Andrew Lilico is Policy Exchange's Chief Economist.
Michael
Portillo has said he does not believe that the Conservatives
will succeed in cutting spending, but instead will use tax rises as the main
mechanism to cut the deficit. I want to
tell you, in no uncertain terms, why that is not an option.
Without
action, the deficit this year and next will be above £200bn — 14% of GDP. According to the Treasury (which is backed in
this by the OECD) just under three quarters of that is structural — about 10%
of GDP; £140bn. That is to say, even
when the economy starts growing again, there will still be £140bn of deficit
(around 20% of spending) that will not disappear. Perhaps some of you want to suggest that we
do not need to balance the books. I
don’t agree, but let’s concede the point for now. Let’s assume we just need to meet the maximum
deficit, for any one year, permitted by the Maastricht Treaty criteria for
sustainability — let’s aspire to have that not as our peak deficit, but as our
average deficit. That means we could run
an average deficit of about £40bn.
So, still
£100bn to find. Portillo says we can’t
do that by cutting spending, because it will be impossible — one presumes he
means politically impossible. Does he really believe it would be
politically possible to raise taxes by £100bn.
If we are naïve, and assume that we wouldn’t damage the economy by
raising taxes on this scale, we can think a little of what that might
mean. We could raise the basic rate of
income tax to 45p. Or we could raise the
VAT rate to 37.5%. Or perhaps we could
try a bit of each — raise income tax to “just” 35p and the VAT rate to “just”
33%. Does Portillo believe that any of
this is politically possible?
Let’s
assume that it were politically possible to make such enormous rises in tax,
and think instead of the economic consequences.
For a start, spending would be at about 50% of GDP, up from just above
40% only three years ago. Under such
circumstances, we can expect each percentage point of GDP added to public
spending will reduce the growth rate of the economy by about 0.15%. (Note
that that’s not my figure, or a figure from any free-market-oriented body. It’s a figure widely used by international
agencies — see, for instance, Afonso, A.
& Furceri D. (January 2008), "Government size, composition,
volatility, and economic growth", European Central Bank working paper 849.) During the 1990s and 2000s the UK grew at
about 2.5% per year with public spending about 40% of GDP. So, since 10% x 0.15 = 1.5%, with public
spending so suddenly raised to about 50% of GDP, we can expect to grow at 1.5%
a year less — i.e. about 1% per year.
So,
Portillo’s prescription implies economic stagnation. Indeed, with growth of only 1% per year, the
UK would struggle to pay its debts — both private debts, which depend for
repayment on wage rises that won’t happen at 1% GDP growth, and public debts,
which would rise to about 100% of GDP and leave us paying 2-3% each year as
interest whilst the economy grew by only 1%.
But matters
would be worse than this. For the
evidence of past case studies Policy Exchange has conducted, and which are published today
(covering six historical episodes for the UK: the 1920s, 1930s, 1968/9, 1976/7,
the 1980s and 1990s; and six international episodes from the 1990s: Sweden,
Finland, Canada, Ireland, Germany and the Netherlands), suggests that
attempting to correct deficits by raising taxes is likely to have at least a
short-term negative impact on growth.
Raising taxes on the scale Portillo suggests could cripple the economy,
driving us back into deep recession.
David Cameron says that the emergency Budget he will
call (as we recommended in June), will focus on growth. The key to growth — both in the short- and
the longer-term — is reduced spending.
In the longer term, that is because high spending impedes growth as we
discuss above. In the short-term that is
because running a £200bn deficit undermines confidence in the economy amongst
financial markets, and with longer-term growth only 1% they will worry that we
will be unable to service our debts, therefore forcing us to pay higher
interest rates today. Many commentators
suggest, on “Keynesian” grounds, that we should not cut spending next year,
perhaps particularly if there is a double dip.
But Keynes never recommended deficits of remotely 14% of GDP.
The case
studies in our report published today suggest that, when deficits are large, if
deficits are cut mainly by spending cuts (the ideal ratio is about 80% spending
cuts to 20% tax rises), then cutting the deficit early is more likely to
promote growth than impede it.
In our June
report, we argued that headline spending needed to be cut by about £65bn,
underlying spending by about £100bn. We
believe that about £80bn of these cuts need to be enacted in the first three
years. The largest one-year cuts of
recent decades in the UK were in the 1970s — about 4% in real terms, equivalent
to about £30bn in one year. We suggest
that cuts of £30bn for 2010/11; £30bn for 2011/2; and £20bn for 2012/3 (with
about £5bn of tax rises in each of the first two years and £10bn in the third)
would be the minimum acceptable to financial markets. We do not believe that this is enough for the
longer-term. It would still leave a 3%
of GDP underlying deficit. But financial
markets would be prepared to return to the matter later if £80bn were taken
off spending early.
Cut deep;
cut early. That is the prescription for
growth.
