Andrew Lilico is Policy Exchange's Chief Economist.
The debate
on what to do about the UK deficit in 2010/11 has two main schools. First, there are those that argue that the
deficit should be cut early – through a combination of whatever spending cuts
can be delivered and some tax rises.
This school argues that the danger of not acting early, in the immediate
aftermath of election victory, is that bond markets may start to fear that
policymakers will not take the tough decisions at all if they cannot take them
when their political strength is greatest.
The consequence would be a fall in bond prices and hence a rise in gilt
yields – that is to say, a rise in interest rates – which would mean mortgage
costs going up just when the recovery was most tender. The economic consequences would be
disastrous.
The other
school argues that recovery is too fragile at this stage for the stimulating
effects of deficits to be withdrawn any more than is already scheduled. According to this view, more aggressive
action risks plunging the economy back into deep recession, and thereby
actually making the deficit worse (as tax revenues fall) rather than better.
Now, we at
Policy Exchange have broadly advocated the first view. In our view, deficits on the current enormous
and unprecedented scale (12.5% of GDP) go well beyond any plausible stimulatory
effect level and well into the zone in which excessive deficits damage recovery
rather than promoting it.
But the deficit is not the main problem, or the most urgent. The main problem is the excessive level of government spending, up from about 41% of GDP in 2007/8 to close to 50% in 2010/11. Government spending should be cut by as much as possible, as early as possible. And what has not really been discussed in the UK debate is the option of combining early spending cuts with early tax cuts, so as to keep the deficit constant.
We do not
advocate this. But if the
60 letter-writing economists really do not want the UK to cut its deficit
in 2010, that is no reason at all not to cut spending. For we could cut
spending by, say, £10bn extra and also cut taxes by £10bn, keeping the deficit
at 12.5%. Would the 60 economists want
to do that?
I suspect
they wouldn’t. And if I’m right, that
tells us something important. What it is
tells us is that it is not the deficit
that they support keeping high; it is the spending. But huge discretionary consumption spending rises, of the sort we have seen since
2007/8*,
are a very poor way to respond to a recession.
Extensive and authoritative international
research suggests
that fiscal stimulus packages based on spending rises are much less effective
than those based on spending cuts. The
same research also suggests that one successful route to cutting deficits
combines spending cuts with tax cuts.
Spending on
the current scale is damaging growth over the medium term, and is unlikely to
be providing much short-term stimulus either.
It is urgent that spending is cut.
If others disagree with us about whether we should cut the deficit early – well, we can have a
debate about that. But we see no
argument whatever for not cutting spending
early.
Cut the spending. Cut early; cut deep. If you don’t want to cut the deficit early, then combine early spending cuts with temporary tax cuts. This is so far the unconsidered option for 2010/11.
*For those of you still under the
popular and widely-reported delusion that the UK’s deficit has been driven
mainly by the fall in tax revenues, the following table might be enlightening:
Table: Contributions to deficits
Source: Public finances databank
Notes: *1989/90 was not the peak in taxes - that was in 1984/5 at
38.2% of GDP.
During the late 1970s, spending fell as a proportion of GDP,
driven particularly by the IMF-required spending cuts. This meant that the deterioration in the
deficit was much less than the fall in tax revenues. Tax revenues did not fall relative to GDP during
the recession of the early 1980s
Note that the last two
columns should not be expected to sum to 100% as there is also the change to
the operating surplus of nationalized industries
