FEW POLITICIANS understand the undercurrents of fiscal policy. They react largely to a public clamour about “tax and spend” which interprets fiscal policy choices as levers to produce instantaneous results.
As is all too obvious, the mass media news cycle promotes this view, reacting with equally instant analysis and commentary; with politicians to the fore claiming they are running the economy well or, in opposition, that they could do so much better.
This mechanical approach is deeply mistaken. Fiscal policy and its effect is like impressionism in art; swatches of nuanced colour create the impact of a work in a mysteriously hidden way. A key insight for fiscal policy is that the perceptions and expectations of different economic actors also generate a total effect through many small marginal changes.
John Maynard Keynes said that the driver of economic growth was what he called “animal spirits”; but he did not explain what he meant by this; probably because, being a mathematician rather than a political or behavioural economist, he could not put numbers to this notion. That’s a pity, because it is in the expression of those spirits that economic advance comes about.
To change views about the potential of the future needs two things; to change perceptions about future government actions and to encourage positive expectations about the outcomes of those actions.
The economist John B Taylor pointed out in his work “Policy Stability and Economic Growth” that if policy actions are not perceived to be rule-based, but rather more random and impossible to anticipate, there are strong detrimental effects on private choices about spending and investment that affect economic performance.
Additionally, fiscal policy has to recognise that the wealth generating effects of private sector innovation need time to take root… in this, expectations greatly matter; businesses and lenders have to expect their investment case to be achievable through time.
If we put these insights into the context of an economic cycle, what does it tell us about the timing of government actions in the “tax and spend” round that will maximise the chance of enhanced growth? Let’s look at the UK’s recent fiscal performance.
Britain’s public finances have improved remarkably. While the left howl that we are stuck in Armageddon with a deep austerity and zero growth, in fact the UK is now on the right side of the three per cent Maastricht deficit rule (although not in Scotland which continues to wade deeper and deeper into red ink with devious delight). We now have enough underlying growth to generate the fiscal receipts such that this improvement can continue.
But is this enough? Could it be improved to release some of the sting from the left’s critique that ten years of spending constraint is crippling the less well-off who are seeing no wage growth? Could we engender faster growth by calling on those animal spirits?
Let’s put those questions in the context of perceptions and expectations.
Mrs May is presently defined by Brexit – her lack of communication skills, or possibly a lack of genuine belief in the value of Brexit – has created the perception that she has no other policies or vision. Additionally, when inklings of new ideas do come out of Downing Street they tend to be rather vague and randomly scattered across the policy spectrum. They are also often alarmingly socialist, needing a commitment to long-term spending to achieve.
Expectations are not high about economic growth; there is a lot of talk about how interest rate rises might curtail consumer spending further. Brexit remoaning colours confidence, even although exports are rising and the 85 per cent of the economy that only trades internally is little affected by EU issues. Philip Hammond’s chancellorship is cautious and dull; lacking any inspiration of where he wants to go beyond (one day) a budget surplus and some debt reduction.
Any government that is lost and aimless with respect to managing these perceptions and expectations needs to get a grip and turn things around. And for a Conservative government the answer should be obvious; it must let go, release the animal spirits and allow perceptions and expectations to change. The mechanism to do that is also obvious; it needs to cut taxes.
When George Osborne became Chancellor, he inherited a real mess. You can see that in the chart above in the deficit at the time. He set off to mend the mess by cutting spending growth (not cash spending) and raising more tax revenues, in particular by increasing VAT to 20 per cent. Now is the time to reverse that increase, it would have a huge effect. Crucially, it needs to be now, because that effect needs time for the animal spirits to evolve new expectations based on a new perception of government intentions.
Look at the present predictions on the fiscal picture over the next few years. The trends are good, yet the increase in economic growth is not – I think because no-one really believes these forecasts. It is much easier to believe that the state will meddle away, and one of the perennial instabilities that threaten UK plc progress; an NHS overspend, defence costs difficulties, rising unemployment, environmental regulations, energy costs, a falling exchange rate; will spoil success.
A cut in VAT would create a major impetus to alter perceptions and expectations. It impacts across the wider economy and helps the less well off, it is largely non-distortive across sectors and, crucially, it puts cash flow back into thriving margin-making businesses. That gives them options on pricing, skills upgrades and capital investment in innovation; helping to achieve all the things that the state wants and appears to be failing to do through government spending actions. In short, ensuring that successful policy breeds successful performance.
We should not be deflected by criticism that the deficit would just grow again. For a start, where is this critique going to come from? The left could not make it; Jeremy Corbyn wants to sell the family silver ten times over by increasing borrowing, and Nicola Sturgeon already has the bills for her government’s profligacy printed in bold in successive GERS reports.
There is in fact an historic precedent for the fiscal outcome being the opposite. Bill Clinton’s presidency is not remembered for its fiscal probity, but it actually had a peculiar trend line. Clinton began by increasing taxes in 1993, but he also cut spending. In particular, he clamped down massively on welfare entitlements in his first term, and created rising employment; a policy pattern similar to the UK since 2010.
In his second term, he became a lame duck; unable to pass new spending through Congress and burdened by impeachment threats and foreign policy issues that kept his hands out of people’s wallets. What happened? The economic growth rate increased steadily and the budget deficit actually disappeared in 1998. That’s difficult to believe today after two Republican administrations that have made the US deficit soar, but it tells you that the flavour of the politician in charge does not always lead to outcomes as expected.
The point here is that it is not politicians and state actions that drive growth; it’s the lack of political meddling and a reduction in state action that releases animal spirits. It does this through creating the right perceptions and expectations. Growth follows.
And where are we in Scotland in this? Well, we can see that one effect of devolution is that it is possible for two nations within one economic union to produce separate trends. The active meddling of the Scottish Government is an all-encompassing perception. The embedded expectation that because of their fiscal ineptitude the policy environment will be perennially intrusive is, sadly, pummelling Scottish animal spirits. As for Mrs May, so for Ms Sturgeon. They both have to learn to keep their hands off and let the economy breathe and create our better future. A VAT reduction would release a lot of oxygen.