Patrick Minford is Professor of Applied Economics at Cardiff University
The chorus of ex-Remainers who dominate the UK civil service and its outriders like the Office of Budget Responsibility (OBR) has begun its ululations over the need for the upcoming Budget to ‘pay off the COVID debt’; and in so doing, abort the recovery process. Their damaging advice must be resisted.
Of course it is true that that the COVID debt is immense. In 2020 government spending related to the coronavirus crisis rose by a mouth-watering £280 billion, 17% of GDP, pushing the ratio of spending (excluding debt interest) to a falling GDP up to 56% from the normal 38% that had prevailed in 2019.
Government receipts were also badly hit, falling to 37% of GDP again from a normal 38% in 2019; with GDP itself falling 11% in 2020, this meant that receipts fell by about 14%, or about £106 billion. The PSBR consequently soared from £43 billion in 2019-20 to a probable £400 billion approx. in 2020-21- a huge, unprecedented number.
But of course it was an unprecedented shock and we should not be marched into ill-judged policy reactions; the UK’s situation is not unlike that of the US and other developed economies, and so it is of some general interest to look at the UK’s figures close up.
The starting point for analysing future public budgets must be a judgement on how spending and taxes will behave as the effects of the virus and the associated temporary measures fall away. There is still uncertainty about the speed with which this will happen; the most recent report from the Bank of England forecasts that the economy will be back to pre-pandemic levels by the end of 2021, given the rapid rollout of the vaccine. This seems to be a reasonable current assessment.
Then we can expect catching-up with two years lost normal growth of (jobs and) GDP of say 5% over the course of 2022 and 2023, on top of what would have occurred anyway.
These developments should mean that by financial year 2022/23 the economy should have returned to normal spending and receipts relative to GDP. Excluding debt interest that would mean spending of 38% of GDP; and a very similar revenue/GDP ratio. This situation of ‘primary balance’ in net spending (‘primary’ meaning ‘with the exclusion of debt interest) was what prevailed before the COVID crisis in 2019.
This seems to be a reasonable ‘normal base case’ assumption, bearing in mind that the COVID recession drove not only GDP but also the spending and tax reaction to it. Withdraw that recession created by the disease and especially the lockdown reaction to it, and the best estimate of the restored situation is the previous one.
However, the OBR projects future spending (excluding debt interest) by 2022 at 41% of GDP. It is hard to see where this comes from. It appears to have simply pushed up its estimates of departmental spending. In fact it says (para 372, November Report) that spending plans have been lowered but as a % of GDP have gone up as GDP has fallen:
“From 2022–23 to 2025–25, TME [total spending] is materially lower than we forecast in March — by £18 billion a year on average — a difference that is more than explained by departmental spending being cut relative to March totals and by much lower debt interest spending. But thanks to the weaker outlook for nominal GDP, despite lower cash spending, the ratio of TME to GDP is actually higher than we forecast in March, settling at around 42%.”
However, this logic really implies that as GDP picks up rapidly, as now looks likely, the ratio of spending to GDP will fall back. So it is that, in the absence of government commitments at this point to such a high spending ratio to GDP, we assume a return to normality. From that we can judge the scope for higher spending growth or tax cuts.
So just as the fall in GDP produced the huge rise in spending and fall in tax, so its reversal should reverse those two variables as well. In my Liverpool Group’s forecast we follow the Bank in its latest much stronger recovery projection, and on spending we project a return to the normal spending ratio.
Table 1. Summary of Forecast by Liverpool Macro Research
1. Expenditure estimate at factor cost
2. Sterling effective exchange rate, Bank of England Index (2005 = 100)
Our projections of the PSBR on this basis give us £18 billion in 2023/4, 0.7% of GDP. The debt ratio by 2024/5 would be about 90% of GDP, down from around 100% today; debt before the crisis was £1.7 trillion, and the extra debt by then would be another £0.7 trillion, making £2.4 trillion in all, or against GDP by then of £2.7 trillion, 88% of GDP. With nominal GDP growth of 5% p.a., and the PSBR running below 1% of GDP, the debt to GDP ratio would reach 60% in a decade from then. But the important point is that the UK is in a totally solvent situation.
Long-term solvency is consistent with a bold fiscal policy pursuing supply-side reform while supporting demand
The key issue is that of long-term solvency; solvency is or should be the objective of any fiscal rules the UK’s HM Treasury should pursue after such a major shock as COVID, which has forced a massive fiscal response.
Facile talk of short run rules of thumb such as balancing the current account or only financing investment spending by borrowing, do not face up to the long-term issue of how best to deal with the large COVID-created debt without wrecking the economy. Let us spell out how this arithmetic works.
Solvency implies that the Treasury will always be able to obtain sufficient tax revenues to pay for its spending plans and also pay the promised interest on its debt. This is equivalent to saying that the market value of the debt is equal to the present discounted value of future taxes minus that of future spending excluding debt interest; in other words the present value of future primary surpluses is ‘backing the debt’ in much the same way that the market value of a company’s equity is backed by and equal to the present value of its future profits.
A rough and ready way of checking this is to project the finances forwards, as we have done in Table 1, and check that in the long term there are primary surpluses, as indeed is implied by our projections for the PSBR from 2024, which is by then below debt interest payments.
As long as there are continuing surpluses indefinitely in excess of interest payments, it is implied that future taxes will pay for both spending and debt interest and then also pay off debt steadily, so ensuring that the Treasury could if it wished pay off all its debts in the long run.
The government has considerable fiscal flexibility owing to very low interest rates. It can without any threat to its solvency both cut tax rates and raise spending to support growth, trade opening and deregulation post-Brexit/COVID
However, of course this very fact also that it does not need to, and can simply roll it over in the market at going market prices based on its assumed solvency.
In considering solvency it is necessary to ask how tax and spending respond to prices and output, or nominal GDP. On the one hand spending is negotiated by the Treasury with departments in nominal terms, so that rising GDP should have little effect on them; their present value is this nominal commitment discounted by the interest rate.
On the other hand, tax revenues respond more than proportionally to nominal GDP because they are progressive. In principle the tax bands are indexed to prices, but this can be and often is in practice overridden or delayed so that this reaction then applies to prices as well as real GDP.
This implies that when the long run interest rate is low as now (it is around 1% pa) and nominal GDP growth is resurgent as now, the projected growth in revenues is bigger than the discount factor, implying that the present value of revenues becomes infinite.
This situation is one where ‘the solvency constraint does not bind’, in the sense that there is a projected (indefinite) excess of future taxes to pay for interest and spending.
This is the situation HM Treasury finds itself in today; and this explains why it has great freedom of action in dealing with the economy’s critical re-entry into the post-COVID and post-Brexit world. It is vital that every means is used to support the economy both on the demand and supply side to ensure solid growth continuing and strengthening beyond the immediate recovery period.
Enormous policy opportunities are opened up by Brexit, as reviewed below; and it is vital that they are not neglected owing to irrational short run penny-pinching accountancy.
It is not simply that taxes can be cut and spending raised without endangering solvency, given the outlook for recovering GDP. Given the long lists of spending needs and the dangers to business confidence from tax threats, the government will need to spend more, and lower key tax rates that damage business incentives, as a minimum response to the situation.
It can afford to do so anyway. But the further key strategic point is that policies that boost growth further loosen the solvency condition. The solvency constraint depends on growth. 1% p.a. higher growth implies that consistent with today’s debt the tax rate (t) can fall by 10% of GDP with the same spending rate (e), or spending rise by 14% of GDP with the same tax rate. This effect becomes bigger with yet more growth; thus 2% more growth p.a. produces a further potential fall in taxes of 20% of GDP, with spending constant at today’s level.
What this means is that if tax cuts or spending increases can raise growth, they are consistent with solvency. While they are financed they create more debt but this is offset by the higher net revenues created.
The situation is illustrated in Figure 1. It shows in the ‘Solvency’ line that as growth rises e-t (net primary spending/GDP) can rise consistently with long run solvency because growth raises net revenues; then both rising e and falling t cause growth to rise, as shown in their two lines, with tax cuts having the bigger impact as they rise, compared with spending whose beneficial effects face diminishing returns. Fiscal policy needs to move to the optimum where tax cuts are generating maximum growth.
Figure 1. Illustration of growth possibilities
What this means is that bold reform policies that cost money in the short run and raise growth in the long run are eminently affordable. This applies to tax reforms aiming to reduce marginal tax rates to boost incentives for entrepreneurs, to collaborative government spending aimed at innovation such as the COVID-vaccine government-pharma collaboration, and generally across spending or tax changes that raise growth but cost short run money.
These can be financed by borrowing with no threat to solvency. What we find from our research on growth is that both national and northern growth are boosted by tax cuts through their effects on incentives and competitiveness, while the effect of extra spending on eg. infrastructure is limited by the size of the (eg. Northern) economy.
Hence once spending reaches a certain level its effectiveness on growth declines compared with extra tax cuts. So while growth permits rising net spending consistently with solvency, it is most beneficial to cut taxes after initially higher spending, as illustrated in Figure 1. In what follows we look at key areas where action is needed.
Key supply-side policy changes in the new era and their fiscal implications1 – trade, regulation and tax reform
Fiscal policy is bound up with all aspects of supply-side policy, for a very simple reason: in order to gain consent to policies that free up markets and put pressures on vested interests, the government often must grease the process with transitional help to those interested parties: that comes at fiscal cost.
We live in a democracy where veto power is widespread; to overcome it people and firms often need help to make the transitions required. Indeed, many of the economic distortions in the EU come from it having no fiscal power to raise taxes and spend money at will in this way.
Instead, the course of least resistance to vested interest demands is to award protection, either through trade barriers or through regulation. The EU environment is heavily encrusted with such distortions as a result.
Trade after Brexit
At the heart of the powers the EU wielded over the UK as a member was the control of commercial policy, that is tariffs and non-tariff barriers, including standards set so as to exclude supplies from certain other countries, notably the US, also anti-dumping duties and quotas on supplies from particular countries.
EU commercial policy is designed to create large trade barriers against non-EU competitors, both in agriculture and manufacturing. In services such as financial, which are not such important EU industries, EU commercial policy is fairly liberal, though national governments remain highly restrictive of foreign competition, including from the rest of the EU; it is only recently that the single EU market has been extended to some services, so restraining national protection against the rest of the EU.
UK service industries operate worldwide and so are little affected by this mainly national protectionism. UK service prices are therefore set by international competition at world prices; this has not changed now we have left the EU.
However, UK goods prices are still currently dominated by EU prices, which are higher than world prices by the percentage of trade barriers, which are estimated in our research and elsewhere at around 20% for both food and manufactures.
Now we have left the EU, we need to negotiate wide Free Trade Agreements (FTAs) with non-EU suppliers so that they gain free access to our markets. This will bring UK prices down 20% to world levels- equivalent in these effects to unilateral free trade.
According to the GTAP model from Purdue University, Indiana, now used by the Treasury for its calculations, this will bring gains of 4% of GDP, through better prices to consumers and competition-led rises in productivity by UK producers.
According to Cardiff research the gain would be double, while simply abolishing half the EU protection would bring in the same gain. Notice however, that any reduction of barriers will meet a hailstorm of business opposition, which largely accounts for the near-total opposition of UK business to Brexit.
The government will need to meet this hailstorm with offers of transitional help, smoothing the business path to higher productivity. A well-known example is electric cars, where the government has pledged support.
Regulation
Regulation is the second major area controlled by the EU, through its powers to regulate the Single Market. It exercises these powers according to a ‘social market’ philosophy. A nation state has the power to tax/subsidise, and it can use this power to redistribute income to the less well-off.
However, as already noted, the EU has no tax powers because national governments have been unwilling to pass them over to it, even partially. Therefore, to achieve social objectives of a redistributive nature the EU uses regulation; examples are labour market ‘rights’ which are essentially subsidies to workers paid for by implicit employment taxes on firms.
Then in order to compensate firms, it awards them protection either through trade barriers or favourable product regulation of standards- effectively creating non-tariff barriers against world producers who meet wider international standards.
Thus one finds that labour market regulation is a series of subsidies to workers and trade unions, paid for by firms. The effects on the economy can be assessed according to the labour tax equivalent, plus the direct implied transfer to worker-households.
It was largely to carry out this assessment that my research team built the ‘Liverpool Model’ of the UK economy; this was the first macro-model of the UK to have a full ‘supply-side’, designed to compute the effects of tax and regulation on the economy’s potential output.
The EU’s regulation extends beyond the labour market, to three main other areas. The first is general product market standard setting, which as we have seen is related to setting non-tariff trade barriers. The general aim of standards is to benefit the main producer industries of the EU.
Thus, these industry lobbies essentially have had the power to legislate what suited them. As Adam Smith noted centuries ago, such power in the hands of business is likely to be anti-competitive; one notices that the EU Competition Directorate takes its most stringent actions against foreign, often US, companies – such as Apple, Google and Facebook.
One can in principle assess this producer regulation as the equivalent of endowed monopoly power, like a consumer tax. In practice, estimates of this are hard to make, other than via the direct effect of the trade barrier; this barrier also puts an effective limit on the extent to which home industries can raise prices. So we have not estimated any additional effect of regulation as such via this route.
The second area beyond labour is finance, a service where the EU has shown a strong desire to control activity, though, or perhaps because the biggest EU finance industry has been in the UK. It has intervened with highly prescriptive regulations in this major UK industry, in a way extremely unpopular among its practitioners- supposedly to protect consumers.
These regulations have given rise to an army of ‘compliance’ executives; but while this has raised costs substantially, gains to consumers have been unclear; in other major markets, such as the US, similar interventionism has been avoided.
We can leave on one side here the new regulations on banks associated with the financial crisis, which relate to monetary policy and in the UK were mostly self-inflicted.
Finally, there is the rest of the economy; the environment and climate where the EU has regulated strongly to force the adoption of non-fossil-based energy; and the regulation of technology, especially in agriculture and pharmaceuticals, where the EU has given primacy to the precautionary principle, and held back technological innovation.
The main effect in the first has been to raise energy costs substantially, instead of primarily focusing on developing new technology, which would be most effective in the long term and least costly in the short term. In technology, EU regulation has held back innovation.
In all these areas we have proposed estimates of the cost to the UK economy. Overall, we suggest a cost of 6% of GDP, of which we suggest 2% can be rolled back now we have left. In a parallel piece of analysis of the Thatcher reform programme we find comparable gains, suggesting this order of magnitude is indeed feasible.
Bringing in this deregulative agenda will not be costless to the Treasury since the beneficiaries of regulation, including middle-class consumers, are vocal defenders of it. To help get agreement there may well need to be transitional subsidies.
Tax reform
The UK needs a tax system for the 21st century, that delivers large and stable revenues without penalising either savings or incentives for successful people. This can be done by rebasing the income tax system on consumption, and cutting marginal tax rates in the process.
Such a reform has been endlessly put off, because it requires a largescale legislative effort, and could also have involved difficulties of EU agreement through its invocation of state aid rules. Post-Brexit, and the need to improve UK competitiveness to maximise growth and recovery, there is a strong case for going ahead.
A good tax system is one that creates the minimum damage to everyone’s incentives to work and save– the ‘Ramsey Principle’ – consistently with financing government spending and achieving the necessary income redistribution.
This is achieved by taxes that are ‘flat’ (ie. the same proportional rate) across people of all incomes (the popularly known ‘flat tax’); that are flat across commodities of all sorts (‘tax neutrality’); and that are flat across time.
This last means that the tax rate is constant over present and future consumption; it implies both that tax should be levied on consumption and that the tax rate should be planned to be constant under forecast conditions (‘tax smoothing’).
Taxes can be cut without being balanced by simultaneous cuts in spending because extra work and less avoidance create an offsetting recovery in revenue (the Laffer effects); and because higher growth generates more future revenue, as we saw above. This is an important implication of tax smoothing.
A UK flat tax on consumption would bring the imputed rent on owner-occupied housing into the tax base and would allow the standard rate of income tax to be cut cautiously to a 15% flat tax rate on consumption, thereafter being cut further in stages as the growth effect rolled in.
Such tax reforms can be brought in with no losers, no cutback in public spending programmes and the key gains from higher growth. From a political economy viewpoint there is therefore a strong case for pressing ahead now, after many years of deferral.
Conclusions: the way ahead for UK policy
Translating all this into practical politics, we can summarise the situation as one in which the government has considerable fiscal flexibility owing to very low interest rates. It can without any threat to its solvency both cut tax rates and raise spending to support growth, trade opening and deregulation post-Brexit/COVID.
The key priority is therefore to boost growth through effective supply-side policy. Fiscal policy should also support demand at the same time as this supply-side policy, both to keep the recovery going and to push interest rates up towards monetary normality.
Endnote
1. These issues are discussed at greater length in Patrick Minford (with David Meenagh)’ After Brexit- what next? Trade Regulation, and economic growth’- Edward Elgar, December 2020.