Darling must cut UK’s huge welfare bill

February 17, 2013

Alistair Darling is staring into the abyss. Unless he makes severe cuts to government spending there is a real risk he will plunge the UK into another economic crisis.

Without a credible commitment to bring public expenditure down to sustainable levels, the bond investors funding Britain’s near £200 billion annual borrowing may demand a risk premium in the form of higher interest rates. A big rise in rates would in turn increase the cost of the government’s debt repayments, threatening a debt spiral which could jeopardise economic recovery.

Growth is already threatened by the well-known crowding out effect of public borrowing, which diverts resources from the productive parts of the economy. This may mean official growth forecasts are too optimistic, making cuts in spending even more necessary.

In the context of these grim economic realities, Darling cannot make savings of sufficient scale without tackling the major areas of government spending – health, education and, most importantly, welfare. Including state pensions, welfare benefits cost about £170 billion per year, around one in four pounds the government spends. This emphasises the magnitude of the problem. Even a highly contentious 10% across-the-board cut would save just £17 billion – worthwhile, but a fraction of what is needed.

Yet many welfare benefits are more about favouring particular groups of voters than providing a safety net to cover basic needs. For example, a whole host of payments have been introduced that favour the over-60s, including pension credits, winter fuel payments and free travel. These special benefits add up to at least £12 billion per year and often go to relatively well off households. They also reduce incentives to work and save.

A combination of phasing out special payments for the over-60s and reducing benefit rates by a relatively small percentage across the board would help ensure welfare played a proportionate role in rescuing the public finances. A failure to address Britain’s huge welfare bill in today’s PBR will augur very badly for the country’s economic future.

9 December 2009, IEA Blog

Filed under welfare Tagged with , , ,

Picking winners and nuclear power

February 17, 2013

Faced with ambitious climate change targets, the government has decided that nuclear power will play a leading role in supplying the UK’s future electricity needs. Ten new plants will be built in the next decade or so, which should provide about a quarter of total supply.

The nuclear option appears to be far more sensible than an equivalent expansion of wind power. Indeed, the unreliability of wind energy means that it must be backed up with conventional capacity, while its dispersed geographical distribution imposes additional costs on the network infrastructure.

Yet nuclear has its own problems. If the new plants are built on schedule and on budget then the impact on electricity prices is likely to be relatively small. Historical experience, however, does not support such optimism.  

Britain’s previous nuclear programmes were economically disastrous. They were plagued by delays, cost overruns, and design flaws. In today’s prices development losses amounted to at least £20 billion, while decommissioning may end up costing another £75 billion.

It is quite plausible that the latest plans will face similar problems. If capital costs rise significantly there will be upward pressure on bills. As a result of political obstacles to new fossil-fuel plants, there is also a severe danger that electricity prices will be pushed higher still by an artificial shortage of capacity if there are delays to the nuclear plant coming onstream.

Then there is the risk borne by the taxpayer if nuclear consortia run into financial difficulties. Given the centrality of the programme to environmental policy, the government will be obliged to ensure construction is completed at almost any cost. And, of course, the difficult-to-price long-term burdens of decommissioning and waste-storage will be loaded on to the taxpayer or electricity consumer.

If the government is determined to reduce carbon emissions then it would surely be more cost effective to set a general framework within which energy companies would be free to choose the most efficient methods of generation. The well-known economic calculation problems facing central planners and the powerful role of special interest groups mean that policies based on micro-management and picking winners are almost always unsuccessful.

1 December 2009, IEA Blog

Filed under energy Tagged with , ,

North to pay heavy price for dependence on public spending

February 17, 2013

Public spending dominates the economy of the North of England. In the North-East region, for example, it accounts for close to 70% of GDP.

Many northern cities seemed to prosper in recent years. The luxury apartments and office blocks that sprang up in Newcastle, Liverpool, Manchester and Leeds were one visible sign. But it was largely a bogus boom based on Gordon Brown’s public-sector spending spree, which included substantial regeneration subsidies.

Times have changed and very severe reductions in government expenditure are now necessary. This suggests that those areas that are heavily dependent on public spending face a particularly painful adjustment process. These regions include not only the North of England, but also Scotland, Wales and Northern Ireland.

In the long-term, however, the cuts should bring benefits. Undoubtedly the bloated public sector has crowded out private sector activity in these areas, partly because it has artificially inflated wages.

Yet it may be over-optimistic to expect the private sector to become the economic dynamo it was during the 18th and 19th centuries and pull the North out of stagnation. Businesses now face barriers that would have been unknown to the great entrepreneurs of that era. Environmental legislation will make life very difficult for manufacturers, while the welfare state has blighted much of the North with endemic worklessness and poor skill levels.

Britain’s stagnating regions are therefore likely to be a major problem for the next government. But it should resist the temptation to repeat the mistakes of the past. Public subsidies to failing areas undermine the adjustment process needed for their economies to recover. Policymakers should instead focus on removing the barriers to entrepreneurship and self-help. This means deregulation to help businesses and improve labour mobility, and welfare reform to end the curse of long-term worklessness.

16 November 2009, IEA Blog

Filed under development Tagged with , ,

US will pay a high price for Obama’s spending spree

February 17, 2013

There is talk of recovery, but little reason for optimism. Government action may have cushioned the initial impact of the recession, but the long-term economic consequences of borrow and spend policies have yet to be felt.

The problems are perhaps most severe in America. President Obama’s spending spree – in the name of economic recovery – means that this year about half the money the Federal Government spends will be borrowed.

Not satisfied with the worst debt levels since World War II, the President is embarking on a whole host of expensive programmes to subsidise healthcare, boost education and protect the environment. At a cost of $787bn, his Recovery and Reinvestment Act is the largest stimulus package in history. Much of this money will be used to fund social programmes and environmental schemes that will require further outlays to keep them going.

This follows eight years of Keynesianism under George W Bush, who increased public spending, strengthened the government’s role in the economy and allowed debt levels to spiral. He did little to tackle the growth of America’s welfare state. And as the baby-boom generation hits retirement age, there is now a big question mark over the future funding of existing healthcare and pension schemes.

As a result of Bush and Obama’s profligacy, the US budget deficit is likely to reach an unprecedented $1.6 trillion for 2009, and there appears to be no realistic strategy to bring it under control.

Such high levels of government borrowing will have a devastating effect on the prospects for sustainable recovery. They will damage the productive part of the US economy by crowding out investment in the private sector. And before long they will lead to higher taxes and interest rates, as the government is forced bring its debt levels under control. This prospect will inevitably undermine economic confidence and deter the business investment that drives growth.

A recent IEA study suggests that in this regard there are strong parallels with the policy mistakes made during the Great Depression. In the 1930s, another Democrat President, Franklin D Roosevelt, launched the “New Deal” in response to economic crisis. He increased government spending, ran huge deficits and launched an interventionist industrial policy which had eerie similarities to that of fascist Italy. Dramatic tax rises were also implemented, with the top rate of income tax eventually reaching 90 per cent.

Contrary to conventional wisdom, these measures delayed recovery by several years by deterring private-sector investment and stifling entrepreneurship. As a result, the US had probably the deepest and longest-lasting depression of all the major countries in the 1930s. Even as late as 1939, unemployment was close to 20 per cent and real incomes were little higher than they had been at the start of World War I.

Yet it would appear that today’s US policymakers have failed to draw the correct lessons from the failure of Roosevelt’s New Deal. Instead of moderating the burden of government on businesses by deregulating and keeping taxes low, they have focused on increased spending and state intervention as the solution to a faltering economy.

As a consequence, America is likely to lose its economic dynamism and will become more like the anaemic, state-dominated countries of continental Europe that have barely grown over the last 20 years.

In the worst-case scenario, the US could follow a similar path to Argentina, which less than a century ago was one of the richest countries in the world. Like Obama, when faced with economic crisis, its politicians turned to socialism, protecting and subsidising favoured industries.

The President’s policies will certainly increase the share of the US population that is directly dependent on government largesse. This risks nurturing the kind of destructive special interest politics that brought misery to Britain during the 1970s and helped to consign South America to decades of relative economic decline.

It also increases the chance of monetary instability. Historically, large budget deficits have often preceded periods of high inflation. When powerful groups depend on public spending, politicians typically find it easier to print money to pay off debts, rather than implementing deeply unpopular cuts.

Such a scenario would not just be a nightmare for the US. The UK, as a major trading partner, would also suffer badly.
Many hope that next year’s elections will bring some much needed restraint to US economic policy by reducing the Democrats’ majority. Recent history suggests, however, that, as in the UK, there is little difference between the major parties – Republicans have been similarly devoted to borrow and spend. If this proves to be the case and the US fails to change course, recovery is likely to be slow and America may lose its position as the world’s economic superpower.

21 October 2009, Yorkshire Post

Filed under political economy Tagged with , ,

Should the UK introduce a carbon tax?

February 17, 2013

Earlier this month, President Sarkozy announced plans to introduce a carbon tax in France. The UK could follow suit. A widely applied new tax, justified on environmental grounds, could prove popular with politicians seeking to address unprecedented levels of government borrowing.

Yet there are strong economic objections. In particular, given the economic and scientific uncertainty on the effects of climate change, together with the essentially individual and subjective character of environmental costs, the setting of a carbon tax rate would be almost entirely arbitrary.

Nevertheless, in the context of the government’s broad objectives on climate change (however misguided), a carbon tax could be a rather less harmful way of reducing emissions than the sector-specific tinkering that has characterised recent British policy. Examples of the latter include the renewables obligation in the energy sector, bus and train subsidies in transport, higher motoring taxes, forced recycling and tight regulation of the waste sector, as well as draconian planning controls. The current approach has imposed enormous costs on the affected sectors, subjecting them to a high degree of bureaucracy and central planning.

In theory, a carbon tax could avoid this kind of damaging micro-intervention and help ensure that cuts in emissions took place in a relatively cost-effective manner. But such benefits would require the tax to be applied evenly across all sectors responsible for greenhouse gas emissions and for the existing mish-mash of climate change policies to be phased out.

In practice, however, implementation is likely to be driven by interest-group politics and the tax-raising imperatives of the Treasury. Accordingly, a new tax would almost certainly be overlaid on existing taxes and subsidies.

Motorists would therefore continue paying high rates of fuel duty on top of any new carbon tax, as well as additional costs resulting from the forthcoming inclusion of road fuel in the EU Emissions Trading Scheme. In contrast, bus and train operators would probably require additional government support to help them pay the new tax burden – a case of taxpayers subsidising emissions.

The position of domestic energy consumers is a particular problem for policymakers. In another example of inconsistent policy, they currently enjoy a reduced rate of VAT on fuel. Indeed, If there is the political will to introduce a carbon tax, then it would be better to charge full VAT on domestic fuel consumption (and public transport) instead. However, in the context of concerns over “fuel poverty”, abolishing the concession could be politically difficult and imposing an additional tax almost impossible.

In conclusion, the politics of energy and transport mean that a carbon tax would probably not be applied consistently and that existing bureaucratic control would remain in place. Thus the new tax could end up aggravating existing distortions and would perhaps do little to ensure that emissions reductions were achieved at low cost.

24 September 2009, IEA Blog

Filed under environment Tagged with , ,

Obama’s folly: high-speed rail in America

February 17, 2013

From China to California, the current slump has been marked by enthusiasm for high-speed rail. Projects typically form part of some kind of “Keynesian” stimulus package.

Here in Britain, there is strong support for a £34 billion route from London to Scotland. Even the Conservative Party supports high-speed rail as an alternative to airport expansion.

This is economic madness when the UK faces its worst-ever peacetime fiscal crisis. Given the history of big government projects, the final cost could end up being closer to £40 billion or perhaps even more. One should also factor in the “deadweight” losses produced by the higher taxation needed to fund such a scheme, as well as the cost of the operating subsidies once the line opens. And all this expenditure would be focused on about one per cent of the UK’s passenger traffic, making the proposed scheme extremely poor value for money.

If high-speed rail makes no sense in Britain, then the economic case is even weaker in the United States. American cities tend to have low population densities and in most cases there are very long distances between them, making rail a highly unsuitable mode of passenger transport. Accordingly, Amtrak, which operates inter-city services, has required substantial ongoing government aid since its formation in 1971.

The fact that high-speed rail in America is not economically viable is implicitly recognised by its inclusion in President Obama’s mammoth Recovery and Reinvestment Act. The costs of construction and operation clearly cannot be covered by passenger fares. Instead, general taxpayers must bear the burden, starting with an $8 billion government down payment.

Accordingly, it seems highly likely that Obama’s support for high-speed rail is based on “pork-barrel” politics and rent-seeking behaviour rather than any genuine economic rationale. Concentrated interests such as local politicians and transport bureaucrats may gain a great deal from high-status grand-projets – at the very least they visibly demonstrate to voters success at obtaining resources from the Federal Government. The victims of government largesse, taxpayers, as a dispersed and fragmented interest group, find it almost impossible to organise in opposition.

10 September 2009, IEA Blog

Filed under transport Tagged with ,

Fuel Duty: the hidden costs

February 17, 2013

Fuel duty rose by 2p this week, the third increase in the last ten months. Governments tend to view petrol taxes as a convenient source of revenue when budget deficits are high. Indeed, the last Conservative government increased fuel duty dramatically in the mid-1990s, introducing a tax escalator at the tail end of the last recession.

The demand for fuel is relatively inelastic, meaning that higher prices do not lead to a big fall in consumption. The tax is also relatively cheap to collect, difficult to evade and can be justified rhetorically on environmental grounds. But despite these political advantages, fuel duty has harmful hidden effects that politicians rarely discuss. One of these is the impact of higher travel costs on labour mobility.

Employment is not worthwhile when travel-to-work expenses are too high, particularly given the availability of welfare benefits to the unemployed. And subsidised public transport typically offers restricted access to workplaces – perhaps only to town centres and narrow route corridors. Opportunities may therefore be severely limited for job-seekers taxed and regulated out of car ownership or unable to afford inflated running costs. 

The result is not just additional unemployment. Businesses may also face higher labour costs as the pool of potential employees is reduced. In addition, transport taxes tend to decrease the number of potential customers by shrinking the area within which exchange is profitable. In wider economic terms, competition is stifled, economies of scale are lost and the deepening of the division of labour is suppressed – with the knock-on effect of lower productivity growth.

The tax receipts from higher fuel duty rates are therefore likely, in the long run, to be undermined by the general losses to the Treasury associated with the higher costs imposed on the production of wealth. In the context of Britain’s worst-ever peacetime fiscal crisis, and an apparent unwillingness to make significant cuts to public spending, the latest tax rise may be yet another example of short-term political expediency overriding the imperatives of longer-term economic efficiency.

3 September 2009, IEA Blog

Filed under tax, transport Tagged with , ,

The dark side of climate change policy

February 17, 2013

The government recently announced a series of measures designed to make Britain a low-carbon economy, including a large expansion of renewable energy (primarily wind), grants for better home insulation and a so-called green transport strategy. Under the Climate Change Act, the UK is “legally bound” to reduce CO2 emissions by at least 26% by 2020 and 80% by 2050 (relative to 1990 levels).

Meeting such ambitious targets will require substantial investment and while ministers have emphasised alleged advantages, such as the creation of 400,000 “green jobs”, there has been little acknowledgement of the wider economic impact.

Higher energy bills and transport costs are likely to be devastating for many businesses. Some enterprises will be forced to close. Others will relocate to locations where energy and transport are cheaper and environmental regulations less burdensome. In some instances, potential entrepreneurs won’t even bother starting new ventures in the UK. Overall, jobs are likely to be lost rather than created.

Then there is the impact on the less well off. People on benefits, for example £64 per week Jobseeker’s Allowance, may already be using around one third of their (non-housing) incomes to pay utility bills inflated by existing environmental policies.

If this share increases further, there will be strong pressure to raise welfare benefits and winter fuel payments to compensate. Taxes will have to rise accordingly and the already weak incentives to enter low-paid work will be further undermined.

However, the most devastating impact of climate change policy is likely to be on the developing world. While some middle income countries may benefit initially from the flight of businesses from rich nations, it is unrealistic to think that a large upward shift in the level of political control and central planning can take place in the West without negatively affecting the Third World.

The resulting misallocation of resources will hamper entrepreneurship and innovation leading to reduced wealth creation. And restricted and constrained markets will inevitably limit the opportunities for trade, thereby hindering economic development.

The impact of climate change policy therefore goes far beyond landscapes ruined by wind turbines and higher electricity bills. Big cuts in CO2 emissions are likely to prolong the misery of hundreds of millions of the world’s poorest.

29 July 2009, IEA Blog

Filed under development, environment Tagged with , ,

Cameron should focus on free trade rather than foreign aid

February 17, 2013

The development economist Peter Bauer famously observed that “Aid is the process by which poor people in rich countries subsidise rich people in poor countries.” Indeed there is a wealth of evidence, both theoretical and empirical, that foreign aid is largely counterproductive.

In particular, aid may help to sustain kleptocratic elites that feed off such infusions. Indeed, income is frequently diverted to buy weapons to suppress internal dissent, typically through the oppression of minority ethnic groups.
Foreign aid also tends to distort markets by creating unfair competition and crowding out local suppliers. Currencies may also be artificially inflated, harming exports. And let’s not forget the negative economic effect of extra taxation on donor countries, which in turn harms their poorer trading partners.

Politically, dependence on foreign aid may breed a bureaucratic, centrally planned, top-down approach to economic development issues, when what is really needed is a framework of basic institutions (such as private property) within which entrepreneurship can thrive. Accordingly, it is very difficult to find an example of a country that has achieved long-term economic development through foreign aid.

Yet despite the overwhelming evidence, and notwithstanding the UK’s worst-ever peacetime fiscal crisis, the Conservative Party has announced that if elected it will ring-fence Britain’s overseas aid budget and meet the UN target of spending 0.7% of GDP on aid by 2013.

David Cameron also wants to change the way aid is delivered to make it more effective. But it is surely naïve to think that, despite repeated attempts to solve this problem, aid can somehow be better targeted so that it doesn’t fall into the hands of corrupt elites. Third World politicians and bureaucrats will simply find different ways of siphoning off money.

If the Conservatives really want to help developing countries they should focus on removing trade barriers, particularly those imposed by the European Union, rather than adopting the failed policies of international socialism.

15 July 2009, IEA Blog

Filed under development Tagged with , ,

Time preference, economic crisis and social decline

February 17, 2013

The last decade has been marked by a combination of low savings rates and high debt levels in both the USA and Britain. Indeed in 2005, the savings rate in the US reached zero, while 13 million adults in the UK – more than 1 in 4 – have no savings or investments.

The lack of savings, together with the readiness to take on debt, suggests that a high proportion of the population has a high time preference. In other words, the present is valued far more highly than the future.

Arguably the current financial crisis cannot be divorced from the short-term, “hand to mouth” culture that has come to dominate the USA and the UK. The widespread unwillingness to defer material gratification contributed to the debt bubble that precipitated the crash.

But the negative consequences do not end there. People with no savings are also more likely to have to rely on welfare-state safety nets when they lose their job or develop a health problem. They will also tend to be more reliant on state handouts in old age and may therefore vote for socialist political parties that promise to increase such benefits. There is also a strong association between high time preferences and criminality.

While it may be tempting to blame “cultural decline” for the phenomenon, the absence of saving in countries such as the UK may in reality be a rational response to artificial incentives created by government policy.

It is perhaps not that low saving causes welfare dependence but the prospect of welfare that causes low saving. Benefit claimants with more than £6,000 may face steep deductions in means-tested payments. If they have over £16,000 they may receive nothing. And when they reach old age, the availability of means-tested pension credits means low to middle income savers will be barely better off than their spendthrift contemporaries.

Another issue is long-term residential care for elderly. While savers will lose their assets, including their home, non-savers on state benefits will generally receive care free of charge – this is a tricky issue but, at the very least, those who do not save should not be able to expect a guarantee of the same standard of provision as those who pay for themselves.

All in all, the incentives for deferring gratification and saving are very weak. This problem should be addressed urgently through the reform of pensions and benefit systems in order to restore the social and economic benefits of a low time preference culture.

24 June 2009, IEA Blog

Filed under political economy, welfare Tagged with , ,

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