What was the problem with the 2012 UK budget? The problem with the budget was not so much what the Chancellor did but rather what he did not do. There was precious little in this budget to address the most pressing need of the British economy, and indeed the world economy: the need for growth.
But the budget does reveal a lot about the government’s economic strategy and inadvertently shines a light on why it is failing.
Tax troubles: A lack of principles
The Chancellor fed some red meat to the Conservative heartland by reducing the top income tax rate from 50% to 45% but needed to sell this to his coalition partners. This was done by a number of wheezes including the tightening of tax loopholes and the reduction of age-related tax exemptions (the so-called granny tax). But the main soak-the-rich policy was a new 7% tax rate on the sale of houses worth over £2 million (land stamp duty). The Treasury puts the cost of the reduced 45% tax optimistically at only about £100m per year, but the stamp duty revenues at well over £200m per year (HM Treasury 2012, Table 2.1).
Unfortunately, the Chancellor has missed a chance to make a real reform to the stamp duty.
- Public finance Principle 1 say that taxing an immobile factor like land is a good thing because it creates less distortions to behaviour – eg land cannot leave the country.
- Principle 2 says that we should tax property values rather than just the proceeds from selling a house.
Someone who doesn’t sell a house has been sitting on a huge untaxed capital gain. The UK has relatively low property taxes, but these ‘council taxes’ hardly touch the big increase in house prices because successive governments have backed away from properly revaluing the housing stock for fear of upsetting voters. But taxing housing transactions reduces the incentive to move, say for the purpose of finding a job. Rather than reform the tax system to make it “fairer, more efficient and simpler”, this complicates it further.
Reducing taxes on the very rich doesn’t seem fair in an age of austerity, but will the reduction in the top rate of tax make a big difference to incentives? The truth is no one really knows (although for a good attempt see Kleven et al 2011). The worry is that wealthier people may not respond by working harder or moving en masse to the UK in the way the Chancellor hopes.
Reducing child benefit for the better-off is a reasonable move, but it would have been better to integrate this properly into the existing system of child tax credits and benefits. Instead it is being bolted on to the whole system, which is going to create more complexity and perverse incentives.
What this whole episode of changing tax at the top illustrates is the triumph of political manoeuvres over sound public policy principles.
The Big Picture: We need an alternative to Plan A
As expected there was no movement away from the Chancellor’s current austerity programme. In my view, the rate of fiscal consolidation is too fast and is raising unemployment and slowing growth more than is necessary (Van Reenen 2011). Economic forecasting is a conservative profession but most regard austerity as directly knocking a third of a percentage point off growth last year and more this year. Unfortunately macro models do not fully factor in the way in which austerity damages the productive potential of the economy through hysteresis effects. This means that unemployment begets more unemployment as scrapped workers lose their skills and motivation. Putting these into macro equations would result in an even larger depressing long-term effect of austerity on growth. The Chancellor’s defence of his tight fiscal stance is that it is needed to calm the nerves of over-anxious bond traders. But I can see no reason why the markets would panic from a set of policies to boost government investment in shovel-ready projects like school buildings or road repair. Unfortunately it is these types of investments that have been curtailed the most severely over the last few years. Nor do I see major costs to our fiscal credibility in offering temporary reductions of National Insurance payments (known as social charges in continental European countries) aimed at mitigating the scourge of young unemployment, which is at record levels.
Putting aside the overall fiscal position though, there are two concerns over the Chancellors’ economic strategy.
- First, the fact that ideology has being trumping evidence; and
- Second, the lack of direction on a decent growth strategy.
Ideology: 1, Evidence: 0
Too many spending cuts have been based on kneejerk slash-and-burn reactions rather than on calm assessments of which policies are valuable. To give two examples:
- The government abolished the Educational Maintenance Allowance, which evaluations have shown to be an effective way of getting kids from poor families to stay in school.
- It abolished investment subsidies for smaller firms in struggling regions, but kept them for large firms who just pocket the money without creating new jobs (Van Reenen 2012).
Sadly, there is almost no allowance made in the government for proper evaluation of the multiple policies it is putting in place. It is another example of placing ideology over evidence. And it is depressing – running experiments to evaluate policies is nigh impossible in macro, but it is technically easy and morally imperative to do this for microeconomic policies.
Wanted: A proper growth strategy
The really big problem with the coalition is the lack of any idea of any sensible growth plan. The attitude seems to be that given the austerity programme, the microeconomics will look after themselves. The Department of Business, Innovation and Skills did announce a growth plan this time last year (BIS 2011). Unfortunately, closer examination reveals less a plan than a mishmash of contradictory and confused ideas. There are too many small-scale initiatives without any thought on how these can be linked to really make a return to sustained growth. The Plan for Growth has over 250 reforms, the slogan seemingly “never mind the quality, feel the width”. The budget has put in such measures as tax relief for the video games and animation industry and enhanced capital allowances for ‘Enterprise Zones’. Each initiative will cost the government the princely sum of £5 million each next year. Credit-easing for small- and medium-sized enterprises finance is also desperately needed, but again the Chancellor is short of change.
One of the bigger ticket items in the budget is the ‘patent box’ (Griffith and Miller 2011), a policy predicted to cost £1.1 billion a year. Although originally touted as an innovation policy, it will not create new ideas. The patent box gives a corporate tax break for holders of intellectual property, but the profits from this can be taken in a different country from where the research is conducted – it is accountants and tax lawyers who decide to take the intellectual property profits. The R&D that leads to intellectual property does create some productivity spillovers in the country where it is based, but the spillover depends upon the location of the R&D, not the legal location of the resulting intellectual property. Even as a method of tax competition the patent box stands to lose significant revenues for the government. A far better use of such resources would be to reverse the 10% real-terms cut in the science budget over the next four years.
The LSE Growth Commission (see here) is addressing this problem by asking:
- What are the conditions for sustainable growth, and
- How can the state have a more proactive plan for growth?
Our first thoughts are in Corry et al (2011) and we welcome contributions from all sources.
I recently laid out some of the ideas in a Special Session at the Royal Economic Society in Cambridge on Monday, 26 March 2012 (see here). These include:
- Tackling the ‘too big to fail’ problem in finance structurally (Van Reenen 2010b, see also the Vox debate on the financial sector here)
- Dealing with the UK’s deficit in managerial capability (Van Reenen 2010a)
- Improving human capital through overhauling schooling (see here)
- Changing planning and local incentives to allow more homes and businesses to be built (see here)
- Getting science out of the lab and into new start-ups
But government can go further than just getting the environment right. It must actively scan where the UK has relative strengths in the future and where global growth is likely to come from. In these areas policies must take a laser-like focus, removing regulatory and other barriers in these sectors as well as considering ways to bolster the strength of firms in these areas. This is what I label ‘Plan V’. An example is immigration policy. The government’s foolish plans to curtail skilled immigration will undermine the higher education sector, one of the strongest areas of future growth. An open immigration policy is good for productivity growth as well as the public finances.
But it’s not all bad news…
There are many welcome aspects of the budget – the increased personal allowances, longer-term government bonds, credit easing, and implementation of the Vickers proposals to reform banking. There are worthy consultations over local pay, integrating National Insurance with income tax and controls over tax deductions. Of course we need to see whether consultation becomes action.
But none of these welcome moves are enough to counter the deeper intellectual vacuum at the heart of the budget and the government’s whole approach to economic growth.