The election by numbers

After six weeks of campaigning the majority of British voters just want to put this election behind them, such has been the cynical nature of a plebiscite designed purely to give Boris Johnson a platform to continue doing whatever it is he wants to achieve as prime minister. Other than "getting Brexit done" most people do not know what he really wants. I suspect neither does he.

It has also been an election in which the issue of fake news has played a more witting role than in the past. We used to think that spin doctors had taken politics to new lows as they put the best gloss on their own policies whilst trashing the plans of the opposition. But today it is dominated by fake news merchants whose job is to repeat simple phrases ad infinitum, irrespective of whether they are true. In a bid to separate fact from fiction, my intention in this post is to boil down the election campaign into a series of key numbers which encapsulate the spin and counter spin of this unedifying campaign.

1. 83 billion. This is the amount of extra current spending (in pounds) that the Labour Party plans to undertake by fiscal year 2023-24. As noted in this post this is an attempt to finance Labour’s redistribution policy in which the biggest spending element is the £13.6bn cost of abolishing student tuition fees. This is offset by a huge rise in taxation, with more than half of the incidence falling on corporates, financial institutions and taxes on capital. Verdict: At least Labour are honest about their desire to raise tax and spending, but it does not appear to be going down well with the voters.
2. 58 billion. This is the amount of unfunded spending that Labour plans in order to recompense women who lost out on pension income as their retirement age was raised to match that of men. The IFS dismisses the policy thus: “The decision was taken at least 15 years before the increase in pension age and most in the group are relatively well off. To believe the whole group should receive compensation is a recipe for complete stasis in policy. How can you ever defend any policy which ever makes anyone worse off if you think this change in pension age, implemented with 15 years notice, designed to equalise treatment between men and women, and in the face of dramatic increases in life expectancy, is in some sense unethical?” Verdict: I’m with the IFS.
3. 50,000. The number of new nurses positions pledged by the Conservative government in its manifesto. But this figure includes an estimated 18,500 nurses who would otherwise quit the profession, implying that the number of new positions is only 31,500. Verdict: A shameless lie.
4. 20,000. The number of new police officers that a Conservative government intends to employ in the next parliament. It turns out to be a bone fide promise but it is only sufficient to restore the number of police officers back to where they were when the Conservatives assumed office in 2010. Verdict: A half truth.
5. 320. The number of seats that a government needs to win a parliamentary majority. The latest forecast from Electoral Calculus suggests that the Conservatives will win 348 seats (31 more than in 2017), giving a majority of 46. Verdict: The Conservatives look set for a convincing win although I would not want to put money on it, especially since the Tories are odds-on with the bookmakers’ at around 1-25 (i.e. you need to bet £25 in order to win £1).
6.  209. The lowest number of seats won by the Labour Party in the post-1945 era. This occurred in 1983 when the Labour Party fought on an avowedly left-wing agenda against a charismatic Conservative politician. Verdict: Labour likely to do better than in 1983 but the Electoral Calculus prediction of 225 would be the second lowest in the modern era. 
7. 49. The number of days between 13 December (the day after the election) and 31 January. This is the timeframe in which Boris Johnson believes he can “get Brexit done.” Verdict: Given a sufficiently large majority, the Conservatives could indeed get the Withdrawal Agreement Bill ratified by parliament, in which case the UK can leave the EU on 31 January. But Brexit will be far from done – the next stage is only just beginning.
8. 40. The number of new hospitals the Conservatives say they will build. In fact, the government has committed the money to upgrade just six hospitals by 2025. Up to 38 other hospitals have received money to plan for building work between 2025 and 2030, but not to actually begin any work. Verdict: Another distortion of economic reality by Boris Johnson's government.
9.  Zero. The probability that Nigel Farage will emerge as prime minister and to the nearest digit, the number of MPs that the Brexit Party is likely to send to Westminster. Verdict: Given Farage’s refusal to stand for parliament, having lost seven times previously, and given the Brexit Party’s lack of representation in Westminster, there is no justification for the British media to continue to give Farage a platform. If anything good comes out of the election, it will (hopefully) be the end of Farage as a semi-credible political force. 

Boiling down an election merely to numbers may be a crude way to distil the complexities of all parties' positions but this has been an exceptionally crude campaign. This is an election nobody wants at a time when people really have other things to look forward to. What a way to spend December.

Macronomics

In a recent fascinating interview with The Economist, French President Emmanuel Macron reiterated his long-held view that the EU has to adapt if it is to survive in a much-changed world. As Macron noted, things that were unthinkable five years ago are now the norm and that “if we don’t wake up … there’s a considerable risk that … we will no longer be in control of our destiny.” It is hard to disagree with this: The historically strong relationship between the US and Europe has become less anchored in recent years, initially as a result of Barack Obama’s pivot towards Asia and more lately thanks to Donald Trump’s retreat from rational policymaking. Since the EU is unable to rely on the US to help deal with the rise of China as a world power, whose interests do not chime with those of the EU, Macron believes that European nations have to act proactively in their own interests.

Whilst most European leaders would profoundly disagree with Macron’s assertion that NATO is “brain dead”, at the very least it should act as a rallying call for Europe to think about its place in the world. This week’s NATO summit in London was a chance for western leaders to get together, which is useful in itself, and even though no great decisions were taken it appears to have passed off cordially enough (the ongoing spat between Donald Trump and Justin Trudeau notwithstanding). But although forward-thinking European politicians will have to rethink what kind of Europe they want, there simply are not enough politicians who share Macron’s vision. Germany may be the economic powerhouse, but Angela Merkel is coming to the end of her tenure as Chancellor and her coalition government is more fragile than it was following the election of the Borjans-Esken duo as leaders of the SPD, both of whom are opposed to continuing the coalition with the CDU/CSU. Nor is the German economy currently in great shape as the economic motor splutters in the wake of the US-China trade dispute. The bottom line is that we should not expect Germany to contribute much to reshaping the EU in the next couple of years – like many countries, it is too preoccupied with domestic political issues.

But the problem is more than just political: The EU will have to focus on the kind of economic model it wants to pursue in future. As I pointed out long before the Brexit referendum, the EU has benefitted from the market-oriented model designed to enhance competitiveness which the British have helped to push in Brussels. However, the UK’s departure will significantly change the nature of the EU. For one thing it will change the balance of voting power. Around 80% of EU laws are ratified by qualified majority voting, meaning that they must be passed by 55% of member states representing at least 65% of the total EU population. Germany, the Netherlands, Austria and Finland, together with the UK, currently represent just over 35% of the EU population which gives the northern nations a blocking minority on policy matters. This will change once the UK leaves and concerns have been expressed, particularly in Germany, that countries opposed to market-oriented solutions could press for a weakening of EU competition policy, which has traditionally been dominated by ideas from the northern countries. This in turn would weaken the EU’s economic competitiveness.

Then there is the nature of the economic difficulties facing France which are likely to sap Macron’s energy to pursue EU-wide solutions. The latest wave of public dissatisfaction revolves around reform of state pensions, which has met with huge resistance and a wave of strikes brought the transport sector to a virtual standstill earlier this week. There is no doubt that an overhaul of the state pensions system is required, since it offers very generous state payouts to workers in certain sectors (railways, merchant seamen, energy workers and some niche workers at the likes of the Banque de France and l’Académie Française). Drivers on the Paris Metro, for example, are able to retire at 52 with an average monthly pension of €3500 whereas private sector workers, who retire at 62, receive only €1360 per month. All told, these special provisions cost the taxpayer €8bn per year (around 0.3% of GDP).

We have been here before, of course. A year ago, Macron’s efforts to impose a carbon tax met with huge resistance in the form of the Yellow Vest protests, which prompted him to put the policy on hold. Efforts in 1995 to reform the French economy were abandoned in the face of massive public protest. As the population ages, the state simply cannot afford to underwrite special privileges for any one group but it is a hard sell to get the electorate to understand that a system that has worked for the last 70 years will not fly in the 21^st century. I have a lot of time for Macron’s ideas but I do not believe that he will be successful in delivering domestic reforms on the scale he desires – there is simply too much resistance. This is not to say that he will not be partially successful – after all, things have changed since 1995 – but it may be left to a future generation of politicians to get where he wants to go. 

All this matters because Europe does not have the luxury of time to decide in which direction it wants to go. Indeed, the more I see how slowly reform is proceeding in France and Italy, the more I am convinced that the EU will be forced to concede that not all countries will be able to move forward at the same pace. Ironically this is the form of EU that the British would have been more comfortable with than the push towards a federalist system that grew out of the hubris of the 1990s. But as the world moves towards a world in which the US and China act as the poles of the geopolitical system, Europe cannot simply afford to pick one side. And this is where Macron is right – US and European interests are diverging, and the EU will have to steer its own course. NATO has to stand for more than “No Action, Talk Only”.

Uninspired choices

It remains difficult to get excited by the impending election in the UK which seems to be more of a low-key event than in 2017. One reason for this is that the majority of voters are suffering from election fatigue, with this being the fourth major plebiscite in just over four years (or five in just over five years if you live in Scotland). Nor is the electorate particularly enamoured of the choices on offer: Boris Johnson is widely expected to win a parliamentary majority only because voters have an even lower opinion of Jeremy Corbyn. It is an unfortunate fact that politics is more about personalities than policies which is why, despite the Tories’ inability to deliver on the latter, Labour is doing even worse on the former.

I highlighted in my previous post the perils of taking opinion poll data at face value and this article in The Guardian illustrates why. The article reflects on 10 years of vox pops conducted around the country in a bid to get as far away from the Westminster bubble as possible and illustrates the extent to which dissatisfaction is still the predominant theme amongst voters. The overriding theme is the feeling of alienation amongst many of those living outside London – an issue which many of those in the capital perhaps fail to appreciate. One of the writers, John Harris, points to the “regular explosions of annoyance about audience members on BBC1’s Question Time” (one of the BBC’s flagship topical debating forums) as evidence of the dissonance in public debate.

A recent example of this was observed during a Question Time debate when an audience member refused to accept that his salary in excess of £80k per year put him in the top 5% of earners, and that it was unfair of a prospective Labour government to make him pay more tax. He is wrong on the first point as the evidence here on the distribution of pre-tax incomes makes clear. But it is less clear that he is wrong on his second point: The gentleman may earn significantly more than the average wage but he is not necessarily in the upper echelons of the wealth distribution, since according to ONS estimates, the wealth held by the top 10% of households is around five times greater than the wealth of the bottom half of all households combined. As Torsten Bell of the think-tank The Resolution Foundation has pointed out, the disparity between the ultra-rich and the well-off has widened in recent years with the result that someone in the top 5% of the income distribution has more in common with the median earner than with the ultra-rich.

Whilst it is easy to be dismissive of our man in the Question Time audience due to the irrationality of his argument in the face of the evidence, he is tapping into a bigger problem. A large swathe of the electorate is suffering from “squeezed middle syndrome.” Real average weekly earnings, for example, are still almost 3% below the 2007 peak. Productivity growth may have been lousy, having risen by only 3% over the past decade, but it is still outstripping real wage growth implying that someone else is reaping the benefits of whatever modest productivity gains have been made. This is not just a British phenomenon – the trend in the US has been even more pronounced over the past two decades (chart below). It is hardly surprising, therefore, that voters are dissatisfied.

Many people have the sense from the UK election campaign that politicians are not talking about issues that involve them. The Labour vision of an economy with a greater emphasis on welfare provision and the protection of workers right sounds good in theory but Brexit is (ironically) the most pressing issue for the electorate (chart below). Accordingly Boris Johnson’s slogan about “getting Brexit done” does tap into what voters want, even though anyone with any understanding of the issue realises that Brexit will not be “done” merely by the UK leaving the EU on 31 January. But this is not the only issue on the agenda and Labour’s refrain that the NHS is safe in their hands, rather than the Conservatives, remains their main angle of attack.

At a time when the electorate is confused and angry at politicians for failing to deliver any improvement in living standards over the past decade, the competing visions of what the main parties want the UK to be and what they can offer to the electorate, do nothing to pour oil on the waters of unrest. There is no sense of broader engagement between politicians and the electorate across a range of policy areas. Neither of the two extremes are what people really want and as a result we will end up with the prime minister who voters dislike the least rather than the one offering the most compelling vision. Inflicting Brexit on a divided country with the near certainty that it will impose short-term economic costs suggests that the malaise that has been hanging over the UK for the past three years is unlikely to lift soon.

Second guessing the pollsters

With polling day less than two weeks away, this curiously flat election that nobody really wants has yet to take off. The opinion polls, for what they are worth, suggest that the Conservatives will easily gain a parliamentary majority as they enjoy a lead of 13 points over Labour. The Lib Dems are struggling to make themselves relevant and the Brexit Party has virtually disappeared as a coherent political force.

It was all so different in the spring, when the Conservatives, Labour, the Lib Dems and the Brexit Party were all capturing a similar share of the vote, around 20% (chart). Whatever else you might say about Boris Johnson, he has the ability to tap into what a lot of people want to hear, and by promising to “get Brexit done” he has consigned Nigel Farage to the political sidelines by taking votes away from the limited company masquerading as a political party. Jeremy Corbyn is unable to generate any form of feelgood factor. As I have long suspected he will not be in any position to repeat his decent performance in 2017 because he has dithered on Brexit, and in the eyes of many voters he is simply untrustworthy. Meanwhile, the Liberal Democrats’ new leader Jo Swinson does not come across well with voters and it increasingly looks as though her party’s commitment to revoke Article 50 was a major tactical blunder.

Whilst the opinion polls can be wrong, it certainly looks as though the opposition parties will have their work cut out to limit the extent of the Tories’ majority. Since the headline polls have proven to be a poor guide to electoral outcomes in the recent past, the commentariat paid a  lot of attention to the release this week of YouGov’s Multilevel Regression and Post-stratification (MRP) model results. This model, which correctly called a hung parliament in 2017 when predictions based on aggregate survey results indicated a large Conservative majority, suggests that on the basis of current data the Tories could win a 68 seat majority on 12 December. I briefly touched on MRP models in the wake of the 2017 election (here) but it is worth reminding ourselves of what political commentators – who would not normally care about regression models – are getting excited about.

The MRP model proceeds in two steps. First, YouGov builds a detailed description of UK local populations to determine the characteristics of each parliamentary constituency. The modellers then use YouGov survey data to determine how voting intentions are associated with individual population characteristics (e.g. how likely a person is to vote Conservative or Labour based on their education levels or their age). Combining these two pieces of information, using survey data from the preceding seven days, allows pollsters to predict voting intentions at the constituency level. It all sounds very scientific but a few points are worth noting. For one thing, a track record based on one set of observations is not very useful. As YouGov themselves note, “despite the strong performance of the method in the 2017 election, it is not magic and there are important limitations to keep in mind.” Second, it does not offer a prediction for what will happen at the election since data may change in the interim. Third, the model is only as reliable as the data input and we can never be sure whether respondents are telling the truth about their voting intentions. Finally, the sample sizes used in each constituency are very small and thus subject to significant sampling error.

Moreover, despite all the work which has gone into constructing the model, it does not generate significantly different results from a simple method which applies a uniform swing to each constituency. Whilst it would be nice to have access to all the data in order to generate an MRP model of my own, it is impossible for individuals to recreate a sample of 100,000 interviews in a short space of time. This got me thinking about whether there are other ways to generate constituency models and I report the results here, albeit subject to huge caveats.

Using Logit models to predict the election outcome

The starting point is to try and find readily available information on a constituency basis that might help us. I start from the premise that MPs who have strong local support and who recorded a solid majority last time out are more likely to be re-elected. Even if the MP is no longer standing for re-election, I assume they enjoy the benefit bequeathed by the previous incumbent. This is proxied by the size of the sitting MP’s majority relative to the total number of votes cast (or alternatively, the share of the vote achieved by the winning candidate). Since Brexit is such an important factor in this election we can also assess whether the constituency’s pro- or anti-Brexit bias is important in determining the outcome (see here for the results collated by Chris Hanretty). A final variable is the regional polling data which, although not available at the local constituency level, is assumed to be representative for each constituency in the region (e.g there are 73 constituencies in London and I assume that support for each party is broadly the same as the London average).

My model is designed to predict whether the incumbent party retains the seat at the 2019 election. To do this, I ran a series of qualitative choice models (technically akin to a Logit model with fixed effects) for each of the five main parties (Tories, Labour, Lib Dems, SNP and Plaid Cymru) across all constituencies in GB (Northern Ireland was excluded). Comparing the results for the five models across constituencies, I looked for the party with the highest probability of winning the seat. The central case forecasts gave the Conservatives between 333 and 351 seats (corresponding Labour figures: between 243 and 220). The SNP took anywhere between 37 and 44 seats in Scotland (though I reckon it could go as high as 50) whilst Plaid Cymru took between 3 and 5 Welsh seats. The model struggled to give the Lib Dems many seats at all. Even making some manual adjustments, it is difficult to see the Lib Dems picking up more than 15 seats.

How do the results compare with YouGov? The answer is pretty well. Their central scenario gives the Tories 359 seats; Labour 211; Lib Dems 13; the SNP 43 and Plaid Cymru 4. For a lot less effort (basically, some playing around with the data in a spreadsheet and a few lines of code in EViews) I can broadly replicate the results. Crucially, the evidence from both models suggests that the Tories can win an outright majority in the December election. As noted above, this is not a done deal by any means – there is a large margin of error associated with any such model. Electoral Calculus, which runs a similar model to YouGov, also looks for the Tories to win 331 seats (Labour 235) but with a range between 252 and 429 (Labour 141 to 304). You might think that is a sufficiently wide margin as to be meaningless, but they do ascribe a 63% probability to the chance of a Tory majority.

Reality does, of course, make fools of us all. But I am satisfied that my low budget modelling exercise replicates the work of the highly-paid pollsters. I can thus either get it right at a much lower cost – or can save someone a lot of money by getting it wrong for a lot less

An ultra-Conservative manifesto

The economics of the manifesto

Last week’s presentation of Labour’s election campaign promises was fizzing with ideas and as Philip Collins wrote of the plans in The Times, “if I were running a radical think tank, with no responsibility for implementing a word of this, I might marvel at my handiwork.” The low-key release of the Conservative manifesto yesterday was the complete opposite. Paul Johnson, Director of the IFS, wrote of the Tory plans, “if a single Budget had contained all these tax and spending proposals we would have been calling it modest. As a blueprint for five years in government the lack of significant policy action is remarkable.”

It really was a content free collection of what I hesitate to call ideas. Of the main economic proposals, the Conservatives promised not to raise the rate of income tax, VAT or National Insurance (NIC). As the Tories learned to their cost in 2017, when plans to raise self-employed NICs caused such an uproar amongst backbench MPs who pointed out that it breached their 2015 election pledge, taking these key levers out of the fiscal equation could severely limit the Chancellor’s room for manoeuvre. It is not good policymaking. The plans also envisage raising NIC thresholds to take lower paid workers out of the tax net. The commitment to raising the threshold to £9500 next year will cost just over £2bn per year and the medium-term aspiration to raise it to £12500 will ultimately cost £8.6bn. Some revenue will be clawed back by Boris Johnson’s pledge not to further cut the rate of corporation tax, which was scheduled to be reduced from 19% to 17% next April, and which will give an additional £4bn of resources in fiscal year 2020-21 compared to the latest OBR revenue projections, rising to £6.2bn by 2022-23. In effect, the government has taken away from corporates to give to low earners which is a nice nod to progression in the tax system.

One thing the Tories have not done is to promise a reduction in the income tax burden for the better off, as Johnson indicated in his leadership bid over the summer. From an economic perspective this is a good move: It is (a) unaffordable and (b) regressive. Against that, it is yet another Johnson pledge that has not been fulfilled. Nor are there any measures to “fix the crisis in social care once and for all” as Johnson promised in his first post-leadership election speech. To do so would be expensive, and the Tory manifesto maintains the fiction of governments over the decades that the UK can continue to deliver high quality public services without raising taxes to pay for them. This is a fiscal fallacy which has dogged the UK for years and could be swept under the carpet so long as the working age population was growing sufficiently rapidly to generate the means to pay for them. But as the population ages, this becomes increasingly difficult and if the UK is serious about restricting immigration in a post-Brexit world, the problem will become even more acute.

An ageing population will obviously mean an increasing amount of resources will have to be devoted to health services and the Conservatives have promised “extra funding for the NHS, with 50,000 more nurses and 50 million more GP surgery appointments a year.” Although these plans were not costed in the manifesto, fullfact.org estimates that an additional 50,000 nurses would result in an additional £2.6bn per year of government outlays.

Of the costs we can estimate more readily, once we add in the £11.7bn of spending announced in the September Spending Round, the manifesto is estimated to add just £2.9bn of additional spending by 2023-24 – a rise of 0.3% – which is a drop in the ocean compared to Labour’s planned increase of almost £83bn. Investment spending amounts to an additional £8bn – again significantly below Labour’s planned boost of £55bn per annum. All told, this is likely to be sufficient to limit the budget deficit below £60bn by FY 2023-24, or around 2.2% of GDP (even an additional £2.6bn of spending to recruit more nurses would not make a material difference to the overall figure).

... and the politics

But as with all manifestos they are more about the politics than the economics. The reason the Tories have no interest in a “once and for all” solution to the social care problem is that the attempt to present a solution in 2017 backfired spectacularly when it became clear that the plans would potentially require households to run down their savings in a way which penalised certain groups at the expense of others. It caused such a furore that the Conservatives have vowed not to repeat the mistake, even if it means saying nothing at all.

The real politics behind the manifesto, however, is that of Brexit. It is, after all, entitled “Get Brexit Done. Unleash Britain’s Potential.” On this point, the wish list is truly mendacious: It repeats the old tropes about “take back control of our laws; take back control of our money” as if the UK had lost these functions as a result of EU membership. The Conservatives also promise that “we will negotiate a trade agreement next year – one that will strengthen our Union – and we will not extend the implementation period beyond December 2020.” Most experts agree that to get the kind of deal that the UK wants in anything less than three years would be a miracle, and a period of five to seven years is more like it.

Recall that if it looks unlikely the trade deal will be signed by end-2020, the UK has to let the EU know by 1 July that it wishes to extend the transition period. By ruling out this option the UK is merely creating another set of unnecessary red lines. Worse still, by refusing to countenance an extension with no guarantee that a deal will be in place (it is nowhere near as “oven ready” as Johnson says it is), the risk of a no-deal Brexit at end-2020 could come back onto the agenda. And if that happens, even the miserably thin set of economic promises in the manifesto will become much harder to deliver.

Labour’s plans are open to criticism for the extent to which they rely on much higher levels of taxation to achieve their goal of redistribution. But the Conservative plans get the same short shrift because they offer no vision of what they want to the UK to be, other than out of the EU, and accordingly offer no economic solutions. If this is, as many commentators claim, the most important election for decades, the main parties are offering the electorate a truly desperate set of choices: More taxes or more austerity, and Brexit to boot. It’s no wonder that many voters find the choice before them unpalatable,

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.

Debt or equity?

One of the reasons offered by market strategists for continuing to buy equities is that the dividend yield on stocks is considerably higher than that on government bonds. It is hard to argue with this. The one-year expected dividend yield on the FTSE100, for example, is currently 4.7% versus 0.7% on a 12-month government security. Assuming that equity values remain broadly stable, it makes perfect sense to buy equities which yield a 400 basis points premium over bonds. Now imagine the choice is between corporate debt and corporate equity. From an investment perspective the same applies. But from an issuer perspective things look very different.

UK A-rated corporate debt trades at around 1.94% - more than 270 bps below the dividend yield on equities. Companies thus have an incentive to issue debt rather than equity in order to cut the amount they have to shell out each year in order to persuade investors to buy into their company. After all, according to the well-known Modigliani-Miller theorem the company’s valuation is indifferent to whether it is financed by debt or equity. To the extent that the dividend yield represents a measure of a company’s profit that is redistributed back to shareholders, there are good reasons why a company might want to reduce it – perhaps to increase the funds available for investment or simply to raise employees pay (or even simply to hike the CEO’s bonus).

There have been suggestions that this is one reason why equity issuance is beginning to dry up. The evidence is not conclusive but latest data from the London Stock Exchange does point to a reduction in equity capital issuance over the past couple of years. Based on annualised data for the first ten months of 2019, we look set for a second consecutive decline in issuance with a figure which is roughly one-third below the average of the past two decades (chart 1).

It is indeed notable that equity investors have not revised down their expected returns on stocks despite the fact that interest rates have fallen to all-time lows. We can derive this from the formulation of the dividend discount model attributed to Myron Gordon, known as the Gordon growth model. Playing around with the formula, we derive the result that the compensation demanded by the market in exchange for holding the asset and carrying the risks depends on the expected dividend yield[1] and the (constant) growth rate assumed for dividends. Since the latter is a constant, the required rate of return is a positive function of the expected dividend yield. The expectation that dividends will remain high has thus conditioned markets to demand ever-higher returns.

My calculations suggest that UK equity investors require a total return of 9.8%, which is the highest since the immediate aftermath of the financial crisis in early 2009 (chart 2). If we subtract the risk-free rate from our estimate of total expected returns, we derive the equity risk premium. On my calculations, this is somewhere in the region of 9% in the UK which is comfortably the highest rate in the 25 years over which I have calculated the data (chart 3). Back in the 1990s, I puzzled over the fact that the ERP was negative and concluded that this was flashing a signal that investors were overly complacent about market risks. This in turn prompted me to be bearish on equity trends long before the markets actually corrected (in truth I was way too early so it is no great boast). We cannot say the same today: It may be the case that Brexit-related uncertainty has prompted investors to demand a higher premium but since it has been trending upwards for the past 20 years, this is not a particularly good explanation.

But markets may still be complacent about risks, as they were 20 years ago, albeit for different reasons. In short, investors appear to expect that dividends will continue to rise. The high level for the ERP is thus a misleading signal based on the fact that expected returns are rising whilst the risk-free rate continues to fall. But investors may one day be wrong about expectations of continually rising dividends. This could certainly come about if companies decide that they are better served by issuing debt rather than equity finance, thus reducing the amount they need to pay out in dividends. Issuers do not appear to have adjusted to the fact that the traditional discount of equity dividend yields relative to bond yields has flipped and is unlikely to revert any time soon.  But company treasurers must be wondering whether now is the time to do what governments are increasingly prepared to do – use the period of low yields to issue lots more debt.

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[1] The true expected dividend yield is expected dividends relative to the expected price but the Gordon growth model depends on expected dividends relative to the current price which is not quite the same thing. For expository purposes, we nonetheless call this term the expected dividend yield.