is best under - stood with the concept of deadweight cost. The deadweight cost of taxation is the loss of output which would have occurred in the absence of the tax – a loss of economic welfare above and beyond the tax revenues collected. The loss of economic welfare arises from the disincentive effect of taxation on labour supply and saving. Deadweight loss is the ultimate stealth tax. No one sees the extra output that would have been created by economic decisions made in the absence of higher taxes. This means that an extra £1 of govern - ment spending costs the economy more than £1 and hence reducing taxes by £1 generates more than £1 of benefit to the economy. How should spending reduction be undertaken? Standard slicing off every departmental budget is the wrong thing to do. There needs to be a fundamental root and branch appraisal of all spending, which is also informed by public choice theory. Public choice theory highlights the self-interest of public servants who may have their own agenda and little or no incentive to roll back the state. Senior civil servants may well need to receive personal incentives in order for them actively to support reduced public spend ing and productivity increasing reforms. Whilst not a perfect illustration, Canadian experience of zero-based budgeting in the 1990s shows that deep inroads into public spending can be made. The public spending to GDP ratio fell from 53 per cent in 1992 to 39 per cent in 2007 (before the current financial and economic crisis took hold). Indeed, between 1992 (the year of the largest deficit) and 1997 (the first year of surplus), spending fell by 9 percentage points of GDP, while the tax/GDP ratio rose by just 0.3 per - centage points. When should the next Chancellor start reducing spending? The answer is sooner rather than later. The obvious immediate critique is that reducing spending during a recession or infant recovery will only reduce aggregate demand. However, the reality is more nuanced. Experience of the March 1981 Budget shows that fiscal policy can be tightened during a recession, if monetary policy is simultaneously eased. The economy may also display ‘Ricardian equivalence’ – when households see rising budget deficits as a portent of future tax increases and merely raise their levels of current saving to provision for this eventuality. The academic literature is somewhat mixed, but it would appear that at certain times this effect can be much more significant and pre-announcing a credible fiscal adjustment, based on lower public spending, might actually boost activity. This may well be one of those times, given the scale of media coverage on the recession and fiscal deficit. The current fiscal crisis is presenting what may be a once in a generation opportunity to tighten dramatically public spending whilst simultaneously maintaining GDP growth during the transition phase to higher long-term growth, by retaining zero bound interest rates. Looking further into the 21st century, one can speculate that the pressure to reduce public spending – because of the negative impact of the taxation required to fund it – will steadily increase for a number of reasons. First, the effect of globalisation, with mobile factors of production and electronic commerce, threatens to heighten tax competition as part of the process to attract footloose foreign investment. Second, long term real income growth may result in future middle income households behaving more like upper income households at present. As a result, their labour supply may become more sensitive to post tax income. It is very difficult to be precise when speculating on the optimal size of public The pressure to reduce public spending will steadily increase. spending in the UK. One very robust conclusion, however, can still be drawn. The threshold at which the relationship between public spending and economic growth becomes negative is dramati - cally lower than the spending ratio at present. Given the potential trade-off between lower spending, reduced taxation and faster GDP growth, consideration of the thoughts of John Maynard Keynes might be helpful. Commenting on the tax burden required to fund public spending Keynes speculated that: ❝…25 per cent as the maximum tolerable proportion of taxation may be exceedingly near the truth. When considering the size of the state, we have tolerated too much for too long. A 35 per cent target for the spending to GDP ratio by 2020 should not be seen as the full solution. We would recom - mend a policy objective of 30 per cent by 2025. Without this approach, the UK economy risks becoming the sick man of Europe, with low trend growth and high levels of public spending and taxation. M ARCH 2010 19
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