With the election campaign here in the UK now down to its final week, and with the party leaders popping up endlessly on various programmes such as the news and more formal debates as well, making a string of probably desperate policy promises to try to win those crucial votes, I am reminded of how they often have less control than we or they like to think over the destiny of the nation. Unforseen economic ‘shocks’ or changes in the economic situation can upset all manner of well-intentioned plans.
To name an example, the Prime Minister David Cameron has promised that, if his party win power again, they will pass a law preventing rises in the main sources of government revenue: rates of income tax, national insurance and VAT. He argues that cutting the deficit should be done entirely by cutting government spending. But such a law, although it could be changed by parliament, would aim to tie the government’s actions on tax. Of course, there would be ways around this, and the law would have to be very carefully specified. In a growing economy, and with rising wages, the tax take from income taxes (which include national insurance) can rise without raising tax rates, and by preventing tax thresholds (the income levels at which each tax rate on income starts to be paid) from rising. This is known as fiscal drag and is a subtle way for any government to put up taxes without adjusting tax rates. Even if the thresholds rise in line with inflation, as long as wages are rising, more people will be dragged into higher rate tax bands. Would Cameron’s law take account of fiscal drag? The explanation of this kind of effect is not suitable for election soundbites, but remains important and if the new law did not account for it, politicians could be caught out and potentially lose the trust of the public even more.
As Robert Peston, the BBC’s economics editor, argued this week in his blog, making promises of this kind assumes that the economy will not be hit by another significant economic shock in the near future, in which tax rates might have to go up to prevent the deficit from becoming too large. Whether or not this is sensible policy in a recession is besides the point, as the chancellor still seems to believe in the austerity mantra he has been peddling for the last five years, and putting into practice, at least some of the time! When 65% of tax revenue comes from the three taxes mentioned above, with Cameron’s new law in place, and unless it was repealed quickly, other taxes such as business rates and the like would bear the brunt of any tax increase and would either harm business profits, a potential source of investment, or lead to higher inflation as firms pass on the cost increase of higher taxes in their prices. It could also lead to wage cuts or job losses, as they struggle to protect their margins if price rises are not possible. All of these admittedly short-term effects would be damaging, possibly more so than tax rises that are more evenly spread across different economic actors such as households. The outcome would be uncertain, but business leaders would not be happy.
Making these sorts of promises remains dangerous politically, in case unforeseen events force leaders to break them. This comes back to the title of this post: the illusion of control. In the UK, the economic recovery seems from a superficial and rather short-term perspective to be quite healthy. Although the GDP growth figures for the latest quarter suggest a significant slowdown to 0.3% (these are often revised over time, up or down), the government has been proclaiming endlessly its ostensibly good record in managing the economy and ‘turning this country round’. Two million jobs have been created in five years, they suggest, the larger proportion of them full-time. But what they fail to mention, of course, is that recent population growth has also been quite rapid, so that GDP per capita (what really matters for average incomes) has been growing much slower in this parliament and is way off-trend compared to before the recession, as this nice chart from economist Simon Wren-Lewis shows. Population growth has been a significant factor in the ‘recovery’. Apart from this, the flip-side of sluggish growth in GDP per capita and strong job creation has been weak productivity growth, which has persisted since the recession, as this post, also from Wren-Lewis, makes clear. This does mean that the ‘pain’ of sluggish growth has been spread more evenly across the population, with more jobs but negligible wage increases, which must be a good thing, but in the long-term, productivity determines the level of incomes across the nation. The governments much-touted ‘long term economic plan’ does not seem to be sustainable, because it is almost entirely focussed, at least in public, on the deficit, rather than productivity. If the latter does not start to pick up, there is no hope for a sustained recovery in living standards and the ‘feel good factor’ from rising average incomes will be conspicuously absent.
Another deficit that the government keeps rather quiet about, and that could derail the recovery is that on the current account, or our foreign trade and investment performance minus UK spending which goes abroad. This has grown over the parliament and was 5.5% of GDP in 2014, the largest proportion since records began in 1948. Weak growth abroad, particularly in the EU, has not helped UK export growth. However, the main change has been the fall in net investment income from outside the UK. This may be partly due once again to weak EU performance. But as I have argued in a previous post, if the UK government wants to sustainably reduce the budget deficit or even start running surpluses and paying off some of the national debt, without a dangerous further rise in private sector debt from already high levels, our current account performance will have to improve significantly and soon. Again, some of the persistence of the current account deficit may be down to policies which have led to current account surpluses in countries such as China and Germany, but UK exporters need to become more competitive to take advantage of any recovery in global growth and aggregate demand from abroad. This may require a positive technology and industrial policy, with cooperation between the private and public sectors to encourage export growth, as well as a sustained weaker currency.
Thus, while our politicians make a range of promises to win our votes, they may be easily derailed by changing economic fortunes which can be hard to control, or even the way in which promises are laid out, such as on tax rates. Shocks such as a new global slowdown or, more immediately, significant imbalances or weaknesses in the domestic economy, which have either not improved or actually worsened in the last five years, present a real threat to sustained growth. We should prepare for our political leaders to sink further in our estimations. Winning the election and forming the next government may be a poisoned chalice.