By James Mackenzie Smith, Economics Research Fellow, Policy Exchange
We have been faced with the dilemma of “our economy needs a stimulus” but “we don’t have any scope to do this because of the public finances”.
Recent murmurings in the press have first hinted at a spending spree a-la-1970’s, then a tax-cutting spree. But both of these however, if unfunded, would have the same effect on the public finances and both of these would have serious long term implications for the British economy: high debt, high long term interest rates and prolonged stagnation - exactly as what happened in the 1980’s.
Britain’s public finances are in a particularly perilous state, not least because of the ‘off-the-balance-sheet’ liabilities such as PFI and public sector pensions (not to mention the borrowing from the banking bailout), but also because the structural deficit is increasing at an astonishing rate and could exceed 1970’s and post-ERM levels - above and beyond the effects of the automatic fiscal stabilisers.
Our research has looked at the theory that ‘fiscal consolidation’ - that is to say bolstering the public finances: in this case through cutting unproductive government spending - can actually have non-Keynesian, positive growth effects, and there is plenty of academic research and evidence to support this. It works for three reasons. First, higher expectations of future wealth can have expansionary effects if the government is seen to be getting the fiscal situation into a sustainable manner.
Second, the capital markets will be more inclined to lend to the government for a lower coupon rate, given the associated lower risk premium, thus lowering long term interest rates. Third, a sustainable fiscal policy can encourage international investment. Our research has focussed on nine studies quoted in an ECB investigation, all of which show that as long as the consolidation focussed on unproductive spending cuts and not tax rises, the credibility effects outweighed the traditional ‘Keynesian multiplier’ effects, especially if there was an initially perceived fiscal problem.
Finally, if any cuts in government spending were to be used to finance tax cuts, which taxes should be targeted? Recent OECD research has prioritised the “most damaging to growth” taxes as corporation, then income, then consumption tax (VAT). The logic here is that we should be using any tax cuts to target unemployment; a cut in employers’ National Insurance is one effective way to do this. Any income tax cuts should be directed towards the lower earners, not least for the social reasons, but also due to their higher marginal propensity to spend. A 2.5% reduction in VAT will merely have a token effect, yet at a huge extra cost to the public finances. The 5% increase in the top rate of tax is also an admission that Britain’s public finances are not well equipped to deal with the problem, though it does not go close to making up the future (and current) shortfalls.
Read the research note here
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