Lord Flight: Smaller governments are better for promoting economic growth

Lord Flight is a former Shadow Chief Secretary to the Treasury and Deputy Chairman of the Conservative Party, who is now chairman of Flight & Partners Recovery Fund.

There is an obvious need for the private sector of the British economy to recover and grow faster to take up the slack in the economy; to employ more young people coming onto the job market as well as those released from the public sector; and to recover and grow tax revenues to help restore the public finances.

But there are difficult answers as to what government can and should do.  The fundamental economic parameters are that the country – both individuals and government – have been “living beyond their means” for some time.  For a while stagnant or even declining personal consumption is inevitable.  This is being reinforced by the increase in costs, particularly energy (also driving up all costs) in an employment environment where pay and particularly take home pay, after tax, will not keep pace with consumption costs.  This means a reduction in living standards for the time being.  Only when the economy eventually starts to recover more strongly is there the risk of “catch up” increases in pay, driving an inflationary spiral.

In the interim, private sector growth has to come from increased exports and increased capital investment.  The supporting macro-economic policies are obvious – a competitive exchange rate, cheap and easy money and a favourable tax regime.

There is, in addition, the difficult, but correct issue raised by Allister Heath of City AM, that there has not yet been the “economic cleansing” which needs to happen, as a harbinger of sustained economic recovery.  Too many businesses are being kept afloat by banks not calling in their loans and by the Government itself extending credit by the back door, in terms of VAT and PAYE owing, amounting to at least £30 billion.  The extent of business failures in this recession, which has been much more serious than the recession in the early 1990s, is still much less than was the case in the early 1990s.  I think Allister Heath is fundamentally right here, but with the qualification that if left “wholly to the markets” many worthwhile businesses would go under, which with a bit of financial support to keep them alive could flourish in the future – particularly in high tech areas.  The challenge is to identify which are worth sustaining.

The standard sort of proposals turned out by the Civil Service of designating particular areas to be exempt from NI increases, or enjoying other forms of fiscal benefit, seek to address the political need for the Government to be seen to be doing something, but in the aggregate tend to be a waste of time.

The fundamental issue is as to what should be the balance between cutting public sector spending and raising taxes in order to restore the public finances and head off the risk of borrowing problems and, ultimately, national bankruptcy. 

The Government opted for a balance of 75% cuts and 25% tax increases although, in practice, this is working out closer to 70%- cuts and 30%+ tax increases.  I assume the economic logic here is that if more were by way of cuts and less by way of tax increases, the private sector might save more/pay down debt, so reducing further the overall level of demand in the economy? 

But the truth is that citizens spend their money much more effectively than governments.  The UK economy has been hobbled by the massive increase from 36.6% to over 51% of GDP constituting public spending with major increases in “welfare-ism” spending.  The Government should be doing that for which the Labour Party attacks it – using the crisis to effect radical reform of the public sector. 

There is plenty of research demonstrating how bloated public spending impoverishes countries.  The latest by Swedish economists Bergh and Henrekson shows that an increase in government size of 10% is typically associated with 0.5% to 1% lower, annual growth.  This suggests the disastrous rise in public spending under Labour has reduced British growth by over 1% per aannum. 

Smaller governments are better for growth.  Nearly everywhere you look in the public sector there is no real accountability and no effective management of how money is spent – basic essentials in the private sector, or you go bust.  As local government is obliged to effect major cuts in spending, the extent to which money has been wasted, with no real accountability by either local government executives or politicians, is coming to light.

While there is a correct, moral, consensus that the welfare state should be there to provide a basic safety net for all, the Labour Government exploited public spending for vote-winning purposes, creating a situation where over 60% of the population are either employed by the State or receiving benefits from the State.  If welfare expenditure hidden in regional expenditure and tax credits, (which are a form of welfare payment but are accounted for as a reduction in tax revenues), are included, welfare spending is approaching £220 billion per annum.  Some £60 billion of this is State old age pensions which arguably are too low. 

But where are the additional £160 billion going, when unemployment, though higher than is desirable, is not at crisis levels?  The answer is all manner of in work benefits and welfare-ism benefits, which have created a society where for too many there is little or no economic incentive to work, and for even more no economic incentive to get skilled up to earn more.  The “natural” market mechanisms which drive economic recovery have been substantially blocked up.

Much of our welfare and employment problems have been the result of endless rules and requirements forced on us by the EU.  Put at its simplest, if people could sell their labour for less than the required minimums and protections, there would be more jobs.  Thinking along these lines is still considered too harsh but the economy will not rebound if “natural market forces” remain inhibited.

My macro-economic prescription is to reduce taxation now, matched by matching additional cuts in public spending, both cutting waste and reducing welfare-ism.  I also fear that the extent of dubious, if not fraudulent, welfare claims, is far greater than the Government estimates.  The spotlight has been turned on housing benefit, but ever since generous single parent welfare was introduced, there has been a sharp increase in parents not getting married and organising their affairs to be able to claim the maximum single parent benefits.

The Government’s initiatives and plans in this area are sound but I do not believe “carrot” alone can work – there needs to be “stick” as well.

In the near term, our overall competitiveness has been helped by retaining our own currency, and the depreciation of Sterling against both the Dollar and the Euro.  Clearly this is beneficial for export competitiveness but there needs to be real improvement in productivity and efficiency, if this is to be sustained.  EU imposed regulation makes this difficult, but it is noticeable that German businesses have been able to achieve this notwithstanding.  This is where capital investment comes in, and where there should be scope for the Government to make capital investment more fiscally attractive, in the shorter term.  This is perhaps the most important area in which taxation should be reduced.

Under the previous Conservative Government, Britain was the most competitive place to do business in Europe in terms of personal and company taxation.  It is now the least competitive.  Our language, laws and stability remain an attraction but we need to restore our fiscal competitiveness fast if we are to attract the international, private sector investment needed to help sustained economic recovery.

Matching this, the Government needs to be asking itself the fundamental questions of what areas it should be involved in; what areas it is involved in, but should not be; and secondly, how should acknowledged public sector obligations be best delivered?  Poorly negotiated and expensive contracts have given PFI a bad name, but there are many areas where public sector obligations are being delivered more efficiently by private sector out-sourcing – particularly in local government – and many other areas where this could be so.

The Government has got the big picture right as regards its plans for restoring the public finances, but the balance of how this is achieved needs re-thinking.  Citizens and businesses spend their money more efficiently and effectively than governments, and the private sector needs restored competitiveness to recover and expand.