CentreRight

Andrew Lilico: Taxing according to the ability to pay

It has become popular to believe that taxation ought to be “progressive” — in other words, that those with higher incomes should pay a higher proportion of those incomes in tax.  This has come to replace an older notion, which was that the amount one paid in tax should be related to the ability to pay.  These concepts are not the same.  In particular, the ability to pay depends on one’s (allowable) obligations in terms of costs.  For example, a single childless person on £40,000 a year would be better able to pay £15,000 in tax than a lone parent of two children on that same £40,000.

But this concept of ability to pay has virtually no role in our tax system.  The tax system has come to regard having a child as a consumption decision.  Recent reports suggest that having a child now costs more than £200,000.  From the tax system’s point of view, you could choose to spend £200,000 on a second-hand Ferrari, or a yacht, or a child — it’s all the same, as far as the taxman is concerned.

This was not always so.  A famous paper by Patricia Morgan detailed how, over the 1960s, 1970s and 1980s the balance of taxation changed dramatically, with taxes on families rising rapidly throughout the period and taxes on single childless people rising much less through the 1960s and 1970s then falling through the 1980s.

That happened partly because there was the explicit removal of tax reliefs to the benefit of couples (e.g. the Married Couples Allowance), partly because the incidence of many “anomalous” reliefs (e.g. MIRAS) removed in periods when chancellors sought to raise tax had actually had an incidence skewed sharply towards couples with children.  But the single most important change was the initial downgrading of the child tax allowance during the 1960s and early 1970s, its conversion into a flat payment mis-baptised “child benefit” in the late 1970s, and then the freezing of that tax allowance/”benefit” during the 1980s.  (This was in stark contrast to the treatment of child tax allowances in the 1920s and 1930s, when they rose continually even when much else was cut.)

Now some readers will doubtless be inclined to respond: “Why should I pay for others to have high benefits to pay for children they can’t afford?”  But I am not discussing benefits here.  It isn’t a question of the state paying anyone to have children.  The question is how much tax people should have to pay.  And the thought is that if you have dependents, your ability to pay taxes is less, so you should pay less tax.  And note that this point is independent of precisely how much income you have — someone on £100,000 that has two children is less able to pay £40,000 in tax than is a childless person on £100,000.

The last element of the tax system that acknowledged this issue in any way was the mis-baptized “child benefit”.  But the proposal to remove child benefit for higher rate tax payers, finally converting child benefit from a residual flat-rate tax allowance into a welfare benefit (and hence something not to be paid to the wealthy), removes even this vestigial in-principle acknowledgement.

Child benefit is an anachronism.  It came into existence in the 1970s on the assumption that mothers would stay at home and look after the children, experiencing the costs of child support, but that men would earn the money so gaining the benefits of a child tax allowance.  To negotiate this problem, the child tax allowance was converted into child benefit to be paid directly to the mother.  But these assumptions are now quaintly outdated.

Over the longer term, child benefit in its previous form as a flat-rate tax allowance must surely be abolished.  Since it has now been redefined as a welfare payment, it must eventually be restricted to levels much lower down the income scale than £40,000.

But that would still leave the question: is a child a consumption choice, like a Ferrari; or is it a dependent person that increases the costs and reduces the ability to pay tax of whoever is supporting it?  This is nothing to do with deficit reduction.  It is a question of the balance of taxation to be paid between the childless and those with children.  Recent decades have seen that balance shift hugely away from taxing the childless and towards taxing parents.  Is that a concept the Coalition is happy to leave in place?

Andrew Lilico is Policy Exchange's Chief Economist.

Some more detail on the outlook for interest rates and inflation

Andrew Lilico is Policy Exchange's Chief Economist.

My previous blogpost attracted quite a bit of attention (probably more than it deserved).  Curiously, attention focused on those parts of the post in which I was repeating opinions I’ve expressed since early 2009 (indeed, have argued in a more general form since 2002, as for example here), and hence that I didn’t defend in any detail.  As a consequence, much of the subsequent press discussion seems to me to have missed a number of important points, which I propose to explore a little more now.

1)      In my view there are three broadly plausible paths for the UK economy from here over the next few years: deflationary slump (let’s call this the “US 1930s” scenario); robust sustainable recovery (let’s call this the “UK 1990s” scenario); unsustainable nominal boom followed by bust (let’s call this the “UK 1970s” scenario).  The scenario I don’t consider plausible is what we might call the “Japan 1990s” scenario — the scenario widely covered in the press and City circles, in which the economy suffers an extended period of very low nominal growth, with growth rates consistently at about 1% and enduring risk of deflation that never quite materialises.

The reason I don’t consider this plausible is that I don’t believe it could constitute an equilibrium.  Specifically, Japan was able to sustain this scenario in the 1990s because it entered the scenario with very high levels of household savings.  That meant that households were able to endure an extended period of low growth with relatively little proximate impact — the Japanese losses were mainly in output foregone (and of course lost asset valuations and huge rises in government debt).

By contrast, the UK entered the post-2007 crisis with very high levels of household indebtedness.  UK households have gambled on obtaining very high levels of nominal wage growth in order to be able to service their debts.  Without that wage growth, the burden of servicing those debts will start to drive widespread defaulting, leading to a snowball effect driving down prices, triggering nominal wage deflation, more rapid defaulting and further financial sector problems, dragging the economy into the deflationary slump scenario (the US 1930s scenario).  Unless we want deflationary slump, then there has to be nominal wage growth — simple stagnation is not an option; our households are too heavily indebted to tough this out.  (For more detail on UK household indebtedness, see this report, especially Figure 2.)

Five politically relevant things about where we are on the economy

1)     Double dips are not uncommon, and I expect there to be one this time.  Chris Huhne suggested recently that double dip recessions are rare and that talk of one occurring this time are Labour scaremongering.  I’m afraid he is certainly wrong on the first; whether I am a Labour scaremonger I shall leave to others to judge.

By a “double dip” I mean a situation in which, following a recession, after a period of growth but before the previous trend level of output, there is a further period of contraction.  Such events are by no means uncommon.  For example, there were double dip recessions in 1992 (output contracted in 1992Q2 after two quarters of growth), 1976 (output contracted in 1976Q2 after two quarters of growth), 1974 (output contracted in 1974Q4 after two quarters of growth), 1962 (output contracted in 1962Q4 after three quarters of growth), 1958 (output contracted in 1958Q2 after two quarters of growth) and 1957 (output contracted in 1957Q2 after two quarters of growth).  Indeed, the only technical recession in the UK since records began that did not involve a double dip was that of the early 1980s — with the early 1980s recession escaping only on the technicality that the initial period of contracting before the second dip from 1980Q1 on involved two quarters of contraction (1979Q1 and 1979Q3) interrupted by a quarter of growth (1979Q2).

Thus double dips are essentially the uniform experience of the UK when there are recessions (and note that the one time spending plans were materially cut back in the midst of recession – in the early 1980s – was the one time a double dip was averted, so double dips historically have occurred quite independently of fiscal consolidation), and I have always expected there to be one on this occasion, also.

Click on graphic to enlarge.

2)      A double dip recession will make it more important to cut spending early, not less important.  If/When there is a double dip, many commentators will presumably urge that the Coalition’s fierce fiscal consolidation plans should be abandoned.  That would be a bad mistake.  With a double dip recession, tax revenues are liable to fall below forecast and expected future debt levels relative to GDP will rise.  In other words, the risk that financial markets will lose appetite for UK government bonds, triggering an upwards spike in interest rates and the serious further slump that would entail, will rise materially.  With a double dip recession, markets will be more demanding of urgent action, not less, and any sniff that the Coalition is losing the political will to carry its programme through could be disastrous.

3)      A double dip recession would be quite compatible with a boom thereafter.  If the US and UK monetary authorities respond to the double dip as they should (and I expect they will) — namely by printing more money — and if the Coalition stays the course on cutting spending, then I expect growth through most of 2011 to be the strongest seen in the UK since the late 1980s (cf the recent experience of Germany).  I believe that this will be the combined result of natural recovery-driven growth and massive and unsustainable investment driven by huge monetary growth.  The model I have in mind is the early 1970s.  Output in 1973Q1 was 10% higher than in 1972Q1; capital formation rose over that period by 25%.  I’m not expecting growth in output or investment to be quite that rapid in 2011, but I do believe that this is an indicator of what enormous monetary stimulus can result in, if left in the system (which it ought to be, and I believe will be, on this occasion — I don’t believe the Bank of England will raise rates above 2% before late 2011 after a double dip, even if quarterly growth is exceeding 1.5% by then).

4)      Once the economy gets growing sustainably, there will be a huge expansion in the money supply, which will lead to inflation.  In the UK, the monetary base (the narrowest concept of how much money there is) has quadrupled during the crisis (most of this increase has been what is called “quantitative easing” or, more loosely, “printing money”).  Under normal circumstances, one would expect the result of such a huge expansion in the monetary base to be a similar expansion in the broader money supply, and consequently a large rise in the price level (if it were all to occur in one year — which it wouldn’t — we’d be talking 300% inflation).  Obviously these aren’t normal circumstances, so the increase in the monetary base (the extra money printed) has actually served to prevent what would otherwise have been a sharp fall in the broad money supply — which is why I favoured it, and favour doing more still; for now the big risk remains, as it has been since 2008, that we will see significant deflation, nominal wages would fall, and people would default on their mortgages.  We need to print more money now to limit that risk.

Raise the retirement age, but understand the implications

Andrew Lilico is Policy Exchange's Chief Economist.

Earlier this month, the Government announced plans to abolish the compulsory retirement age, on which it will consult until October.  With rapidly increasing longevity and changes in the nature of work, the compulsory retirement age has for some time been an anachronism, dating back to an era of manual labour in which life expectancy after retirement was restricted to a few years.  With significant numbers of today’s children expected to live beyond a hundred years, having not even finished their studies until their mid-20s, if the current rules were maintained many people would be retired for longer than they had worked.

Furthermore, compulsory retirement squanders the wisdom and experience of many older workers.  Many 65 year olds today are still healthy, focused, and interested in their work.  Why should they be forced into idleness by rigid and outdated laws?

So, abolition of compulsory retirement is welcome.  However, to work as a concept it will have to be combined with measures that are likely to prove very controversial and that have not, thus far, seen anything like the public debate and discussion they merit.  Specifically, absent compulsory retirement, it will probably be necessary to significantly diminish employment protection for older workers.

Let me explain this paradoxical thought.  Current employment law envisages a particular pattern of the working life: promotion and salary increase as job experience advances, right up to the point of retirement.  For a firm to demote a worker or reduce her salary it requires a good reason, such as a specific failing on her part or her salary falling as part of a company-wide salary reduction.  An employer can pick a specific worker and decide to raise her salary and promote her without any material impediment.  But to specifically target a worker for salary reduction or demotion is likely to lead to an employment tribunal and a claim for constructive dismissal.

An interesting innovation?

Andrew Lilico is the Chief Economist of Policy Exchange.

The Office for Budget Responsibility has released its first report this morning.  Here are some interesting points to note:

• The growth rate for 2011 has been downgraded to 2.6% from the Labour government’s previous 3.25% (that seems about right to me).
• The trend growth rate of the economy has been downgraded from 2.75% per year to 2.35% per year out to 2014 and 2.1% thereafter (this still seems rather too high to me, but not ridiculously so).
• The estimated structural deficit (the bit of the deficit that recovery in growth won’t eliminate) has been increased from 7.3% of GDP to 8% (about £110bn).
• The headline deficit for 2010/11 is virtually unchanged at £155bn (the previous figure was £163bn as in Labour’s budget minus the £6bn of spending cuts announced after the Election = £157bn).
• The OBR estimates a 20% probability of another recession in 2014 (I expect such a recession in 2013 or 2014).
• Growth in whole economy earnings is expected to rise more slowly than the RPI for the next three years (not good for bankruptcies!).
• Claimant unemployment is expected to fall consistently from here on (not gonna happen).
• Residential property prices are expected to rise hereafter (unlikely, I think).
• The forecast short-term interest rates at 1.8% for end-2011 (which seems about right to me), but show them rising only slowly thereafter (which I consider unlikely).
• They have the gilts rate rising above 5% in 2014.

All in all, an interesting document and a useful basis for debate.  If all OBR statements prove as rich in interest as this one, the OBR could prove an interesting innovation.

ONS blunder of political and financial market importance

Andrew Lilico is the Chief Economist of Policy Exchange.

Last Friday, the Office for National Statistics’ press release stated: “Services growth in December pushes up GDP estimate”.  This led to considerable excitement, both in political and financial market terms.  Market watchers expected the pound to strengthen.  There was speculation that Gordon Brown might call a General Election.

But the pound actually tanked, to some initial confusion.  This should not, however, have been a surprise, since GDP was actually revised down, not up.  The ONS press release headline was simply wrong.  The initial estimate for GDP in the final three months of 2009 was £315,845m as you can see here (cell G289).  This was revised last Friday to £315,712m as you can see here (Table C2).

The ONS had managed to confuse the level of GDP with the growth rate of GDP.  What happened was that (as has happened regularly during this recession) the GDP level in the previous quarter (Q3) was revised down quite a lot (things were quite a bit worse than previously thought).  So the change (the increase) between the third and fourth quarters was re-estimated up to 0.3% from 0.1%.  That is obviously a bad news story – the economy was worse than we had thought.  But the ONS headline managed to turn that bad news story into a (wrong) good news story.  Only the Telegraph ran the true story.

Given how politically sensitive GDP data is, and how jittery financial markets are at present, this is a terrible blunder for the ONS to have made.

The Unconsidered Option

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.

No backtracking

Andrew Lilico is Policy Exchange’s Chief Economist.

There has been much excitement in the press over the weekend about a supposed softening in the Conservative line on spending cuts, focusing particularly on Cameron’s comments that cuts needed to begin early but that the early cuts didn’t need to be “particularly extensive” and that there would not be “swingeing cuts” in the first year.

Many commentators have connected these statements to the very poor GDP figures and the growing expectation of a double dip, with the suggestion being that the recovery may not be sufficiently robust for the economy to tolerate significant spending cuts.  But does the prospect of a double dip stymie the case for early action to correct the deficit?

It is certainly true that, for much of late 2009, the Conservative Party emphasized that if there were recovery in 2010, there would be no need for additional fiscal stimulus and that with a recovery in growth, a normalisation in fiscal policy could begin.  But this was not the case for fiscal consolidation we at Policy Exchange offered.  In our view, the case for early action to address the deficit is even stronger if there is a double dip.

A mild double dip may well commence before the General Election, perhaps as early as the first three months of 2010 or more probably in the April to June period.  This was, for example, the experience in 1992, when, after growth from October 1991 to March 1992, the economy slipped back into contraction from April to June.  This will come before any action to cut spending or raise taxes – indeed, spending will still be rising rapidly over this period.  Double dip will make it all the more urgent to cut spending.  Why?  Well, suppose that we left spending at about 50% of GDP and left the structural deficit (that bit of the budget deficit that won’t go away once the economy is growing well again) at about £125bn.  The result would be that financial markets would become very concerned that the British political classes lacked the will (and the economy lacked the growth) to address the deficit when times were tough and that unless everything went smoothly thereafter, Britain would be at risk of inflation or even defaulting.

The Pre-Budget Report

Andrew Lilico is Policy Exchange's Chief Economist.

Alistair Darling’s pre-Budget report (PBR) today was a disappointment, though perhaps not an unexpected one.  In particular, it contained no plan to cut spending further or earlier.  Indeed, spending is rising this year by £5bn, and current spending is rising faster (0.8%) than projected in the Budget (0.7%).  The Government is now relying upon inflation to do the work of spending control.

There is no plan to cut the deficit faster.  This is projected to reach 5.5% of GDP in 2013/14 - exactly the same as in the Budget.  The plan is for the deficit to fall to 4.4% of GDP by 2014/15.  In today's terms, that would be £62bn - a larger deficit than the UK had ever experienced up to 2008/9, even after an entire Parliament of fiscal consolidation.  The PBR boasts (at B.30) that "Cyclically-adjusted borrowing is lower than at Budget across the medium-term forecast."  But this is entirely because of a redefinition of the cycle, not because of any reduction in the deficit!

In the meantime, the UK is projected to be borrowing around £175bn in 2009/10 and 2010/11.  At 12.5 % of GDP, this is far in excess of any plausible level at which deficits could be expected to stimulate the economy in the short-term, assisting it through recession.  Instead, a deficit on this scale acts as an anchor on the economy, raising interest rates and creating concerns amongst households that their taxes will rise.  The structural deficit (that bit of the deficit that won’t go away as the economy recovers) is estimated at 9% of GDP, some £125bn (down slightly on the 9.8% figure estimated at the Budget, but only because of a slightly changed assessment of the cycle).

Taxes are indeed projected to reach 37.3% of GDP in 2011/12, a figure not seen in the UK since 1985/6.  Indeed, taxes not been above 37% of GDP since 1986/7.  Recent Treasury research suggests that there is some 1.7m of suppressed unemployment, with workers keeping their jobs only because they were willing to accept reductions in hours, pay freezes, or pay cuts.  (Our own research puts the number at above 1.9m.)  Yet the PBR increases employer and employee NICs.  Imposing such a tax on employment at this time could well tip matters over the edge for a significant number of these people, accelerating what will, anyway, be a significant rise in unemployment over the next year.

At 4.75% contraction, 2009 is the worst year for the UK economy since comparable records began in 1948.  Indeed, it is worse than the likely estimate for 1931 (4.6% contraction).  As regards the forwards-looking estimates, to get growth of 1-1.5% for 2010, the economy would need quarterly expansions of some 0.4-0.5 throughout 2010.  I believe there will be two quarters of contraction, and GDP will be much closer to flat on the year, but 0.4-0.5% growth per quarter is certainly not out of the question.  To get 3-3.5% growth in 2011, the quarterly expansion would have to be around 0.9-1.0%.  I believe that’s comfortably doable, albeit at the cost of high inflation.

Some commentators seem to be suggesting that if there is growth of 1.25% in 2010, then Darling’s 2009 Budget growth forecasts will have been vindicated.  That is a somewhat confused idea.  The 2009 Budget forecast growth in 2009 at minus 3.5% and plus 1.25% in 2010.  Since the actual contraction in 2009 was 4.75%, the economy starts about 1.25% smaller at the beginning of 2010.  So if it grows only the 1.25% the 2009 Budget projected, it will be about 1.25% smaller in 2010 than the Budget thought it would be.  That means lower wages, less employment, lower tax receipts.

There is a special freeze on the higher rate threshold for 2012/13.  I think we can safely say that Darling does not anticipate deflation in that year.  I think it’s pretty clear that the Treasury expects high inflation that year (as do I), so that a freeze that year will be a significant money-spinner.  The PBR forecasts RPI inflation of 3.5%.  I think they must believe it will be higher (I expect 10%).

Overall, with rating agency and gilt-purchaser warnings about the UK’s credit status ringing all around, it is clear now that the UK's ability to borrow and its credit rating now rely upon bond market expectations that the real decisions will be taken after the General Election.  We’d better hope that whoever wins will be up to taking them.

Doing it all with tax rises is not an option

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?

Why the Conservative Party should not spell out a list of explicit cuts

Andrew Lilico is Policy Exchange's Chief Economist.

Cameron and Osborne are coming under increasing pressure to spell out an explicit list of planned spending cuts.  Some of this pressure, naturally, comes from their political opponents, but there have also been lists of cuts propose by, among others Reform (£30bn) and last week the Taxpayers’ Alliance and the Institute of Directors (£50bn).  Whilst it is useful for think tanks to produce ideas for debate, I believe it is a mistake when they go further and demand of political parties — especially of opposition parties — that they spell out their own alternative lists.  I shall explain why.

First, we should note that the lists of cuts set out so far are simply not enough.  For headline public spending to fall by the £65bn or more required, core spending needs to fall by upwards of £100bn, because in the short-term there will be £35bn or more of additional spending required as a fairly unavoidable consequence of the recession and the consequent unemployment to come.

This point of scale is crucial.  If the cuts required were only, say, £5bn, it might make sense to identify specifically what they are intended to be.  But to cut £100bn means cutting across an enormous area of public spending.  To make cuts on this scale, it is vital that, before they are committed to in detail, bureaucrats in the relevant departments have the opportunity to fine-tune the scheme.  Otherwise, what will happen in practice is that some cuts “committed to” in opposition will prove undeliverable in government.  Once that starts to happen, then other departments or programmes scheduled for cuts will ask why they are being targeted when others on the supposedly fixed cuts list were spared.  The whole programme could quickly unravel.

Finkelstein is talking from the past - Spending must be cut now

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.

The latest GDP data and their implications for future public spending

Andrew Lilico is Policy Exchange's Chief Economist.

This morning’s GDP data constitute a horror story for businesses, for unemployment prospects, and for the public finances.  Contrary to the expectations of only a few weeks ago that the second quarter might have been flat (neither growth nor contraction) or even of the consensus expectation this morning of a 0.3% contraction, GDP in fact contracted by 0.8%.  Government Ministers have attempted to spin this as a “considerable easing in the downturn”.  “Easing” of this sort, if sustained for the rest of the year, would result in a full year contraction of above 5.2% of GDP – worse even than the peak of the Great Depression in 1931.

It is clear now that in Q2 we have only the shrivelled yellow shoots of recovery, probably largely as the result of an inventory snapback (in the final quarter of 2008 and the first quarter of 2009, companies produced little and ran down their inventories to very low levels, so that in the current quarter it was necessary that firms should increase their production, just in order to avoid running out of stock).  Looking forward, it is now less likely that the third quarter will see growth, but my view remains that we will get growth in the fourth quarter and perhaps also in the first quarter of 2009.

This will mean that, going into the likely General Election period, the Government will be able to claim that growth has returned.  It will probably seek to take credit for this growth, as a result of Government policy.  It will be correct, and that is a problem.  Because the growth over those six month will, in my view, be the inevitable lagged effect of a one-off massive policy stimulus consisting of interest rate cuts of more than 5%, a doubling (perhaps by then a tripling) of the monetary base (the quantitative easing programme), and a £200 billion budget deficit.  If economic stimulus on this scale does not result in at least one or two quarters of growth then the economists might as well go home.

Cuts in the Budget go Much, Much Deeper than you Think

Andrew Lilico is Policy Exchange's Chief Economist.

Policy Exchange is currently engaged in a major programme on public spending.  Our first report considered the scale of the challenge, demonstrating that there is currently a huge surge in public spending (up £120bn in just three years) and arguing that there would need to be cuts of £55-£65bn from 2010.

A week or so after our report came out, the public spending debate blew up following Andrew Lansley’s comments that the 2009 Budget already implied cuts of 10% in departmental expenditure limits if NHS spending is ring-fenced.  Gordon Brown seized on these remarks, claiming that they indicated an intention by the Conservatives to cut all spending by 10% in contrast to what he claimed was Labour’s intention to keep raising spending each year.  Subsequent press commentary has exposed the blatant untruth at the heart of Brown’s claim.  For Labour’s own Budget scheduled a halving in the capital spending budget and cuts in departmental expenditure limits of 7% from 2011-2014.

But in fact much the largest cuts announced in the Budget have had almost no publicity at all.  Look at paragraph 2.81, p35 of the 2009 Budget.  This states:

This Budget puts the public finances on a path to achieve a cyclically-adjusted current balance in 2017-18. The cyclically-adjusted current deficit falls from 6.7 per cent in 2009-10 to 3.2 per cent of GDP in 2013-14, an average improvement of over 0.8 per cent a year... A further adjustment of 0.8 per cent of GDP a year from 2014-15 would eliminate the deficit on the cyclically-adjusted current budget by 2017-18.

What this says is that from 2014-5 to 2017-18, the 2009 Budget schedules fiscal tightening (tax rises or spending cuts) of 3.2% of GDP, that is to say, a little under £50bn.  Because this is about addressing a structural deficit, it won’t be corrected by the economy returning to healthy growth – this 3.2% is the deficit even when the economy is growing well.

Does this mean £50bn in tax rises or in spending cuts?  Well, the 2009 Budget contains explicit fiscal tightening made up of 80% spending cuts and 20% tax rises.  This is inevitable – historical and international experience suggests that it is impossible to achieve fiscal tightening on remotely the scale required by raising taxes (raising taxes causes the economy to fall deeper into recession and so revenues fall and so the deficit does not fall by nearly so much as the tax rises).  Thus we can reasonably assume that £50bn in fiscal tightening will be made up, as with the other fiscal tightening in the Budget, of about 80% spending cuts and 20% tax rises.  In other words, the Budget schedules about £40bn in spending cuts, Labour cuts of £40bn, from 2014-2018.

I emphasize again that these £40bn of spending cuts are in addition to the 7% cuts in departmental expenditure limits already being discussed (amounting to about £25bn) and the halving in capital spending (amounting to about £20bn).  If Conservatives are serious about spending less than Labour, we need to work out how to cut spending by more than £40bn, over-and-above the spending cuts of 7% in DELs and the halving of capital spending.  And the reality is that, with the ratings agencies having placed the UK on notice that our AAA rating will be under threat if a credible fiscal consolidation plan is not introduced by the next government, we will not be able to wait until 2014 before doing it.

The (in)significance of the inheritance tax pledge

Andrew Lilico is Chief Economist of Policy Exchange.

The current debate over public spending has involved claims by Conservative frontbenchers that departmental expenditure limits (DELs) will have to fall by 7% after 2011 and may need to fall by 10% in some areas — these figures, of course, being those implied by Labour’s 2009 Budget, a fact that a number of Labour minister appear not to grasp.  One only hopes that the Treasury ministers, in particular, will have a better grasp of their own figures shortly.  Of course, cuts of 7%-10% in DELs are neither nearly sufficient in the way of cuts nor is post-2011 rapid enough.  Labour’s own plans indicate that they would be likely to need to reduce their plans by a further £40bn-£60bn in today’s money (the Budget states that this will occur after 2014) and the Conservatives would be likely to seek additional cuts over-and-above this.  Furthermore, these cuts would need to happen more quickly than currently scheduled if the country is to avoid a gilts crisis that could come as soon as late next year.  But the message about the need for cuts is at least now being debated.

A number of Government ministers, notably Byrne and Balls, have suggested that Conservative plans are driven by the need to find funding for the pledge, announced in the autumn of 2007, to raise the inheritance tax (IHT) threshold to £1m.  Let’s examine that claim for a moment.

Changing of the guard

For reasons I think the Editor will explain in a ToryDiary soon, this will be my last posting on CentreRight qua CentreRight blogger Andrew Lilico.  I've been blogging on ConservativeHome for about two years now, first as a Platform contributor, then in the more elevated role of weekly Columnist, then for the past year more humbly as a CentreRight contributor.  I have benefitted from your sharp criticisms, found reassurance in your kind remarks, and been amused by your outrageous insults.  I hope to have made some small contribution to debate in the Conservative Party, and I am continually impressed by what the Editor and his team have achieved in making ConservativeHome the pre-eminent right-wing political website in Europe.

Fare thee well.

Abolish the right not to be tortured

If a government believes that it creates a right, then it will also believe that it is entitled to modify that right.  This is how we should understand the shameful discussions of recent years over when it might be legally permissible to torture someone, to render someone to another country so he can be tortured, to deport someone to another country knowing that he might be tortured there, and when our courts should accept evidence obtained under torture.  Since New Labour believed that it created the right not to be tortured with the Human Rights Act, it also believes that it can modify that right.

The solution is not to create some new "British Bill of Rights", for the problem is not that there is something wrong with the details of the Human Rights Act.  The problem was the whole concept that it is for governments to create and modify the right not to be tortured.  Thus, the solution is to give up that idea - to abolish the right not to be tortured.

Insofar as it makes any sense to talk of our having "rights" not to be tortured, these are morally or divinely or naturally given.  They are not creations of governments, and governments cannot take them away or modify them.  As far as a government is concerned, the question is not "Do my citizens have a right not to be tortured?"  Rather, it is "Will I allow my citizens to be tortured, and if so, when?"  I should not have a government-given right not to be tortured.  Instead, I should have freedom from torture which begins as a state of nature and is not eroded by the government permitting anyone to torture me.

On Capitalism

Capitalism is a system in which the providers of investment capital, the capitalists, are different people/companies from those that run/manage businesses.  That is its fundamental property.  (I focus here upon capitalism in its narrow investment sense, rather than upon the free markets that many consider the natural partner of capitalism.)

A private capitalist system (i.e. a system in which the capitalists are private citizens) is very attractive, for at least three kinds of reason:

• First, those that have money are not always those with the best ideas for how to use it.  Under a capitalist system, this does not prevent those with good ideas and talent from getting the opportunity they need.  If the provision of capital is diversified - if no one social group has control over the distribution of capital - as tends to happen under a private capitalist system, then a capitalist system is intrinsically the enemy of rigid class or caste structures.
• Second, under a private capitalist system most money tends to be invested depending on risk and return, rather than any other merit of projects.  This moral quasi-neutrality is a natural partner to a tolerant liberal society.
• Third, because those projects that will secure the highest returns can find investment capital under a capitalist system, risk-taking and innovation are facilitated.  This means that private capitalist economies tend to grow rapidly and evolve dynamically and richly (with a great variety of products and richness of ideas).

Could the next election be the end for the Labour Party?

In a spirit of idle weekend speculation, I offer you the following thought: Perhaps the Labour Party will never (say for at least two generations) win a British General Election again.

Quantitative easing - the practice

As widely reported, the Bank of England is intending, over the next three months, to purchase some £75bn of assets - mainly gilts - in an operation of quantitative easing (i.e. printing money).  The right-wing press and blogosphere seems highly disconcerted by this, even in some cases outright opposed.  I think it is right to be nervous about this policy, and I shall propose a refinement, but I support it nonetheless.

Talk of printing money (which is broadly the right way to describe what is happening) is liable to make us imagine that the Bank of England is increasing the money supply.  Consequently, of course, we suspect that that will lead to inflation.  Inflation may be a kind of solution to our woes - inflating away our debts - but (one might think) might the medicine not be worse than the disease?

Myners' pension reported as being with RBS

The Evening Standard reports that Lord Myners, who signed off for the government on the deal that gave Sir Fred Goodwin his notorious pension, himself has a pension with RBS valued at £4m.  Of course, since I want the government not to renege on its deal with Sir Fred (at least, not until after it has already reneged on its deals with bondholders in RBS), I have no objection to Lord Myners keeping his pension.  But can the same be said of others?  Presumably, since his pension is with an institution Vince Cable states is bankrupt and ought to pay no pension above £27,000, the same would apply to Myners?  Does Harriet Harman think it is "unacceptable and won't be accepted" that Lord Myners pocket a pension of £242,000 per year, benefitting from a failed institution?  Will the government be seeking every legal avenue available to see whether they can avoid making this payment to him?

Hat Tip: James Forsyth

Demonizing your opponents

With no apologies at all to Jenni Russell...

For 100 years anyone who thought themselves vaguely on the right has been able to rail against the worthlessness of Socialism. We deplored their devotion to the politics of class, their hatred of the market, their callous indifference towards all those who aspired to flourish in a tough, competitive world. We detested their xenophobia (cf anti-Americanism), racism (cf Kenyan Asians), sexism (seen many women Trades Union leaders?) and inverted snobbery. We knew, from grim experience, how willing they were to let the economy crumble and public services become at the same time poor in delivery and massively over-expensive to run. We exhorted (and still exhort) them to abandon their disgraceful politics - but remain comfortably certain that they never will.

Who on earth (or elsewhere) do they think they are?

Harriet Harman, speaking yesterday on the Andrew Marr show:

Sir Fred Goodwin should not be counting on being £650,000 a year better off because it is not going to happen. The prime minister has said that it is not acceptable and therefore it will not be accepted.

And it might be enforceable in a court of law, this contract, but it is not enforceable in the court of public opinion and that is where the government steps in.

What??  So now the Labour Party deputy leader does not accept the rule of law?  She simply does not care whether he's legally entitled to the money, because she thinks she has "the court of public opinion" with her and so little things like the law don't matter and she feels able to state categorically that his she-concedes-perhaps-legally-entitled pension "is not going to happen"!

This is terrifying.  What's she going to take against next, stir up public opinion in opposition to, and then over-ride the law if necessary?  Will she decide that I've been paid too much and just take away my property in the way she proposes to take away what she concedes might be Sir Fred's legally-defended property?  What about if someone does something she doesn't like but happens not to be illegal - is she just going to have them locked up because public opinion is on her side?  Is that where we are now in Britain - mob rule, and to hell with the law?

UPDATE (2.30pm): The Treasury and Number 10 appear to have been desperately rowing back on this this lunchtime, emphasizing that they will be bound by the law.  Good.  Is Harman's position now tenable?  Should she resign?

The rising role of the State

I've previously tried to convinced you that we should aim to have public expenditure in 2010/11 some £95bn or more less than the government's current plans.  I sense that few of you were really convinced.  So I want to express the matter another way.  Forget the niceties of fiscal management and complicated thoughts about sovereign risk.  Just concentrate on an idea I hope is politically familiar: the role of the State.

Click on the graph above to see it full size.  The government's current expenditure projections imply a truly astonishing rise in the role of the State over the next couple of years.  Even on its own figures in the pre-Budget Report (PBR) in November (see Chart B.2 on p209 here), and setting aside the support provided to banks, the government intends to raise public expenditure from 41% of the economy in 2007/8 to 44% in 2009/10.  This compares with 36% in 1999/2000 - a rise of 22% in the size of the state, relative to the economy, in just ten years.  But, of course, no-one believes those projections, because they were based on hopelessly optimistic growth forecasts.

Fred Goodwin's Pension

I'm not a lawyer, and I know no more about Fred Goodwin's pension than I read in the papers, but here's how it seems to me.  The government took over RBS.  It decided that Goodwin had to go.  Goodwin would have had some protection under employment law and might have contested his dismissal, and in any event even dismissal would have contractually obliged a payment to him equivalent to about fifteen months of his salary.  This might have been politically embarrassing, so intead Lord Myners talked him into taking early retirement in exchange for foregoing his fifteen months' salary payoff.