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September 11, 2013 5:39 pm
Two years before the next general election, the British economy appears to be recovering rapidly after a longer and deeper recession than almost anyone expected. Wary of repeating the mistake of Norman Lamont, his predecessor, the chancellor still refuses to talk about “green shoots”. There is reason for caution: even as the data have improved, the housing market has taken off and the country’s mood has turned up, the public finances remain disappointing. Government borrowing has come down but, as the Institute for Fiscal Studies says, “a lower-than-expected growth rate of tax revenue” is undermining deficit reduction.
I am describing October 1995, but the facts also apply to Britain’s economy today. Then, Ken Clarke, the chancellor between 1993 and 1997, began to get so worried about a shortfall in value added tax receipts that he set up internal inquiries into the so-called “VAT hole”. Today, George Osborne’s Treasury is planning to keep a very close eye on revenues this autumn, amid concern that the deficit has not improved as much as other economic data.
Business surveys and official figures suggest that economic growth in the third quarter is running at an annualised rate of 4.5 per cent, yet the Office for Budget Responsibility reports underlying revenue growth of only 3.2 per cent so far this financial year. Normally, the revenues grow far faster than the real economy as inflation amplifies price rises, income gains and the taxes we have to pay.
I hear that the few Treasury officials old enough to have been working in the mid 1990s are telling the chancellor not to worry. Revenue growth lags behind the economic cycle, they say, often for good reasons such as companies’ ability to carry forward past losses to set against their current corporate tax bills. The old hands on Horse Guards Road add that, in the 1990s recovery, revenues roared back for reasons that were hard to fathom. The bounce was so big, in fact, that Gordon Brown, Mr Clarke’s Labour successor from 1997, enjoyed five years of unexpected riches.
Outwardly, Mr Osborne seems not to be fretting much. In his agenda-setting speech on Monday, he declared victory over those advocating milder austerity. For every new study showing, hypothetically, that the recovery would have been better with less aggressive austerity – such as recent work by Professor Alan Taylor of the University of California, Davis – he can counter with analyses of his own. The OBR’s evaluation of its forecasts, for example, shows that there is no need to resort to thinking about unexpectedly large effects of tax increases and spending cuts because disappointments in the recovery are explained once account is taken of the eurozone crisis, commodity price increases and weakness in banks.
This argument also offers an explanation of the sudden return to growth. Meanwhile, those complaining at the pace of austerity have no postponed spending cuts or tax increases to cite as the basis for the turnround.
The parallels with 1995 cannot be taken too far. Then, the economy was already well into its third year of recovery; today it is barely into the third quarter. Recovery is welcome, but still at risk from domestic and foreign shocks.
The puzzle about weak receipts was also much deeper in 1995 than it is today. Then, nominal spending on British goods and services was rising at rates between 5 and 7 per cent a year. Explanations for lacklustre VAT growth rested on complicated theories and indications of surging fraud in the system. In the event, the VAT hole went away without ever being fully resolved.
In contrast, it is clear today why receipts have so far been weak. Until nominal spending picks up from the still abnormally low rate of 3.2 per cent in the second quarter to somewhere closer to 5 per cent, it will remain insufficient to bring borrowing down rapidly. Only when Britain gets back to nominal gross domestic product growth at these rates will the chancellor be able to watch his austerity in departmental outlays bring public spending down rapidly as a share of gross domestic product watch the deficit close.
Britain’s real economy might have turned the corner, as Mr Osborne said, but nominal growth remains too slow and too fragile. Politics dictated the timing of his complacent jig this week, but he would have been wiser to resist a while longer.
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