Policy Research in Macroeconomics

Cameron & tax – low politics, high ideology

Le avventure di Pinocchio ,   by Carlo Chiostri, and A. Bongini, Bemporad & figlio, Firenze 1902

Le avventure di Pinocchio, by Carlo Chiostri, and A. Bongini, Bemporad & figlio, Firenze 1902

The more we look at Prime Minister David Cameron’s tax reduction “promises” in his conference speech, the more they spin before our eyes. On the one hand, they are sold as huge gains for 30 million employed tax-payers.

Even the Financial Times journalists were taken in at first: “David Cameron pledges sweeping tax cuts for low and middle earners”, the headline shouted at us

On the other hand, their financial and fiscal impact is made to seem positively Lilliputian by contrast, to be easily digested. How has this trick been performed?

Let us look at each of the two main promises.

  • First, the basic income tax allowance will be lifted from £10,000 today to £12,500 from 2020 (n.b. 6 years away).
  • Second, the 40% tax threshold will be raised from around £42,000 today to £50,000 from 2020.

The Institute for Fiscal Studies estimates the cost as being in total £7.2 billion, made up of £5.6 billion for the first “promise”, and £1.6 billion for the second.

But these IFS numbers assume something quite different from the surface spin – namely that the basic tax allowance and the 40% threshold will in the meantime have been lifted annually in accordance with inflation, so that the real underlying ‘promise’ is seen as roughly this:

The basic tax allowance will be raised from £11,620 to £12,500. The tax gain per tax-payer would thus be not 20% of £2500, or £500 per person, but 20% of some £900, or around £180 (the IFS estimate £160).

Similarly with the 40% threshold. Instead of being raised by some £8,000, which would have meant a gain of around £1600 per person, if the current c.£42,000 gets an annual cost-of-living uplift, the final annual gain per affected tax-payer would be 20% of around £2,000, or £400 (the IFS say £430).

But if we take Mr Cameron at his word as spun, the tax give-away is far higher than £7.2 billion. The cost to the Exchequer of a straight uplift in the personal allowance of £2500 would cost something in the region of £10 billion (we assume 20 million tax-payers at £500 each, but note that Mr Cameron refers to 30 million who will gain – i.e. the entire workforce, which is patently absurd as many work for less than £10,500).

Next we add in the cost of the 40% uplift, of say £1500 per person, which we guesstimate at £2 billion – around 15% of taxpayers (4.5 million) pay the 40% rate, but many will be at the lower end and would only partly gain.

So overall, from the perspective of Mr Cameron’s big “selling” of the tax reductions, the tax take would be reduced by something like £12 billion, if not more.

From all this foggy confusion, smoke and mirrors, we know we’re in the realm of low politics, not breathing the pure air of macroeconomics!

Tax cuts need to be paid for

Whether we take £7.2 billion or £12 billion, Mr Cameron has not said how any of this will be paid for, other than an assertion that it won’t be paid for by borrowing. Here is his minimalist statement:

“If you work hard, we will cut your taxes, but only if we keep on cutting the deficit, so we can afford to do that.”

And again – and here he refers to “the plan”:

“And our commitment to you for the next five years: we want to cut more of your taxes. But we can only do that if we keep on cutting the deficit. It’s common sense – tax cuts need to be paid for.

So here’s our plan.

We are going to balance the books by 2018, and start putting aside money for the future. To do it we’ll need to find £25 billion worth of savings in the first two years of the next Parliament.

That’s a lot of money, but it’s doable. £25 billion is actually just three per cent of what government spends each year. It is a quarter of the savings we have found in this Parliament.

I am confident we will find the savings we need through spending cuts alone. We will see the job through and get back into the black.”

Yes well… hey ho the plan is.. to just do it! And note how he avoids costing his own tax cut proposal and adding it to what he calls £25 billion (and which needs to be added to, to “put money aside”, and then added to again, to pay for his promises!)

Tax cuts and tax cons

All this is quite astonishing, given what his Chancellor has said, and given the incessant lambasting of any hint of a spending pledge by the Opposition – unless matched by an etched-in-blood precise cut elsewhere – as evidence of spendthrift irresponsibility.

To recall what George Osborne said of Gordon Brown in 2008:

“If he doesn’t explain how it is going to be paid for then it isn’t a tax cut, it is a complete tax con.”

Here again is Mr Osborne, in a speech he gave on 6th January this year, repeating what has been (till now) the Party line:

“There are no easy options here if we’re to fix our country’s problems and not leave debts to our children. It’s far too soon to say ‘job done’. It’s not even half done. That’s why 2014 is the year of hard truths. Britain is on the rise, the economy is doing better. I just want to make sure we don’t squander what we’ve achieved and go back to square one.”

Hmm. Alice in Squanderland?

The Conservatives’ fiscal  strategy

But just what would be the impact of Cameron’s putative tax reductions on the Conservative Party’s strategy?

Now supposedly, the Conservative Party is aiming to create by 2018/19 a budget surplus. To get there, the Institute for Fiscal Studies noted on 19th September:

“However, the latest forecasts for the public finances imply further deep cuts to public service spending, which have not yet been set out in any detail. To achieve the currently forecast levels of borrowing, without any further tax increases or cuts to welfare spending, the government would need to cut spending by government departments by a further 10.6% in real terms (or £37.6 billion) between 2015–16 and 2018–19. This is on top of the £8.7 billion cut that has already been set out for 2015–16. (My emphasis).

£37.6 billion plus £8.7 billion makes £46.3 billion. We now need to add a further cut of between £7 and £12 billion, to compensate for Mr Cameron’s promises, if the strategy is to stand. Making a total of between £53 and £58 billion. And the Party’s logic (or dogma) is that it must all be paid for by yet further cuts in government spending.

Government budgets and the cuts to date

The spending side of the budget is in effect in two parts. There are Departmental Expenditure Limits (DEL) which are supposed to reflect those parts of the budget over which departments can exercise real spending control.

Then there is Annually Managed Expenditure (AME) which includes most benefits and other less easily controlled costs including government debt interest payments. The total annual spending is then put together and called “Total Managed Expenditure” (TME).

Excluding the NHS (around £110 billion per year) and international development (around £10 billion), in real terms (allowing for inflation) the DEL budget for all other departments will have been cut, between 2009/10 and 2015/16, by around 25%, according to the government’s Public Expenditure Statistical Analysis 2014.

Total Managed Expenditure, from the same source, will have been reduced in real terms over this period by a far smaller 1.5%, or – if one excludes the NHS + international development – by 3.7%. That is because many significant areas of spending are inescapable or protected.

Therefore, if we are looking for possible areas of future cuts, we need to exclude many other heads of spending which are virtually fixed, such as debt interest payments, depreciation etc., or where there is a strong policy bar to cuts, such as old age pensions.

The real terms cuts

So if we take Total Departmental Expenditure, which excludes interest and other inescapable payments but includes benefits, but also remove pensions as well as NHS and international development, we can calculate the following cuts that have been or are to be made from 2009/10 to 2015/16*:

Total departmental expenditure in real terms, excluding protected priorities:
2009/10: £692 billion minus £224 billion = £468 billion
2015/16: £648 billion minus £249 billion = £399 billion
Real terms reduction = 14.7%

Still working from the Public Expenditure Statistical Analysis 2014, the real term reduction in Education over the period to 2015/16 is 8.3%. The real term cut in Local Government funding is 25.1%. In Justice, 39.4%. In Defence, 15.1%. Work and Pensions – which holds the main “welfare” budgets – has also taken a very substantial real terms cut, if one excludes the roughly (and growing) 50% attributable to pensions, and note too that the population has grown about 2.5% over the period.

Circumscribed options for the future

Let us be frank. If the Home Office and Defence are seen as too risky to cut further in a major way for security reasons, the “choices” for making further large-scale cuts are becoming ever more tightly circumscribed, and likely to be increasingly unpopular in the coming years.  The Chancellor’s newly announced cuts in benefits go only a very small way towards reaching the total.

The IFS, as we have noted, estimate that a further overall budget cut of 10.6% after 2015/16 would be required to meet the Conservative Party’s goal, even before the Prime Minister’s latest tax cut addition, amounting to around 1% to 1.5% more. Say, a grand total of a further 12% cut in the government’s budget AFTER 2015/16.

But the amount of the budget actually available for cutting is much reduced, and the areas remaining to cut will be increasingly sensitive and damaging.

Much of the above is due to the Conservatives’ self-created problem of seeking a more rapid end to deficits and the creation of a budget surplus which covers not only current spending but investment too.

This is a bizarre priority, unless the dominant goal is simply to reduce the size of the state as a proportion of GDP, enabling the better off to pay less tax, without worrying about the impact of reduced services for the population.

Focus on deficits – not a question of economics

We argue that the emphasis since 2010 on government deficits is not a question of good economics but of low politics and high ideology. As the economy recovered, the deficit was going to reduce, both in actual pounds, and as a percentage of GDP. A deficit is not a thing in itself that can be controlled, but the result of changes in income and expenditure.

Good economic activity produces (via the multiplier) more tax receipts and also reduces expenditure on unemployment or related benefits. Real interest rates on government bonds have remained modest if not negative, which is no surprise nor risk given our central bank’s ability to purchase them.

The aims for our economy

The emphasis of a modern economy – barring the risk of excessive inflation which is the least of our worries at the present time – should be on (a) providing full employment, with good quality, reasonably paid jobs, and (b) organising or encouraging productive investment for our future – which means major green investment, far higher R & D, excellent broadband for all, and so on.

These goals, the government has not achieved. True, more people are in employment of some kind, but those in employment on average earn 6-10% less than in 2010, whilst the army of the self-employed, many struggling to survive economically, has grown apace, especially in the last year. The government has been subsidising employers paying low wages via tax credits.

Instead of preparing for the future, we have lived through a long period of low investment by both public and private sectors. The most egregious error – shared alas by the last government’s plan as well as the current government – was to cut back heavily on public investment as part of the austerity programme.

Though public in funding source, most public investment in fact goes via procurement to the private sector, and this would have not only led to stronger and speedier recovery, but also helped to provide a stronger economic base for the future.

Cynicism and economic competence

At the end of the day, the Prime Minister’s tax proposals are not ones we would oppose in themselves – it is generally right to raise allowances etc. for inflation each year, which Mr Osborne has failed to do in relation to the 40%.

But we object strongly to the cynical manner in which this has been announced and spun, and the failure by the Prime Minister to spell out – in terms of his own Party’s strategic goals – what must be sacrificed to pay for the changes, and who will bear the consequences.

Taken together with the abolition of the 45% tax rate, it is clear that the main beneficiaries by far of these tax policies are those on incomes far above the median.

The Conservative Party has had a clear lead in the polls in relation to “economic competence”. Mr Cameron has now bravely tried to level this playing-field.

*Please note that we have made our own approximate real terms estimates for pensions here, using other PES tables, but the broad orders of magnitude are reliable for this purpose.  If a reader has a more accurate real terms figure for pensions over the period, we would be happy to use it and adapt the figures as calculated.

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