Labouring under an illusion

The release of the Labour Party’s election manifesto today was a big deal. It has been described across much of the mainstream media as representing a swing to the left, proposing a significant increase in the role of the state including a big nationalisation programme and a major increase in government investment. It certainly represents a radical departure from the conventions of British politics over the last forty years by proposing fewer market solutions to economic management issues. As regular readers of this blog will know, I have long argued that the economic model of the past four decades, in which the market is predominant whilst the state plays a subordinate role, has run its course. But the plans presented by the Labour Party arguably represent a swing of the pendulum too far in the other direction.

Whatever one’s views, however, an impressive amount of work has been put into the economic plan. We can roughly divide it into two areas – redistribution and investment. Turning first to the redistributive element, the document outlining Labour’s funding plans is a serious piece of analysis, the likes of which I do not recall seeing in an election manifesto. It entails a significant medium-term increase in current outlays on areas such as education, health and social care and work and pensions. Total current outlays by fiscal year 2023-24 are projected to be £83bn higher than measures announced in all previous fiscal events – a 20% increase over current plans (on the narrow definition of spending outlined in the document - it represents an increase of around 10% in total spending).

In fairness, Labour has gone to great lengths to explain how this increase will be funded. Around a quarter is to be generated from raising the corporate tax rate from its current level of 19% to 26% by FY 2023-24 (bringing in £23.7bn). The next largest chunk comes from raising capital gains tax and dividend taxation in line with income taxation (yielding £14bn), followed by £8.8bn from a financial transactions tax. Of the other headline grabbing items, income taxes will be raised on those earning more than £80,000 per year (roughly three times the average wage) which is expected to yield about £5.4bn of revenue. It is notable too, that the plans attempt to allow for changes in behaviour in response to higher taxes so the figures quoted are net expected yield, rather than simply the gross yield. Like the underlying ethos or not, I thought that the funding plan was an impressive piece of economic analysis that people have put a lot of thought into.

The investment spending side of the plan confirmed the expected boost of £55bn per annum (2.5% of GDP). In effect, Labour intends to borrow only to fund investment with the redistributive element of the plan funded by higher taxes. Consequently, the simulation analysis I recently conducted on Labour’s plans still holds. Assuming that in the medium-term Labour injects £55bn per year into the economy, my analysis suggests this will raise the public deficit from 2.5% of GDP in the baseline to around 3.9% by FY 2023-24 (chart) and raise real GDP by 1.8 percentage points above the baseline. Incidentally, this implies a fiscal multiplier of around 0.75 (i.e. a fiscal boost of one percentage point of GDP increases output by 0.75%) which is not far out of line with estimates produced in an OECD paper in 2016 (and cited in Labour’s document).

In order to assuage market concerns regarding its plans, Labour has proposed a fiscal credibility rule which will (i) eliminate the current budget deficit within five years; (ii) maintain interest payments below 10% of tax revenue and (iii) improve the strength of the government’s balance sheet during the next parliament. Part (i) is, in my view, achievable but (ii) will depend very much on how markets decide to set interest rates. Part (iii) is economically very interesting. Labour recognises that there are significant costs associated with its nationalisation plans but in buying up companies the state also acquires an asset. It thus proposes targets that take into account the net balance sheet position of such transactions. The idea is based on work by the Resolution Foundation (here) and it is a genuine fiscal innovation. There are indeed good reasons for incorporating it into the fiscal framework since the public sector balance sheet is increasingly a tool of macroeconomic management (an approach pioneered by central banks in recent years). 

But just because the plan is interesting and innovative does not mean it is sensible. It is a good old-fashioned soak-the-rich strategy, allied with a plan to tax financial institutions and the corporate sector. Paul Johnson of the well respected Institute for Fiscal Studies said in a radio interview that the manifesto will produce “just about the most punitive corporate tax regime in the world”. It will crucify the City of London, where financial services generate 40% of the surplus on services trade and which in turn offsets a large part (though not all) of the deficit in goods trade. Simply put, the UK will be a far less attractive business location. A combination of this economic plan and Brexit would undo decades of work to improve the UK’s standing as a business-friendly location (although Labour does promise to put any Brexit deal it secures with the EU to a public vote and include an option to remain).

It appears from the latest opinion polls that Labour has little chance of getting sufficiently close to the levers of power to actually implement its plans. But it will move the dial. The electorate has had enough of the austerity forced on them over the last decade and the Conservatives will be forced to respond with a policy which also implies additional public spending. As even the FT’s economics correspondent Chris Giles pointed out in an article today  “taxes cannot be something that other people pay.” If the UK is serious about improving the quality of public services, notably the sacred cow which is the NHS, taxes will have to rise. But everyone has to make some contribution and it is dishonest to suppose that only big companies and the rich should pay the taxes that everyone else benefits from. 

It is right that we have a proper debate about the role of the state in the economy. The benefits of a low tax, light-touch regulation regime worked for a long time but in the wake of 2008 the limits of this system were shown up. It’s just that Labour’s 1970s-style socialism is not the way to go either.