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Saturday, 25 July 2009

Hard choices ahead

We are going to hear about some "hard choices" that have to be made in the next year so let us look at the situation in round numbers.

UK annual GDP is £1,400 billion, of which £700 billion is expenditure by the government, which is funded to the extent of £500 billion in taxes.

That means we have a budget deficit (of £200 million) equal to 14% of GDP or 29% of government spending. Let us assume that this is deemed to be foisting the cost of paying for today's benefits onto tomorrow's citizens and is thus unfair. There are other aguments for not running up a large deficit such as the unpredictaility of interest rates, the risk of an inability to refinance or repat the debt etc, so we would like to reduce this number for arguments sake to 0%.

Well the first way would be to raise taxes to cver the shortfall, which would be equivalent to a 40% increase in all forms of taxation. One can run all sorts of arguments about uncompetitiveness, and it might indeed reduce GDP because there would be a lack of incentives and some may emigrate etc. thers might emigrate, but let us ignore those for the moment.

The second way would be to reduce government spending, but we see that when we cut governmen spending we reduce GDP. Let us assume that the tax raised is exactly proportional to GDP, so tax receipts will also drop by 5/14ths of the drop in spending. With more unemployment, benefit costs may also rise but for these purposes, let us ignore that. This means that we have to cut spending by £14/9 to save £1 in deficit (£1 = £14/9 *(1-5/14)), so a deficit equal to 29% of government spending would require a 29% * 14/9 = a ~44% drop in spending.

The third alternative is to run a deficit. To put it into a mathematical formula, we can have

x% of a 14% deficit,

y% of a 44% cut in govenment spending, and

z% of a 40% increase in taxation,

where x+y+z = 100, {x, y, z: >=0, <=100}.

Let us say we go with a third of each, then we have a 15% cut in government spending, a 13% increase in all taxes and we would still have an uncomfortably high deficit of 5% (by way of an example, 3% is the limit for euro convergence, implying a stable economy). That means a higher rate of tax at 45% and a basic rate at 23%, VAT at 20% etc, and the gap would likely be filled by freezing all public sector salary increases until the deficit was reduced to less than 3% of GDP.

When ministers or opposition MPs talk about smaller numbers than these, you know that either they are obfuscating or they do not appreciate the gravity of the situation. 2% of this or 5% of that is never going to bring the economy back to health.


BrianSJ said...

Not quite sure I follow your formula (a 100 of what?). However, we need to factor in a drop in GDP. For government spending, the equivalent of disposable income is constrained by large and rising proportions allocated to servicing debt and paying pensions (inc. all the early retirements that will ensue from cuts). The real money available for 'nurses and teachers' is going to go down a long way.

Alex said...

x,y&z are just numbers used as percentages.
You could have:
x=100,y=0,z=0 to have 100% deficit, or x=0,y=100,z=0 to have 100% cuts, or x=0,y=0,z=100 to have 100% tax increases, or any other combination where x+y+z=100.

The point is that if politicians talk about 2% spending cuts (5% of 44%) and a 3% (7.5% of 40%) increase in taxes, they are hardly serious about reducing the deficit which would still be at 12% ((100%-5%-7.5%) of 14%) of GDP.

Charles said...

But it isn't impossible. Remember that Ken Clarke as Chancellor was able to bring the budget into balance. I would also argue that much of the spending over the last 12 years simply hasn't been productive, so the big flaw in your argument is that it will reduce GDP. Sure it will hurt the Guardian by reducing their advertising, but that isn't necessarily a bad for the economy as a whole.

Alex said...

I don't follow your argument.

The most common definition of GDP is
GDP = private consumption + gross investment + government spending + (exports − imports)

so GDP goes down if government spending (productive or not) is reduce, irrespective of its knock on effects.

I would agree that much government spending is probably ineffective and could be cut, and I don't doubt that it is possible to cover the deficit with budget cuts, but the amounts that are being tossed out by politicians at th moment don't come close to the amounts required.

Charles said...

The chances are there will be a painful rebalancing period. However, from what I remember of my economics degree (too many years ago) is that if government spending increases then the net positive impact on the economy is less than one because some private spending is crowded out. Surely we should then just see a reverse of this effect:

A reduction in the level of government spending will free up more resources to be spent more productively, increasing overall GDP/GNP.

I'm more arguing that it is not a straight line relationship like you imply than with the basic thrust of your approach.

Alex said...

I think your economics tutors must have assumed that the government was operating a balanced budget so that every penny spent by the government was paid for out of taxation receipts, the payment of which reduced private sector spending capacity.

What we have now is a vast deficit paid for by government borrowing on an epic scale. Spending less does not free up resources if the "saving" is simply used to borrow less.