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.

As more evidence comes to light ...

Nigel Farage likes to claim that he is speaking for the ordinary citizen and has argued strongly against immigration, suggesting that the studies which show the benefits of immigration to be flawed because they fail to account for the cost of in-work benefits such as tax credits. But right-wing politicians are not the only ones to be concerned about free movement within the EU: One of Jeremy Corbyn’s key union supporters, Unite’s Len McCluskey, suggested this week that Labour should also take a tough line on free movement of workers. But the evidence clearly shows that both are ignoring the economic benefits of free movement to the UK and their opposition to immigration is based on a false premise.

Three months ago HMRC published data which showed the revenue and expenditure contribution of EU citizens to the UK’s tax and benefit system for fiscal 2016-17 which paints a very different picture to many of the claims made during the  EU referendum campaign. The figures show that EU and EEA citizens received around £3.2 billion in child benefit and tax credits. But they paid in £21.3 billion, meaning that they made a net contribution to the UK Exchequer of £18.1 billion. Although this figure does not include all tax and revenue streams, it is a safe bet that this these figures are a fair reflection of the overall fiscal contribution of EU citizens. To put it into context, a figure of £18.1bn is more than the current budget surplus for FY 2016-17 (£17.4bn). Without the fiscal contribution of EU and EEA nationals, the current balance on public finances would have been in deficit. 

Citizens of all EU countries made a positive exchequer contribution, with the largest net sums being paid by French (£2.9bn) and Irish (£2.2bn) nationals, with the Poles chipping in a net £2.1bn. On a per capita basis, the biggest contributors were Danish nationals, who paid an average of £25,090 followed by the French (£24,090, chart). The average European per capita contribution was £7,260 with the overall figure being depressed by the relatively low contributions made by central and eastern European nationals. The figures tell us two things: Most obviously European nationals come to the UK to work, not claim benefit as has often been claimed in the recent past. Second, the distribution of per capita contributions highlights the fact that western European nationals tend to be highly skilled and are therefore high earners whilst those from newer EU member states tend to be lower paid.

Even before the end of free movement, the UK is no longer an attractive destination

For all the fact that EU nationals make a significant contribution to the UK economy, there is clear evidence that fewer of them are entering the UK than was the case three years ago. Although the UK immigration data are subject to significant methodological flaws, they are all we have at present and they show that in the year to March 2019, a net 226k foreign nationals entered the UK compared to 311k in the year to June 2016. The net inflow of EU nationals has slowed to 59k versus 189k in the year prior to the referendum, with net outflows of EU8 citizens as many of the huge wave of migrants from Poland begin to return home. But the real kicker is that in the year to March, a net 219k non-EU nationals entered the UK compared to 171k in the year to June 2016. Recall that this is the part of immigration that the UK government can actually control, so if the electorate really does have a problem with immigration they are going to be mighty dumbfounded by the government’s current policy.

It has long been recognised that there are substantial costs associated with pulling up the drawbridge and the government appears to have quietly dropped its unrealistic pledge to reduce the net number of immigrants below 100k. But it might be too late: Large sections of the UK public sector rely on foreign labour input and there has been a 70% fall in the number of EU citizens coming to the UK to work. In the absence of a sudden surge in Brits willing and able to take on the tasks, these positions will have to be recruited from outside the EU, which may explain why the numbers arriving from outside the EU have increased.

Moreover, one of the flaws with the data is that it includes those coming to the UK to study and who make a net overall contribution to university coffers. Prior to the EU referendum roughly one-sixth of the net immigration figures was attributable to students – there has been a reduction of around 20k in new student numbers over the past three years with anecdotal evidence suggesting that many have been put off by the more hostile climate. This is certainly not a desirable outcome for universities which are seeking to expand their footprint in an increasingly competitive global education market.

Whatever one’s views on immigration, it is clear that a policy of restricting the flow of EU citizens into the UK will have economic consequences. This may only be evident initially at the margin. But it remains one of the potential underrated consequences, whose full effects will only become evident in the fullness of time.

The fiscal politics of the 2019 election

As the UK general campaign gets underway politicians have been falling over themselves to demonstrate their willingness to spend what sound like huge amounts of money in order to revamp the economic infrastructure. From my standpoint, as one who has been severely critical of the government’s fiscal stance over the past nine years, an opening of the fiscal taps is welcome. But numerous people have asked me how a Conservative government that has made such a big deal of economic austerity, can suddenly switch from fiscal famine to feast. It’s a fair question and the answer is quite simply because the Tories realise that it is a popular idea whose time has come. 

Common ground as both parties seek to ease fiscal policy 

Dealing first with the details, the Conservatives have ripped up their old fiscal rulebook in order to allow them to spend an additional £22bn (1% of GDP) per year. The Labour Party, which in 2017 campaigned on a platform of much higher spending, is committed to a plan that envisages an additional £55bn (2.5% of GDP) per year. Neither party will therefore abide by the current fiscal mandate designed to limit borrowing to 2% of GDP by 2020-21. The current framework also has two supplementary aspects: (i) to eliminate borrowing altogether by the mid-2020s (the ‘fiscal objective’) and (ii) that net debt should be falling as a share of GDP by 2020-21 (the ‘supplementary target’).

The fiscal objective is a non-starter and the supplementary target will also be blown out of the water. To a large extent, the fiscal objectives had been blown off course anyway by changes to the treatment of student loans in the national accounts, which raised borrowing by around 0.5% of GDP. But on the basis of my preliminary calculations, even a modest additional £20bn per year of public investment will raise the deficit ratio to at least 3% of GDP by fiscal year 2023-24 (the March OBR projections put that figure at 0.5%).

The Chancellor Sajid Javid noted in a speech on Thursday that the Conservatives are committed to balancing the current budget on a three year horizon (i.e. excluding investment). Whilst this will leave little room for additional day-to-day spending on issues such as social care or tax cuts, this is eminently achievable on the basis of my estimates. But calculations reported in the FT suggest that the Chancellor only has around £7bn of headroom on his current spending plans, which essentially rules out big tax cuts such as Boris Johnson’s promise to raise the threshold for higher rate taxpayers.

One of the reasons the Conservatives have changed tack is that ongoing fiscal austerity is not politically popular and they risk being outflanked by Labour. I will deal with the specifics of the Labour proposals another time but essentially they involve a "social transformation fund" which would spend around £30bn per year on upgrading the social infrastructure (schools, hospitals, social care facilities and council homes) and a "green transformation fund" spending around £25bn a year on areas such as energy and transport and insulating existing homes. Labour also remains committed to a National Investment Bank in order to manage the disbursement of funds. This is not a bad idea and I looked at some of the specifics of this policy in the run-up to the 2017 election (here). 

But it will not come cheap 

The big question is how all this will be funded and the obvious answer is that it will require a huge increase in borrowing. Whilst it does make sense to loosen the purse strings at a time when interest rates are at all-time lows a huge increase in borrowing could actually force bond yields up, particularly if the UK is outside the EU which might raise the risk premium on debt anyway. Moreover, given the market’s scepticism towards Labour’s plans, particularly on tax, it is unlikely they will be able to fund the plans at anything like current market rates. In the event that a Labour government is elected (unlikely, but you never know) my guess is that they will not be able to enact a fiscal expansion on this scale. Recall that Francois Mitterrand’s victory in the French Presidential election of 1981 on a platform of nationalisations, wealth taxes and a wage increase was followed by a swift U-turn two years later as economic orthodoxy was restored. 

... and international investors may get cold feet 

The outbreak of fiscal largesse was accompanied yesterday by Moody’s downgrade to the UK’s credit outlook. My initial reaction to this was “so what.” As I have long pointed out, it is incongruous that the UK should have a lower credit rating than Germany when the UK issues debt in a currency which it controls but Germany does not. Sovereign credit events tend to occur when countries issue debt in foreign currency and run out of the necessary funds to repay creditors. Whoever is in office after the election, this is not a problem the UK will have to worry about.

But on closer inspection, Moody’s statement provided a damning indictment of the institutional framework: “The increasing inertia and, at times, paralysis that has characterised the Brexit-era policymaking process has illustrated how the capability and predictability that has traditionally distinguished the UK’s institutional framework has diminished … This broad erosion in the predictability and cohesion of policymaking is mirrored in areas of policy that are significant from a credit perspective. Most importantly, the UK’s broad fiscal framework characterized by features such as multi-year budget plans and more detailed revenue and spending decisions … has weakened.”

Politicians of all stripes want to play fast and loose with the institutional framework. Let us not forget that last year Labour wanted to expand the role of the BoE to target UK productivity growth – a ridiculous strategy if ever there was one. But since the Tories have been in office during the last three years, they deserve most of the blame for the Brexit-related policy debacle by trying to ride roughshod over parliament. From an economic policy perspective, the fiscal and monetary frameworks devised in recent years have done much to improve the transparency of policy and prevent governments from twisting it to meet their political needs. If Brexit is about a political return to the 1970s, governments seem to be doing their best to ensure a return to 1970s policy ad hocery – and we all know how that turned out.