Fonte telegraph – All is still to play for on the fiscal front but the worst is over.
According to Mark Twain, nothing in life is inevitable except death and taxes. Much of the commentary last week about fiscal prospects after the next election seemed to suggest that this should be amended to read “higher taxes – or spending cuts”. In reality, neither of these alternatives is inevitable. Everything depends upon the performance of the economy.
There is no doubt that the current government’s fiscal plan for the next parliament involves substantial further tightening, from a mixture of spending cuts and/or tax rises, amounting to about £20bn per annum, roughly the equivalent of an extra 5p in the pound on the basic rate of income tax each year. But this is not the end of the matter.
For a start, the fiscal plan is not cast in stone, whatever the Government might encourage you to think. As it stands, the plan aims to bring the budget into overall surplus by the year 2018–19. To a good many judges, this seems to be overly tight. It would not cause a disaster for the public finances or a panic in the markets if the fiscal tightening programme stopped well before this, with government borrowing, although much lower than it currently is, still running at 1pc–3pc of GDP. This would enable the debt ratio to continue to fall, as long as the economy was growing normally and the overall price level was rising rather than falling.
It is true that this government has made disappointingly slow progress in improving the public finances. The deficit peaked at just over 10pc of GDP in 2009–10, but it is still running at 5pc of GDP. The debt ratio has risen inexorably and now stands at 81pc of GDP.
Nevertheless, there is no real fiscal crisis and no need to panic. The worst is over. On current plans, the debt ratio starts to fall in 2016–17 and by the end of the next parliament it will be down to 73pc. The downward trajectory is more than adequate to ensure the continued confidence of the financial markets. It would not matter if debt were set to fall a little more slowly.
The key requirement to retain financial confidence is the belief that the economy will continue to grow well. This is as true for the United Kingdom as it is for Greece. The difference is that in Greece, despite the presence of massive excess capacity, under the current set–up, it is difficult to see a vigorous economic recovery. By contrast, in the UK there are good reasons to believe that the economy can grow strongly for many years.
Indeed, I suspect that the consensus view on growth prospects may be too pessimistic. In my long career as an economist, I have experienced several surprises about the fiscal situation – in both directions. Many readers may recall some of the ghastly episodes, such as when in 1976 the then Chancellor of the Exchequer, Denis Healey, had to borrow from the IMF. In 1975–76, the budget deficit was 7pc of GDP. There were also periods, such as in the early to mid–1990s, when economic growth did not produce the increase in tax revenues that was expected on the basis of past experience.
The greatest favourable shock was the experience of the late 1980s, when the budget went into significant surplus. Believe it or not, at this point some serious commentators actually foresaw, and analysed the consequences of, the paying down of the whole national debt.
The worry was how the financial system would function without gilts as the bedrock. As we all know, these experts need not have bothered. The gilts market has all too easily managed to survive.
This history ought to make one cautious about blindly accepting the current conventional wisdom, and to be on the lookout for factors that might cause an upset.
Recently, there has been a negative fiscal surprise in the form of a lower tax–take at a given level of economic activity, largely because of the interaction between the growth of lowpaid employment and the large increase in the personal tax allowance. Is there scope for a comparable fiscal surprise in the opposite direction over the coming years? I have wracked my brains on this issue but I have failed to come up with a plausible surprise rise in the taxtake. Mind you, it’s in the nature of surprises that they surprise people.
I think the most likely source of a favourable fiscal surprise is an indirect one, namely for it to turn out that the economy did not lose a very large amount of productive capacity in the Great Recession, and that accordingly there is now scope for the economy to grow faster for longer as it uses up spare capacity. To the extent that this happens, more of the government deficit will be erased simply as a result of economic growth, without further fiscal tightening.
Admittedly, it would not be wise for the Government to bank on this being true. On the contrary, the wise and prudent thing is to assume something close to the worst. This then allows scope for a favourable surprise later, permitting lower taxes, higher spending or lower borrowing.
Whichever choice were made, it would be sensible to avoid the same mistake that has been common in the recent debate, namely to analyse the Government’s contribution to the economy largely in terms of the ratio of government spending to GDP.
This is a very Brownite view of the way the world works: more state spending equals more benefits from state–provided services. Yet by now it ought to be obvious that the state is a very bad provider of almost every sort of service. Indeed, it is massively inefficient at producing outcomes that most consumers regard as inferior or inadequate.
If the state were made more efficient then, other things equal, the ratio of government spending to GDP would fall, without there being any damage to people’s well–being. Indeed, the resources released, and transferred to the public through lower taxation, would be available to bring other benefits.
Over the next few decades there could be a revolution in the way that public services are provided that could see a mixture of public funding and private provision, part–payment and insurance.
If this happens, comparisons of the share of public spending in GDP across time will be a very poor indicator of the benefits that citizens receive from public services – or even of the extent of the state’s role in the economy.