Deficit reduction or growth? Everyone wants both, but which should come first?
This is the question at the heart of the increasingly polarised debate on UK economic policy ahead of the Budget. But it’s the wrong question. We should first ask: what can be done to boost the economy without borrowing more money? The answer shows that strengthening deficit-cutting credibility and stimulating growth can go hand in hand.
In November the Office for Budget Responsibility substantially downgraded its growth forecast. It also highlighted the need for a further £15bn of annual spending cuts or tax rises by 2016. So the government’s fiscal strategy is vulnerable on two fronts. Weak growth is putting pressure on plans to cut the deficit, yet there is no adequate strategy to boost it. And the government’s deficit-reduction credibility has taken a knock since it decided to wait until shortly before a general election to tell us how it plans to distribute the extra £15bn of fiscal pain.
The perils on both sides of the debate are severe. Borrowing more to boost growth risks a catastrophic loss of confidence among investors. But continued austerity risks a slump and permanent damage to the supply side of the economy through high and persistent unemployment and idle physical capital. As the growth outlook has deteriorated and borrowing has increased, each side in the “growth or cuts” debate has become more entrenched, implausibly claiming that the latest gloom can only be interpreted in support of their solution.
But growth and deficit reduction are not incompatible. The inevitability of a further £15bn of annual fiscal tightening by 2016 creates an opportunity for the chancellor to implement a potent growth strategy within existing borrowing plans.
He should do three things at the Budget. First, he should identify tax breaks and spending with a low or negative impact on economic output. Second, he should cut those policies now, rather than wait until 2016. Third, he should switch the money thus saved into measures known to have a high impact on output, for the next four years.
So what are the low-growth measures he should axe? Tax breaks that encourage the wealthiest to take money out of the economy and transfers to people likely to save them should top the list. Options include ending higher-rate tax relief on pensions saving, cutting winter fuel payments to well-off pensioners and limiting maximum Individual Savings Account holdings to £15,000 per person.
Recycling these savings into the UK’s creaking energy and transport infrastructure would amount to an investment of more than £50bn over four years. To the relief of investors in UK government debt, it would also be credibly temporary: motorways don’t vote.
How much impact would this £50bn switch have? A conservative interpretation of the OBR’s figures suggests the net effect would be to raise economic output by at least 0.7 per cent of gross domestic product for each of the next three years.
The long-term impact would also be substantial. The programme would directly add £50bn to the UK’s capital stock, lowering costs for companies. Households with sound finances would be encouraged to sustain consumption. Both effects would give companies reason to invest. The plan would also create jobs, reducing the mounting human, social and economic costs of long-term unemployment.
Other policy proposals for boosting output are weak and costly by comparison. This plan would have twice the stimulus effect of reversing last year’s VAT rise, but without adding a penny to the deficit. The VAT cut, by contrast, would involve borrowing an extra £13bn per year. Compared with an unfunded increase in the personal tax allowance to £10,000 from this April, adding £9.5bn to the deficit, the plan would be three times as potent.
This strategy would boost output, restore deficit reduction credibility and help lay the infrastructure for the new economy that must emerge from the crash. It’s time to move beyond the sterile debate that sees these goals as incompatible. Each side characterises their plan as the all-or-nothing solution, like a fiscal version of Hobson’s choice. An alternative to both is available.
The writer is director of the Social Market Foundation
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