The Chancellor is still gambling on strong medium-term growth

March 4, 2013

At the time of the last Autumn statement, the Office for Budget Responsibility (OBR) was predicting growth of 0.7 per cent in 2012, followed by 2.1 per cent in 2013, 2.7 per cent in 2014 and a robust 3.0 per cent in 2015. Yet again, these forecasts have been downgraded, to -0.1 in 2012, 1.2 per cent in 2013, 2.0 per cent in 2014 and 2.3 per cent in 2015. Forecasts of strong growth of almost 3 per cent have now been put back to 2016 and 2017.

Despite the unreliable nature of such forecasts, the Chancellor is still gambling that strong medium-term growth and the consequent increases in tax revenues will allow him to meet borrowing targets without making radical spending cuts. So far this strategy has not been successful. As a result of lower-than-expected growth over the last two years, government borrowing in 2012/13 on a like-for-like basis will be around 50 per cent higher than projected in the original deficit reduction plan. Borrowing in 2013/14 is now forecast to be almost double the figure expected back in 2010. At around 7 per cent of GDP, it will remain at a similar or higher level than in several countries currently experiencing debt crises, such as Italy, Spain and Portugal.

In addition, there are good reasons to believe that the long-term ‘trend’ rate of growth in the UK has declined over the last decade or so. This reflects a large rise in public spending – to a peak of 50 per cent of GDP – as well as an expanded regulatory burden on businesses. Moreover, various government stimulus policies since 2008 have hindered recovery by preventing necessary adjustments, such as the liquidation of boom-time malinvestments and the reallocation of resources to more productive activities. Going forward, significant increases in energy and transport costs, resulting from the government’s environmental policies, are likely to have a negative effect on economic output. And, as the Chancellor mentioned in his statement, the ongoing euro zone crisis adds further uncertainty to the medium-term growth outlook.

In this context, the Treasury is taking a major risk in basing its deficit reduction plans on growth forecasts that are likely to be inaccurate. Given that government borrowing remains at dangerously high levels, and that the confidence of the bond markets could quickly be eroded if outcomes disappoint, there is a strong case for taking much more radical action to reduce public spending. The real terms reductions in working-age benefits are a good start, but the Chancellor could also have acted to cut age-related benefits, as well as abandoning the coalition’s deeply unpopular plan to increase foreign aid. Significant medium-term savings could be achieved by cancelling major projects such as Trident and High Speed 2. The IEA’s recent publication, Sharper Axes, Lower Taxes, provides a long list of potential savings.

5 December 2012, IEA Blog

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Set the economy free to meet tough challenges ahead

February 23, 2013

Despite the cuts, the coalition government will raise the national debt by almost £500bn over this Parliament. This is just the official debt. When other liabilities such as pensions are included, the total debt is already £5 trillion and heading higher. This amounts to a staggering £80,000 per person in the UK.

If the government thinks the cuts will solve the problem, it is deluding itself. In real terms, public expenditure will fall by just three per cent by 2015. Spending on politically sensitive areas such as health and welfare will be maintained, while the foreign aid budget will actually be increased. More money will also have be spent on interest payments as the debt continues to rise.

Recent tax rises won’t solve the debt problem either. Indeed they may even make it worse. When tax rates are already high, increasing them further tends to reduce the amount raised.

Take the 50p rate of income tax. This will deter hard work and encourage tax avoidance strategies. It will also make it harder for UK-based firms to attract top international talent. Some companies may even decide to move elsewhere.

Higher taxes destroy wealth and make both individuals and the government worse off. With little room for manoeuvre on tax rates and cuts, the Chancellor hopes that economic growth will deliver the extra revenues needed to balance the books. But if the recovery falters, the public finances could be in deep trouble again.

Worryingly, there are several reasons to be pessimistic on the economy. The massive surge in government spending under New Labour is thought to have knocked at least one per cent a year off Britain’s trend growth rate. An increasing share of resources has been devoted to inefficient public-sector projects rather than the private-sector investment.

The situation is worsened by a rapidly ageing population. The importance of the “grey vote” makes it far more difficult to reduce public spending on the elderly, and they have largely been shielded from the cuts so far.

Yet without a more radical approach to issues such as public sector pensions and healthcare, government debt levels are likely to carry on growing and there will be upward pressure on taxes.

On top of serious demographic challenges, there are several less predictable factors that could drag down growth. These include the euro crisis and rising oil prices. After unsustainable booms, large parts of Europe now face a prolonged slump. Britain will inevitably be affected by these problems, particularly if taxpayers end up funding bailouts of major countries such as Spain and Italy.

A 1970s-style oil crisis could be even more serious than continued turmoil in the eurozone. Political upheaval in North Africa and the Middle East has already helped send prices to record highs, raising costs for businesses. Britain’s North Sea Oil reserves previously offered some protection from this kind of shock. But they are dwindling rapidly – a trend likely to be speeded up by George Osborne’s short-sighted windfall tax on oil and gas production.

Higher energy costs will also result from the government’s environmental policies. Around £200bn will be diverted into power projects such as offshore wind farms over the next decade, largely to meet ambitious climate change targets. As a result, businesses outside the energy sector will be starved of investment capital. Their growth will be further hampered by higher fuel bills and it may also be necessary to raise taxes to address rising fuel poverty.

These extra costs will pile on the misery for struggling small enterprises already suffocated by red tape. But rather than deregulating, the coalition has added yet more burdens. Examples include the Equality Act, the extension of paternity leave, new controls on migrant workers and increases to and extensions of the minimum wage.

With so many reasons to be negative about the UK’s growth prospects, it would hardly be surprising if government forecasts prove too optimistic. The consequences could be dire. A slower than expected recovery would mean the deficit remained at unsustainable levels. This could undermine the government’s credibility on the financial markets, pushing interest rates higher. In the worst-case scenario, Britain could be caught in a Greek-style debt spiral, having to borrow more and more money just to afford interest payments.

Radical action is therefore needed to lower government debt, particularly given the risk of a serious external shock within the next few years. The cuts need to be deeper and should be combined with a systematic programme of deregulation. Rather than paying lip service to the growth agenda, the coalition needs to reject decisively the wealth-destroying policies that hamper businesses.

13 April 2011, Yorkshire Post

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