It was a bold Budget, all right. It was hailed as the most significant Budget in years, which is odd because they said much the same of Alistair Darling’s Budget of just a few months ago. You could say there are two key points that stand out. Firstly, George Osborne wants to reduce what’s called the structural budget – that is to say the underlying budget deficit that is unrelated to the point we stand in the economic cycle, by the time of the next election. And by that point, he also wants to see government debt falling. Secondly, Mr. Osborne wants to see the UK economy shift from one that relies on consumer spending for growth to one that relies on investment and exports.
The markets appeared to like it. Okay, the FTSE 100 was down slightly yesterday, but this was probably unrelated. The index has risen sharply over the last two weeks, so yesterday’s mild falls are pretty insignificant. Sterling rose one cent against the dollar and the euro, but, again, the movements were so small that one can’t really read much into them at all. More significantly, the yield on ten-year UK government bonds dropped from 3.51% to 3.46%, the joint lowest yield in some time. But it was the comments from the credit ratings agency Fitch that are the most significant. David Riley, who is in charge of sovereign ratings at the agency, said of the plans in the Budget to cut government debt: “if delivered upon, will materially strengthen confidence in UK public finances and its AAA status.”
It is unavoidable that growth will falter in the short term as a result of this Budget. But that is not necessarily a criticism. In a way, you could say Osborne wants growth to be slightly lower this year and next. After all, it wouldn’t be painful otherwise, now would it. This Budget is about trying to improve the economy over the longer term. By reducing debt, interest payments on repaying our debt will fall eventually, so that eventually taxes can drop. By trying to shift the economy’s balance towards exports and investment, it is hoped that the UK will be more stable, and future growth won’t be at the expense of another bubble.
The big problem isn’t so much with the Budget. Rather it lies with the groundswell of opinion across the world, and the somewhat short-sighted view taken by markets. Markets failed us in the noughties, and seemed quite inept at seeing the crisis in the making for what it was. We keep hearing things like ‘no one saw it coming’, but this is not true. Plenty of publications, including this one, warned of a crisis in the making, and judging by the feedback we received from readers at the time, our views had common parlance amongst the public. The markets, by contrast, seemed unable to see it.
They can’t see it now. Once again they are proving inept.
As for George Osborne, to express our criticism it is first necessary to say what was wrong with Gordon Brown.
Brown’s followers say the recession was down to factors beyond his control. That the cause of the budget deficit was an international meltdown in markets. But these people forget the standing that GB had during his years as chancellor. Gordon brown stood centre stage in the great failure of the noughties. He, and his biggest fan come friend Alan Greenspan, and his second biggest fan the IMF, were the most influential economic policy makers in the world. They loved Gordon because his views were pretty much smack on what they thought. And they were all wrong.
Gordon’s policies did not cause the international crisis, but he was a part of an international consensus that got it hopelessly wrong.
Alas, it seems George Osborne is similarly cursed. The spirit of his Budget was in keeping with the spirit of the international consensus. And just like in the last decade, the consensus is wrong. The ultimate result could be disaster.
But before we say why, here is a brief rundown of some of the specifics and whether they are a good or a bad idea.
VAT increase is bold move, but danger lurks
To be honest, the increase in VAT was as close to a no brainer as you could get. The snag with increasing tax is that sometimes the effect can be less tax revenue. Economic theory calls it the Laffer Curve. Increase income tax, or capital gains tax, then people’s behaviour changes, they won’t work so hard, they pursue tax avoidance with renewed enthusiasm, high earners may move abroad, others just stop taking risk. Tax receipts fall. VAT is different. Sure, there might be an increase in people working for cash in hand, but in the scheme of things this is not significant. We all have to spend money in the shops at some point. The increase in VAT will raise money.
It is a little ironic, because Alistair Darling’s big idea to kick start the economy during the recession was a cut in VAT. The move drew wide criticism, and was very expensive. But what it did do was inject money into people’s pockets. And in that sense it may have been quite effective at boosting growth for a while. (By the way, economic theory says a tax cut designed to boost the economy has no effect because people have perfect knowledge, and realise tax will have to rise to compensate for the cut in the future so they leave the money they save for the tax cut in the bank. But we know Darling’s VAT cut did lead to a rise in consumer spending, and thus we know at least one piece of economic theory is bunkum.)
VAT is usually seen as a regressive tax, because it penalises the poor as a proportion of their income more than the rich. On this occasion this criticism may not be valid, as Mr Osborne did introduce measures to compensate for this effect.
It does of course make some Lib Dem politicians, and even David Cameron, look stupid because before the election they waxed lyrical about why an increase in VAT was a bad idea. Their excuse that government finances were worse than thought, or that market conditions had changed, were just excuses. If they had any kind of competence in economics at all, they should have known before the election that VAT was going to rise. They didn’t tell us the truth, because, well, because in the words of Jack Nicholson from the film, ‘A few good men’, they thought we “couldn’t handle the truth”, and we would then vote Labour.
What the VAT rise does do is to help re-balance the economy away from spending. For too long the UK was reliant on the High Street for growth. So we bought our advent calendars for dogs, and the High Street saw a boom that was simply absurd.
In that sense the rise in VAT is a good idea.
The counter argument is that the real problem of the noughties was that workers were not getting a sufficient share of growth. The growth in corporate profits outstripped growth in wages, therefore the only way demand could meet capacity was via debt. This argument would suggest lower, not higher VAT is what the UK needs.
Incentive to work
Gordon did have another failure. Not only was he a part of an international consensus that got it wrong, he was the architect of a benefits system that was horrendously complex and destroyed the incentive to work. By playing around with the benefit system, reducing some benefits, including housing benefits, child tax credits for families earning more than £40,000, freezing child benefit, reducing benefit for lone parents when their children go to school, and playing with sickness benefit, Osborne has helped himself to a large stick to try and beat the unemployed back to work.
The rise in personal allowance is the carrot to complement Osborne’s stick.
We would prefer more carrot and less stick, but in essence we think his ideas are about right.
Certainly the lack of incentive to work has been a factor in keeping people off the job market, and this in turn costs the Exchequer billions every year.
There are two snags. Cut benefits and you are likely to see a rise in crime. Secondly, it matters not how great are the incentives to work if there is no work available. Indeed, some argue that high benefits in a recession are essential in order to maintain demand for goods and services.
Help the poor
Osborne has balanced out his VAT rise, to help the poor with an increase in child benefit for low income families, help for pensioners and extending personal allowances. Public sector employees at the low end of the income scale will get pay rises.
On balance, the Budget was surprisingly mild for people at the low end of the income scale, given the massive hits to be suffered by most people.
Soft on banks
The Chancellor imposed a bank levy, in line with a similar levy imposed on the same day in France and Germany.
Of course, banks are not so important to the economies in France and Germany, so the fact they implemented a similar policy is something of a so-what development. The City will lose some of its competitiveness as a result of the Budget, but this will be partially cancelled out by the cuts in corporation tax.
On balance, given the rhetoric from Vince Cable before the election, the banks have got off lightly.
The cuts in corporation tax will, over time, be quite significant. The rise in the threshold at which employers pay NI will encourage investment and employment in the private sector.
The fact that businesses are seeing taxes fall at a time of austerity does indicate how serious the chancellor is about re-balancing the economy.
One possible doubt relates to the fact that corporate profits have been rising faster than wages for some time. This would suggest that, actually, the economy needs higher, not lower corporation tax. But we realise this is a radical argument, and in any case the argument about the relationship between wages and profits is more relevant in Germany and China, than it is in Britain
For entrepreneurs this was a good budget. They will now be able to sell their business for £5m, and only pay 10 per cent tax. (In his last budget Mr Darling put the limit at £2m.) The small companies’ tax rate will be reduced to 20 per cent, and rules on employers NI contributions for new businesses are being softened quite significantly.
Capital gains tax (CGT) is to rise from 18 to 28 per cent for higher tax payers. The move has come in for some criticism.
Firstly, some say the rises don’t go far enough. Why should CGT be less than income tax? The counter argument seems to be that had this tax rate risen higher, tax receipts would have fallen.
Don’t forget, a few years ago you paid CGT at 40 per cent.
Others say the chancellor should have offered some kind of taper relief, so that CGT is less for people who make long-term investments. Under the new rules, CGT on shorter profits, made for example from derivatives, will be the same as CGT on profits that are arguably better for the economy.
Spending cuts are to be massive, and it is surprising that more has not been made of this across the media. Most departments are to cut spending by a whopping 25 per cent.
There is no getting away from this, job losses will result. The question is, will these jobs be replaced by new ones in the private sector?
Expect it to hurt for a few years. It will take time for the economy to re-balance. Export sectors are not going to start hiring straight away. Don’t expect a sudden explosion in investment.
The danger lies in the possibility that the re-balance never occurs.
We are concerned that all governments, except for the US, are banging the same drum, the drum that says fiscal cuts. Such global austerity drives are without precedent. It always worries us when a consensus emerges and the counter view is ignored.
This proved to be a problem in the last decade, it may be a problem now. Five years ago, warning about debt or predictions of a banking crisis were laughed at. Now it is those who say we need to carry on spending that are laughed at.
If the UK was acting in isolation that would be fine, but we are not, and that’s the problem.
Keynesian economics has become a joke. This is tragic. Keynes’s big ideas concerned what to do in a depression. His ideas have never been adopted. Except, it could be argued, during the Second World War, when UK government debt hit 250 per cent of GDP and his policies were adopted by mistake.
For 25 years after the Second World War, Keynesian economics was the only economics there was. The result was something of a disaster, at least for the UK. But Keynes never did argue for spending just to smooth out the economic cycle. It is doubtful the great man would have agreed with the use of his ideas during the 1950s, 1960s or 1970s. Indeed, some economists argue that Keynes was not a Keynesian.
Right now is the only time since Keynes’s ideas were published that has mirrored the period in which he developed his ideas.
But Keynes was also concerned with what should be done in times of global imbalances. He wanted to force trade surplus countries to buy more. Those ideas are precisely what the world needs now.
The big danger with Osborne’s plan is that everyone else wants to do something similar. And when every country tries to spend less, invest more, import less and export more, the result is economic depression.
© Investment & Business News 2013