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Greek bond yields show their spending cuts weren’t deep and fast enough

Sep 8th, 2011
by Rory Meakin.
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Financial markets have recently lost much of the little faith they had in the Greek government’s ability to repay its debt. A bond promises to pay the bearer a fixed sum on a fixed date. One year bonds are those where the due date is one year on from now. Yields on these have rocketed to 96 per cent on Greece’s one-year government bonds, meaning investors are only prepared to pay just over half the value of the promised payment due in a year’s time.

The Greek government simply cannot borrow money at a sensible rate, because it has borrowed too much for too long and its public spending cuts are too slow and too shallow. The Treasury’s Budget 2011 forecasts predicted that the government would pay almost £50 billion on debt interest this year. British bond yields are less than one per cent. Britain’s economic position is much more stable than Greece’s, but the Greek experience does show what happens when governments which spend too much money fail to cut public spending deep and fast enough.

Take a look at our Real National Debt paper and watch the video below to find out more about how much debt the Government really owes.

Latest OBR figures show public spending is still rising. Time to cut it

Jul 25th, 2011
by Rory Meakin.
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Central government spending soared by 4.9 per cent to £52 billion in June 2011, up from £49.5 billion in June last year according to Office for Budget Responsibility (OBR) figures. The higher than budgeted figures led to an increase in public sector net borrowing from £13.6 to £14.0 billion. Tax receipts also rose, but not as rapidly as government spending. Nida Eli of the Ernst & Young Item Club said:

“The government still has a very long way to go in order to meet its target of reducing borrowing by £20bn this year. With nine months to go it needs to reduce borrowing by more than £2bn a month compared with last year’s figures.”

The figures show a large gap between the terms of public debate on spending and the facts. With the official Consumer Price Index of inflation at 4.2 per cent in June, spending is still rising even after adjusting for inflation. The so-called cuts simply aren’t happening and that is dangerous for two reasons: high public spending is holding back the economy and the enormous borrowing means we risk runaway debt service costs and, ultimately, a sovereign debt crisis.

Athenian austerirty riots

Britain has a debt problem. It’s not as bad as Greece’s; our official debt is approximately 80 per cent of the economy compared to 140 per cent for Greece. The average ‘maturity’ of our debt, the length of time left before we are obliged to repay it, is also much longer meaning that in each year a smaller proportion of our debt needs to be refinanced with new debt. But the scale of our borrowing problem is very similar to Greece’s and, unless we tackle our massive borrowing problem, our debt problem might soon look a lot more like Greece’s than we’d like it too.

The Government must act now to reverse the rise in spending and bring borrowing back down not just to the Government’s own tame budgeted proposals, but lower still to create room for tax cuts and growth in the private sector. The credibility of the Government’s spending plans is at stake and if capital markets stop believing the Government’s promises to keep spending under control they will become more nervous about the possibility that their loans might not be repaid. That means they will demand a higher rate of interest to make up for the increased risk. This in turn means higher government spending which can easily turn into a downward spiral (of higher spending on interest and worries about higher spending leading lenders to raise interest rates) into the kind of sovereign debt crisis now engulfing Greece.

Bold cuts to public spending are needed to avoid following that example. Britain’s taxes are already too high and too complicated. The only answer to the borrowing problem is in spending control. But reducing spending will boost the wider economy too, not just the public finances. More public sector spending means more resources being allocated by the public sector according to politicians’ priorities and bureaucrats’ convenience rather than consumers’ actual wants and needs. And that leads to slower growth in the economy and a less prosperous society. While they are always difficult at first for those whose jobs are lost or whose incomes are reduced, over time spending cuts lead to growth in the private sector and the economy as a whole.

Why tax hikes aren’t the answer to our long term fiscal problems

Jul 14th, 2011
by Matthew Sinclair.
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The Office for Budget Responsibility seem to have inherited the unfortunate habit of the Institute for Fiscal Studies, who feel the need to express any fiscal gap in terms of the tax hike that would be needed to fix the situation.  Or at best talk neutrally about the amount that spending needs to be cut or taxes need to be raised.   In reality, as I set out in our response to that report, higher taxes will choke off economic growth and therefore do nothing for the Exchequer in the long run.  The empirical results surveyed and produced by Patrick Minford and Jiang Wang for the IEA report Sharper Axes, Lower Taxes launched yesterday evening reinforce that solid finding from the economic literature.

They report a number of other studies which have come to the same conclusion, and then their own results:

Overall, there is an overwhelmingly strong negative relationship between tax and growth, with some models showing a stronger relationship than others.  Specifically in our preferred model there is an elasticity of growth to tax of approximately -1.4 at the mean of the growth rate (1.6 per cent).  The effects are not expected to be linear in the tax rate but, if they were, then a fall in the tax rate by 25 per cent of its existing value (from 40 to 30 per cent) would lead to a rise in the growth rate to 2.7 per cent if the initial growth rate were 2 per cent.

2 per cent to 2.7 per cent might not sound like a lot but it is.  Over 30 years an economy growing at 2 per cent a year will grow by around 80 per cent, whereas an economy growing at 2.7 per cent a year will grow by more than 122 per cent.  That will erode most of the increase in revenue.  So even if you don’t specifically target tax cuts in order to maximise the dynamic returns, just the overall impact on the trend growth rate would almost pay for the tax cut on its own.  And everyone will be far more prosperous.

There are huge problems in the public finances.  Researchers at the Bank for International Settlements (BIS) found in March 2010 that Britain was, in terms of the projected share of GDP that could go on debt interest, facing the worst fiscal position of any of the developed countries they looked at.  The only way we will deal with that problem is by ensuring the Government lives within taxpayers’ means.  As the BIS researchers put it:

Taxes distort resource allocation, and can lead to lower levels of growth. Given the level of taxes in some countries, one has to wonder if further increases will actually raise revenue.

While there will be challenges financing substantial tax cuts in the short term, in the long term reforms to deliver lower and simpler taxes will deliver for the Exchequer as well as families and businesses.

Big march, little alternative

Mar 28th, 2011
by Matthew Sinclair.
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Over the weekend I was responding to the March For the Alternative in the media.  Looking at the footage, the one thing that really stood out for me, besides the UKUncut crowd’s vandalism, were the placards saying “No Cuts”.  Those placards really placed the march beyond the realistic policy debate.  The crisis in the public finances comes after a decade in which tax rates went up not down, so there is no way we can raise the money to plug the deficit without placing a completely intolerable tax burden on ordinary families.  If that deficit isn’t dealt with then Britain will go the way of Greece or Portugal.  That would mean sooner or later far more drastic cuts would have to be made, when investors conclude we aren’t serious about paying them back and demand much higher gilt rates or force us to seek a bailout which will come with stringent terms attached.

The March For the Alternative with "No Cuts" placards. Photo courtesy of Rory Meakin.

In response, some commentators said that I was constructing a straw man, that they didn’t really want “no cuts”.  They wanted somewhat less cut from spending and somewhat more slowly.  There are three problems with that.  First, if you are willing to accept substantial cuts then maybe put down the placard that says “no cuts”, it might mislead people.

Second, the claim lacks credibility if the March For the Alternative doesn’t actually set out any alternative but ideologically convenient fantasies.  They need to do more than pretend there is some huge pot of tax avoidance money Governments desperate for money have somehow failed to dip into all these years.  Last week Tim Worstall released a report for the IEA that showed how a lot of the UKUncut claims about tax avoidance are confused.  If the marchers really thought some level of cuts would be acceptable, they need to tell us which cuts they would accept and a clear idea of when.  Otherwise it all just sounds like a rhetorical cover for an unwillingness to countenance any cuts.

Finally, cutting spending less would be a bad idea even if they did mean it.  That would mean we would rack up more debt, and would have to pay more debt interest.  Bear in mind the overall cut in spending is less than four per cent over four years in real terms.  That isn’t so dramatic and will only take us back to roughly where spending was in 2006-07.  The reason it will feel more painful than that in some areas is that we are spending the money on different things.  Partly we are sending more money abroad, in EU contributions and International Development spending.  But more than that we are paying a lot more in interest on public sector debt.  If we delay or diminish the cuts package then we’ll have more debt and have to pay even more in interest.  That will make the eventual cuts sharper.

Things will be worse than that if the investors we are relying on to lend us money look at the Government backtracking and conclude that we aren’t serious about living within our means.  If that happens then the interest rate will go up.  More debt multiplied by a higher interest rate would equal dramatically higher interest payments.  Again, that would mean sharper cuts when they eventually are made.  The marchers can delude themselves that they are campaigning against cuts.  They aren’t.  If their campaign was successful we would have more cuts, eventually.

Higher spending would also mean lower economic growth over time.  Researchers at major international institutions and by top academics have studied the issue and found that lower spending is associated with more economic growth.  Higher spending diverts activity from the more innovative, productive private sector and brings higher taxes which means the economy grows more slowly.  We summarised the evidence in a research note recently.  There is a Keynesian argument that higher spending can be a stimulus in the short term during a recession but that is less likely to work with high and rising debt – people know they have to pay the money back sooner rather than later, so bigger deficits sap confidence – and we aren’t looking at an immediate crisis and recession now.  We need policies to encourage growth over a number of years and decades to ensure we can all enjoy greater prosperity and make it easier to deal with a monumental debt we’ve built up.  Not more irresponsible short term fixes.  That long term growth is best delivered with lower spending.

So even if the marchers hadn’t been marching under a banner of “no cuts” – and had instead gone with “cut less, later” – they would still have been wrong.

Strong revenue in January doesn’t mean the 50p rate is working

Feb 23rd, 2011
by Matthew Sinclair.
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Duncan Weldon is over the moon claiming that all the “scaremongering” that the 50p rate could well lose money, which has come not just from the TPA but also the Institute for Fiscal Studies and consultancy the Centre for Economics and Business Research, should be rejected because we saw strong income tax returns in January.

Debt interest as a share of national income projections, Bank for International Settlements

Yesterday’s figures were a pleasant surprise, but we aren’t anywhere near being out of the woods yet.  Just yesterday there were fresh warnings about our long term fiscal position.  The Press Association reported a new study by analysts Maplecroft.  Our “high public spending on health and pensions, massive borrowing and shrinking working population” were cited as we were rated as having the tenth worst long term fiscal pressure.  That warning follows a Bank of International Settlements report last year which also suggested a grim long term picture.

January revenue figures don’t mean the 50p rate has been effective either.  The 50p rate will affect two groups of workers:

  1. Employed.  Given that the rate came in from April 2010 why would resulting revenue suddenly start showing up in the public sector accounts in January 2011?
  2. Self-employed.  Self-employed workers did pay tax in January, but on their 2009-10 income, before the rate came in.  As Fraser Nelson points out on the Spectator Coffee House blog, many high earners may have brought forward income so that they paid at the 40 per cent rate levied in 2009-10 instead of the 50 per cent rate in 2010-11.  In other words, high revenues last month may well be evidence that the 50p rate does have an effect on incentives, not that it doesn’t.

The evidence that the 50p rate will lose money was summarised in our book How to Cut Spending.  In it we ran the numbers showing how even the Treasury’s own sums suggest it will lead to lower revenue if you adjust the “Taxable Income Elasticity” to a more reasonable figure in line with that found in HMRC studies.

Duncan Weldon is either ignorant of the facts or trying to create a useful myth.  The reality is that all of the best estimates available suggest that ordinary people are going to have to pay more, or face greater spending cuts, for the luxury of spiting the rich.  That makes the policy indefensible.

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