A healthy squeeze?
We'll be debating the timing of Britain's fiscal budget squeeze until at least the next election. But what about the how?
On the Today programme this morning, Richard Murphy, director of Tax Research UK, made the case for raising an extra £47bn in taxes to fill the fiscal hole, almost entirely from the top 10% of earners or corporations. It has a good populist ring to it. But it doesn't seem likely to win over the public - or most economists.
True, the Liberal Democrats' tentative plan for a mansion tax drew a lot of support in our special BBC poll last week. No doubt a windfall tax on the banks would also go down well - especially if the revenue raised were used to fund, say, an extension of the cut in VAT. (I'd be surprised if the Treasury were not exploring something similar for the pre-Budget report. January could well be a fragile time for the economy - it won't help matters to have VAT go back up to 17.5%.)
Even Martin Wolf, the FT's chief economic commentator, now thinks that a bank windfall tax is a "ghastly idea" whose time has come. As he notes, "it's hard to argue in favour of exception interventions to bail out the financial sector at times of crisis, and also against exceptional interventions to recoup costs when the crisis is past. 'Windfall' support should be matched by windfall taxes".
Some say a tax on bonuses would be better - because that, by definition, is not money that could help underpin new lending. But even if a windfall tax on banks or banker bonuses were feasible (and some say it's not), it's going to have more a cathartic value than a fiscal one. It's never going to be more than a populist warm-up act for the main feature - namely years of higher taxes and/or spending cuts that will be felt by all of us.
When it comes to that, our poll showed that most people favoured spending cuts over tax rises. Policy Exchange, the centre-right think-tank, now has a report out [1.49MB PDF] claiming that economic history is on their side.
The authors look at 12 historical cases where governments have cut public spending sharply - on average by more than 6% of GDP, or £90bn in today's terms. They find that, on average, countries grew 3% a year over the four years following the cuts, "suggesting that getting debt under control helps recovery and growth".
They also find that the "successful" tightenings (ie where borrowing has not gone back up) have tended to place most of the burden on spending cuts - about 80% versus 20% on tax rises. This echoes a respected study by Alberto Alesina and Robert Perotti, first published in 1996 [215MB PDF]. It concluded that "fiscal adjustments which rely primarily on spending cuts on transfers and the government wage bill have a better chance of being successful and are expansionary. On the contrary, fiscal adjustments which rely primarily on tax increases and cuts in public investment tend not to last and are contractionary."
The Policy Exchange authors are especially taken with the Swedish example in the mid-to-late 1990s. There, spending was cut by 10% of GDP in five years (about 3% in real terms), and the government deficit moved from a peak of more than 11% of GDP to surplus in just five years. Yet the economy grew, on average by 3% a year.
So, does this settle yesterday's argument between Gordon Brown and David Cameron once and for all? Alas, no.
The study sheds some interesting light on what works and what doesn't - for example, the authors observe that the British have usually taken a very centralised approach to their budget cuts. Other countries - notably Canada, but also Sweden - have often left it up to individual departments to decide what to cut, apparently with some success. It can put pressure on departments to come up with savings that bureaucrats might never have thought of.
If they win the election, senior Conservatives are keen to decentralise the tough decisions as much as possible. One I spoke to told me it was the natural corollary to Labour's targets:
"when you're spending a lot more money, there's a case for targets to show that it's not being wasted. But when you're cutting budgets, you want to give officials in individual departments the freedom to cut in the least costly way."(Assuming, he might have added, you have a public sector wage freeze so they can't spend it all on pay...)
But, this research does not answer - cannot answer - the multi-million pound question of whether a tighter budget squeeze next year will stall the economy. Why? Because, by definition, none of the case studies they explore are exact parallels to Britain's situation today.
In nearly all of these earlier examples, the countries concerned had two big advantages that Britain next year will almost certainly not have: room for a dramatic reduction in long and short term interest rates, and an external environment of healthy global growth.
In the Swedish case, as the authors point out, the budget's cuts halved the interest rate on government debt from 10% to 5% between 1994 and 1998. In Finland, which had also suffered a financial crisis, rates fell from 9% to 5%. There is no chance of that here.
A serious plan to curb borrowing could take something off gilt yields, but they are already historically low. Yes, it could prevent a rise in both short and long-term rates which might otherwise have occurred. But barring a major run on the pound, no-one can seriously suggest that the rise prevented would be on the order of five percentage points.
Between 1995 and 2000, when Sweden and Finland were doing their thing, growth in the OECD countries averaged 3.2%. Now, the OECD predicts on average its members will grow by 1.9% in 2010 and 2.5% in 2011 - and for our major trading partners in the Euro area, the forecast is for just 0.9% growth in 2010 and 1.7% in 2011.
Sweden is an awkward example for another reason too. They raised taxes almost as much as they cut spending - according to the report, the ratio of spending cuts to tax rises was about 55:45, though, looking at OECD figures I find that tax revenues did not rise very much as a share of GDP, probably because GDP was growing at the same time.
That, of course, is the key point. The report suggests that spending cuts can be consistent with economic growth, and maybe promote it. That much is true. But by definition, the 12 examples do not include all the times where governments have been preventing from cutting spending by a declining economy. It is almost impossible to lower spending (either in real terms or as a share of GDP) for any length of time when GDP itself is falling, and unemployment is going up.
As it happens, the Conservatives and Labour seem to agree that most of the budget squeeze should be achieved through tighter spending. In the chancellor's own budget plans for 2011-2014, the ratio of spending/investment cuts to tax rises is roughly four to one.
But history alone isn't going to tell us when the squeeze can safely begin. Pity.