What would Lilico say in the PBR?

The Conservative Front Bench has chosen its path, so it won't be able to argue the line that I would.  But for those fools among you daft enough to have read my many missives, since July, on the issue of fiscal stimulus this autumn, it may be of some independent interest to understand what I would have recommended we do had anyone on the Front Bench paid any attention to what I thought, and the ways I expect Darling to get it wrong.

So, what would I do?  Let's start at the high level.

• I would announce unfunded tax rebates of £30bn, over and above the large falls in tax revenues that will occur naturally as a result of the recession (but the deficit associated will be partly reduced by measures suggested below).  I would spilt this evenly between income tax and corporation tax.  In the case of income tax, I would spend the £15bn raising personal thresholds.  In the case of corporation tax, I would announce a one-year reduction in the corporation tax rate.  Cheques would be sent to households in respect of their 2008/9 income tax bills, to arrive in April 2009.
• I would announce a cut in the annual rate of growth in public expenditure to 1.5% in real terms in the period out to 2011.  Since I anticipate the inflation rate to be approximately zero in 2009/10 and deflation of 1% or more in 2010/11, that means cash rises of only 1.5% in 2009/10 and about 0.5% in 2010/11.  That compares with the government's current plans of cash rises of 4.6% in 2009/10 and 5.2% in 2010/11.  This difference saves around £20bn in 2009/10 and nearly £50bn in 2010/11.  Of course, the most significant driver of this difference is the dramatic fall into deflation, hence there could be a significant fall in tax revenues driven by this deflationary process.  Nonetheless, containing growth in spending to 1.5% in real terms is likely to be tighter than the government's ambition.
• I would set a medium-term path for rectification of the budget, but would not attempt to establish any new "fiscal rules" (I believe all such rules hubristic and likely only ultimately to prove an excuse for over-spending).
• The medium-term rectification path would involve an expectation that in the period 2011-2014 spending would rise at only 1.5% in real terms (potentially, alas, faster than the economy as a whole, but nonetheless quite tight).  I would also emphasize that the corporation tax cut is only one-year and would apply to the carry-forward of losses (increasing tax receipts in later years).
• I would pre-announce an intention for a tax reform to be enacted in 2010 or "when the recession appears complete".  This reform would certainly involve a rise in the income tax rate to 25p - that would be pre-committed.  It would be stated that, at that point, a judgement would be made as whether there would be scope to raise the income tax threshold, reflecting the tax reform (a higher rate and a higher starting threshold) or whether deficit rectification would necessitate keeping the threshold down.
• I would also announce the suspension of the legal injunction, introduced in the early 1990s, against underfunding the deficit (i.e. against printing money to pay for public expenditure).  I would indicate that the weapon of printing money to fund public expenditure would not be used soon, but would be available if necessary to counter deflation, and would only be considered in close consultation with the Bank of England.  (Thus, its function would be as a tool of monetary policy, not as a mechanism for financing the deficit under financing pressure - e.g. because of unwillingness of agents to purchase UK government bonds.)

Thus plan would thus contain the elements:

• An immediate tax-cut based fiscal stimulus
• A statement of how this stimulus would be reversed
• A plan for controlling the future growth in public expenditure
• A plan for returning the budget to balance over the medium term by raising the income tax rate
• A statement of intent in terms of the future direction of income tax measures - towards the raising of the starting threshold rather than the lowering of the basic rate.
• The making available of an additional tool of monetary policy, but not yet its employment.

Darling's plan is likely to deviate in five very important ways.

1. Darling will presumably announce reductions in public "current" expenditure plans in later years (this will happen partly through efficiency savings - which I have consciously not included in my plan above - but also because of the reduction in inflation).  Darling will probably announce some rescheduling forward of "investment" plans and a commitment to maintaining the total "investment" level over the period - which in practice will mean a commitment to raising real growth in "investment".  This will, I believe, be money wasted.  But his overall expenditure figures will be noticeably higher than mine.  This will mean that his aggregate debt-build-up figures will be noticeably larger than those implied by my scheme, and hence his corresponding need to raise taxes later will likewise be larger.
2. Darling will focus tax cuts on the poor, perhaps by the use of tax credits.  This is a mistake.  It is imagined by some commentators that by focusing on the poor, one gets around the problem that people will anticipate tax rises later and so save.  It will not.  Effectively, this scheme involves a huge increase in taxes on the wealthy (who will pay the tax rises later) to the benefit of the poor and middle income-earners.  But the wealthy will not fail to notice this, and to the extent that Ricardian Equivalence holds (which I do not believe it will in this situation, because of the impairment-to-credit-markets mechanism that I have discussed extensively before) it will hold even with a tax cut focused on the poorer - the rich will increase their savings today (cut their consumption) to set money aside to pay for the higher taxes to be imposed upon them tomorrow; the fact that they don't receive the tax rebates today doesn't change that, and hence doesn't change the net effect upon the economy of the stimulus (I don't believe that, beyond the very poorest people of all, the net economic returns to providing money to the less-well-off are higher - otherwise it would always be better to have more progressive taxation (higher tax rates on the rich) than we have had in the past, not just in recession!).  I do not believe that effectively pre-announcing a massive tax rise on high earners is well-geared to getting us through this sort of recession.  (I can, however, appreciate the argument that says the bank bailout already helped the wealthy, so this is quid pro quo, but since I opposed the bank bailout, and believe that it should still be avoided to the extent that it can be, I shall persist with my own position.)
3. Darling will probably pre-announce two years of tax cuts.  I would announce only one.  I might indicate a willingness to contemplate a further stimulus later, but would indicate that the stimulus was specifically related to the impairment of credit markets, and if credit markets appeared to be functioning again (or if the fiscal stimulus appeared to achieve little) then the exercise would not be repeated in the same form (I might employ later tax-cuts with corresponding deficits if deflation appeared dangerous, but these later cases I would print money to fund the tax cut - this would be the only time I would fund such tax cuts wholly with debt).
4. Darling's medium-term tax raising method appears to be via VAT, rather than income tax.  I can appreciate that this might be seen as a slightly devious anti-deflation device (and it's certainly better than the ill-judged proposal to cut VAT just as deflation hit!), but I suspect that deflation will be with us long enough that the dropping out of the statistics of the VAT-raising effect will create a big dip in the deflation figures at an unfortunate moment.  I do not believe that tax measures directly manipulating prices (either up or down) are wise at this time.  Darling may also announce some additional "green" taxes to apply from 2010.
5. Darling's plan will include some new set of "fiscal rules".  I believe that all these will really achieve in the medium term will be a return to moderate deficits with the "locking in" of a new UK debt-to-GDP ratio of something like 60% (vs just over 40% now).

Darling will also probably not yet talk of underfunding the deficit.  And of course he is unlikely to employ my income tax reform.  He may also have some tax credit "rebates" arrive more quickly than I would - perhaps even by Christmas 2008.

I shan't comment here on how the Conservatives are likely to respond to Darling and what will be the strengths and weaknesses of their case.  But I will say this.