The political and economic debate on fiscal policy has become increasingly polarised in many countries, and as a result seems to have reached a dead end. Some economists are so concerned about the present rapid rise in government debt that they favour immediate fiscal tightening. Others are so concerned about the risk of renewed recession, and are so unconcerned about the risks from extra public debt, that they demand immediate fiscal easing on a large scale.
In many economies, this debate has now reached a stand-off, in which governments are trying to reduce deficits and debt only very gradually, while hoping that a recovery in private expenditure will keep the economy out of recession. The result, which satisfies nobody, is very slow GDP growth and a continuing rise in public debt ratios.
Only in countries where the risk of a debt crisis has turned into grim reality (i.e. the peripheral countries of the eurozone) has the stand-off been broken, with a much sharper move towards fiscal retrenchment. So far, the results of this shift have not been at all encouraging.
For the most part, politicians in the developed world have been loathe to break away from the impasse, either by accelerating the pace of fiscal tightening, or by heading boldly in the other direction. The UK is often seen as an exception to this rule. While the government and opposition both accept that there is a need to reduce the budget deficit, the speed at which this should be done represents a key polemical difference between the parties. Whether the difference is really as great as the polemics make it seem is another matter.
George Osborne’s rhetoric supports a more rapid fiscal tightening than Ed Balls’, though it is noticeable that the UK chancellor did not actually implement that tightening last year in the face of slowing GDP growth. Instead, he simply accepted the over-run in the budget deficit in the near term, and vaguely promised further unspecified public spending cuts after 2015. He is not quite as inflexible on the fiscal path as he is often painted.
Meanwhile, Mr Balls, the shadow chancellor, calls for a cut in VAT or other taxes, but this does not seem sufficient to place the economy on a radically different path from the one which is emerging from the government’s strategy. Although Mr Balls’ repeated warnings about the results of austerity in the 1930s suggest that he favours a much more full-blooded Keynesian response to the crisis, he knows that this is not something which the public would accept at present. At least for now, Mr Osborne’s Conservative party has won the political debate on borrowing, even if the substantive debate in the economics profession is far from over.
Should UK fiscal policy be eased in the immediate future? Certainly, it would result in stronger GDP growth for a while, and Mr Osborne would be wrong to deny this. The chancellor is right, however, to suggest that it would also involve a greater chance of a fiscal crisis which could ultimately prove very difficult to reverse. Just because the fiscal crisis has not happened yet, this does not mean that it will not ever happen. But the trade-offs between immediate GDP gains versus increased, and hard-to-measure, “tail” risks of a crisis later are opaque, complicated and very difficult to translate into practical politics (see this earlier blog). So both sides in British politics make large claims about the relatively small differences between them.
Enter Ian Mulheirn of the Social Market Foundation, a UK think tank. This week, he said in the FT that this is all rather depressing, and he is right. He therefore suggested a useful package, which would increase taxation in areas where the impact on demand is small, while also increasing infrastructure spending, where the impact on demand (and supply) might be fairly large. Since the infrastructure spending would be time-limited, this package would temporarily boost GDP, while also allowing the government to achieve the long term control over public debt which it desires.
The Mulheirn package makes use of what economists call the “balanced budget multiplier”. The budget deficit does not change, but aggregate demand does. Since almost half of UK GDP passes through the hands of the government, there is plenty of scope to reshuffle the government’s tax and spending activities to impact both aggregate demand and long term productivity, without increasing public borrowing.
The specifics of the Mulheirn package, though well argued, are perhaps less important than its central principle. (My own inclination is not in favour of raising taxation on the savings made by those in the upper part of the income scale, though this bias on my part could easily be purely selfish.) But the idea of using the composition or timing of tax and spending to influence demand while leaving the budget deficit unchanged in the long run is worthy of further investigation.
There is no shortage of ideas here. A temporary cut in indirect or corporate taxation, offset by subsequent rises, can increase the incentive to consume or invest now compared to the future. A rise in VAT offset by an equal cut in payroll taxes has the effect of raising the price of imports relative to exports, thus mimicking the effects of devaluation. This so-called “fiscal devaluation” can be very useful for countries locked into a currency union. See this IMF analysis.
It is easy to think of objections to these ideas. Some of them might have undesirable incentive effects at a micro-economic level. And the scale of the benefits to GDP and unemployment would be fairly small (0.7 per cent on GDP for 3 years in Mulheirn’s estimation), which would not satisfy those who favour much larger fiscal expansions.
But trying to achieve the best should not be the enemy of the good. These ideas about altering the fiscal composition would at least start to move economies in the right direction, and that is not to be dismissed lightly.
