The popularity contest

I had the pleasure today of participating in a roundtable discussion on the subject of (yes, you guessed it) Brexit. In the course of chatting with some of the attendees, I happened across a senior and very well-connected businessman who told me that in the past he had dealings with Theresa May and her department in her capacity as Home Secretary. What was shocking was the story he told of how he had tried to make certain policy suggestions in order to improve business operations, only to be told to get them in the Daily Mail first and then government would listen (I am not making this up).

His reaction was the same as mine: How on earth can a government whose job it is to manage the country in the interests of its people possibly think that policy can best be served by courting the tabloid press? All politicians know that you can’t please all the people all the time but sometimes you have to take unpopular decisions in order to do the right thing. I am reminded of the great quote from the BBC satire The Thick of It (here), which I must confess to having used before but it is so accurate in this instance, which states that many political decisions are taken by “a political class, which has given up on morality and simply pursues popularity at all costs.”

With this little snippet of information in mind, many aspects of government policy now become a lot clearer. It explains, for example, why Theresa May has suddenly gone from being a nominal supporter of the Remain campaign to one of the most ardent advocates of a hard Brexit. And it certainly explains today’s decision by Chancellor Philip Hammond to reverse the increase in National Insurance Contributions for the self-employed. As I noted a few days ago (here), the economic rationale for raising NICs was sound enough. Indeed, the Chancellor reiterated that “the government continues to believe that addressing this unfairness is the right approach … However, since the budget, parliamentary colleagues and others have questioned whether the increase in class 4 contributions is compatible with the tax lock commitments made in our 2015 manifesto."

But if the rationale for implementing the policy was correct, then it logically follows that he has made an economic mistake by reversing the decision. Quite clearly, the decision has been made on political grounds, with the manifesto commitment used as justification. That in itself raises a question of whether the government – and don’t forget that the decision to raise NICs in the budget would have been approved by the prime minister – recalls what it promised in the 2015 election campaign? Or did they just think that no one would notice? Having caved in to populism on this issue, what is to stop the tabloid press making life even more difficult for the government in future? Flip-flops on policy issues like this do not bode well for the government’s policy credibility and should be avoided at all costs.

It also raises a bigger question, which one of the participants raised at today’s event. If in, say, 2019 or 2020 the UK economy has been severely damaged by the prospect of Brexit and the electorate is restive, would the government be tempted to backtrack on its Brexit promise? My answer to that question was, given what we have heard on the issue so far, it would be most unlikely to do so. But knowing what I know now, if the Daily Mail were to change its mind, you would not bet on a change of heart from the government either. Or as Carole King put it, in the song Change in Mind, Change of Heart, “The things that once held meaning / We're no longer sure about.”

Just another day in Brexit Britain

As the self-imposed deadline for triggering the Article 50 legislation draws nearer, it has been a fascinating day of political developments in the UK. First, we had the spectacle of Scottish First Minister Nicola Sturgeon issuing a demand for a second referendum on independence following the plebiscite in 2014. This was followed by the House of Commons voting against any amendments proposed by the House of Lords to the Brexit bill. It thus looks set to be passed into law tonight which in theory will allow the prime minister to formally launch the UK’s departure from the EU tomorrow. One of these events is historic enough, but the prospect of both coming to pass will irrevocably change the nature of the UK. No more United Kingdom, more Little Britain.

First, the Article 50 legislation. Regular readers will know my views: Leaving the EU is a leap in the dark which no amount of breezy confidence from politicians can conceal. Anyone who has ever done a parachute jump will know that for all the pre-jump training, nothing compares to that moment when you leap out of the aircraft for the first time and hope that nothing goes wrong with the chute. So it is with Article 50. If the EU does not play ball on the terms envisaged by the UK government, we could hit the ground with a big thump.

A fine article in The Times today by Clare Foges (here, although apologies for the fact it is behind a paywall) reiterated a point which I have long made, that far too many British politicians hark back to the way which Margaret Thatcher dealt with the tricky subject of UK-EU relations more than 30 years ago, and misinterpret what happened. Thatcher may have thumped the table in order to get her “money back” at the Fontainebleau Summit in 1984 but she did so knowing how far she could push German Chancellor Kohl and French President Mitterrand. She well understood that both Kohl and Mitterrand needed something in return which they could sell to their domestic electorates. In fact, Thatcher got less than she wanted – she was forced to settle for the minimum rebate – and she subsequently became a passionate advocate of the Single European Market. Moreover, as Foges points out, the UK was in the club looking forward to a future in Europe, and although the path was rocky the UK was broadly travelling in the same direction as other EU members.

Fast forward more than three decades to the tin-eared politicians braying that Theresa May should remember the spirit of Fontainebleau. The prime minister can recall the spirit of Nikita Khrushchev to her heart’s content by banging one of her many pairs of shoes on the conference table, but the EU will not listen to threats. The experience of Greece, which tried to dictate terms to the EU over its bailout package in 2015 but was humiliatingly forced to accept austerity conditions worse than those previously rejected, should serve as a salutary reminder that a confrontational approach will not work – even if the UK is not in quite the same position as Greece.

It is against this backdrop that Nicola Sturgeon has reactivated the prospect of another referendum on Scottish independence. Sturgeon’s position appears to be motivated by the fact that the Scottish people overwhelmingly voted to remain in the EU and they are certainly not keen on the hard Brexit option being driven by Westminster. In Sturgeon’s words, “all of our efforts at compromise have been met with a brick wall of intransigence.” And whilst many people will have sympathy with Sturgeon’s view on Brexit, there is also a sense that she is using this as a device to push for what the Scottish National Party really wants – and all it has ever wanted – which is independence from the rest of the UK. But under the terms of the Scotland Act, a referendum can only be held with the consent of Westminster – it is not in the gift of the Scottish government to call it. And with Whitehall likely to be completely preoccupied in dealing with Brexit, it certainly will have no appetite for a referendum within the next two years, as Sturgeon is demanding.

As for what the people of Scotland want, there appears to be no great appetite for independence amongst the electorate at present, according to recent polls. Nor is Scotland’s economic position any better than in 2014 – arguably it is worse (I will deal with the economic situation another time). But just like 2014, any referendum will ultimately not be fought on the basis of economic logic. Already up to a third of voters retain an open mind on the prospect of independence and it will likely to be an easier sell than it was the first time round, so it could yet gain a great groundswell of support.

All in all, Brexit threatens to turn the UK political scene into an unholy mess (if it has not done so already). There is a sense that the government only cares about the views of the 52% who voted for Brexit; the Labour Party, which is nominally the opposition holding the government to account, has gone missing in action, and the SNP wants only to distance itself from the whole show. There is nothing United in the Kingdom nor Great about Britain, and if we get the politicians we deserve, what does that say about the voters?

GDP: A question of input and output

The focus on headline GDP growth is a highly misleading macroeconomic indicator and is routinely used and abused by politicians, journalists and (some) economists. It is an aggregate measure of all output, income and expenditure activity and has numerous shortcomings, as I have discussed in previous posts (here, for example).

Precisely because it is an aggregate measure, the more rapid the growth in factor inputs, the more rapid is growth in headline GDP. Thus, for example, the more labour we allocate towards productive output, the more quickly will GDP grow. In the early stages of its expansion, the extraordinary rates of growth in China were due to rapid rates of population expansion which, between 1980 and 2000, boosted economic output by more than 20%. Strictly speaking, of course, we should use employment or labour force growth rather than headline population, but this is a decent proxy and in any case is easier to obtain on a cross-country basis. This methodology essentially gives a rough measure of the extent to which growth is driven by productivity and how much is simply attributable to labour expansion.

In a 1994 book, Paul Krugman noted that “productivity isn’t everything, but in the long run it is almost everything.  A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.” So it is perhaps surprising to note that in the US between 1980 and 2007 fully one quarter of the increase in GDP was the result of an expansion of labour input, just as in China (see chart). This may go a long way towards explaining why although the US economy appeared to be growing rapidly and creating huge numbers of jobs, it never created the prosperity that politicians claimed.  By contrast, over the period 1980 to 2007, the UK experienced an average real GDP growth rate of 2.7% with GDP per capita growing at 2.4%. Thus, population accounted for just 9% of the rise in UK output over that period.

What is remarkable is how much of a change we seen across many industrialised economies since 2008. US GDP per head has slowed from 2.1% over the period 1980-2007 to 0.7% between 2008 and 2016. The corresponding figures for Germany are 1.7% to 0.9% and in the UK 2.4% and 0.4%. This is the much-discussed productivity puzzle which has exercised many fine minds over recent years. Nobody has a convincing explanation for such a slowdown, let alone how to resolve it, but a slowdown there has definitely been. If we accept Krugman’s view, the western economies appear to have a substantial problem in boosting living standards at the same pace as they did prior to the recession. And it is perhaps no surprise that people are unhappy with their economic circumstances with the result that we saw electorates vote for Brexit and Trump.

Indeed, although UK per capita GDP growth has slowed sharply since 2008, to the point that it took until 2015 for output per head to recoup the losses suffered during the recession, the slowdown in measured GDP has been less dramatic. What this implies, as the economist Simon Wren-Lewis has pointed out, is that immigration into the UK has helped to support measured GDP growth in recent years. Moreover, if immigration is curbed as a result of Brexit, an absence of any pickup in productivity suggests that UK measured GDP will also slow. With the UK government possibly poised to trigger Article 50 proceedings as early as next week, this is a message worth taking on board.

It also suggests that we should beware the pronouncements of politicians who extol the virtues of rapid GDP growth, as UK Chancellors are wont to do. An economy’s output performance depends on the quality of its inputs. GDP is not necessarily a measure of living standards: It just means that we produce more, but if there are more of us that is what we should expect – as anyone who regularly battles London commuter traffic will know only too well.

Back to fiscal basics

Fiscal rules sound good to economists and are eagerly seized on by politicians as a good way to appear responsible when it comes to matters of public finance. Unfortunately, all too often they fall short of the standards required of them. We all know about the Maastricht fiscal targets which many EMU countries have found difficult to adhere to. Similarly, the UK has experimented with a plethora of rules over the years, beginning with the idea of a ‘golden rule’ designed to ensure that the government only borrows to invest over the cycle with current spending matching current income. When that did not work, the government adopted a policy of reducing the structural deficit – a policy which relies heavily on estimates of the output gap, which in turn is subject to a huge amount of judgement.

But one of the less clever ideas of recent years was the 2015 Conservative manifesto commitment “to no increases in VAT, National Insurance contributions or Income Tax.” It is not a fiscal rule in the sense of those previously outlined but it represents a “promise” to the electorate upon which an election was fought. It is thus not hard to imagine why Chancellor Philip Hammond’s budget announcement that he planned to raise national insurance contributions (NICs) on the self-employed to bring them closer into line with those paid by employees created such a political furore.

The first point to note is that a commitment not to raise taxation is a foolish policy choice: Every government needs some policy flexibility. By closing off this fiscal option, monetary policy has to do more of the heavy lifting and it is thus ironic that the Bank of England has been criticised by politicians for its policy choices when the government has taken a deliberate stance on taxation. Technically, the Chancellor did break an election pledge – though he can justifiably argue that it was made neither by him nor the current prime minister, and that economic circumstances have changed.

There is also a strong economic case for doing so. The Chancellor’s argument is based on the problem that many people change their employment status to self-employed to benefit from lower taxes in order to sell their services back to their former employer which in turn results in a revenue loss for the Exchequer. Under the current system self-employed people pay NICs at 9% versus employee NICs at 12% and a supplementary rate of 2% on higher incomes. The Chancellor argued that “employees and self-employees use public services in the same way but do not pay for it in the same way.” As Paul Johnson of the Institute for Fiscal Studies argued “A tax system which charges thousands of pounds more in tax for employees doing the same job as someone else needs reform.  It distorts decisions, creates complexity and is unfair. The incentives for companies to claim that people who work for them are self employed rather than employees are huge.”

Lest we forget, NICs are supposed to be a tax designed to fund the social welfare safety net. At a time when welfare budgets are under huge pressure the Chancellor is hardly likely to turn down the opportunity to claw back some extra revenue. But one problem, as Ed Conway pointed out in The Times yesterday, is that employee NICs are no longer a hypothecated tax – they are simply seen as a branch of income tax. So why not get rid of them altogether? As the system works at present, those paying the basic rate of income tax face a marginal rate of 32% (20% income tax and 12% NICS) which quickly rises to 42% (40% income tax and 2% NICs) at incomes above £46k per year. A quick set of calculations suggests that assuming tax bands remain as specified for fiscal 2017-18, but abolishing NICs and replacing them with a higher rate of income tax, it is possible to set tax rates which leave most people with a higher post-tax income.

Thus, instead of levying income tax of 20% on the first £33.5k of taxable income (i.e. over and above the £11.5k threshold) plus NICs at 12%, we could replace this with an income tax rate of 33%. The bulk of earners would thus actually receive a post-tax income boost despite the fact that they are actually paying more income tax than they do now. This purely because they are no longer paying NICs which are often viewed as a hidden tax. For upper and higher rate tax payers, it turns out that their incomes are very sensitive to the higher rate (currently 40%). Raising this rate to 41% gives them a bigger income boost (blue line in the chart) than those earning the median wage but increasing it still further, to just 42% means that they suffer modest declines of no more than 0.3% (red line).

These are little more than back-of-the-envelope calculations but they demonstrate how easy it is to play with various tax options to benefit particular income groups. It tells us, too, that much of the current furore over what level to set NICs for different groups is misplaced. Tax simplicity is a critical element of any tax system. And as the influential Meade Committee Report noted in 1978 “the very fact that over recent years there have been so many changes in the tax system suggests that an essential need is to put a stop to this bewildering process of altering each element of the tax system as soon as the taxpayer gets used to it and arranges his affairs appropriately.” What was true almost 40 years ago is still true today.

We're not living beyond our means!

As a general rule I am not one for predicting what the Chancellor might say during his budget speech, but I would not be at all surprised if the phrase “living within our means” crops up at some point tomorrow. George Osborne said it ahead of the 2016 budget; Philip Hammond used the phrase at the Conservative Party conference in October and he was at it again over the weekend, telling the Sun on Sunday that we must “ensure we get back to living within our means.”

We all know that this is just another way for Chancellors to say that they intend to reduce the budget deficit further. But as a statement of economic fact, it’s nonsense. Over the years, Chancellors have told the public that “we must live within our means” as if somehow state finances are the equivalent of running a household budget or a corner shop. And the public continue to fall for it. But there is a major difference between an entity with a limited lifespan, such as a household or a one man business, and a state with a much longer lifetime – if not infinite, then close enough for the purposes of investors. Households operate under a lifetime budget constraint in which all current spending and borrowing have to be paid out of the finite lifetime income which it generates. A sovereign state such as the UK will (hopefully) still be around in 100 years’ time (notwithstanding the Scottish secession threat). There is thus a pretty strong likelihood that an entity which has never defaulted outright on its debt will still be around to pay its dues. For the UK, living within its means implies thinking over a much longer time horizon.

Let’s look at the counterfactual by supposing that “living within its means” requires the sovereign state to fund its commitments out of current income. How would we finance investment? Is it right that today’s taxpayers should provide all the funding for a long-lived project – such as a housebuilding or hospital expansion programme – without requiring future generations that benefit from them to pay anything? And while we are at it, how do governments fund wars? After all, UK government debt rose by 100 percentage points relative to GDP between 1939 and 1947 – proportionally way more than anything we have seen in the last decade. Imagine history’s reaction if Churchill’s government in 1940 had said something along the lines of “obviously, we are committed to freedom and democracy but we are not prepared to fight for it because we have to live within our means.”

So as statements of economic policy go, this is just dumb. However, I guess most Chancellors know it but since they are politicians first and foremost, they have to get the message across in ways that people understand. Of course, it is not just British politicians who are guilty of this fallacy. German finance minister Wolfgang Schäuble remains committed to maintaining budget balance despite the fact that Germany saves too much and invests too little (that, after all, is why it runs a huge current account surplus). Yet his message goes down well with an electorate that sees saving as a virtue – which it is, though not as an end in itself.

I am not as such opposed to a degree of consolidation in public finances – though as I noted on Sunday, we may be overdoing it in the UK. What I object to is the misrepresentation of the government’s budget problem as though it were managing a household budget for it gives a misleading impression of how state finances operate. We are living within our means if we can finance most current spending from current income and have to rely on a small sub from the markets for the rest. After all, markets lend to governments because they know they will be compensated – though not terribly well at present – and get their money back. Nobody is forcing them to do so. We know we are living beyond our means when markets cease to buy government debt. And despite record low interest rates, there is no sign of that happening just yet.

Running out of road on austerity

Next Wednesday will see the occasion of the annual UK parliamentary set piece otherwise known as the presentation of the annual budget. The principle of parliamentary approval of the budget plans date back to the late seventeenth century when the nation’s finances were squandered once too often by a spendthrift monarch. The final straw came during the reign of Charles II in 1667, whose navy was laid up due to a lack of funds and which was subsequently caught unawares by a Dutch raid.

Budget presentations in their current form began in the early eighteenth century, with the word budget itself derived from the French "bougette", which was the little bag from which the Chancellor of the Exchequer would reveal his plans. Incidentally, this explains why the Chancellor "opens" his Budget. The UK is just one of a handful of countries whose fiscal year begins in April (of which Japan is the only one not a former British colony) reflecting the historical fact that when the economy was primarily based on agriculture land tax was collected in April, hence budgets are held in spring.

Over the years the budget became one of the main parliamentary events of the year although its importance in recent years has dwindled somewhat. Nonetheless, it provides us with a good opportunity to focus on the state of UK government finances and fiscal policy. The good news from a macro perspective is that the budget deficit has fallen sharply, from a peak of 10.1% of GDP in FY 2009-10 to an expected 3% in 2016-17 (it reached exactly 3% in calendar 2016, chart). The previous policy of targeting a surplus by the latter part of this decade has been abandoned in favour of a rule which requires reducing the structural deficit below 2% of GDP by 2020-21 and ensuring that the debt-to-GDP is on a downward trajectory ratio by the end of this parliament – both of which seem highly achievable.

But the fiscal improvement has come at a significant cost. Total managed expenditure (the sum of public sector current expenditure, net investment and depreciation) fell from a peak of 45.3% of GDP in 2009-10 – the highest since the mid-1970s – to current levels just below 40%. At the same time, receipts have risen by less than 1% of GDP which is a clear indication of the extent to which the squeeze on public finances has come from spending cuts. Additional spending cuts are already baked in thanks to measures taken by former Chancellor George Osborne. One of the measures which most worries me is the reduction in central government grants to local authorities, which by 2019-20 are set to fall by 80% relative to 2008 levels. This is without a doubt the key reason why local authorities are having to cut frontline services, and I remain of the view that this savage austerity was one of the reasons why the electorate voted to stick two fingers up to the government last June.

Former minister David Laws has already warned that the UK is “reaching the socially acceptable limits to public sector austerity,” and the Institute for Government reported last week that public services are reaching a breaking point (here). It suggests that whilst “the 2010 Spending review was largely successful” in achieving its objectives, “the Government is struggling to successfully implement the 2015 Spending review … [with] clear signs of mounting pressures in public services.” Newspaper headlines over the winter have highlighted the strains on the NHS and the IfG notes other areas where strains on public services are mounting. The report makes four key points which the Chancellor ought to take note of when framing his budget plan: The government:

• is failing to develop alternative strategies despite the clear warning signs in the data
• is continuing to pursue approaches that are no longer working
• is being forced into emergency actions in response to public concern
• is providing emergency cash to bail out deeply troubled services.

In other words, austerity has gone as far as it can. Moreover, there has been no recognition from the UK government (or, for that matter, from most European governments) that fiscal multipliers have proven to be far higher than expected before the financial crisis. Fiscal austerity has had a bigger adverse impact on European growth than policymakers expected. Undoubtedly Chancellor Hammond will point out that the UK has been one of the better performing growth economies in recent years. But that is not how it feels to many people outside the south east of England. Employment growth has been very strong in the last four years but real wages remain below pre-crisis levels. Workers have priced themselves back into a job but their position feels a lot more precarious than it once did.

I am not convinced that Mr Hammond is going to substantively address these concerns next week. His is a government which has an ideological conviction that deficit reduction is an end in itself. But it is not: After all, it’s not government money – it’s ours and we hand it over to the government to facilitate the running of the state. The government thus has a duty to use that money to manage the economy in the best interests of its citizens. And despite the evidence from the macro numbers, I remain as convinced today as I was in 2008, that fiscal policy has a key role to play in helping to make life better for taxpayers.

Brexit: More on the exit costs

It has widely been suggested that the European Commission will try and extract a high price from the UK in terms of the Brexit bill when it finally departs the EU which I looked at last week (here). But a report published today by the UK House of Lords (here) makes the point that “the UK will not be legally obliged to pay in to the EU budget after Brexit.”

The argument hinges on what happens if the Article 50 legislation expires without an agreement. One school of thought argues that under international law (the Vienna Convention on the Law of Treaties, established in 1969) “obligations undertaken when the UK was still bound by the EU Treaties would not disappear at the moment of Brexit.” But another interpretation is that Article 50 offers no provision for measures to be applied in the event that the UK and EU fail to come to an agreement. Indeed, there is no provision to decide who is the competent jurisdiction to adjudicate on post-Brexit matters or conflicts. So if the Article 50 negotiations fail there is no way that the UK can be held to account.

The problem is, of course, that there is no simple legal answer to the question and like economists, lawyers tend to offer a range of different opinions. Prime minister May has already suggested that the UK will be willing to make some form of contribution so the idea of making no payment is unlikely. Equally, however, it suggests that the €60bn bill which Michel Barnier, the EU’s chief negotiator, is reportedly aiming for will be rejected outright by the UK. But this is when matters start to get tricky because a large part of the time available under the Article 50 arrangements will be wasted trying to resolve this problem. This, of course, plays to the EC’s advantage because even if it has no realistic possibility of securing a €60bn payout, it can tie the UK in knots for months. Then when it does finally get round to discussing trade arrangements, the UK will have little time to respond and may be forced to accept an arrangement which can only be described as a second best option.

Precisely because the UK government wishes to maintain close ties to the EU, it will be almost morally obliged to make some sort of payment. Ingeborg Grässle MEP, Chair of the European Parliament Budgetary Control Committee, suggested in testimony to the Lords that a figure as low as €22bn might be sufficient to cover the UK’s obligations. I reckon that is the sort of figure the government could live with.

Looking further ahead, there is the question of how much the UK will have to continue to pay in order to maintain access to certain EU projects. On a per capita basis, calculations presented in the Lords report suggest that at €115 per annum, Norway pays around 45% more than the UK does now (€79). Of course, Norway pays for access to the single market which PM May has already ruled out for the UK. But if the UK wants to continue accessing the EU market it will need to pay – either in the form of an annual membership fee or via tariffs. As Richard Ashworth MEP noted in his Lords testimony, a regular annual payment to the EU budget might work out far cheaper than paying tariffs. In his view, “the tariff  that will  be  paid ... seems to be a very, very substantial sum of money indeed ... I do not think it has dawned on people yet quite how big that sum is going to be.”

That being the case, the prospect that the UK continues to pay an annual fee for tariff-free access to the EU is a realistic one. But how high would the subscription cost be? Let us start from the premise that the UK will pay no more than half its current net cost. That would put the upper limit at around £5bn per annum. The government could claim that this represents a significant saving on its current bill (almost £20bn) and that it has saved £15bn per year. However, the reality is that since the UK receives back almost half its gross contribution in terms of rebate, agricultural subsidies and other items, the actual savings are relatively small. Continuing to pay a contribution to the EU is not what Brexit supporters had in mind during the referendum campaign. But if the UK is able to get away with a £5bn (€5.8bn) annual contribution and a one-off exit payment of €25bn, that would count as a good deal in my book. If I were on the UK negotiating team, that would certainly be an outcome I would be pushing for.