Do we need to make further spending cuts?

March 4, 2013

George Osborne is taking a reckless gamble by extending his fiscal target out to 2017/18. Government borrowing will now remain at dangerously high levels for a prolonged period. Worse still, the deficit reduction plan could easily be derailed by lower-than-forecast growth. The Chancellor is relying on robust growth in the medium term to boost tax revenues and enable him to meet his targets without the need for radical spending cuts. This outcome cannot, however, be guaranteed. Recent history shows that OBR forecasts are extremely unreliable. Borrowing in 2013/14 is already likely to be almost double the figure originally expected. If stronger growth fails to materialise, the UK could quickly lose the confidence of the bond markets and face a debt spiral. Given the risks, a wiser Chancellor would have taken a much more conservative approach. Deeper cuts would have made Britain much more resilient to future growth shocks.

6 December 2012, City AM

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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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Do we need to make further spending cuts?

March 4, 2013

The government has behaved recklessly. Assuming a strong recovery with high growth and rising tax revenues, it gambled that relatively modest spending cuts would be enough to fulfil the deficit reduction plan. The latest borrowing figures betray the magnitude of this miscalculation. It seems likely that the deficit will remain dangerously high, and there is a very real risk of the UK losing credibility in the bond markets.

Given the gravity of the situation, a combination of more substantial spending cuts and radical deregulation is the only realistic option for the Chancellor. The former would reduce the deficit directly while the latter would translate rapidly into higher growth. By contrast, a stimulus programme would only increase the risks facing the economy. Additional borrowing would put the deficit further into the danger zone and an even larger state would suffocate private-sector activity.

23 August, City AM

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Cut more, regulate less

March 4, 2013

Relying on growth was always going to be a risky strategy. Yet a healthy recovery, with robust GDP increases of 2%-plus, formed the core of the government’s deficit reduction plan. In this context, the combination of prolonged recession and yesterday’s higher-than-expected borrowing figures is a cause for deep concern. Indeed, there are several reasons to believe that the outlook for the UK economy is bleak and that growth will not be sufficient to play the key role in deficit reduction assumed by the government.

Firstly, the stimulus policies adopted after the onset of recession have hampered the necessary market adjustment process by which resources ‘malinvested’ during the artificial boom are reallocated. In other words, stimulus measures have cushioned the decline in the short term but at the expense of recovery in the longer term. Secondly, the expansion of the state under New Labour will have reduced the long-term growth rate of the economy by crowding out wealth-creating private sector activity. Finally, there are a number of more specific negative factors, including an ageing population (contributing to slowing labour force growth); regulatory pressure on the banking sector; the euro crisis; and the potentially disastrous impact of various green policies on business costs.

Since the government can no longer rely on growth (and the extra tax revenues that flow from it) to bring the deficit down and stimulus measures would be counterproductive, spending cuts are the only realistic policy option. And the likely scale of the tax shortfall resulting from the double-dip recession means that these cuts will have to be very substantial indeed. Many of these cuts can, however, be combined with reform to produce long-term economic benefits, as set out in the recent IEA study, Sharper Axes, Lower Taxes. In particular, spending reductions should be combined with deregulation. Reducing unnecessary burdens on business feeds directly into higher productivity. Strict planning controls, green energy policies and restrictive employment legislation are key restraints on business growth and should be urgent priorities for liberalisation.

22 August 2012, IEA Blog

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Pride before a fall: Osborne looked to special interests, not the UK’s perilous state

February 23, 2013

The Autumn Statement showed that George Osborne has failed to grasp the gravity of the economic crisis facing the UK. Urgent action was needed to brace the economy for double-dip recession and the fallout from the euro crisis. Instead, the chancellor announced a big increase in government borrowing, together with a series of measures that, while attractive to key groups of target voters, will do little to encourage growth.

Worse still, collapsing growth means the government’s deficit reduction plan is now in tatters. Government borrowing has been increased by £110bn over the next four years, meaning a staggering £350bn added to the national debt.
This may in fact be a best-case scenario. The Office for Budget Responsibility predicts slow growth of 0.7 per cent in 2012 but then assumes a healthy recovery, with growth rising to 2.1 per cent in 2013, 2.7 per cent in 2014 and a robust 3.0 per cent in 2015. But given the severity of the euro crisis, high levels of public and private debt, and the possibility of a downturn in overheated emerging markets, it is equally plausible that Britain will go into recession next year, followed by several years of stagnation.

A wise chancellor would be preparing for such a scenario. Vague talk of contingency plans does not pass muster.
A double-dip recession would decimate tax revenues while adding to welfare spending through higher unemployment. If UK GDP were just five per cent lower than predicted in 2015, for example, this would reduce the annual tax take by around £35bn.

Under such circumstances, with the budget deficit remaining unsustainably high, the chancellor cannot assume that the UK will retain investor confidence and continue to pay very low interest rates on its debt. With high debt and low growth there may be little to separate Britain from the struggling economies in the rest of Europe, such as Spain and Italy.
Given the severity of the potential risks, Osborne should have had the courage to announce further cuts – at least enough to return the deficit reduction plan to its original trajectory. He should also have taken far bolder steps to encourage growth, through radical deregulation and by rationalising the tax system.

He could, for example, have cut spending by uprating benefits rates in line with average earnings rather than inflation. Planned increases in foreign aid – deeply unpopular with a sceptical public – could have been abandoned at negligible political cost.

Instead, several new spending announcements were made, using money that could have been used to reduce government borrowing. Ill-conceived “credit easing” policies will mean taxpayers will guarantee risky loans to businesses and first-time buyers. Additional enterprise zones were announced, even though these subsidise firms to relocate to sub-optimal locations. An extra £1bn was found for the Regional Growth Fund for England, despite five decades of failure in regional policy and governments’ lamentable record at picking winners.

Much was also made of extra infrastructure spending: £5bn extra over the next three years plus significant additional investment from the private sector. Unfortunately, a high proportion of this expenditure is politically motivated and the economic returns will be negative. Loss-making public transport schemes will require ongoing operating subsidies, creating significant future liabilities for short-term political gain.

The counterproductive gimmicks were combined with almost a complete absence of policies to reduce burdens on businesses and thereby encourage growth. Osborne made some welcome statements on the need to liberalise planning controls, reduce the cost of employment law and simplify business taxes – but few concrete measures were announced.

In fact, current government policies are likely to work in direct opposition to many of the chancellor’s announcements. For example, new regulations forcing builders to produce expensive “zero-carbon” homes will dwarf the impact of special help for 100,000 first-time buyers. Indeed, Osborne recognised the calamitous impact of the government’s green policies when he announced subsidies for energy-intensive industries struggling to cope with spiralling costs.

The lack of action on deregulation is mirrored in tax policy. Several tax rates are now so high that they actually lower revenues by destroying incentives to work and invest. The Autumn Statement was a golden opportunity for Osborne to signal his intention to rationalise the tax system. In particular, a cut in the 50p rate of income tax would have increased tax revenues and sent a strong message to international investors that the UK offers a pro-business climate.

On this and other issues the chancellor proved too timid to step up to the challenge. He missed his chance to prepare the country for economic turmoil by cutting spending and removing key impediments to growth. It now seems likely his hand will be forced by events.

30 November 2011, City AM

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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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Osborne’s Budget chips away at the top of an iceberg

February 23, 2013

In this year’s Budget, George Osborne had the opportunity to bolster economic recovery by removing barriers to growth. Alongside some welcome proposals, he unfortunately also introduced a series of gimmicks that do little to address the high levels of tax and regulation that severely hamper entrepreneurs.

Perhaps most disappointingly, the Chancellor failed to reverse several recent tax increases that are on the wrong side of the Laffer Curve (counterproductive tax rises that lose the Treasury more than they raise). Room for manoeuvre is limited but George Osborne really should have been more specific about abolishing the 50p Income Tax Rate and should have reversed the increase in Capital Gains Tax. The reduction – and announced future reductions – in corporation tax are, of course, welcome.  

While there was talk of deregulation – for example, through tax simplification and the reform of the planning system – the proposals  are insignificant in terms of the overall burden of red tape. Hugely expensive regulations to meet environmental targets, for example, remain in the pipeline.

There has also been no serious attempt to address youth unemployment. Radical liberalisation is desperately needed here, including the abolition of the minimum wage and the removal of reams of burdensome employment law. The announced expansion of subsidised apprenticeships will do nothing to address the fundamental problem that state intervention has priced low-skilled young people out of the labour market.

The approach to business growth echoes the interventionist policy on employment. Twenty-one enterprise zones will be created with tax relief for firms locating in them. Enterprise zones have been tried before, of course. They create economic inefficiencies by artificially distorting the spatial pattern of economic activity. Businesses outside the zones also face higher taxes to pay for the tax breaks and activity may simply be displaced from one area to another. Worse still, the political imperative to make a success of the zones may encourage further government subsidies (for example, the c. £6 billion spent on transport infrastructure to regenerate London Docklands). Against this, the proposals to marginally liberalise the planning system more generally may bear some fruit.  

If Osborne had been serious about removing barriers to growth he would have turned the whole of the UK into a low-tax, low regulation ‘enterprise zone’. As it stands, the 2011 Budget is a missed opportunity to liberalise the economy.

23 March 2011, IEA Blog

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Bad news for social democrats – the Swedish model doesn’t work

February 23, 2013

Classical liberals can point to numerous examples of robust economic growth coinciding with low taxes and light-touch regulation: Britain in the 18th and 19th centuries; the US before the 1930s; and more recently Hong Kong since the 1960s. Of course, it must be conceeded that these examples were far from night-watchman states and the role of government remained significant in certain areas. But the general hypothesis that economic liberalisation aids the production of wealth receives further empirical support from the large number of countries that have experienced rapid growth after adopting free-market oriented reforms – from China in the late 1970s to some of the ex-communist nations of central and eastern Europe in the 1990s.

The history and geography of wealth creation is far more problematic for supporters of big government. Yet they often claim empirical support from the economic success of Scandinavia and Sweden in particular. The latter is said to combine a very large state with high levels of prosperity. But unfortunately for social democrats, the economic history of Sweden appears to be far more consistent with the classical liberal analysis than their interpretation.

Sweden enjoyed significant relative economic success in the first half of the 20th century. In this period, Sweden had a very small state by modern standards. In 1937, for example, state spending in Sweden constituted just 16.5% of GDP (see Crafts, 2002), lower than China today, while in the UK it was far higher at 30%. Even in 1960 – just after Sweden had overtaken the UK in GDP per head – state spending in Sweden was still only 31% of GDP – lower than in Britain. 

In relative terms, economic growth has been sluggish in Sweden since the early 1970s, since the size of government there had become really huge. For example, per capita GDP in Sweden was 16% higher than the UK in 1980 (and public spending accounted for a mammoth 60% of GDP), but only 3% higher in 2008. Indeed, Sweden suffered a severe fiscal crisis in the early 1990s, so high was the level of state spending, and radical reforms had to be introduced in an attempt to curb the growth of government.

While one should be cautious about drawing too many conclusions from growth statistics, Sweden’s economic record certainly fails to falsify classical liberal theories on the relationship between government intervention and economic prosperity.

13 January 2011, IEA Blog

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Bonfire of the quangos is mostly hot air

February 23, 2013

There are over 1,000 quangos in the UK. Today’s news that 192 of them are to be abolished appears to be concrete evidence that the coalition is taking radical action to reduce the role of government and cut the deficit. But then one reads the small print.

In reality most of these quangos will be abolished in name only. Their functions, and in all likelihood their staff, will simply be transferred to other government bureaucracies. The Regional Development Agencies, for example, will be transformed into Local Enterprise Partnerships with some of their responsibilities offloaded to BIS. Rather than abolishing a pointless layer of government, the coalition is rebranding it. With this process repeated across the quangocracy, it is far from clear that there will be big savings in expenditure.

The underlying problem is arguably the government’s attitude to regulation. Unless it takes serious steps to rescind the huge volume of legislation introduced in recent years, the coalition will find it difficult to scale back the associated bureaucracies. This relationship between regulation and quangos is clearly seen in the field of financial regulation where the government’s attempts to increase the volume of regulation will lead to one quango evolving into three or more. The important role of the European Union in the regulatory sphere is another obstacle to cutting many of these agencies.

The “fairness” agenda also appears to have hampered the process of scaling back the quangos. It is notable, for example, that the Low Pay Commission, which advises on the level of the minimum wage, has survived. A genuinely liberal government would of course abolish the minimum wage, together with the bureaucracy that goes with it – just as, in another Conservative age, the wages councils were abolished. Even a prudent socialist administration could save money by replacing this quango with a simple inflation-linked formula.

Cutting the quangocracy is in many ways an open goal. Many of the agencies have low profiles and are not highly valued by the public. The coalition’s failure to use this opportunity to achieve a significant reduction in the role of the state therefore augurs badly for next week’s Comprehensive Spending Review.

14 October 2010, IEA Blog

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Big government is here to stay

February 23, 2013

24 September 2010, Public Service

Public sector workers are understandably concerned about the outcome of the Comprehensive Spending Review (CSR). Trade union leaders have recently spoken of strikes and civil disobedience against planned cuts.

Yet such reactions are mostly based on rhetoric rather than reality. The fine print of George Osborne’s Emergency Budget reveals that government spending in real terms will remain more or less steady over the next five years. Indeed, when ministers speak of cuts, they often mean a reduction in previously planned increases in expenditure. The Treasury’s optimistic forecasts for economic growth are the key to the coalition’s deficit reduction programme rather than any dramatic scaling back of public services.

Nevertheless, since the budget for the NHS has been ringfenced, many of the mammoth welfare costs are politically untouchable, and because debt interest payments are likely to rise significantly, there will be immense pressure to make savings in some areas.

The history of previous “post-recession” periods suggests that capital expenditure will be a major target. We have already seen the cancellation of hundreds of school building projects and this will be just the start. Social housing grants to councils and housing associations will be pared back still further. And while expensive transport schemes such as Crossrail and High Speed 2 probably won’t be abandoned, their timelines may well be extended and their specifications reduced. A similar strategy is likely to be applied to major defence items such as Trident. The rate at which new hospitals are commissioned is likely to slow to a trickle as the NHS budget is diverted to “front-line” services to cope with the needs of ageing baby-boomers.

Another focus will be big IT projects, which in recent years have been plagued by delays, huge cost overruns and embarrassing failures in implementation. The Treasury has estimated total government IT spending at about £16 billion a year, and this clearly a relatively easy expenditure item to slash without significant political repercussions.

Such a policy will, however, mean ending the cosy relationship between departments and a small number of large IT companies. Similarly, the firms that rely on government contracts in defence, transport, education and so on, are likely to bear the brunt of economies in these areas rather than public sector workers.

The UK’s network of quangos will be another focus of the CSR. There are over one thousand of these agencies in the UK and a programme of rationalisation is certainly on the cards. Many quangos have a low profile and their roles are not well understood by the public. This makes them an easy target when political expediency rather than economic efficiency is the overriding determinant of where the axe falls.

Having said this, a significant proportion of quangos are very difficult to abolish. Some perform the basic functions of government, such as HM Revenue and Customs and HM Courts Service, while others are effectively required in order to implement European Union directives. It was instructive that the coalition was unable to remove an unnecessary tier of government by abolishing the Regional Development Agencies (RDAs). Instead, it is replacing them with Local Enterprise Partnerships and transferring some of the RDAs’ responsibilities to the Department of Business Innovation and Skills.

This pattern is likely to be repeated across government following the CSR. Quangos will certainly be abolished and ministers will speak of radical action being taken to tackle the deficit and reduce the role of the state. But in practice most of the staff and nearly all of the functions will be transferred to other agencies. There appears to be no genuine appetite within the coalition for the kind of attack on red tape necessary to slim down government bureaucracy significantly.

In conclusion, most public sector workers have little to fear from the findings of the CSR. There will be high-profile casualties, but the era of big government is definitely here to stay. Even if union predictions of 200,000 job losses in the near term come to fruition, this will represent well under 5 per cent of the total public sector workforce.

The coalition’s lack of radicalism may be reassuring to government workers, as well as the millions dependent on welfare benefits, but it also means that policymakers are doing little to create the kind of low-tax, low-regulation environment where entrepreneurship can flourish. The deeper issue of Britain’s rapid relative economic decline is not being addressed and as a consequence both public and private sector employees will be poorer in the long run.

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