Britain’s fiscal stimulus

A shot in the arm

The government of Britain announces tax cuts designed to boost the economy

BRITAIN’S contribution to a global effort to add a shot of fiscal adrenaline to ailing industrial economies was delivered by Alistair Darling, the chancellor of the exchequer (finance minister), on Monday November 24th. He produced an emergency winter budget, which had been preceded by a deluge of leaks, to the House of Commons. He is notorious for the tranquillising effects of his oratory but this event, at least, stirred significant excitement.

The scale of the giveaway certainly sounded impressive. The centrepiece of the fiscal package was a big reduction in the main rate of value-added tax (VAT), which is charged on most goods and services, from 17.5% to 15%. This will take effect from the start of December and last until the end of next year at a total cost of £12.4 billion ($18.5 billion), equivalent to 0.8% of annual GDP.

The busy Mr Darling, keen to contrast Labour’s willingness to intervene to support the economy with the opposition Tories’ reluctance to endorse tax cuts financed by extra borrowing, had much else to give away. There was a package of measures to support small businesses, including a deferral to April 2010 of a planned increase next spring in the small-firm corporation tax rate from 21% to 22%. He also dipped into the public purse to help pensioners and families with children.

The chancellor had to make some further amends for the upset caused by Gordon Brown’s last budget when it came into effect this spring and put over 5m families out of pocket. That had prompted a £2.7 billion unfunded tax relief for basic-rate income taxpayers, which was announced in May. Mr Darling made this help permanent and more generous at a cost of £3.6 billion next year.

Taking all his measures together, the chancellor is injecting an extra £9.3 billion into the economy in 2008-09 (the fiscal year runs from April to March) of which he had already announced £3 billion since his spring budget; rising to £16.3 billion in 2009-10, of which £1 billion had already been announced. That adds up to new measures worth £21.5 billion, of which £3 billion consist of planned capital spending being brought forward from 2010-11.

That may sound a big boost, but because it is spread over two years it is less so. Mr Darling’s policy announcements since his budget in March will ease the fiscal stance by 0.6% of GDP in 2008-09 and by 1.1% in 2009-10. As a result Britain is still heading for a painful recession, despite the government’s fiscal stimulus.

The reason why the Treasury was unable to do more was clear from the borrowing forecasts that Mr Darling unveiled. Although these include his new fiscal measures they were still breathtakingly high, as George Osborne, the Tory shadow chancellor, immediately pointed out. This year borrowing will double to £78 billion, and it will then jump to £118 billion in 2009-10. In relation to GDP, it will rise from 2.6% in 2007-08 to 5.3% this year and to 8% in 2009-10, the highest in records stretching back to 1970. Furthermore, net public debt (using the Treasury’s measure, which excludes the liabilities of nationalised banks such as Northern Rock) soars from 36% of GDP in 2007-08 to 57% in 2012-13, again the highest over the past 40 years.

So big a deterioration in the public finances cannot be blamed on the downturn in the economy. In fact, Mr Darling’s growth forecasts, while slashed from his whistling-in-the-wind predictions earlier this year, were still quite optimistic: the Treasury’s central forecast is for GDP to decline by 1% in 2009 and to bounce back by 1.75% in 2010. By contrast, the IMF thinks that the economy will contract by 1.3% next year. Rather, the worsening state of the public finances reflects the particular shape of this recession as the Treasury loses two of its big moneyspinners over the past decade, the buoyant tax revenues from the financial sector and the property market. As a result the cyclically-adjusted budget balance will reach 7.2% of GDP next year.

Conscious of the need to retain the confidence of the financial investors who will have to finance the flood of new borrowing, Mr Darling set out plans to bring Britain’s books back into order once the economy starts to recover. These include tax rises on the well-off, with a politically significant though fiscally insignificant increase in the top rate of income tax from 40% to 45% for people earning over £150,000. More important, the chancellor is raising social-security contribution rates and most significant of all public spending growth will be yoked back. Underpinning his projection of a return to budgetary health is a helpfully high assumption about how fast Britain’s underlying growth rate will be after the dust has settled.

Hanging over Mr Darling’s fiscal statement was the prospect of a general election, which must be held by June 2010. The task of fiscal consolidation will fall to a new government. Almost certainly that government, whether it is Labour or Tory. will find that more harsh fiscal medicine is needed to restore Britain’s public finances to sound health.

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