The Criterion for judging a government’s budget.

Britain’s new Labour Government will present a budget on Wednesday 30 October 2024. How should it be assessed?

Finance ministers have to make decisions about spending, taxation and borrowing and on the manner that fiscal policy should interact with monetary policy and the institutional relationship the finance ministry should have with their central bank.This note will consider how these things should be assessed, if will focus on the particular circumstances of the UK, but much of it could inform the work of policy making in other advanced economies that are fully sovereign.

A Political Vision with numbers attached to it

A budget should be a statement of economic policy. It should explain how an administration thinks an economy works and how its policies will improve its functioning. At their best government budget statements offer a political vision, framed in economic analysis with numbers attached that exemplify a direction of travel that exemplifies political choice.

Realism about scale of decisions, economic rates of return and the multiplier effects arising from measures

The starting point for interrogating the significance of budget measures when they are presented is clarity about the context of individual measures and the expectation of what they will achieve. The capacity of policies to change the performance of an economy will depend on two things: their scale and and the multiplier effects that may flow from them. A policy that appears ambitious in a ministerial announcement may turn out to be modest in cash terms. Particularly when considered in the context of the overscale of GDP, and the economy’s total capital stock. In Cash terms UK money GDP, that is the flow of national income is over £2.7 trillion, The total size of the economy’s capital stock is probably around £11 trillion.

In terms of understanding the likely effects of fiscal measures, they will turn on their multipliers. For example in 1981 a decision to tighten fiscal policy by around £5 billion to reduce the public borrowing and the structural budget deficit, at the bottom of a large fall in output, was criticised by 364 academic economists. They asserted that it would make an economic recovery impossible. In fact a recovery in output started in the same quarter. It was driven by loosening monetary conditions, a falling exchange rate and powerful real balance effects arising from falling inflation. The fiscal tightening certainly slowed the pace of recovery in 1981 and 1982, but the economists who criticised it, used multipliers that exaggerated the effects of the budget measures, and as a result their estimates of the impact of the fiscal tightening, were misleadingly high. 

Full Cost of Public Expenditure is greater than its cash cost given the deadweight costs it involves

Measures to spend will involve resource costs and opportunity costs. Those real resource costs will be greater than their cash cost because of the deadweight costs associated with public expenditure and taxation. Different taxes will exhibit different deadweight costs. Changes in the composition of the tax burden should aim to minimise such deadweight costs. 

The Structural Problem of Public Spending in OECD economies: crowding out and limits on taxable capacity

The public sector is financed by taxation and receipts from the private sector. The central question in public finance is how much is spent. How it is financed between debt and taxation is a second order issue.In advanced OECD economies that sort of countries that can be described as the rich, comfortable mature democracies, public expenditure presents a structural problem. In the middle of the 20th century there were big increases in public spending. Governments took on responsibility for secondary education, higher education, health, social services and transfer payments to smooth incomes over the life cycle, such as support for low income households with children and basic pension incomes. In the 1950 and 1960s.This expansion of public services was associated with improvements in the functioning of economies across the OECD.

 Further increases in the scale of public expenditure and the functions of the state in the 1970s and 1980s exhibited less success. They were not associated with improvements in education, health and social mobility in the same way as in the 1950 and 1960s. Disappointing results from increases in spending at the margin were also accompanied by disappointing macro-economic performance in terms of economic growth, growth in employment and growth in incomes. Large public sectors in advanced OECD economies exhibited a structural problem where public spending and taxation crowds out private sector activity. In short there are limits to the taxable capacity of the private sector that finances the public sector. 

These were first exposed in the UK economy, the world’s first industrial economy, the first large economy to construct a comprehensive welfare state, and the first economy to go through a comprehensive de-industrialisation . This dynamic of public sector crowding out the private sector was initially explored by Robert Bacon and Walter Eltis in the book Britain’s Economic Problem Too Few Producers in 1976, during the UK’s economic crisis in the 1970s. Other economists looked at similar issues. A good example is Asser Linbeck’s work on Sweden and the Nordic economic model. Vito Tanzi, the Director of the Fiscal Affairs Department at the IMF for twenty years with Ludger Schuknecht in 2004 published Public Spending in the 20th Century: AGlobal Perspective. It offers a comprehensive international study of public spending, its costs and broad economic effects They broadly corroborated the crowding out thesis making the point that once economies are spending around 35 per cent of their national income, through the state, additional spending at the margin, yields disappointing results. 

For any significant planned increase in public spending in an economy where the ratio of General Government Expenditure to GDP is close to two fifths, the burden of persuasion should be on the finance minister to explain the expected rates of return involved. Given that the present the level of the present expenditure ratio, a British Chancellor of the Exchequer would have a challenge in terms of explanation.

Interrogating the profile of the ratio of public spending to GDP in the economic forecast

The profile of the ratio of General Government Expenditure to GDP in the official OBR forecast should be critically interrogated. In the UK context over the economic cycle it ought to be projected to fall from its present ratio of around 44 per cent of GDP. This involves examining the level of expenditure and the realism of the forecast for economic growth. The trend rate of economic growth in the UK is around 1.7 per cent. Any suggestion of an acceleration in it before it can be retrospectively interrogated should be treated with caution. Gordon Brown, for example, announced in the 2000s that his policies had raised the trend rate of growth to 2.75 per cent. This was not reflected, however, in tax receipts and it was exposed in Alistair Darling’s March 2010 Budget Rebook to be wishful thinking.

Collecting tax receipts from taxes that exhibit least deadweight cost and distortion

To raise a given level of revenue, which taxes exhibit the most deadwights costs and which involve the least deadweight. All taxation involves distortion. Neutrality is a property that finance ministers ought to seek in the structure of their tax system. 

Collecting tax in manner that involves least complexity

Another artifact of tax systems is their potential complexity. Finance ministers should avoid complexity and seek simplicity.

Merits of the use of neutral expenditure taxes such as VAT and GSIs

Economists tend to prefer expenditure taxes because of the double taxation that taxes on income and capital involve. In the UK context Value Added Tax is a broad neutral tax on expenditure of all the principal source of revenue receipts VAT is the tax that involves the least distortion and deadweight cost. It is not as comprehensive as a General Goods AND Services Tax on the Australian or Canadian models, but it is more neutral than excise duties or the old British version of Purchase Tax that VAT replaced in the 1970s and the sales taxes that many American state governments levy. If revenue receipts have to be raised VAT should be the first tax to be considered. A great problem for public policy in the US, for example, is the Federal Government’s reliance on income, corporation, capital gains and payroll social security taxes and the absence of a widely based expenditure tax such as a VAT or GSI.

Income and Capital Taxation involves double taxation of savings income 

Taxation of income and capital involves the double taxation of savings. A a malign artifact of the by John Stuat Mill in his book the Principles of Political Economy published in 1848. An income tax on individuals has to be supported by a profits or corporation tax regime and capital gains tax. These prevent economic agents from avoiding income tax.Without an effective corporation tax, people turn themselves into corporations to avoid paying income tax. Likewise rich people and company directors arrange for their regular income to be presented in the form of capital gains in the absence of a capital gains tax. A capital gains tax regime is needed to protect the revenue base of an income tax from being eroded. This is not popular with rich people in general and rentiers in possession of capital.

Income taxes, corporation tax, capital gains tax and capital taxes at death all involve the double taxation of saving and blunt the incentive to save and invest. Ideally the top marginal rate of income tax, corporation tax and capital gains tax should be broadly aligned. Corporation taxes present a particular problem for savers who hold part of their savings in equity. They encounter the conventional double taxation of saving inherent in an income tax system and an additional tax on dividend income that amplifies it. The problem with capital gains tax is that without generous indexation for inflation it becomes a draconian levy on capital based on paper capital gains in periods of inflation.

Corporation tax involves the aggravation of the double taxation of savings held in equities 

The double taxation of saving in the context of the UK income, corporation and capital gains tax regimes has become a problem. The sensible but complex measures taken to mitigate double taxation and the taxation of inflationary paper profits, made by previous chancellors have gone. The aggravated effects of Corporation Tax were mitigated by a complex tax credit on dividends paid from UK generated profits. This was reduced in the early 1990s by a Conservative Chancellor Norman Lamont and completely ended by Gordon Brown in 1997. This has contributed to the phenomena of ‘thin’ capitalisation, company balance sheets being overloaded with debt instead of being financed through equity and the atrophying of public equity markets. It is worth noting in a context of high taxation, sensible measures to mitigate aggravated tax burdens create complexity.

The problem of inflation and capital gains taxes

Nigel Lawson avoided the problem of taxing paper profits in capital gains tax by introducing a generous indexation regime for inflation, reliefs for entrepreneurs and then levied the tax at a taxpayer's marginal income tax rate. This was both sensible on grounds of equity and fairness and reasonable in not imposing a capital levy on paper gains. For accountants and professional advisers it did involve an element of complex and irritating arithmetic, which was unfortunate but it resulted in a broadly fair and neutral treatment of income and capital gains.

The taxation of income is a second best revenue raiser, its sensible use in a modern economy turns on restraint. There should be a high threshold in relation to average earnings before a person has a liability to tax, there should be a simple structure of tax bands and low marginal tax rates. The taxation of individual incomes, corporate profits, dividends and capital gains can only be coherent and broadly neutral if the system in its structure of tax rates and thresholds is simple and light. Income tax allowances and thresholds should be indexed for inflation to avoid ‘bracket creep’ or fiscal drag. This was the purpose of the Rooker-Wise amendment to the Finance Bill in 1977. It was undone by Rishi Sunak when he was Chancellor of the Exchequer. It has resulted in the restoration of fiscal drag to income income tax, made worse by an episode of high inflation. Any assessment of the budget should involve a careful analysis of projected forecast changes in real household disposable income..

After expenditure taxes such as VAT, income tax is the next best tax to levy although it will involve double taxation of saving.

Malign consequences of National Insurance and Payroll Social Security taxation

The least good taxes to raise to increase revenue receipts are payroll social security taxes on employees and employers. Over many years economic modelers in the UK identified national insurance as the most expensive tax to collect in terms of deadweight costs and the damage done to employment. High payroll social security taxation played a significant part in the structural unemployment problems in European economies in the 1980s and 1990s.. This is why the EU Commission and the Council of Ministers agreed in the 1990s that the approach to climate change and decarbonisation should be to raise carbon levies and fuel duties and then use the revenue receipts to lower payroll taxes, such as national insurance.Increases in either employees or employers’ rates of national insurance would have malign implications for the functioning of the labour market.

The Manhattan Skyline of Income Tax

The British income tax system now exhibits a series of marginal income tax rates that do not align with a person’s place in the earnings distribution. A person with children can pay rates of 20 per cent, 40 per cent, and then at £60,000 the marginal tax rate rises to 60 per cent as Child Benefit is withdrawn, then the marginal tax rate returns to 40 per cent, before rising to 60 percent as the personal allowance is withdrawn at £100,000 and then 45 per cent once the allowance has been tapered away. There has been a similar web of complex benefits and tax reliefs phasing in and out over the earnings distribution for years in the US Federal Income Tax, which has been cataloged by Laurence Kotlikoff. The result is something that looks like an approximation of the Manhattan Skyline.

Apart from the effects of social security transfer payments targeted by income, at the bottom end of the earnings distribution to relieve poverty, the UK tax system until 2010 did not exhibit this sort of distortion that damages work incentives for highly productively and well paid taxpayers. The withdrawal of Child Benefit at £50,000 by George Osborne in the Conservative-Liberal Coalition Government - since raised by Jeremy Hunt; and the withdrawal of personal allowances at £100,000 introduced by Alistiar Darling at the end of the Labour Government in 2010, have introduced significant damage to work incentives for people that the economy would benefit from fully employing. A test of any Chancellor is to see progress in remedying this Manhattan Skyline of marginal tax rates.

Fiscal Rules, Public Sector Borrowing and a direction that lowers public spending on average over the economic cycle.

Since the late 1990s the UK has had a series of fiscal rules that have never made much sense. At best they are a presentational attempt to reassure financial markets that they are acting prudently. At their worst they have been employed as a ratchet to raise taxes, in order to cut borrowing facilitating a permanent rise in taxation. The IMF noted twenty years ago that the defect in Gordon Brown’s fiscal rules was no rule curbing spending. The so-called golden rule only borrows to finance investment makes little or no sense given that much public sector capital spending involves current spending. The hospital without the doctor or the school laboratory without the physics teacher is close to useless. Public debt since the 17 century has been a useful way of smoothing pressure on the public finances to smooth the financing of war, the response to adverse economic shocks and recently for managing a public health emergency. 

Government debt represents delayed taxation and inter temporal choices about the financing of expenditure. It smooths the tax burden. In the modern world of highly liquid integrated global capital markets it is even easier for the UK Government to use debt finance than it was when the UK had a much more closed capital market framed by foreign exchange controls. In modern international capital markets where the total size of the sovereign bond ‘risk free’ market is well over $50 trillion, the marginal changes in bond yields arising from incremental movements in the borrowing requirement of the UK that presently stands at around $3.5 trillion, should not be exaggerated.

The best policy for the UK Government would be to junk the fiscal rules that relate to borrowing, a second order matter. They should be replaced by a commitment to reduce the ratio of General Government Expenditure to GDP on average over the economic cycle to something below two fifths of national income - moving in the direction of 35 per cent.

Monetary Policy,the Inflation Target and the relationship between the Treasury and the Central Bank

The Treasury sets the Inflation target for the Bank of England’s Monetary Policy Committee. The Chancellor of the Exchequer should review the target and explain the criterion used to assess the target and why it has been set.

Finance ministries with independent central banks have to accept that monetary policy and fiscal policy cannot be neatly and reliably consistently separated. That was the lesson of the financial crises and Great Recession between 2007 and 2010 when they became effectively fused.

The economic recovery from the economic crisis between 2010 and 2020 revealed that there could be protracted periods when monetary policy loses traction as a source of stimulus. In future finance ministries should be read to use unorthodox fiscal policies to raise household cash balances to stimulate spending and demand when monetary policy instruments have lost traction. 

HM Treasury is like the US Treasury Department is responsible for exchange rate policy. There may be future shocks to international commodity prices where the central bank should tighten domestic monetary conditions and raise the exchange rate to dampen the passthrough of higher prices on the domestic economy, while using fiscal policy to protect household incomes. The proportion of national debt denominated in index linked debt linked to the Retail Prices Index provides a reason for doing this in order to contain debt service costs of index linked debt in such circumstances. The Conservative Government between 2020 and 2023 when it confronted a series of international cost pressures displayed a damaging passivity in the face of international price shocks. The practical working relationship between the finance ministry and the central bank needs to be reassessed. Fiscal policy and exchange rate policy should not be assumed to be placed on some form of automatic pilot in the event of shocks or significant changes in circumstances.

Conclusion

These are the criteria that should be employed in assessing a budget statement by a finance minister. Despite the flummery of the historic office of Chancellor of the Exchequer, with its famous historic Gladstone Budget Box, the alcoholic beverage traditionally placed beside the Chancellor of the Exchequer's dispatch box in the House of Commons, their decisions pretty much come down to these questions.

Warwick Lightfoot

28 October 2024

Warwick Lightfoot is an economist and was Special Adviser to the Chancellor of the Exchequer between 1989 and 1992.