Tax hikes or spending cuts? No – both!

The conventional wisdom is that in the autumn UK budget in November the Chancellor will have to raise taxes or cut spending. Actually, he will have to do both. Given a looming chaotic Brexit, this will come at a delicate moment.

Under Pressure

Some weeks ago I explained how the British Tory government is adopting a policy of tax-and-spend. In the last week of June Mrs May announced that the National Health Service (NHS) in England would receive an additional £20 billion a year by 2022 as a seventieth birthday present. This equates to a 3.4 percent increase in funding above existing levels while the UK economy grew last year by half that at 1.7 percent. It will most likely grow this year at around just 1.4 percent[i].

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Other departments are also clamouring for more funds. The Defence Secretary, Mr Williamson, is vigorously putting the case for increased defence expenditure in order to maintain the UK’s place at the top table. (Mrs May has apparently questioned why the UK needs to be a top military power.) He has been encouraged by General Mattis, the US Defence Secretary, who recently intervened in this discussion. He said that unless the UK increased defence expenditure significantly then the UK would cease to be the USA’s partner of choice. Instead, he added pointedly, the US would favour France (a country which spends less on defence than the UK).

Then the Ministry of Housing Communities and Local Government (affectionately known by Whitehall insiders as MoHoCoLoGo), presided over by James Brokenshire MP, which has an annual budget of more than £28 billion, is desperate for increased funding. More than eight years of extreme austerity is now leaving its mark on the shires. Britain (or at least England) is becoming a land of potholes, overgrown hedgerows and unemptied litter bins. And that is just the visible symptoms of the malady. What goes unseen by most is the overstretched care services for vulnerable elderly people (of which the growing army of dementia sufferers) which are failing to make ends meet – and with tangible consequences in terms of human misery. One recent estimate claims that social care now accounts for one quarter of local councils’ expenditure.

The Department of Justice now presides over an ever more frustrated and unhappy police force. As crime increases – especially violent crime in the capital – the budget for the 43 police forces in England and Wales, which has been cut in real terms by 18 percent[ii] since 2010-11, looks increasingly inadequate. Many of us have very low expectations of whether uniformed coppers would actually turn up at all in the event that we were burgled.

(By the way, the cause of the rise in crime – and its economic consequences – is something I would like to come back to soon. Suffice to say for now that one underlying theme is the way that illegal drugs are distributed by gangs – and that in turn begs the question of whether liberalisation of drug laws might reduce crime. I am not in favour of legalistion, however – as I shall explain.)

There is a feeling amongst Tories that, although the fiscal deficit is still between two and three percent of GDP, something must give.

Education too, so the teachers tell us, is much in need of cash. In fact, teachers have been terrifying parents by telling them how little Johnny (who is such an amiable boy) will be permanently disadvantaged by envisaged cuts (and thus his life will be entirely ruined).

In the last week of July, the government announced pay increases of above one percent for teachers, prison officers and serviceman and women for the first time in five years. This heralded the end of the Tories’ much hated public sector pay cap. In the forthcoming spending review (provisionally scheduled for spring 2019) almost all departments will need more cash just to cover their increased payroll costs.

Taken together, the politics of austerity, inaugurated by the Cameron-Osborne pantomime horse in 2010 to eliminate the deficit (eventually) has, even within the Tory Party, come into question. For the Labour Party, the SNP and others, austerity has always been a stick with which to beat the Coalition government, then the Tory majority government of 2015-17 and now the May minority Tory government. But there is a feeling amongst Tories that, although the fiscal deficit is still between two and three percent of GDP, something must give. That inevitably means higher taxes – imposed by a government that is ideologically committed to lower taxes.

The question now is where and on whom these tax hikes might fall.

Spreadsheet Phil’s default setting

The man who will ultimately answer that question is Chancellor of the Exchequer Philip Hammond. In some ways, Mr Hammond’s survival in his post for more than two years now is even more remarkable than the Prime Minister’s survival in hers. He is an open Remainer who has upset much of the Tory Party by talking down Brexit and talking up concessions to the Europeans. Most recently, he suggested that European workers should have privileged access to the UK labour market – a very sensitive topic since most Brexiteers (Tory and Labour) thought they were voting for a substantial drop in European immigration.

In terms of his fiscal policy, Mr Hammond changed tack after the June 2017 election debacle. Hitherto, the Tories’ had set hard targets for the elimination of the deficit. As I wrote here at the time, the November 2017 budget effectively abandoned any such target date. The ball was kicked into touch – sometime in the early 2030s – much, no doubt, to the distaste of the now editor of the Evening Standard.

But according to The Times on Wednesday (01 August) Mr Hammond has told Whitehall to prepare for another round of cuts before next year’s spending review[iii]. Apparently, Mr Hammond wants ministries without protected budgets to identify more areas where there is potential for savings.

According to some sources, last week’s public sector pay rises will have to be paid out of existing budgets.

Last week, Chief Secretary to the Treasury, Liz Truss, wrote to a number of departments calling for further savings. These will be set in stone during the spending review next spring. According to some sources, last week’s public sector pay rises will have to be paid out of existing budgets.

The root cause of this is that Mr Hammond has persuaded the Prime Minister that there will be no more borrowing above and beyond the fiscal rules. These require the government to reduce the cyclically adjusted fiscal deficit (tax receipts minus public expenditure) to below two percent of GDP by 2020-21. They also determine that the UK debt-to GDP ratio should fall by the same date.

Additional taxation will be required to pay for the extra £83 billion in NHS spending envisaged over the remaining life of this parliament. But there will still be a need for further cuts if additional borrowing is to be avoided. As I reported back in March, tax receipts exceeded estimates in the last fiscal year and the final borrowing figures were better than anticipated. Mr Hammond now has £15 billion of headroom to fulfil the 2020-21 deficit target – but everyone knows that that could be wiped out if growth figures deteriorate, of even if they do not pick up.

Indeed, growth is the real challenge right now. Everyone knows that there are prospective headwinds – not least protracted dislocation further to a no-deal Brexit, which would seriously impact growth. The fact that European growth would be negatively impacted as well should be of consolation to no one. The eurozone economy is already winding down and any major shocks could damage it further – meaning that our European neighbours will buy less of our goods. Not to mention that such a scenario would put the future of our world-class automotive and aerospace industries in doubt.

The Times reported that Defence Secretary Williamson wants to boost the economy with a Trump-style tax give-away. That view is unlikely to prevail. In the US, the level of corporate profit tax was already out-of-line with other leading countries; while the UK’s level of corporation tax is already the lowest in the G-7. It is not at all clear that, given falling inward investment caused by Brexit uncertainty, further reductions in UK corporation tax would stimulate investment.

Additional taxation will be required to pay for the extra £83 billion in NHS spending envisaged over the remaining life of this parliament.

Everyone knows that the UK needs to stimulate its flagging levels of productivity. But, as I have explained here before, lower productivity is largely a function of the UK’s ultra-flexible labour market. It will be difficult to improve overall productivity, at least as measured by OECD economists (GDP divided by labour hours worked), without increasing unemployment which would, in any case, incur higher spending on benefits.

I doubt that the additional spending on the NHS will dramatically improve its performance. Ultimately the only way to reform it will be to change the model radically – but the British people still seem overwhelmingly resistant to that: therefore, the politicians deem it not worth the political risk.

In the meantime, the May-Hammond wheelbarrow seems to have adopted the concept of zero-based budgeting (ZBB). This was a management tool developed by Texas Instruments (NASDAQ:TXN) in the 1970s. Under ZBB, budgets are not set incrementally but all types of expenditure are re-evaluated each year. Mr Hammond, let us recall, is by profession a management consultant.

Brexit negotiations: the calm before the storm

It is now clear that the Brexit negotiations have run into the sand. Mrs May’s Chequers Plan, as set out in the White Paper of 12 July – which was subsequently amended by the House of Commons – will be rejected by the EU negotiating team led by Monsieur Barnier. In an article published in 20 countries on 02 August he described the Chequers Plan as a threat to the Single Market. That is as good as Non!

The problem is not just that the negotiations have been protracted and directionless, but that the crunch-time will come precisely at the moment that Mr Hammond will be setting out his new fiscal strategy (assuming that Mrs May, who is losing credibility by the day, is still Prime Minister).

Some Tory Ultras have already hinted that they could use the threat of opposing the budget as a weapon in the battle against the expected marshmallow Brexit.

The problem for Mr Hammond (and Mrs May) is the timing of the budget. James Forsyth of The Spectator, who certainly has his ears close to the ground in Westminster, reported last week[iv] that the Treasury wants to stage the budget early in October so that it can go through the House of Commons before any key Brexit votes. Some Tory Ultras have already hinted that they could use the threat of opposing the budget as a weapon in the battle against the expected marshmallow Brexit. Mr Forsyth thinks that Mr Hammond still prefers November because the Chancellor anticipates that the key Brexit divisions will take place in December. This is a government walking on egg shells.

One option for Mr Hammond might be to delay the announcements of new taxes and new spending cuts until the spending review has been concluded – so, about the time of Brexit D-day. To align the announcement of higher taxes and spending cuts at precisely the moment the UK is leaving the EU – especially if there is a strong perceived risk of a chaotic Brexit – might be more than the markets could take. Indeed, the gilts markets could seize up completely – a scenario that I have explored before.

The long-term picture

If the short-term fiscal situation is a political and economic minefield, the long-term picture is one of potential financial Armageddon. In mid-July the Office for Budget Responsibility (OBR) published its latest Fiscal Responsibility Report[v]. This suggested that Britain faces 50 years of tax increases and spending cuts as the costs of supporting an ageing population spiral out of control.

In this report, the OBR extrapolates future spending plans, particularly on health, social care and pensions 50 years hence and balances these against tax receipts based on growth projections. The OBR’s weed-crazed interns may have been up all night on their spreadsheets – but the report is definitely of interest to fiscal conservatives such as this writer – and many of my readers.

Broadly speaking, the fiscal position is unsustainable if the public sector is on course to absorb an ever-growing share of national income simply to pay the interest on its accumulated debt. This notion of sustainability can be quantified in several ways, which we discuss in the report. On these measures, the baseline projection in each of our reports since the first was published in 2011 has pointed to an unsustainable fiscal position over the long term.[vi]

Britain faces 50 years of tax increases and spending cuts as the costs of supporting an ageing population spiral out of control.

To put flesh on the bones of this unsustainable fiscal position: the OBR calculates that the UK debt-to-GDP ratio will triple from about 85 percent today to more than 280 percent in 2067 on current trends. As the population gets older, so more people will be in receipt of state pensions and will have complex health and social care needs. This will have to be paid by a shrinking percentage of people in work. Furthermore, as the national debt grows, the burden of interest costs will get heavier – even if interest rates remain at historically low levels. The interest burden on new debt issued at the short end will rise significantly.

Even the government’s primary deficit (which does not take account of interest costs) is likely to rise from 0.3 percent in 2022-23 to 8.6 percent in 2068, according to the OBR. And even if the primary deficit could be held at 0.3 percent indefinitely by means of tax hikes and spending cuts, the aggregate national debt will only decline very slowly, and the debt-to-GDP ratio in 50 years’ time would still be 66.9 percent. This compares to a level before the financial crisis (the days of Brownian prudence) of 35-40 percent. To reduce the figure to 40 percent, the UK will have to resort to fiscal tightening of around 1.9 percent per decade.

Mr Hammond’s options

We know that Mr Hammond is itching to squeeze more tax out of Britain’s 5-6 million-strong army of self-employed people because he tried to do so in his first budget (November 2016) – and failed.

What he wanted to do then was to align National Insurance Contributions (NICs) for better-off self-employed people with those of equivalently paid employed people. While this might sound reasonable, it breaks a fundamental covenant between citizens and government. The self-employed make a conscious choice to become sole traders because that status gives them flexibility, control of their schedule – and opens the possibility of deducting some inevitable expenses from income, thus lowering their tax liability.

On the other hand, the self-employed sign up to being second-class citizens. They receive no holiday pay and no pension provision beyond what personal pension schemes they enrol themselves in. If they have had enough, they cannot just sign up for Jobseekers’ Allowance – they have to de-register as self-employed first. Self-employed women do not receive maternity pay (though this is under review). Most self-employed people, when they reach state retirement age (66 for people born after 1954 – but rising to 67 for people born after 1961) receive state pensions which are invariably inferior to those of lifetime employees. As a result, if Mr Hammond tries this tactic again, there will again be outrage.

If Mr Hammond tries this tactic again, there will again be outrage.

And it is no use talking about a Brexit dividend – given that Mrs May signed a cheque for £39 billion or so last Christmas which will largely have to be settled by the end of the next European budget cycle in 2025. Furthermore, any slowdown in the economy post-Brexit will hit government tax revenues and thus increase the deficit. The OBR estimates that, of the £13.3 billion net contributions that would have been paid to the EU in 2022-23, £7.5 billion will go on the divorce bill that year – and £5.8 billion will have to be committed elsewhere, for example in farm subsidies, scientific research and so forth.

Mr Hammond could cancel the budgeted reductions in UK corporation tax over 2019-22. But, again, that could send a perverse signal to big business at a time when inward investment is slowing. Or he could reverse Mr Osborne’s 2011 cut in higher rate income tax from 50 percent to 45 percent on incomes above £150,000 – or even introduce a 50 percent plus rate for incomes over, say, £1 million. This type of thing, as we know, generates business for clever tax accountants who will book their clients’ marginal incomes to overseas jurisdictions where taxes are much lower or non-existent.

If the rich are mobile, the poor are static – and therefore can be taxed much more easily. We can forget further increases in the personal allowance (the level above which people pay income taxes) – which was the great achievement of the Cameron-Osborne panto horse, lifting millions of low-paid workers out of income tax altogether.

Mr Hammond might even consider an increase in the standard rate of UK VAT, currently 20 percent. The VAT rate across the EU ranges from 19 percent in Germany and Cyprus to 25 percent in Sweden[vii]. If Mr Hammond were to align the UK VAT rate with the Irish rate of 23 percent, that might seem like trying to lessen the tension over the “Irish border” question.

Decisions, decisions…

It is time to think outside the box (of which the esteemed OBR is quite incapable – because it is part of the deep bureaucratic state). The financial consequences of the Juvenescence discussion (much animated by our Chairman) have not been worked through. If people are going to live longer and remain healthy, then they should continue to work and pay taxes. If vast numbers of them get dementia and become uncontrollably incontinent aged 109, then should your children and grandchildren be beggared for evermore…?

Answers on a post card, please, dear readers – or, better still, by email. Eugenicists need not apply.

[i]See, for example the estimate by the National Institute for Economic and Social Research out in May: https://www.theguardian.com/business/2018/may/04/uk-growth-prediction-2018-scaled-back-by-thinktank-niesr

[ii]According to the estimate by Full Fact. See: https://fullfact.org/crime/police-funding-england-and-wales/

[iii]Hammond orders Whitehall tom plan for cuts, by Sam Coates, The Times 01 August 2018, page 6.

[iv]Why austerity is ending, The Spectator, 28 July 2018, page 8.

[v]Download at: http://cdn.obr.uk/FSR-July-2018.pdf

[vi]Ibid. page 8.

[vii]See: https://www.asd-int.com/en/list-of-vat-rates-in-the-european-union/