IEA Blog

Some of the old video recorders made in the 1980s had an annoying kink: they could not hold the freeze frame mode for long. Shortly after pressing the pause button, they would automatically switch into play mode again.

This is also a common property of caps and freezes on public expenditure programmes. George Osborne’s Emergency Budget speech showed that the coalition is set to press quite a few pause buttons. Fair enough. But this will not prevent the play mode from kicking in again in a couple of years, because the underlying dynamics of cost increases are left in place.   

The treatment of Housing Benefit (HB) epitomises the above. Through measures like quantitative upper limits on the reimbursement of housing costs, a decline of HB spending by £1.8bn over the next five years is envisaged. This is an achievement, after a long upward trajectory. Osborne’s honesty was also encouraging: “Costs are completely out of control. We now spend more on Housing Benefit than we do on the police and on universities combined.”

But costs spiralled out of control for a reason. HB works, in practice, much like a cost reimbursement scheme. The amount which can be claimed is equal to the median rent for a specified property type in a specified area, the so-called ‘Broad Rental Market Area’ (BRMA). But since there are so many BRMAs – England alone is divided into 153 of them – a claimant’s actual rent will usually come quite close to their reimbursable rent.

This means that there is little incentive for HB recipients to economise on housing. Moving from an average-priced 1-bedroom-flat in Inner North London to one in Outer Northeast London would cut rental costs by almost £5,000 per year. But it would cut entitlement to HB by exactly the same amount.

This leads to the absurd situation that 30% of all households living in Inner London receive HB. The national record is held by the borough of Hackney, with a share of 44%.

The number of BRMAs should be cut down to a dozen or so, and HB should be paid out as a fixed lump sum based on household size. HB could be gradually reduced, as recipients would gradually move to cheaper areas. Far from “penalising” the poor, this would mean treating HB recipients like adults, who make a trade-off between housing and other goods like everyone else.

The coalition government has spoken of emulating Canada’s success in enacting austerity measures. They should go Canadian, but it is important that they grasp all aspects of the Canadian success.

Paul Martin and Jean Chrétien have rightly been commended for their austerity measures, starting with the 1995 Federal Budget; however, austerity went from the bottom up. Beginning with the NDP government in the province of Saskatchewan in 1992 and moving on to the Progressive Conservatives in Alberta in 1993, provincial austerity swept east. Even though Ottawa cut transfers to provincial governments by a third, provincial governments by and large kept their budgets balanced or in surplus. Indeed six of ten provinces enacted laws banning or penalising deficits in some way. Accordingly, if the UK wants to emulate Canada, local councils must make a significant proportion of the spending cuts.

Another important lesson from Canada is the importance of economic growth to deficit reduction. Between 1992 and 2000 Canadian GDP rose 40% – making it far easier to balance the books. In contrast, as Tim Congdon has pointed out, there are several reasons to be pessimistic about the medium-term growth prospects of the UK. This suggests George Osborne will have to be even more radical than the Canadians in cutting spending.

A related point is that the Canadian government never ruined the country’s comparative advantage during its fiscal crisis; it did not engage in any significant tax hikes or punitive taxes on certain groups. This is instructive given that the coalition government has proposed large increases in Capital Gains Tax.  Hampering the British economy with higher taxes or onerous regulations would clearly undermine the effectiveness of the austerity measures.

George Osborne has the chance to do something really radical tomorrow in his Budget statement. He must cut public spending to shore up Britain’s precarious economic situation – he has no choice. But the fiscal crisis also means he can do far more than this. Indeed, the Chancellor has perhaps the best opportunity in a generation to make the sweeping changes necessary for the UK to reduce the size of the state and restore economic growth.

Imagine using the Budget to restructure how we tax: flattening income taxes, reducing corporation tax, getting rid of bizarre exemptions to VAT, abolishing inheritance tax along with Capital Gains Tax and simplifying enormously the tax rules for individuals and businesses…

Read the rest of the article at Reuters.

“Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery.” This is the immutable financial insight told to David Copperfield in Charles Dicken’s eponymous classic. The quote neatly underlines the common sense wisdom to spend less than you earn. And as Adam Smith said, “What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom.”

We can apply this logic to the spending cuts announced by George Osborne yesterday. The Coalition has, as promised, set out £6 billion worth of cuts, including £1.1 billion from discretionary spending and some £600 million from quangos. But these numbers are deeply disappointing.

It is an obvious point, but worth restating, that our deficit is £159.2 billion per year. Every single year, we borrow and spend more than we earn, and last year that figure was more than the GDP of New Zealand. This is unsustainable. Osborne would need to make cuts of not £6 billion but £160 billion to balance the books. Moreover, debt is nasty and it compounds: the government is already wasting a significant proportion of its income servicing debt interest.

There’s another problem too – the kind of borrowing that the government undertakes. Borrowing to buy a house generally makes sense; over the long term, property prices are expected to rise. Borrowing to buy a car, on the other hand, can be a bad idea because cars depreciate in value, losing money. The lesson is that it is sensible to leverage to purchase things that will increase in value (or produce income). However, the government’s spending is worse even than the proverbial car. It borrows to provide services which have zero resale value: the money is literally going down a black hole. Gordon Brown perhaps knew this when he invented the Golden Rule: only borrow to invest. However, it is patently obvious that the Labour government quickly abandoned this principle.

Unfortunately, George Osborne’s announced spending cuts do not even come close addressing the resulting debt problem. The new government, despite the spending cuts, will continue to borrow heavily, risking dragging the UK into a debt spiral. For a government formed of two parties that were so critical of Labour’s economic record, their solution surely cannot be to borrow a feeble 4% less than Labour did in its highest spending year.

The new Chancellor of the Exchequer’s proposal to set up an independent Office for Budget Responsibility sounds like a good idea. But how sad that government ministers cannot be trusted to tell the truth. Who thinks that Sir Alan Budd and his team will come to the conclusion that Alastair Darling’s estimates of likely national economic growth rates over the next few years were too low?

The Greek government, it now appears, told lies in order to pretend that they had “qualified” for entry into the euro. But as the government of almost every other current member-state in the eurozone did the same thing, the only sensible rejoinder is: “Join the club!” After seeing what France did to the Stability and Growth Pact, it hardly seems the eurozone is yet ready for budget responsibility.

Perhaps other British government departments could follow the Treasury’s example. What about an independent Office of School Honesty, to get away from the pretence that standards in state schools have been rising? Or why not an independent Office of Military Straightforwardness, which could reveal genuine statistics about the quality and quantity of the armed forces’ equipment?

The possibilities are endless, though we must be realistic and not let our hopes rise too much. Obviously one couldn’t have accuracy in election results, given electoral fraud in this country that (as one magistrate pointed out recently) would disgrace a banana republic. And it would hardly be England if one could trust the statistics on crime or immigration.

Somehow I doubt if it will catch on.

George Osborne’s announcement that he intends to reverse the increase in National Insurance Contributions has rightfully received applause from a number of business leaders, who called the planned rise an additional tax on jobs.

However, instead of saying which expenditure items they want to see cut in order to avert the NIC rise, Osborne and his supporters from the business world put up the old smokescreens of “efficiency savings” or “increasing public sector productivity”.

When politicians talk about “efficiency savings”, what they usually mean is that they need a large sum of money and don’t know where to get it from. Obamacare, too, will allegedly be co-financed through “efficiency savings” in Medicare, though nobody really believes it.  

In one of the IEA’s early Hobart papers, Gordon Tullock convincingly explained why “efficiency savings” (he does not call them such) don’t usually happen. Bureaucrats do not want their organisation to shrink, and they can use their superior knowledge about the internal workings of their own bureaux to block cuts. Tullock recalls various anecdotes about public or semi-public officials who saw their budgets cut and who responded by deliberately cutting out their organisation’s tenderloins while leaving the fat reserves untouched. The objective was to impair the organisation’s functionality in order to exert pressure on the government to increase the budget again.

Penalising work is about the last thing the UK economy needs at the moment, but “efficiency savings” are not a credible alternative. Osborne should have picked out a number of selected organisations or programmes of questionable value to the taxpayer, and declared his intent to scrap them altogether.

I have written before that co-ops and similar ventures are part of the rich tapestry of a market economy. After all, before the days of statutory regulation, the Stock Exchange was a mutual – you can’t get closer to the market economy than that. Co-ops and mutuals certainly have their limitations – access to capital and corporate governance being the two main ones. People complain about profit-making banks being owned by shareholders but mutuals can be captured by management and pay poor interest rates to savers and co-ops can be captured by a senior management clique without any possibility of facilitating change. There is a big literature on all this and I hope that Osborne’s team has read it. Neverthelessm, mutuals and co-ops definitely have their place. Three cheers for George Osborne’s attempts to create co-ops in the public sector then? Not yet.

As ever with Conservative proposals the small print is not easy to understand. What is proposed seems to be worker-managed institutions which have to accept public sector wages, conditions and pensions. Furthermore, though they can keep some of “surplus” the organisation makes (for some reason it cannot be called profit) they have to provide the type and quality of service that the state would like them to provide. Who actually owns the capital of the hospitals and schools that are “co-operatised” is unclear. This model seems to be much closer to the collectivised farms and so-called co-operatives in some communist countries than something to which free-market liberals should aspire. A union leader suggested that David Cameron was using the language of socialism. That would seem to be true – for good reason as the proposals seem to be socialist. But a few tweaks could set that right.

What would free-market policy in this area look like?

1. Co-operatives would be free to determine their own terms and conditions of employment.

2. Co-operatives would own the capital of the institution that was co-operatised.

3. Co-operatives would exist in an environment of competition for health and education in which the user of the services and not the state decided what was provided and how and the user of the services was the only arbiter of standards.

4. Other organisations must be allowed to compete (including profit-making schools) – yes let school and hospital co-ops have some first-mover advantage if that helps sell proposals politically but, unless there is competition, then co-operatives will be simply a different way of managing the provision of state-controlled services. If competition is not the arbiter of quality, the state will always step in.

In some situations (village schools, for example) co-operatives may get a substantial foothold in the provision of services, in others profit-making corporations may do better. It should be the user of the service that decides upon the nature of the provider, not the government.

It is good news, at least to some extent, that George Osborne has announced that some cuts will be made in government spending as soon as the Conservatives enter office. But, he should be careful. His targets are easy ones: tax credits for the better off, child trust funds for the better off, and government advertising.

The third item is part of a general declared strategy and that is fair enough. The other two items are certainly valid candidates for cuts, but he should consider the micro-economic consequences as more may need to be done if the cure is not to be worse than the disease. Things such as tax credits and child trust funds were extended to higher earners or introduced as universal for a good reason. In the early years, Gordon Brown’s huge efforts to transfer income to poor pensioners and families with children led to enormous marginal tax rates. His poverty-reduction strategy almost guaranteed that poor people would stay poor because it was not worth earning more. So the benefits were extended up the income scale (or introduced as universal in the case of child trust funds) to reduce the disincentives that resulted from earlier policy. Thus we ended up with the situation that people earning nearly £60,000 a year receive regular state welfare top ups.

George Osborne will land us again with the problems that Gordon Brown created when he introduced tax credits. He needs to look at the whole system – and quickly. Benefits might well have to be cut across the board – and certainly for middle-income people. It certainly makes no sense to be raising National Insurance contributions for the whole workforce whilst refusing to take the step of cutting tax credits (which are, in fact, welfare payments) for the whole workforce. And, as for the child trust fund, this should just be chopped altogether – immediately. It surely has no long-term place in our welfare system. To be taking taxes from hard-pressed parents – who might be in debt – in order to put the money in the name of their children locked up for 18 years has to rank as one of the most perverse policies ever.

It is difficult to know where to start in writing a blog post about George Osborne’s proposals to ban high-street bank bonuses in cash of more than £2,000. Let me, instead, raise a number of questions.

1. It will be possible for banks to continue paying bonuses in shares. As such, will bank employees be allowed to borrow cash (from high street banks) using the shares (or anything else) for security? If so, any reasonably well paid banker would simply regard the shares as fungible.

2. Will the employee be able to sell the shares? If so, then the whole object of the plan is defeated.

3. This will only apply to high street banks and not investment banks – how do we distinguish between the two, especially as highly paid employees within (say) RBS will be working for a banking group and their work will cut across several subsidiaries?

Osborne could do with attending an elementary corporate finance course. If (say) HSBC pays out £1m in bonuses, then this comes out of profits that would have been otherwise distributed to shareholders or retained within the business (and, of course, we expect it comes out of additional profits generated by the employees who are being rewarded). It would be ridiculous for a bank to forego profitable lending opportunities to pay such bonuses so we can expect no change in lending habits by banks. If the bank creates more shares to give to its employees instead then there will be more cash to pay to shareholders as dividends and these increased dividends will compensate shareholders for the fall in the value of their diluted equity.

No doubt George Osborne has thought of all this. No doubt too, he is in the process of having a huge rulebook drafted with anti-avoidance measures. Bankers will then come up with anti-anti-avoidance measures and a rulebook will be drafted of anti-anti-anti-avoidance measures for each of the anti-anti-avoidance measures. Soon the area of City bonuses will look like every other area of financial regulation, nobody will be able to see the wood for the trees and lawyers will have a field day. Just as we called the post-war period “Butskellism” perhaps we will be calling the period from 1997 to 2017 the “Brownborne period”. 

The International Monetary Fund has just presented perhaps the gloomiest forecast for Britain’s public finances so far. It predicts that by next year, Britain’s debt will stand at 81.7% of GDP, going up to 98.3% by 2014.

Clearly, such projections require tough policy actions. As the state already accounts for about half of economic output, there is little scope to start the consolidation of public finances on the revenue side. Besides, the top rate of income tax will rise to 50% next year. What would be required instead are substantial spending cuts. It is doubtful, though, that either of the two major parties will be able to deliver them.

The Labour Party is not only responsible for the spending increases that got Britain into the current situation but it was Prime Minister Gordon Brown who initiated them as Chancellor of the Exchequer. For these reasons, we cannot expect any radical policy reversal from the current Labour government.

In any case, Labour is unlikely to win the next election, which has to be called by June of next year. Current polls suggest a new Conservative government under David Cameron as Prime Minister. So the real question is whether Cameron and Chancellor George Osborne will have the courage to turn things around and fix Britain’s broken public finances.

Having worked at Policy Exchange, a think tank close to the Conservative party leadership, for some years, I have doubts whether the next Tory government will be up to the monumental task of fixing Britain. When I was in London, Tory economic policy was not only cautious but quite cowardly. For fear of not alienating voters, the Tories were unwilling to tackle Britain’s fiscal problems. For some time, they had even promised to honour Labour’s spending plans – which obviously weren’t worth the paper they were printed on.

Before the financial crisis, the Tories tried to keep everyone happy by hiding behind the empty formula of “sharing the proceeds of growth” between tax cuts and spending increases. Now that there is hardly any growth left and nothing to share, it is plain that such hollow rhetoric will not do.

To be fair to the Tories, at their last party conference in Manchester George Osborne finally spelt out that a future Conservative government will be cutting public spending. But even the £23 billion over the next five years that Osborne announced amounts to little more than a rounding error in Britain’s public finances. Even in the face of the greatest economic crisis that Britain has experienced in decades, Tory policy remains timid and unimaginative. If the Tories can’t offer anything better than managing Britain’s decline, then what’s the point of a change in government?

This post is taken from a speech given by Dr Hartwich at The Centre for Independent Studies (Sydney) on 13 October 2009. To read the full text click here.