Andrew Lilico is Policy Exchange's Chief Economist.
In this
morning’s Times, Daniel Finkelstein continues a theme he has pursued in
a recent series of exchanges with Tim Montgomerie. He argues that public services reform will
deliver savings, but that such savings take time to emerge. He cites the example of changes to the
retirement age for women, introduced in 1995 but only now yielding savings.
The implication, in his view, is that the proper procedure will be:
- Raise taxes to address the deficit problem
- Reform public services
- Down the line, public service reforms will yield spending reductions
- Since spending has been reduced, taxes can then be reduced as well
I believe that this is a point of view that does not properly recognise how much the world has changed since 2007/8. Then, we were spending around 41% of GDP. This was up from 36% in 1999 and the discussion was about how we had allowed spending to rise too fast during a boom period, “not fixed the roof whilst the sun was shining”, and spent a great deal of extra money on public services without reforming them with the predictable result that productivity returns in the public services were very poor.
But by
2010/11, with a likely incoming Conservative government, government
spending is scheduled to be more than 50% of GDP (and, as pointed out in this Policy Exchange paper, most of the £120 billion rise in
spending involved is nothing to do with the recession). Addressing this with tax rises is simply not
an option, for a number of reasons:
- First, with spending at 50% of GDP, the economy is unlikely to have a sustainable growth rate of above 1-1.5% per year. Debt is likely to be above 100% of GDP, even setting aside implicit obligations to the banks or implicit obligations for public sector pensions or PFI. At such a slow growth rate our ability to service our debts will be seriously compromised. This is why Standard and Poor’s has placed our AAA rating on watch. If we try to solve this with tax rises, financial markets may well lose confidence, and a gilts strike could ensue.
- Second, the sheer scale of tax rises required would seriously damage economic growth in the short term. Raising £100 billion rise in taxes would require something like an extra 10% on VAT and an extra 10% on income tax and some other tax increases, once one took account of the massive reduction in economic activity that would result from such huge tax rises. This would induce steep rises in unemployment and lead to very large demands for additional loans from the banking sector so that people could borrow to pay taxes, placing further strain on our weak financial sector. Finkelstein argues that spending cuts can’t be imposed quickly enough to be useful. But the reality is that tax cuts definitely can’t be imposed quickly enough to be useful.
- Next, the sheer scale of tax rises required would not be politically feasible. People worry about the potential public resistance to spending cuts on the scale needed. But imagine the public resistance to 10% rises in both VAT and income tax.
Even were
there an option to raise taxes in the short term and wait for the longer term
for spending reductions to come through, this would not be advisable. Evidence from the historical and
international experience suggests that fiscal consolidations based on tax rises
almost invariably fail, whilst those based overwhelmingly on spending cuts
often succeed. Furthermore, in the UK’s
specific case it is clear that spending has risen so much in such a short time
(£120 billion in just three years) that large spending cuts could be achieved
whilst returning the real level of resources merely to those common in recent
years – 2005/6, say. This is not a
situation in which large spending cuts would mean the real resources available
for public services would be lower than we are used to. It would mean returning real resources to
those we have been used to until only this year.
Furthermore,
we know that the large rises in spending on public services have delivered very
poor productivity returns. That means
that much of the extra spending has not achieved much in the way of additional
output of services. So spending can be
reduced whilst not cutting service output very much, even before one reforms
the way services are delivered to as to increase productivity (which
Finkelstein is quite right to emphasize must be done).
We must cut
spending by something like £80 billion, as a minimum. Of course taxes will have to rise as well as
spending being cut, but Finkelstein’s scheme – tax rises in the short term,
spending cuts in the longer-term – is a recipe for a gilts crisis, significant
additional recession, and sustained low growth over the medium term. Let’s not go there.
