Tuesday, 4 October 2011

The UK Needs an Economic Growth Strategy . . . . so here it is! (2nd half)

This is a continuation of Part 1, found below. Basically, it's widely admitted that our economy is faltering and the government needs to do more to boost growth. I think it needs to do this, but in a manner that stays within the plans for cutting the deficit that is current government policy, the so-called Plan A. I've tried to cover every major area the government could act on to boost and secure long term growth in our economy, to give the (also so called) Plan A+. If there's anything I've missed or where you disagree with me, let me know.  What do you think?  


6) Radical Tax Reform.

Spending money efficiently is one side of the equation. Raising it efficiently is the other.  40% of UK GDP goes through the tax system every year. With £600 billion a year going through the tax system how efficiently this is done makes a difference of many billions of pounds a year. Because tax rates are so high their application to some economic areas but not others can have a powerful effect, distorting price structures and skewing economic activity on no particular rational or even deliberate basis. Almost all other public services in the UK have been thoroughly critiqued and over-hauled numerous times over the last 50 years.  Our tax system, on the other hand, has not. As it is not something that is tangible, and because it so directly involves money, which means with any change the losers shout a lot more loudly than the winners, there is a powerful incentive to not look at it too closely, and to not change it. This is the so-called tyranny of the status quo. This means our taxation system is a mix of what is practical with layers of historical accident and political expediency plastered on top.

This is not necessary though. IFS, the renowned think tank, has conducted a comprehensive assessment of the UK tax system, recently published as the Mirrless Review, looking at how the tax system could be designed to raise revenue with the minimum distortion to the economy while still retaining most of its traditional structure, and while achieving objectives of redistribution most efficiently. It outlines significant changes to Income Tax, VAT, Corporation Tax, Council Tax, Business Rates, Capital Taxes and the taxation of savings and financial services. These would remove numerous distortions thus saving the economy several billion pounds and raising billions more in additional revenue. They would also cohere remarkably with many of the other measures I have mentioned. Changes to Income Tax and NI would complement deregulation saving businesses hundreds of millions in costs; the over-haul of council tax and business rates would complement planning reform driving more efficient use of land and property; rationalisation of green taxation would cut the cost of Green Policy; a Financial Activities Tax would cut the cost of finance for businesses while making it more expensive for individuals to get into debt. In fact the possible effects of these changes are so considerable, especially with our current deficit crisis, that I mean to go over them in detail in a future article.        

7) Secure Radical Banking reform.

The ease of access to money makes a huge difference to the real economy and in a modern economy the circulatory system that disperses the supply of money is the banking system. The global recession was begun by a credit crunch that unsurprisingly most badly hit the heavily indebted developed economies. This disaster was compounded by the necessity of investing vast amounts of public money 'bailing-out' some of the major banks. To secure a reliable stream of finance for businesses, to ensure a healthy financial sector (a significant part of the economy), and to ensure that the disastrous bailouts are never repeated, radical banking reform is an essential pro-growth measure.

The government's program of banking reform has three branches.  The Bank Levy to raise extra tax from the financial sector, to disincentives the riskier forms of funding in  major institutions. The 'Merlin' agreement to go some way to reigning in bank bonuses and securing lending to the real economy, and the Vickers Report to reform the structure of the banking industry.  This report has recommended the 'Ring-fencing' of major banks, separating retail banking from investment banking. Retail banking is storing saving and lending money from and to individuals and businesses, what most of us think of as banking. Investment banking is the more high-octane, esoteric end of banking, investing in funds, shares, Derivatives, CDO's, currency and commodity speculation etc, often involving large amount of money being bet for very brief periods to secure very low margins of profit, but done over and over again making vast amounts of money very fast. Separating investment and retail banking will remove the risk of having to bail-out investment banking in order to secure the essential retail functions they are attached to. It would also incentivise major banks to shift emphasis onto retail banking and away from investment banking, due to the implicit government guarantee attached to retail and not investment banking and thus should increase the flow of funds to retail banking and thus reduce the cost to customers, i.e. the wider economy. It is essential these measures should be pushed through and implemented.  There is also a possible argument that more needs to be done to reform accountability and transparency in pay and bonuses in the wake of the decidedly mixed impact of 'Project Merlin', but I don't have anything particular to say about that.      

8) Secure Greater Investment: Including Green, Big Society and Regional Investment Banks.

One of the issues consistently raised as holding bank the economy is the difficulty small and growing businesses face gaining finance and investment, especially in developing industries and more deprived areas. Various proposals have been made to help rectify this problem by setting up various small, dedicated investment banks that would be commercial banks, initially funded by the state, that would be focused on leveraging funds to invest in certain industries or areas. The government has already committed to establishing a Green Investment Bank and a 'Big Society' Investment Bank.  The first would be focused on investing in green technologies, especially for power generation, and the second would focus on investing in social enterprises and socially responsible projects.

Various think tanks have suggested setting up regional investment banks to help fund private sector growth in particular regions. They would focus on financing sustainable growth in their particular region, with the suggestion that people in those regions would be more willing to place their savings with such a bank, knowing it went back into financing the economy in their own region. This would follow a similar model used with success in various European countries such as Germany. One question these ideas bring is how would these banks be initially financed? There has been considerable discussion among government about whether the Green and 'Big Society' Banks should be true Banks, able to borrow and lend and leverage their initial capital. There has been reluctance to let them do this for fear these debts would be added to general government debt. This seems a slightly odd objection though. When the bailouts occurred the government and ONS started quoting (for the first time) a figure for government debt specifically excluding financial interventions, and this figure has been used as the 'proper' national debt ever since. There's no obvious reason why such a distinction couldn't be made for these targeted investment banks, assuming they would pass into mostly private ownership as their success occurred.

Quantitative Easing has been suggested as a further, more radical solution for funding. The Bank of England has already run £200 billion of Quantitative Easing, basically printing money electronically. The BoE's previous scheme involved buying government bonds from various banks. There are question marks as to whether this actually worked though. Banks largely took the money to bolster their assets, rather than actually increasing lending, a phenomenon Keynes called 'pushing on string'. With the economy struggling so much again there have been calls for further QE. The problem with QE is that it also raises inflation, which is already high at 4.5%. One possible proposed solution is to engage in more limited QE but aim it more directly at the economy. A £50 billion QE program could be lent directly to businesses through a government investment agency, either a new fund or the government's existing network of regional development agencies, or more radically using it as original capital for the 'Big Society Bank', 'Green Bank' and a network of regional investment banks that could then leverage out that money to raise further finance. This would hopefully have a greater economic impact but because of the smaller over-all amount of money a considerably smaller impact on Inflation.          

9) Boost Government Investment +£5 bn
(Possible Business Investment +1£bn. Possible Science Investment +£1bn).

The measures so far outlined involve cutting costs to the economy, boosting the efficiency of public sector spending, boosting the supply of finance and lending to the economy and loosening monetary policy. All possible within the confines of the spending cuts and tax rises of the Coalition's Plan A, without any problem. Slightly more difficult policies that start to scrape up against the edges of that plan are also possible though. It is widely agreed by economists that government Investment is by far the most economically efficient from of government spending when it comes to boosting the wider economy, both in the short term and in improving the long term capacity for growth. In particular most of the loss of output in the recession came from a collapse in private Investment. If the government is going to undertake any financial stimulus at this point as the economy struggles then it makes a lot of sense to do it through boosting Investment.

The government's original spending plans contained some £17 billion of cuts to investment, about a 25% cut. This is somewhat understandable politically, as people don't tend to complain about possible future construction projects not happening, compared to schools and hospitals having their budgets cut. But economically it's silly. The government is already talking about straining every sinew in Whitehall to bring forward infrastructure projects to begin as soon as possible. But it's still rejecting boosting the spending available. This makes no sense. If there are identified projects that would boost the economy, in transport infrastructure, power generation, etc, then they should be begun now, especially if it makes the difference to the economy falling back into self-reinforcing recession. The government could increase investment by £5 billion each year to 2015, boosting the economy now and our capacity for growth in the years to the future.

Obviously pulling back on spending cuts threatens to break the confines of Plan A. But not directly. The government has two 'Plan A' fiscal targets that it has committed to meeting.  Firstly, balancing the structural, current budget; And secondly, debt falling as a percentage of GDP, both by 2015-16. The structural, current budget is the budget excluding 'cyclical' spending (the result of short term increases in unemployment caused by economic slump), and excluding investment. In other words the government can increase Investment spending without affecting this target. Obviously increasing investment spending risks missing the target for debt to be falling as % of GDP. But if the extra spending boosts growth and hence GDP, especially if the economy is teetering on the brink, then it may actually help hit that target both in year and through boosting the capacity for growth in each year to come.

There are other possibilities for boosting our core capacity for growth. Instead of, or in addition to, boosting state investment the government could take measures to boost private investment, such as increasing the generosity of tax credits offered for investment, in the hope this would encourage cautious firms to invest. Another suggestion has been boosting the Science budget, regarded as key to future innovation, development, research etc. Currently it has been protected in cash terms, meaning a roughly 10% real cut to 2015. It could be protected in real terms (a relative boost of £800 million) or increase it further (by say £1 billion). Both of these measures would possibly boost long-term growth, but they are more difficult because they are both current, rather than investment spending and hence risk both of the government's targets, unless they contribute a significant boost to GDP over the next 4 years.  

10) Rush Increase in Personal Allowance to £10,000.

If increasing Investment spending is not enough there are one final group of possibilities for boosting growth, and that is increasing government spending or cutting taxes. But obviously this goes straight against the confines of Plan A. But there are ways of minimising the danger of missing those essential government targets while supporting demand and confidence in the short-term. Research indicates that the most effective forms of stimulus are investment and tax cuts directed at poorer workers, as the poorer you are the higher proportion of your income you spend rather than saving and hence the more money actually spreads into the economy.

This offers an obvious solution to stimulate the economy in a manner that coheres with the Coalition's already stated aims. That is raising the Personal Allowance for income tax to £10,000. Now there is no space in the financial calculations, but the government could still push on with this extremely popular policy. They inherited an allowance at £6,500 and they've already increased it to £8,000, but they could announce in the Autumn financial review that immediately from 2012 the allowance will go up to the £10,000 target. They could also use the mechanism, used before, of reducing the 40% rate threshold by an equivalent amount so the top 15% (in income) don't benefit. This would give a £400 tax cut to millions of working households and cost about £9 billion. (Or if they don't think they can afford that raise the allowance by £1000 giving everyone a £200 tax cut and costing £4.5 billion.) I would also suggest at the 2012 budget following this cutting the top rate of tax from 50%->45% (assuming the forecasts for its revenue are accurate), in order to remove the possible damage caused by this uncompetitive rate of tax.

This would give a roughly £10 billion stimulus to UK consumption, which could give consumption the shot in the arm it needs to avoid collapse and, due to its crucial role to supporting the economy in general, the wider economy as well. The question is how this can be justified without breaking apart the essential constraints of Plan A. Firstly, the government currently has some leeway on this. Last estimates state that the government will hit its target a year early in 2014, and by 2015-2016 will overshoot it by 0.6% of GDP, about £8 billion. The government could formally abandon this aim to hit the target a year early, shift its aim to 2015, and spend that putative £8 billion overshoot now. It could also commit to making up the £10 billion committed now through the proceeds of the radical tax reform already outlined; immediately beginning the preparations needed to merge NI and Income Tax and bring in new House Value Taxes, A Business Land Tax, and Financial Activities Tax in 2014; to replace taxes currently on land, property and financial services, boosting revenue in time to hit the government's targets with new, economically efficient, rationally designed taxes, replacing the rubbish we currently have. Other moves could include looking again for cuts to such areas as generous benefits for the elderly that have so far escaped the axe.

All this would act essentially as not so much a genuine fiscal loosening but only a net shift of tax rises, from the start/middle of the Plan to nearer the end 2014 or so, when hopefully the economy will be in better shape to supply the tax revenue necessary, and doing so in manner that coincides precisely with the Coalition's already stated promises and objectives. These calculations also ignore any hoped for stimulus effect. If the economy is on the edge of decline these measures may be enough to hold it steady, and in that case the £10 billion (hopefully temporary) fiscal damage would do much less damage than a genuine second economic slowdown.  The government has made much of denying charges of economic dogmatism, claiming there is 'flexibility' in its plans.  Well, if that is true now is certainly the time to use it. Some government spokespersons have characterised this flexibility by saying the government would allow the natural stabilisers, rising welfare spending due to unemployment, falling taxes, etc, caused by a slowdown to occur.  But this is to have everything backwards. What point is there spending more money to slow the economy's descent once it has started falling? Surely it is better to spend the same money now to try to stop it from falling in the first place? (If we are currently convinced that we will have to spend the money one way or the other.)

11) One final thing: Co-ordinated International Action.

This last heading is so obvious that it almost doesn't need mentioning.  The major threat to our economy currently doesn't come from our own spending cuts but from the poor state of the world-wide economy.  A rising tide lifts all boats. A receding tide leaves everyone stuck in the mud on the bottom.  The largest cause of instability in the world economy today is the Eurozone debt crisis. Since the initial bold moves in May 2010 there has been no solution worthy of the name to come out of the Eurozone as the crisis deepens and deepens. Either Greece must be allowed to default, or it must be given the money it needs for as long as it needs it until it can restore growth. There is no 3rd option, and the failure to whole-hearted commit to one or the other, or indeed both, is what is doing the most part of the damage. Markets are forgiving of a good plan or a bad plan. What they scare at is prevarication, hesitation, being told things that everyone knows to be unsustainable nonsense, or the obvious sight of no coherent or credible plan at all. And bits of each of these is precisely what the EU has given them to the point where it is actually threatening the entire world economy.

So, firstly, the Eurozone nations need to get off their backsides and commit absolutely unequivocally to one of these solutions f they want to protect the Euro, or they must eject Greece as soon as possible. Secondly, the USA's politicians need to come down to planet earth, admit that the fear that the USA will be unable to repay its debts is the biggest threat to their recovery, whether that comes from future unsustainable spending, or madmen bringing their country to the edge of default in the here and now. Agree a serious long-term deficit reduction plan that includes both major tax rises and spending cuts and start to take a systematic look at the economic health of their country, rather than promising simplistic, magical solutions whether of one off stimulus bills or pointless tax cuts. To be honest in both cases politicians need to admit that it is their incompetence that has allowed things to get so bad, and that they need to massively shape up.

If that wasn't enough miracles to be hoping for at once: thirdly, Global leaders should agree a massive global, selective stimulus, re-balancing plan, whereby surplus, or low deficit, fiscally stable countries boost spending and their deficits and high-deficit, fiscally unsustainable countries cut theirs. Ideally by sufficient amounts to equal the reduction in demand in countries like the US, UK, Greece, Ireland, Portugal etc; or if this can't be achieved, by as much as possible. Now obviously the UK government does not get to decide whether these do or do not occur, so it is perhaps slightly unfair to file them under the heading of a growth plan.  But it can certainly throw its considerable international weight behind calling for them, and hence perhaps offer some of the global leadership that has been so sorely lacking recently.

Conclusion

With that I think that I have covered about every single major area of policy that the government could and should cover.  In fairness in many of these things are stuff the government is already trying or considering doing, but many are not. None of these things are particularly esoteric, but they will all annoy someone and involve fighting political battles, but the government cannot afford not to.  If the economy tanks again they will go down with it, and so will we all (to a degree). But follow through on all these areas and the government will put us in the best economic shape to face the 21st Century we can be in, for better or worse. But what do you think? Do you agree or disagree? And do you think there are any obvious areas I've missed?

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