Friday, 30 April 2010

Flawed Analysis From the IFS

by Michael Burke

The Institute for Fiscal Studies (IFS) has produced an analysis of the three main parties’ budget plans. The IFS has a reputation for voluminous and detailed analysis. The latest analysis runs to seven documents, but it is deeply flawed.

The essential points of the IFS analysis are to highlight the level of cuts required by the three main parties in order to meet their own targets and timetables for budget deficit-reduction. According to the IFS, the Tories would need to make cuts in public spending of £63.7 billion by 2014/15, (and so far have only identified 17.7 per cent of these). Labour would need cuts of £50.8 billion (of which they have currently identified 13.3 per cent) and the LibDems would require £46.5 billion of cuts (and have specified 27 per cent of those). The differences arise mainly from timing as well as the proportion of tax increases adopted. At the upper end, the Tory cuts are equivalent to the entire current budget for children, schools and families in the current financial year, in addition to the current budgets for international development, transport and most of the work and pensions budget too.

No Mandate

The unspecified spending cuts have led to the charge that the parties are being dishonest with the electorate, a charge which was widely take up by the media after the publication of the IFS report. This is so, even though the Labour and LibDem plans are estimated to be the tightest since the IMF was called in to Britain in the late 1970s, while Tory plans are reckoned to be the worst ever, certainly since WWII.

Clearly, there is no mandate for the type of swingeing cuts outlined, and cuts themselves remain deeply unpopular. In particular, public opinion is firmly against cuts to the schools’ or training budgets, health and pensions. It is also against increasing student fees or interest payments, as well as removing winter fuel payments and free TV licenses for the over 75s. Apart from cutting the BBC license fee, one of the other most popular cuts would be on scrapping Trident.

No Logic

While there is no support and no mandate for the cuts programmes, there is no logic to them either. The IFS actually does a great disservice to the level of the debate about the economy and government finances. This is because, simply accepting the Treasury economic forecasts and casting them in stone, IFS entirely ignores the economic impact of the cuts. Therefore it entirely misses the consequences of those cuts on the issue it raises above all else, namely the public sector finances.

In effect, the IFS approach mistakes action for effect. Therefore, every cut becomes a saving. On the IFS website, like that of the Financial Times, it is possible to construct your own package of spending cuts, and tot up the totals - a macabre computer game for neo-Thatcherites.

But for serious policy discussion it is vital to gauge the effect of every action on the economy and therefore on government finances. It is possible to do that from the Office of National Statistics’ Input-Output Tables, previously highlighted on SEB. These show the multiplier effects of government spending on other sectors. The multiplier for the category of government spending on ‘Health, Education and Social Work’ is 1.854. That is, every £1bn withdrawn from government spending in this area will lead to a decline in total output alone of £1.854bn. That is, lower government spending on health will lead to lower private sector output of medicines, health equipment and machinery and so on. This does not take account of the additional effect of lower spending by health workers laid off or whose pay has been cut, as the ONS struggles to compute that, for technical reasons. On the basis of output alone, the effect of cuts spelt out by the IFS would actually lead to decreased economic activity of £118bn in the case of the Tories, down to £86bn in the case of the LibDems. These are equivalent to 9.3% of GDP and 6.8% respectively, based on 2009 levels. This is more severe than the current recession that Britain is only now slowly emerging from.

As it was put in the New York Times on similar effects on other countries: “Officials from Standard & Poor’s said the main reason for downgrading the debt of Greece and Portugal was the prospect that forced austerity packages would be an even bigger drag on economic growth. It is the most vicious of circles: stagnating economies are forced to cut back more, which reduces their ability to generate revenue and thus pay off their debts."

That this much lower output has its own negative impact on government finances can clearly be seen with the UK also. This arises from two areas; lower taxes from lower levels of activity and increased government spending in other areas, mainly unemployment and welfare payments. SEB has previously shown how the ‘Treasury Ready-Reckoner’, the official Treasury analysis of the relationship between government finances and the economy, estimates this impact.

In effect 75 per cent of all changes in output are reproduced as changes in government finances in the second year. 50 per cent arises from changes to taxation revenues and the remainder from changes in government spending. Therefore we can calculate the actual change in government finances arising from these cuts.

In all cases the deficit actually worsens under the impact of the cuts programmes, with the deterioration in government finances ranging from around £12bn to £25bn.

Nor is it the case that a greater reliance on tax increases from Labour and the LibDems automatically alleviates the problem. Only transfers to the poor from the rich have the effect of boosting total demand, as the poor spend a greater proportion of their incomes. In this regard, the IFS argues that only Labour’s tax plans marginally favour the poor over the rich, whereas LibDem tax plans favour those on middle incomes, to the detriment of both the rich and the poor. Within a decimation of public services, pay and jobs, Labour’s plans are fractionally less harmful to the poor than those of the LibDems, while the Tories would need to be the worst government in post-WWII to achieve their plans. In reality, the effect of the cuts programmes are much worse even than the IFS estimates.

Wednesday, 28 April 2010

100 Years Out of Date- The Tory/UUP Joint Election Manifesto

by Michael Burke

The Tory Party has launched a joint manifesto with the Ulster Unionist Party.

This is a revival of a formal alliance that stretches back nearly 100 years, when the anti-Home Rule wing of the Liberal Party (the 'Liberal Unionists') split and joined the Conservatives to form the Conservative and Unionist Party. This was the political force most opposed to Irish independence and which helped to organise the illegal arming of the Ulster Volunteers as well as the 'Curragh Mutiny' - the rebellion by anti-Home Rule British army offices stationed at the Curragh camp outside Dublin.

However the UUP is not the force it was, the dominant representative of political Unionism. It lost 5 out of its 6 remaining seats in the 2005 General Election with Reg Empey now as its sole representative at Westminster. Both parties have perhaps been hoping for a lift from the remerger; the UUP aiming to win seats from the DUP, and the Tories having an automatic back-up ally in the event of a narrow majority in current election. Politically, both have proclaimed that the manoeuvre signals that 'Northern Ireland' is now an ordinary part of and "no longer semi-detached from the UK."

However, their own manifesto shows that this is not true, politically or economically

The only concrete policy for the northern 6 counties seems to be turning it into an 'Enterprise Zone- different from the rest of Britain. This is to be a regulation-free, low-pay and low tax area, an extreme echo of the early years of Thatcherism, which one commentator at the time dubbed 'Welcome to Slumsville'.

Economically there is too a qualitative difference. In an interesting map in the manifesto reproduced below, there is a geographic representation of the relative size of the economies, with the 6 Counties shrunken and shrivelled. This is a function of the current phase of colonialism in this part of Ireland.

Per capita output in NI is approximately one-third below the British average. A key feature of the economy in NI, and primary cause of this underperformance is that it is a closed one. Its most recent trading performance shows annual foreign sales (equivalent to exports) of just £12bn, with just £5bn going to non-British destinations. By contrast, Britain's total exports amounted to £421bn, and even this is a weak performance by international standards. At the same time exports from the rest of Ireland amounted to €84bn, even though the population is only just over 2 1/2 times greater.

This is a direct product of colonialism, which the policies of the UUP/Tory Party will only deepen.

Tuesday, 20 April 2010

Growth Is the Fix for British Finances

by Michael Burke

‘Growth is the Fix for British Finances’ is the excellent title of a recent piece in the Financial Times from Martin Wolf.

In contrast to all of those who have argued that ‘overspending’ by Gordon Brown has created the large public sector deficit, the FT’s chief economics commentator sets the record straight. He points out, as SEB has done previously, that the decline in tax revenues is the cause of the crisis in government finances. In the 2010 Budget, spending is just 2.2 per cent higher than was projected 2 years ago, despite the recession, while tax revenues are 18.1 per cent lower. In addition, the 9.3 per cent fall in nominal GDP has increased all debt/GDP measures.

From this the policy prescription is equally clear, as Wolf argues, “the single most effective way to bring the public finances back under control is greater demand and higher GDP. This needs higher investment and net exports and more dynamic supply. Measures that seek to close the fiscal deficit, but destroy demand in doing so, will not help: fiscal austerity is just not enough.”

But the actual policy prescriptions advanced are wide of the mark. Wolf ends the piece with a renewed call for spending cuts and tax increases. He must know that these directly run counter to the stated goal of creating “higher demand and higher GDP”.

This is because his starting-point is the need for the government to pander to a reluctant private sector, to tempt it to increase its investment levels through taxpayer-funded tax cuts. But Britain, in common with all the OECD economies, is experiencing an investment strike. The slump in business investment is the main component and driving force behind the recession. Private investment continues to fall, even as other areas of activity rebound moderately.

This is because private investment is driven by profit. Unless national incomes can be driven up, or labour’s share of national income driven down, businesses will continue their investment strike. All proposals for cuts, including Martin Wolf’s, amount to an effort to secure the second option, at the expense of workers and the poor.

In addition, any policy based on encouraging businesses to invest is likely to be wholly ineffective. SEB recently highlighted IMF research on the various forms of fiscal stimulus [1]. It is worth returning to, as it deals precisely with this question. Its finding is that corporate tax incentives are the least effective of all possible fiscal stimulus measures examined.

According the research, based on seven different macroeconomic models from leading central banks and agencies such as the IMF, OECD and EU, stimulus equivalent to 1 per cent of GDP comprised of corporate tax cuts yields an increase in GDP of just 0.5 per cent of GDP over 5 years. By contrast, government investment yields the highest return, up to 4.5 per cent of GDP over 5 years. In the words of the authors, “only target transfers [to the poor] come close.”

Their key conclusions are worth quoting more fully, “First, there is a robust finding across all models that fiscal policy can have sizeable output multipliers, particularly for spending and targeted transfers. Second, the effectiveness of fiscal policy will be largest in circumstances in which monetary policy supports fiscal policy by accommodating stimulative fiscal actions through holding interest rates constant for some period of time. Third, more persistent stimulus, if the additional stimulus is measured in years rather than decades, is even more effective if monetary policy remain accommodative.”

The authors’ sole caveat is that the fiscal stimulus should last years, not decades. But if fiscal stimulus has not worked even over that timescale, then a ‘somewhat more comprehensive socialisation of investment’ would be on the agenda.

The first task is to recognize the nature of the problem, as Martin Wolf has done. But, as the IMF research demonstrates, relying on the private sector to correct the crisis of its own making will not provide the fix Britain needs.


1. IMF, The Effects of Fiscal Stimulus in Structural Models, IMF WP/10/73

'Readers may be want to see the new article by Michael Burke 'Tory economic plans: the stakes could not be higher' in Tribune.

Thursday, 1 April 2010

GDP Data Proves That Investment Works

by Michael Burke

SEB has recently argued that the Budget shows that the fiscal stimulus of 2009 worked. Stimulus measures of £50bn led to an increase in taxation revenues of £9.5bn in the first year alone, to be followed by reductions in the public deficit of £53bn in the first 5 years, and more in future years. Government investment lifts economic activity and is self-financing.

This is confirmed in the latest revision to GDP data in the final quarter of 2009. The growth rate was revised upwards to 0.4 per cent, but still leaves the economy 5.8 per cent below its peak in the first quarter of 2008. However, without the increase in government spending over that period the economy all other sectors of the economy would have contracted by 7.5 per cent, with all the consequent job losses and business failures, if the fiscal stimulus had not taken place.

It should be stressed that this is not an evaluation of the effects of stimulus, but simple arithmetic. Government spending is a component of GDP and forms part of gross fixed capital formation. At the very least, if you cut government spending you cut GDP by the same amount.
But there is also an evaluation to be made of the effect of government on the rest of the economy. This can be done using the official Input-Output tables, for some key components of government spending as shown below.

Table 1. Multipliers Arising From Government Health, Education and Social Work Spending

Source: ONS

These show the effects on other areas of the economy when, say, government investment in education leads to increased private sector output of books or computers. This ‘multiplier’ is 1.854. In this way the increase in government activity was equivalent to 1.7 per cent of GDP, but led to an overall boost inactivity of 3.15 per cent. This means the recession would actually have been more than half as severe again without government action.

This is also the source of the ‘surprise’ increase in tax revenues between the December’s Pre-Budget Report and the latest Budget. Next year the tax revenues are officially expected to be £8.6bn higher after this year’s gain of £9.5bn. These are tremendous returns on investment, on average over 18 per cent in the first two years.

The private sector is unwilling to invest currently and remains on an investment strike. Investment fell again by 2.7 per cent at the end of 2009 even as other areas of activity rebounded, led by government spending. In total private investment has fallen by 26.3 percent or £54bn. This represents 70% of the entire fall in GDP.

By contrast, government investment has softened the impact of the recession. It is also boosting government finances. The private sector isn’t working; government investment can.