Sunday, 6 March 2011

Structural deficit denial?

By George Irvin

The following article explains what is a ‘structural budget deficit’ and how this concept is misused by those attempting to justify Tory cuts.

* * *

In a recent Guardian piece, George Osborne accused Labour of a ‘reality deficit’ in attacking his deficit reduction plan, since they themselves proposed much the same.[1] Indeed, the notion that Britain must close the ‘structural’ budget gap by some combination of cuts in government spending and tax increases was accepted by Alistair Darling and not merely by Osborne. What’s wrong with Osborne’s argument?

A ‘structural’ deficit is defined as one not associated with recession. The view that the budget gap is mainly structural - as opposed to cyclical - has allowed Mr Osborne to argue that it was Labour’s spending, not the recession, which ‘caused’ the budget gap. In the words of Robert Chote, then Director of the Institute of Fiscal Studies (IFS) and main author of their 2009 Green Budget:

Labour entered the current crisis with one of the largest structural budget deficits in the industrial world and a bigger debt than most OECD countries, having done less to reduce debt and - in particular - borrowing than most since 1997.[2]

It should be added that the IFS, though often characterised in the media as one of Britain’s most influential independent think tanks, played a key role in promoting the notion that Britain’s structural deficit had grown far too large. The Office of Budget Responsibility (OBR), initially under Alan Budd but currently under Chote, has peddled the same argument.[3] But the most pessimistic view of all has come from the Treasury, which has argued that the structural deficit accounts for as much as two-thirds of the total deficit.[4]

What is the difference between the so-called ‘cyclical’ and ‘structural’ components of the deficit? During a downswing in the business cycle, tax receipts fall and social spending on items such as unemployment benefit increases, thus giving rise to the so-called cyclical component of the deficit. This component is self-liquidating since the opposite happens during the business cycle upswing. So the budget should balance over the cycle as a whole unless -and this is the crux of the matter - there is a further ‘structural deficit’; ie, a gap between current receipts and revenue which remains even when the economy returns to growth with full employment.

At this point, the argument gets a bit more complicated. During a run-of-the-mill recession, the economy may turn down for a period but soon recovers its previous path---the so-called ‘potential output’ path. In a serious and prolonged downturn such as the one we are experiencing in Britain, part of the country’s productive capacity is lost forever, thus permanently shrinking the tax base and reducing the employment and output potential. When this happens, economists have serious difficulty predicting both by how much potential output has fallen, and how long it will take to get back to the (now lower) full-employment non-inflationary growth path, sometimes abbreviated as NAIRU. Moreover, the story is even more complicated if any external inflationary pressure exists since it is claimed the non accelerating rate of unemployment (NAIRU) may be higher than that which prevailed before the recession.

For example, the Treasury and the OBR differ in their respective forecasts of the ‘recovery’ rates of growth the UK will experience between now and 2015. And on the Monetary Policy Committee (MPC), Andrew Sentance has recently argued that firmer action must be taken to combat the inflationary danger, inter alia, because the gap between current output and potential output, or output gap, may be smaller than we think.[5]

Nevertheless, there are serious reasons for believing that the notions of structural deficit, output gap, and NAIRU are all quite shaky. First, NAIRU is notoriously difficult to quantify, particularly at present when inflation is largely imported and wage pressure on prices is negligible.

Secondly, how large is the output gap? If the pre-2008 trend-line for output is taken as the reference point, the gap measured as a share of GDP is currently 11%. But the Treasury now thinks that 6.5% of GDP has been permanently lost, leaving the (reduced) output gap at 4.5%. If Britain’s output, employment and tax base has shrunk that much, it helps explain why the Treasury believes the two-thirds of Britain’s deficit is now structural; ie, the reduction in full capacity output means that Britain can no longer ‘afford’ to spend as much as it could in ‘normal’ times.

Thirdly, the budget (or ‘government savings’) gap cannot be separated analytically speaking from the other national accounting savings identities. For simplicity, assume that the external current account remains constant - in reality, a tenable assumption. For a given level of national income, if the private sector decides to save more (say in order to rebuild its savings), the public sector must spend more by definition. In short, policy makers lack the autonomy to reduce public spending without having an impact on other variables - in particular, the level of national income (as the Irish and Greek cases clearly demonstrate).

Fourthly, the structural deficit argument depends on assuming a fixed structure of revenue. But the tax-revenue response to each percentage point rise in income is not carved in stone; it can be changed through tax reform. In 2010, a study undertaken for Compass indicated that a further £50bn per annum in tax (about 4% of GDP) could be raised merely by raising the tax paid by the top decile group whose overall percentage tax contribution is currently smaller than that of the bottom 10% of households.[6] Indeed, a Tobin tax of only 0.05% would bring in even more.[7]

Finally, the obvious rejoinder to the argument that the structural deficit is higher because potential output (and output gap) is now lower is to call for more public investment directed towards increasing the economy’s output potential. Such investment - say in modernising infrastructure - would have two effects. It would both help to ‘crowd in’ private investment while, through the multiplier effect, raising national income and employment and thus tax receipts.[8]

Chris Dillow, a columnist for the Investors’ Chronicle, has summed up the case against the structural deficit concept admirably. As he argues, there are some countries with large structural deficits but low debt-to-GDP ratios in which the bond markets still have confidence, while there are others with much smaller structural deficits which the bond markets have turned against;

I fear, then, that the idea of a structural deficit serves a political rather than analytical function. It's a pseudo-scientific concept which serves to legitimate what is in fact a pure judgment call - that borrowing needs cutting. By all means, make this call. Just don't think that talk of a structural deficit helps enlighten us.[9]

The next time you hear George Osborne reassert the overriding need to eliminate Britain’s structural deficit during this Parliament, ask yourself whether his call is anchored in sound economics or merely in right-wing shrink-the-state ideology.

References

[1] See http://www.guardian.co.uk/commentisfree/2011/feb/28/labour-reality-deficit-ed-balls

2 See http://www.ifs.org.uk/publications/4623

3 See http://socialisteconomicbulletin.blogspot.com/2010/06/fake-independence-of-office-for-budget.html

4 See http://shrvl.com/69SCW

5 See http://www.bankofengland.co.uk/publications/speeches/2011/speech476.pdf

6 See http://clients.squareeye.com/uploads/compass/documents/Compass%20cuts%20WEB.pdf

7 See http://www.guardian.co.uk/commentisfree/2011/mar/02/deficit-cuts-banks-robin-hood-tax?

8 I am grateful to Michael Burke for emphasising this argument.

9 See http://shrvl.com/ax6HQ; also http://www.levyinstitute.org/publications /?docid=1258

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