The squeeze is on

The politics …

It is hard to recall a time when a government has been so out of touch with the electorate as that led by Boris Johnson. As the squeeze on incomes posed by inflation rises up the agenda and the government doubles down on Brexit, there is a sense that a lot of things are becoming unglued. In a series of events guaranteed to cause apoplexy amongst party communications managers, Conservative MP Lee Anderson suggested that people needed to learn how to cook and budget "properly", rather than use food banks whilst his colleague Rachel Maclean recommended that people could improve their circumstances by working “more hours or moving to a better-paid job.”

Up until six months ago, despite the warnings signs of incompetence, the Conservatives were still ahead in the polls. The Owen Paterson affair provided the first sign that the electorate was fed up with being taken for fools – a trend which was reinforced by the Partygate scandal. Despite the flow of bad news, however, the Tories are not as far behind in the polls as might be expected. Indeed, Labour’s lead has remained steady at around six percentage points and were this to remain unchanged, it would unlikely be able to form an outright majority following the next election. For the record, Electoral Calculus currently predicts that Labour will win 315 seats – six short of an outright majority (for what it is worth, my own assessment is that Labour might struggle to top 300 seats).

… and the economics

Despite all the political noise surrounding Partygate which has sent the commentariat into overdrive, it is good old-fashioned economics which poses the biggest current threat to the Conservatives’ electoral chances. The cost of living squeeze, triggered by a 40-year high inflation rate in April (CPI at 9% or 11.1% using the RPI measure), is the biggest current problem. In fairness, this is largely the result of exogenous factors beyond the government’s control, particularly with regard to energy prices. However the government does have control over its response, and as the comments from the two MPs above illustrate, this has been sadly lacking.

The main criticism is that it has done little to nothing to protect low income households from the full impact of the squeeze. An uplift of 54% in the energy price cap last month is a regressive move that will hit poorest households the hardest, whilst low income families also have to contend with a food inflation rate running at 6.6%. The March Budget represented a wasted opportunity to provide some support whilst at the end of April, Chancellor Rishi Sunak suggested it would be “silly” to provide support on energy bills before knowing what is likely to happen to prices in the autumn (this from someone who, along with his wife, has just been named as the 222^nd wealthiest person in the country). In fairness, the government has granted a £150 Council Tax rebate this year but according to the OBR much of this will be clawed back over the next five years via a new tax on energy bills, which on a Ricardian equivalence basis does not represent much help at all.

In addition to blaming the public for their inability to cope with the inflation crisis, senior Conservative politicians have tried to pin the blame for the inflation spike on the Bank of England. It was accused by the Chairman of the Treasury Committee of being “asleep at the wheel” whilst the Tory peer Michael Forsyth accused it of “unleashing inflation in our country through failing to meet its proper mandate.” I will deal with the BoE’s position in a future post, but suffice to say that although it has made mistakes, this represents a blatant attempt by the government to deflect blame for its own failures.

Aside from the welcome support provided during the early stages of the pandemic, fiscal policy has generally been too tight over the past decade. George Osborne’s misguided austerity policy meant that the BoE was required to do much of the heavy lifting on policy in the wake of the GFC and the failure to provide sufficient fiscal support in recent months is one reason why the central bank has not been more aggressive in raising interest rates. There is general agreement that fiscal rather than monetary policy is the appropriate tool to provide targeted help to those most in need, and it is incumbent on the government to act rather than apportion blame. It is not as though there is a lack of options.

What can they do?

In the first instance, the government could reintroduce the uplift to Universal Credit payments used during the pandemic with NIESR calling for a rise of £25 per week which it estimates would cost £2.7bn this fiscal year. The Chancellor would doubtless argue that this will simply raise the fiscal deficit. However, it would do so by less than he thinks given that higher-than-expected inflation will boost revenues via fiscal drag following last year’s decision to freeze tax thresholds. An additional measure would be to temporarily reduce VAT on domestic fuel bills to zero and sell it as a Brexit win (EU rules do not permit this to fall below 5%). Removing the levy to fund renewables investment and energy efficiency improvements from household bills, as energy suppliers have called for, would shave another 7.8% from outlays. Adding in the Council Tax rebate, these measures would limit the latest rise in household energy bills to 23% rather than the 54% mandated by the energy price cap.

Labour has called for the imposition of a windfall tax on the profits of energy companies – a measure which the government has so far resisted. There is some merit behind the idea of such a tax. Shareholders who happen to be holding stock at the right time have simply benefited from an exogenous factor beyond their control whilst energy consumers bear the cost. With energy companies making big profits and BP’s profit having doubled in the first quarter of the year, it may be an idea whose time has come (again). Such windfall taxes have been tried before: In 1997, the Labour government imposed an additional levy on the profits of recently privatised industries, arguing that they had been sold off too cheaply. In 1981, Margaret Thatcher’s government taxed the additional profits made by banks as a result of rising loan spreads which were a result of rising short-term rates.

However, there are also many good arguments against the idea. The basis of a good tax system is that it should be fair, certain, convenient and efficient but a windfall tax would violate some of these principles. Most voters would agree that a windfall tax is fair; it is also convenient in that it would be easy to collect. However, it would introduce uncertainty about the future tax regime which would undermine the basis of the system. It would also be fiscally inefficient since it could hamper investment in cleaner energy where energy companies are in the vanguard. Finally, since a windfall tax is designed to tax supernormal profits, how do we determine what is a normal level? There is also the problem that the revenue derived from taxing energy companies would come too late to provide relief for households that are struggling right now. My own conclusion is that whilst there is a discussion to be had about levying higher taxes on energy companies, it might be more efficient to do so via the usual channels by which changes are advised well in advance. In the meantime, some of the other measures outlined above might be more appropriate.

Act now or risk an electoral drubbing

There is no doubt, however, that households are struggling to make ends meet. Consumer sentiment has fallen to its lowest level since the data were first reported in 1974 (chart above) and forecasts from both NIESR and the BoE reckon that the UK will come very close to recession by end-year (even if a technical recession is avoided). Whilst acknowledging that many of these factors are beyond the government’s control, it does control its response. Since the government sold Brexit as an idea that would make people better off whereas the opposite has occurred, there is increasingly a sense that it has a duty to step in (Brexit will undoubtedly be the subject of another post). Failure to deliver on this most basic of Brexit promises is likely to mean the electorate will not be in a forgiving mood the next time the government asks for their vote.

Pleasing nobody

In its assessment of Chancellor Rishi Sunak’s Spring Statement (as the March fiscal set piece event is now known), the OBR pointed out that the first quarter of the 21^st century has seen the economy subject to a number of unprecedented shocks of which the war in Ukraine is just the latest. Each shock appears to be worse than the last but with inflation expected to head towards 40-year highs, the economic fallout from the Covid pandemic and the Ukraine war have combined to produce a hit to living standards, the likes of which many people have not seen in their working lifetime. In the course of March 2020, Sunak unveiled a package of measures appropriate to the scale of the problems facing the economy. His efforts in March 2022 were a woefully inadequate response to current problems, managing to be both ineffectual and badly targeted.

The nature of the cost of living squeeze

Last year Sunak announced that he was freezing income tax thresholds at 2021-22 levels until 2025-26. This would be bad enough if inflation was running at or slightly above the 2% target but with CPI inflation set to average more than 7% this year – the fastest pace in almost 40 years – a lot more people are likely to find themselves dragged into the higher income tax bracket if wages follow suit. Last September, Sunak also announced that he planned to raise National Insurance Contributions from April 2022 which I argued at the time was an unnecessary risk when the economy was only just recovering from a severe recession. Most worryingly, domestic energy bills are set to rise by over 50% from next month with the prospect of further big hikes in October. Altogether this combination of events is helping to stoke what many commentators are calling the UK’s biggest cost of living crisis in decades, with low paid workers set to pay the biggest price.

Sunak’s response was risible. He announced a temporary 5p per litre cut in motor fuel duty which (a) sends the wrong signal for a government which likes to talk up its green credentials and (b) does nothing to help the least well off who are more likely to spend money heating their homes than running a car. If the Chancellor was serious about helping this group he could have announced a temporary suspension of VAT on domestic fuel bills and thereby use one of the few additional policy levers derived from Brexit (EU rules require setting VAT on domestic fuel at a minimum of 5%).

To add insult to injury, Sunak announced that from April 2024 he intends to reduce the basic rate of income tax from 20% to 19%, thereby increasing the wedge between the taxation of earned and unearned income. The economic rationale for this is questionable and such is the uncertainty surrounding the economic outlook it may not even be affordable. It was also a blatantly political move, designed to burnish Sunak’s leadership credentials and his party’s standing ahead of an election in 2024, allowing him to continue making the claim that his is the party of low taxation. This is, of course, not true. According to the OBR, the overall tax burden is set to rise from 33% of GDP in 2019-20 to 36.3% by 2026-27 – its highest level since the late 1940s.

The OBR goes on to point out that “net tax cuts announced in this Spring Statement offset around a sixth of the net tax rises introduced by this Chancellor since he took over the role in February 2020, and just over a quarter of the personal tax rises he announced last year.” The FT’s putdown of Sunak’s credentials was funny, damning and accurate: “Sunak is a low-tax Chancellor, in the same way that people who play air guitar in their bedrooms are rock stars. He tried his best. He cut fuel taxes by 5p per litre, which means that, when your house is flooded by climate change, it’ll be cheaper to drive far away from it.”

The bigger economic picture

There is a lot of very good analysis on the state of the economy and what the spring statement implies and I will not repeat it here. The OBR’s mighty tome is the original source for a lot of the analysis (here) and the Resolution Foundation also produces an excellent synthesis (here). However a few issues do bear highlighting. The OBR’s analysis makes the point that “real household disposable incomes per person fall by 2.2 per cent in 2022-23, the largest fall in a single financial year since ONS records began in 1956-57.” It also highlights that in the wake of the decision to leave the EU, the UK “appears to have become a less trade intensive economy, with trade as a share of GDP falling 12 per cent since 2019, two and a half times more than in any other G7 country” (chart below).

Obviously governments cannot be held responsible for exogenous shocks which hit the economy but they do bear responsibility for the manner in which they deal with them. In this regard Sunak’s package of measures falls far short of what is required. Those on benefits face a particularly savage cut in real incomes, with benefits rising by 3.1% as inflation heads above 8%, compared with expected average weekly wage increases of 5.3%. As the IFS has pointed out, the current method for uprating benefits does not work when inflation is high and variable (chart below). A wider point made by the commentator Chris Dillow is that our current system derives its legitimacy from supporting all members of society. Ignoring the poorest undermines that legitimacy. That said, the Tories have hit the poorest voters hardest for more than a decade without any adverse consequences at the ballot box.

When it comes to trade, the government bears full responsibility for the adverse impact. By leaving the EU Single Market, the OBR maintains that the UK will suffer an output loss more than double that of the pandemic. At a time when living standards are under enough strain, the boiled frog problem of Brexit will place a significant additional burden on the economy. This matters because in a little-publicised report, the Government Actuary’s department has calculated that from the 2040s, the National Insurance Fund will be insufficient to maintain projected state pension payouts. Therefore we will either need faster growth, higher tax rates or lower pension payouts to ensure that the fund remains in balance. As an aside, it was notable that one of the measures announced yesterday was an alignment of the starting thresholds for income tax and NICs. How long before the government phases out employee NICs and folds them into income taxes (a subject I covered here)?

Last word

Sunak prides himself on his Thatcherite approach to fiscal management believing in an “ethical” mission to halt the expansion of the state, minimise taxes and restore fiscal self-discipline. I have long criticised politicians who treat state budgets like household finances and Sunak, who is an otherwise intelligent man, appears to have fallen into this trap. Within two years, the current budget balance is projected to return to surplus and overall public borrowing to fall below 2% of GDP. It may well be that the Chancellor will have to use some of these resources to provide extra help to the poorest in society. When even traditional supporters such as the Daily Telegraph balk at the lack of support, you had better believe more needs to be done.

The Magic Money Tree

Modern Monetary Theory (MMT) is back in the headlines following a recent piece in the New York Times (here). In truth, the article is more a profile of one its best known proponents, Professor Stephanie Kelton of Stony Brook University, than an attempt to examine MMT. Mainstream economists have nonetheless queued up to criticise it, probably because the original headline was titled “Time for a Victory Lap” (it has since been changed to “Is This What Winning Looks Like” so the subeditor has a lot to answer for). However, the article still contains the phrase “Kelton … is the star architect of a movement that is on something of a victory lap”. This has enraged the mainstream economics community because far from enjoying a victory lap, MMT remains untried, unproven and untestable.

A lot has happened since I first looked at the subject three years ago: Kelton’s book The Deficit Myth has become a best seller whilst the pandemic has focused minds on the role of government deficits. This fascinating area is thus worth revisiting. However, the quip that Modern Monetary Theory is not modern, is not about money and is not a theory still holds true. It is not modern because it has its roots in Abba Lerner’s Functional Finance Theory which first saw the light of day in 1943 and which suggests that government should finance itself to meet explicit economic goals, such as smoothing the business cycle, achieving full employment and boosting growth. It is also more a fiscal theory than a monetary one. At heart it is based on the premise that since the government is the monopoly supplier of money, there is no such thing as a budget constraint because governments can finance their deficits by creating additional liquidity at zero cost (subject to an inflation constraint). It is most definitely not a theory about how the economy works. Instead it is closer to a doctrine to which its adherents passionately adhere whilst regarding non-believers as having not yet seen the light (or worse, economic heretics).

What particularly riles the mainstream community is that there is no formal model which can be written down and therefore no testable hypothesis. In the words of blogger Noah Smith, “MMT proponents almost always refuse to specify exactly how they think the economy works. They offer a package of policy prescriptions, but these prescriptions can only be learned by consulting the MMT proponents themselves.” This is particularly irksome because it allows MMT proponents to sidestep the criticisms of the doctrine, of which there are many.

Many of these criticisms centre around the role of money, upon which the fiscal analysis is founded. For example, it treats money as being primarily created by the state (defined as the government sector plus the central bank) and has little or nothing to say about the role of banks in the process. It also treats money as a public good which should be used to maximise social welfare rather than its more prosaic use as a medium of exchange. This in turn assumes there is only one form of money in the economy, but as I have pointed out before this is not the case. Domestic actors may choose to use foreign currency, for example, or opt for digital options. Thus, although governments can create money almost without limit, there is no guarantee that demand will match supply. Increasing supply way beyond demand will only lead to currency debasement. In an excellent paper by the Banque de France[1] (here) the authors do a good job of picking holes in the theoretical underpinnings of MMT, noting that none of its supporters acknowledge “the reason modern literature on money puts  forward for what makes legal currency “acceptable” by the public, i.e. monetary policy credibility.”

Whilst MMT does rest on shaky theoretical foundations, it is not the only area in modern macroeconomics to suffer from such problems. The New Keynesian school, which is the predominant model used by central banks, assumes no role for the quantity of money. It also imposes perfect pass-through from the policy rate to all other rates in the economy, thus giving the central bank a powerful lever to affect intertemporal decisions, which is extremely questionable. Nobel Laureate Joseph Stiglitz published a paper in 2017 which argued that “the DSGE models that have come to dominate macroeconomics during the past quarter-century [apply] the wrong microfoundations, which failed to incorporate key aspects of economic behavior. Inadequate modelling of the financial sector meant they were ill-suited for predicting or responding to a financial crisis; and a reliance on representative agent models meant they were ill-suited for analysing either the role of distribution in fluctuations and crises or the consequences of fluctuations on inequality.”

It is thus perhaps a little unfair to single out MMT which has fallen victim to the fetish for quantification in economics. Current academic practice seems to believe that if something cannot be quantified it is not a valid explanation of how the economy works. It is instructive to remember that the ideas of Keynes, which came to dominate the agenda after 1945, were also subject to significant criticism following their publication in the 1930s. Nonetheless there is a lot wrong with MMT and I concur with the conclusion to the BdF paper: “Such a stark contrast with mainstream economics analysis and recommendations would be understandable if MMT economists engaged into a debate with their colleagues to explain and justify their positions, from both a theoretical and empirical point of view. However, they rather prefer to talk between themselves, repeating consistently the same ideas that others formulated in a distant past, disregarding facts and theories that do not fit into their approach, and accusing those who do not share their ideas of being incompetent.”

Yet despite all these reservations MMT has opened up a debate about the role of government both during and in the wake of the pandemic. One of the core ideas of MMT is that governments are not like households because they have an (almost) infinite life and therefore debt can be repaid over periods extending over many generations. There is thus no rush to impose significant fiscal tightening as the economy recovers from the Covid shock. This view is, of course, not unique to MMT: It is a standard element in fiscal dynamics but it is a lesson that governments should heed as the rush to take away support after the pandemic gathers momentum.

If it has opened the eyes of politicians to the uses of fiscal policy after decades in the doldrums, then maybe MMT has served a useful function. But a policy of near unlimited fiscal expansion is for the birds. It calls to mind the other acronym often applied to MMT: The Magic Money Tree.

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[1] Drumetz, F. and C. Pfister (2021) ‘The Meaning of MMT’, Banque de France Working Paper 833

Not what it said on the tin

As I have noted many times before, UK budgets are a strange mixture of policy announcements and pantomime and they exist in their present form purely for reasons of tradition. Once upon a time they were put together behind closed doors with ministers sworn to secrecy in case any of the details leaked out. Back in 1947 Chancellor of the Exchequer Hugh Dalton resigned after an off-the-cuff remark which hinted at forthcoming tax changes. But the era of ‘Budget Purdah’ is no more: We have been bombarded with news of what was likely to be in the autumn budget for weeks as the process morphs from a one-off event to a rolling news story. Indeed, the Speaker of the House of Commons expressed concerns that budget measures were leaked to the press before being announced in the House of Commons, which is a breach of protocol. The Deputy Speaker who presided over proceedings on Wednesday welcomed Chancellor Rishi Sunak to the Despatch Box with the pithy comment that she looked forward to the “remainder of your announcements.”

This does not mean that the process of digesting the information is any easier. The government’s 2021 budget was accompanied by the usual 192 page Budget Redbook, which this year also contained details of the Spending Review, whilst the OBR put out its regular 244 page Economic and Fiscal Outlook. Once we factor in the plethora of supporting documentation, it is clear that there is a huge quantity of material to digest. You can thus be sure that a serious amount of work has gone into the impressive overnight summaries produced by think tanks and the detailed analysis conducted by the quality press.

There are essentially three things to focus on in this year’s budget analysis: (i) what are the economic assumptions underpinning the budget; (ii) what fiscal measures has the government announced and (iii) how big is the spending envelope within which government departments have to work? These allow us to form an overall impression of the fiscal stance: The bottom line is that the projected outturns do not square with the message which the Chancellor has tried to put over. In short, living standards are likely to improve much more slowly than in the recent past; we are all going to be paying more taxes and the voracious health sector will continue to gobble up an increasing proportion of the nation’s resources. If the low tax, small state policies of Margaret Thatcher have long since been buried, this latest budget represents a dance on their grave.

The state of the economy

One of the defining features of the economic forecast is that real output is projected to get back to its pre-pandemic level by end-2021 which is slightly earlier than in the March projection and far sooner than anticipated last year. The OBR also reduced its estimate of the impact of the pandemic and now anticipates a permanent output loss of 2% (this was projected at 3% in March). However, it reckons that Brexit will lead to a permanent output loss of 4% in the longer-term. For all the concerns about the economics of the pandemic, it is Brexit that will inflict the most long-term damage. Obviously the pandemic feels like a big deal because the economic impacts are compressed into a relatively short time frame. Moreover the wider social costs are incalculable (140,000-plus deaths and counting) but much of the economic damage will be recouped quickly.

In many other ways the economy is predicted to quickly resume its pre-pandemic state with the unemployment rate on a two year horizon projected to fall to 4.2% – close to pre-2020 levels. One thing we will have to get used to is higher inflation, which the OBR forecasts will peak around 4.4% in the second quarter of 2022 – more than twice the BoE’s target rate – with risks tilted to the upside. Whilst this will squeeze real household incomes it will also inflate the tax base which will support tax revenues. All in all, there is not much to get excited about in the macro forecast. There are always areas for discussion but on the whole it seems a solid enough assessment. The real areas of disagreement lie in the fiscal detail.

The fiscal measures

The biggest single giveaway represented changes to Universal Credit designed to provide a boost to low earners (a £3bn giveaway over five years). This was welcome following the announcement last month that the temporary uplift to welfare payments during the pandemic was to be scrapped. In response to the storm of criticism that followed this decision, the Chancellor announced that the taper rate at which benefits are phased out as claimants transition back into employment is to be lowered. This was previously set at 63%, meaning that above a certain income threshold claimants lose 63p of every pound of benefit they receive, implying a very high marginal tax rate. This is to be reduced to 55% and is a move I have been advocating for a long time. However, as the Resolution Foundation points out, this is “not sufficient to compensate most UC recipients for the loss of the £20 a week uplift introduced at the start of the pandemic.”

Looking down the list of items, the next biggest giveaway was a further freeze on fuel duties (£1.6bn) – somewhat ironic given next week’s COP26 Summit at which the UK is hoping to take credit for brokering a global climate deal. Sunak also announced a 50% reduction in domestic Air Passenger Duty in order to “bolster UK air connectivity” which is similarly incongruous.

The spending envelope

The good news is that almost all departments will receive an increase in their day-to-day budgets over the period to fiscal 2024-25. The bad news is that in real terms many departmental budgets will remain below the levels prevailing when the Conservatives came to office in 2010. The era of austerity may be over but not by enough to overcome the damage done in the decade prior to the pandemic. One of the lessons we have learned the hard way is that spending on health is important and that it was underfunded prior to 2020. Thus spending on health and social care is projected to be over 40% higher in real terms by 2024-25 than in 2009-10. However, spending by the Department of Transport will be 32% lower in real terms and the Ministry of Justice will suffer a 12% cut (chart below). Sunak made great play of the fact that “the health capital budget will be the largest since 2010” and that the budget “will restore per pupil funding to 2010 levels in real terms.” Yet it is hardly a great boast that spending levels are to be restored to levels prevailing when the Tories took office 11 years ago, and calls into question what was achieved by the years of austerity.

What to make of it all

By common consensus this was a high tax and spend budget. It marks a seismic shift in the fiscal philosophy of a Conservative Party that has extolled the virtues of a small state and lower taxes for the last 40 years. Sunak’s goal may be to reduce taxes, as he told us in his budget speech, but in reality the overall tax burden is set to rise to its highest in 70 years. In some ways this is an inevitable response to the challenge posed by the pandemic. 

In his parliamentary speech Sunak outlined his old-style Tory leanings: “Do we want to live in a country where the response to every question is: “what is the government going to do about it”? Or do we choose to recognise that Government has limits.” The truth is that many people do want more government – or at least, they don’t want less. For a start they want some return on the large slice of income that they hand over in taxes. Furthermore the pandemic has highlighted the importance of having government act as a backstop (ditto the GFC of 2008-09). 

Sunak is an intelligent man and I am sure he knows this. The thought therefore persists that the budget was in part a job application to the Tory faithful in the event that they tire of Boris Johnson as leader, whilst simultaneously following Johnson’s requirement to shower the electorate with money. In the end all budgets come down to politics but this one perhaps more so than usual.

Unpleasant choices redux

As expected, the UK government did indeed announce the widely trailed rise in NICs that I looked at in my previous post. The package of measures represented a budget in all but name and will take the tax burden relative to GDP to its highest since 1950 (chart). If nothing else, this highlights that the era of low taxation is over. This is a reflection of the reality that the UK cannot continue to cut taxes whilst simultaneously meeting the electorate’s demand for better public services. It is also a reflection of demographic reality. The tax cuts of the 1980s were possible because the last of the baby boomers were still entering the workforce. But over the last four decades, the population share of those aged 65-plus has risen by four percentage points to 19% and is set to rise to 25% by 2050. Some thoughts on these issues below.

What was announced?

Dealing first with the package of measures, both employer and employee NIC rates will rise by 1.25 percentage points (a touch more than anticipated) from April 2022 and the rate of dividend taxation will rise by a similar amount. All told, this is expected to generate £12 billion pa of funds for health and social care (0.5% of GDP). From April 2023, underlying NICs rates will return to their previous level and a formal legal surcharge of 1.25% will be levied on wages which will be ringfenced only for health and social care purposes. Another important part of the package is that the government plans to introduce a cap of £86,000 on the amount that households (in England) will need to spend on personal care over their lifetime. This is designed to reduce the problem that individuals will be subject to high and unpredictable long-term care costs (an issue I looked at ahead of the 2017 election).

What is it likely to mean in practice?

The tax hikes come on top of the £25 billion (1.1% of GDP) of medium-term tax raising measures announced in March. It is notable that the UK is the one major developed economy to raise taxes in the wake of the pandemic – which, by the way, is not yet necessarily behind us. It may be that this will prove to be a tax hike too soon. Moreover, contrary to previous expectations, the funds raised by what the government calls a Health and Social Care Levy will be used largely to fund the NHS rather than fix the problems in the social care system. Over the next three years the social care programme will receive just £1.8bn in additional revenues (15% of the total raised by the Levy). The government has taken the (probably well-founded) view that voters are not going to be too exercised by whether the funds are used for the NHS or for social care – at least in the short-term. This might change if the government is forced to come back for more money in a few years’ time.

A deeper dive into the details

Although the government is using the Levy as a way to find sorely needed funds for the health system rather than primarily to fund social care, this is not necessarily unwelcome – after all, many of us have pointed out that the pressures on the NHS arising from demographic change meant that it has been underfunded over the last decade. But those of you with long memories might recall that the Brexit campaign, backed by Boris Johnson, promised that leaving the EU would generate savings of £350 million per week (£18.2 billion per year) which could be used to fund the NHS. That being the case, you may wonder why workers are being hit with additional taxes to do exactly that.

There is also some confusion regarding the impact of the lifetime social care spending cap. The £86,000 lifetime limit refers only to how much individuals pay for care. It does not include daily living costs which are incurred by living in a care home, such as food, energy bills and the accommodation itself. The average costs associated with living in an old age care home are currently £36k per person per year. Daily living costs are estimated to account for one-third of that. It would thus take the average person 3½ years to run up £86k of health costs (3.5*(36-12) = 84) – but 75% of those admitted to care homes do not live longer than three years, suggesting that the £86k limit is (a) not very generous and (b) still leaves residents having to use an additional £40k of their own money to cover daily living costs before they hit the limit.

The macroeconomics of the tax hike

Whilst there was much criticism about the generational aspects of the plan, some of this is to miss the point that there is always a transitional element in tax policy. Admittedly, today’s retirees do benefit at the expense of younger workers but assuming no changes to policy in future, today’s young workers can be expected to benefit from similar funding when they eventually retire. There is no doubt, however, that those in the early stages of their career and those on low to middle incomes will bear a considerable part of the load. At the younger end of the age spectrum graduates already face significant costs as a result of having to pay back their student debt. New graduates with an average debt of £47k and earning an average salary of £30k per year are subject to a debt repayment charge equivalent to 1% of gross income, and are now being asked to contribute an additional 1.25% to fund the health levy. As an inter-generational move, this is not a vote winner.

In any case, many were left wondering why there is any need to raise taxes at all in this fragile stage of the economic cycle. The UK is coming off its biggest peacetime recession in history and is responding by tightening the fiscal stance. It is unlikely that the impact on growth will be significant but on the basis that the government will almost certainly need to tap taxpayers for additional funds for social care, this tax hike may have political repercussions.

Nor has the government had any problem raising funds in the bond market. It could quite easily have kicked this can down the road for a year had it wished in order to assess the longer-term effects of the pandemic. Chancellor Rishi Sunak argued that to continue borrowing would be “irresponsible at a time when our national debt is already the highest it has been in peacetime.” But this is misleading. The BoE owns almost 40% of the debt – a significant proportion is thus held by the one institution that is not about to get cold feet and demand a higher risk premium.

What to make of it all?

We should not be overly critical of efforts to try and secure more funding for the NHS. However, we can be more critical of the way the government has gone about it with too much emphasis on taxing the incomes of working people (not to mention the additional costs to employers) whilst not enough of the burden falls on those who derive income from non-labour sources.

Two final thoughts spring to mind: First, the Chancellor has announced a spending envelope which is unchanged overall. Thus although health spending will rise and some areas of spending will be ringfenced (e.g. schools) this implies real spending cuts for unprotected departments. It also implies that future Covid-related spending will not be funded by borrowing (e.g. to cope with the effects of scarring) but must be met from taxation. This leads us to the second point: Over the past decade, spending on health has risen from 30% of total outlays to 38% today (even after taking out Covid effects). This squeeze is likely to continue as demographic pressures intensify, suggesting that if the state is to remain the primary provider of health and social care, more tax rises are likely before the decade is out. 

And to think that Boris Johnson wrote in the Conservative manifesto in 2019: “the Labour Party … would raise taxes so wantonly.” Life comes at you fast.

That sinking feeling

Are we really talking about fiscal consolidation already?

Former German finance minister Wolfgang Schäuble is known for his adherence to monetary and fiscal rigour and a recent opinion piece in the Financial Times confirmed his reputation. He argued for a “return to monetary and fiscal normality [and that] the burden of public debt must be reduced.  Otherwise, there is a danger that the Covid-19 pandemic will be followed by a “debt pandemic”, with dire economic consequences for Europe … Thus, all eurozone members must engage in efforts to return to stricter budgetary discipline.” It is striking that following the biggest economic hit since WWII we are already hearing calls for fiscal tightening. Whilst acknowledging that there will come a point when fiscal support will have to be eased back, such calls require more nuanced thinking than Schäuble tends to apply to fiscal issues.

In what sounded suspiciously like a lecture to the finance ministers of euro zone member states, notably Italy, Schäuble noted that “the need to pay back the debt later is often overlooked. Many governments focus on the “easy” bit of Keynesianism – borrowing – and then postpone repayment of their debts.” This is, of course, not true. If bond investors were worried about not getting their money back they would cease purchases of euro zone debt. Aside from the obvious case of Greece (of which more later) that has not happened. Indeed, many EMU member states have agencies dedicated to managing the national debt which is an indication of how seriously they take the problem.

The article appeared to be based on a misunderstanding of how fiscal policy works, which is somewhat unfortunate from a former finance minister. For a start, he makes the amateur mistake of treating public finances in the same way as those of a household. In other words, he fails to account for the near-infinite lifespan of a government which allows debt to be repaid over multiple generations. And if he is worried about governments borrowing but not repaying debt, Schäuble might want to take a look at the level of German public debt which has doubled in the past 25 years at roughly the same pace as Italy (chart below).

Schäuble’s Italian concerns

That said, Germany’s performance in holding down its debt-to-GDP ratio is far better than that of Italy (chart below). Whilst the level of gross debt has increased at roughly the same pace since the mid-1990s, the fact that Italian GDP has grown more slowly than Germany means that there has been a significant divergence in the debt ratio performance. Italy has struggled to generate decent growth in the two decades since it joined the single currency. This can partly be ascribed to low productivity growth in a fixed exchange rate environment and there are many who believe that Italy’s days in the euro zone may be numbered.

The travails of the Italian economy can wait for another day but you can be sure that if Italy proves to be the catalyst for another euro zone debt crisis it will shake monetary union to its foundations. Precisely because it is in nobody’s interests to allow the euro zone to fall apart, the economy has to be managed in a way that accommodates the fiscal position of southern European countries. Whilst this is not what Germany signed up for, and Schäuble’s views are coloured by those of the people he serves – the electorate – politicians across the euro zone have to take some of the responsibility for allowing Italy into the single currency knowing that it failed the excessive debt criteria.

And he has form on Greece

For all Schäuble’s concerns about Italy, his role in the Greek crisis as German finance minister highlighted the perils of adherence to economic orthodoxy. After Greece was forced to put in place stringent austerity measures in 2010 in return for an emergency loan that was sufficient only to pay interest on existing debt and keep banks capitalized, his insistence on further measures in return for additional aid were more than savage. Former US Treasury Secretary Tim Geithner has recorded how Schäuble was willing to sanction Greece being kicked out of the euro zone, and he continued to hold Greek feet to the fire even in the face of IMF concerns that Greece would be crippled by its ultra-high debt.

The cost to Greece of the fiscal measures forced on them by other euro zone states has been high – even before the pandemic Greek real GDP was almost 30% below mid-2007 levels. In anyone’s book that has to go down as a depression. We can argue about how Greece found itself in such a predicament in 2010 and the extent to which it was the author of its own demise. But the actions of the German government, spearheaded by Schäuble as finance minister, illustrate that the costs of applying orthodox solutions at the wrong time can inflict huge damage. Anyone tempted to heed the siren calls for fiscal consolidation would do well to ponder the Greek case.

He ain’t no Keynesian

In his opinion piece Schäuble invoked the spirit of Keynes. Unfortunately he seems not to have understood Keynes’ prescriptions. He noted that “Keynesian economic experts like Larry Summers or Olivier Blanchard lament the crossing of red lines on public debt and point to the increased likelihood of runaway inflation.” But there is no clear link from high debt to inflation, other than that it is to the debtors advantage if the debt burden can be inflated away. High levels of debt do not, per se, result in high inflation – just ask the Japanese. The criticism levied by the likes of Summers and Blanchard is that a US economy with little spare capacity which receives a big fiscal boost may be prone to inflation, but it is not a question of the debt level itself.

In any case, the treatment of debt did not get a lot of attention in Keynes’ most famous work. In The General Theory of Employment, Interest and Money, I counted 22 uses of the word “debt” and one of them was to point out the perils of reducing it too quickly. As Keynes pointed out, “the desire to be clear of debt” may exacerbate existing economic problems by stimulating more saving than would otherwise occur, resulting in “a diminishing … propensity to consume” – the famous paradox of thrift argument. This is not merely a 1930s problem. IMF simulation analysis conducted in the wake of the GFC pointed out that when all countries are involved in fiscal consolidation with interest rates at the lower bound, the costs of lost output are twice as large as when one country performs fiscal contraction in isolation. If Keynesian analysis offers any insight, it is that there can simply be too much fiscal consolidation.

But we do agree on one thing

Despite the fact I disagree with most of his policy prescriptions Schäuble did make one argument that I found very appealing, suggesting that “a promising approach for Brussels to take would be a eurozone debt redemption pact, similar to the sinking funds devised by Robert Walpole and Alexander Hamilton.” Indeed, I made this very proposal some years ago (here). As I pointed out at the time “few investors will buy undated Greek consols, so the fund would have to be guaranteed by a body such as the ECB.” Last year’s joint borrowing plan suggests that maybe the European Commission itself might be an appropriate guarantor. There are many issues regarding how such a fund might work. Would all countries place debt in the fund or simply those with excessive debt (anything above an arbitrary limit such as 120% of GDP)? The issue of guarantor would almost certainly provoke a political storm.

However we are at the stage where the old pre-Covid orthodoxy no longer holds. As the last decade has demonstrated, unsophisticated consolidation is not guaranteed to produce good outcomes. If Europe is to emerge strongly from the pandemic it cannot afford to be encumbered by navel-gazing over appropriate debt levels. A sinking fund in which a large proportion of debt can be converted into undated consols might be one way to deal with the problem. If even someone as orthodox as Schäuble is talking about it, maybe this is an idea whose time has come.