George Osborne is unusually reluctant to show how a smaller Budget is financing tax cuts, because new evidence suggests that won’t promote economic recovery, argues Alan Shipman.
Pressure to cut taxes has become overwhelming – and not just because it’s a time-honoured tactic for winning back votes as an election approaches. When households are complaining about frozen (and declining) incomes and rising utility bills, and businesses blame higher taxes for restricting their investment, there is a seemingly strong case for government ‘giving back’ to the private sector by taking less from it.
Former defence secretary Liam Fox put this case a week before the Budget, arguing that lower taxes are the high road to faster wealth creation. To the increasingly powerful liberal lobby that Fox represents, tax cuts would accelerate budget deficit reduction if matched by reductions in welfare spending. Leaving more income to businesses and employed households would encourage them to invest it, while redistributing less via benefits and tax credits would galvanise initiative by ending the ‘dependency culture'.
Despite some headline-grabbing concessions on excise duties, income and capital taxes, the Chancellor has resisted such radical steps towards a minimal state. That’s partly because Fox as a cabinet colleague was notably less keen to find the budget cuts required by tax reduction. But it’s mainly because, even if governments could achieve deep spending cuts alongside deep tax cuts, it wouldn’t guarantee the return to growth on which budget deficit reduction depends.
The belief that tax and spending cuts would fast-track recovery – economists’ ‘expansionary fiscal contraction’ – rests on the assumption that the private sector spends money productively while the public sector wastes it. So if the state consumes less, businesses can invest more; and if the state redistributes less, incentives are boosted both for the households that are taxed less and for those that are subsidised less. But for the past three years, in the UK and across Europe, extra money given to the private sector hasn’t been spent more productively – because it hasn’t been spent at all. Instead, it’s been used to pay back debts and rebuild savings after the over-borrowing that preceded the 2008 crash.
Quantitative Unease
The most dramatic illustration of this is the £275bn that the Bank of England has pumped into the economy since 2009 through ‘quantitative easing’ (buying public debt so that equivalent sums stay in private hands). The Bank argues that this helped to combat ‘double dip’ recession, but effectiveness is difficult to demonstrate. Critics point out that most of the money ended up back with the Bank, strengthening commercial banks’ finances but no-one else’s, and diverting the rest from long-term into speculative short-term investment, or overseas.
To address these concerns, the Bank switched in 2012 to ‘funding for lending’ (FLS), which aims to give banks a further £60bn on the condition they lend it to businesses and households. The economy’s subsequent stumble towards ‘triple dip’ casts doubt on whether FLS has been any more successful. There’s evidence that it has discouraged private-sector saving, but much less that it has stimulated the economy through higher investment, consumption or housing-market recovery.
Divided over Multipliers
Old-style economists wouldn’t be surprised at this. Trying to revive a stalled economy entirely through monetary policy was traditionally likened to ‘pushing on a string’. It gives the private sector the means to invest and consume more, but not the incentive. Tax increases matched by public spending increases might be expansionary, because they mobilise the extra funds (as investment or consumption) and raise expectations of demand, which prompt businesses to produce more. But tax reductions matched by public spending cuts will only deepen the malaise.
If (as in Europe and the US since 2008) the private sector is intent on saving more than it invests, then most economies can only revive if their public sectors spend more than they take in tax. Smaller countries may be able to offset the private-sector surplus with a surplus of exports over imports, still balancing their budgets – a path that Estonia, Latvia and possibly Ireland have successfully followed. But for the larger ones, the public deficit is the inevitable counterpart of the private surplus.
The old-style, ‘Keynesian’ reading of this identity is that governments must continue to run deficits until the private sector feels confident enough to reduce its saving and raise its investment – a path the US seems to have successfully followed since 2008.
The new-style reading – embraced by Liam Fox, the International Monetary Fund (IMF) and the EU Commission – is that the fiscal deficit causes the private-sector surplus, and that private investment will recover as soon as public spending is brought down. George Osborne may once have shared this belief. But it was severely dented when the IMF admitted last year that it had greatly underestimated the short-run damage to confidence and output from the imposition (or even the announcement) of deep public spending cuts.
On revising its earlier methodology, the IMF found that while ‘revenue multipliers’ (from tax cuts) are small, ‘expenditure multipliers’ from higher public spending are significant when national output (GDP) is a long way below potential. Budget expansion is more than matched by subsequent increases in GDP. The Office for Budget Responsibility calculates that the government’s combination of spending cuts and tax rises reduced GDP by 1.4% in 2011/12.
These attacks by previously supportive voices have made the government much keener to trumpet its increases in infrastructure investment, and play down its tax cuts. Taxing less, while spending more, sounds suspiciously like a reversion to the Keynesian medicine – which Labour has long called for, so neither the Conservatives nor Liberal Democrats can publicly embrace it.
Alan Shipman 20 March 2013
Alan Shipman is a lecturer in Economics at the Open University. He is responsible for the modules You and your money:personal finance in context and Personal investment in an uncertain world, part of the foundation degree in Financial Services.
The views expressed in this post, as in all posts on Society Matters, are the views of the author, not The Open University.
Cartoon by Catherine Pain
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