Fiscal Facts & Fables

Hello readers,

Welcome back to my blog. I recently discussed monetary policy and the role of interest rates in the economy. In this post I thought I would do some research into fiscal policy and assess some of the different proposals that have been introduced over the years by Osborn and Hammond. For those of you who don’t know, fiscal policy refers to government spending and taxation and such changes are announced in the annual budget. In the 2017 budget which took place last month the main policy we saw being implemented by the chancellor was abolishing stamp duty for first time buyers purchasing homes under £300,000. Although the aim of this was to enable such buyers to gain a foothold in the property market, it is likely that house prices may just increase by the amount that is being saved or by more as a larger number of people will be able to afford a house which they were previously unable to afford, thus increasing demand and pushing up prices. Furthermore, most homes in London are well above this price and there will be no impact to these buyers. Aside from that there were few major changes other than the usual increase to alcohol duties and the implementation of a tax on new diesel cars. More money was inevitably promised to fund the NHS and Hammond has announced that he will be increasing the budget for teaching mathematics across the country as this is vital for long term productivity gains. If you have any questions about the budget or after reading this post, please comment below.

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  1. Phillip Hammond’s Current Fiscal Objectives:

Taxation

  • Chancellor says that £140bn has been raised since 2010 by tackling tax avoidance evasion.
  • Top 1% now pay 29% of all income tax.
  • People’s choices for employment should not be driven by tax implications.
  • Sugar tax set at 18p and 24p.
  • Corporation tax set to fall to 17% by 2020.

Infrastructure

  • £300m of previously announced fund to support “brightest and best research talent”; £200m for local projects to leverage private sector investment in fibre broadband networks; £16m for a 5G hub; £270m for robots.
  • £90m for the north and £23m for the Midlands for “pinchpoints” on the national road network.

Education and skills

  • “While investing in education and skills helps to tackle our productivity gap… it does something else as well: it delivers greater fairness,” Mr Hammond says.
  • Funding for a further 110 new free schools on top of the existing 500, including new specialist maths schools.
  • £216m more investment in the schools estate over the next three years, taking total investment in schools of over £10bn in this Parliament.
  • Loans for part-time undergraduates and doctoral students.
  • Increase by more than 50pc the number of hours of training for technical students aged 16-19 so when they qualify they will be “genuinely work ready”.

Healthcare

  • £2bn of additional grant funding for social care over the next three years, with £1bn available in 2017-18, allowing local authorities to “act now” to commission care packages.
  • £425 million more for NHS development and A&E departments.

2. Current Level of National Debt:

The UK national debt is the total amount of money the British government owes to the private sector and other purchasers of UK gilts. According to the ONS General government gross debt was £1,731.4 billion at the end of December 2016, equivalent to 89.3% of gross domestic product (GDP); an increase of £65.4 billion on December 2015. The UK national debt grows at a rate of £5,170 per second. The truth however is much worse, factoring in all liabilities including state and public sector pensions, the real national debt is closer to £4.8 trillion, some £78,000 for every person in the UK. Although 89% of GDP is high by recent UK standards, it is worth bearing in mind that other countries have a much bigger problem. Japan, for example, has a National debt of 225%, Italy is over 120%. Also, the UK has had much higher national debt in the past, e.g. in the late 1940s, UK debt was over 200% of GDP. Prior to the crash the debt to GDP in 2007 in the UK was 42% and after the recession in 2010 it was 76% of GDP.

3. Current budget deficit (annual borrowing):

The budget deficit is the annual amount the government has to borrow to meet the shortfall between current receipts (tax) and government spending. Net borrowing for the UK 2016/17 is £45bn or 2.3% of GDP. The forecast for 2017-18 is net borrowing of £58bn or 2.9% of GDP.

In 2009/10 at the height of the great recession net borrowing was £152bn or 10% of GDP. This was due to:

  • The financial crisis which led to falling tax revenues, e.g. lower incomes led to less income tax revenue; fewer house sales-led to lower stamp duty.
  • Expansionary fiscal policy including ‘VAT holiday’.
  • Higher spending on unemployment benefits during the recession.
  • Long term spending commitments, e.g. government spending increases in the early 2000s.

4. Role of the OBR:

The Office for Budget Responsibility was created in 2010 to provide independent and authoritative analysis of the UK’s public finances. It is one of a growing number of official independent fiscal watchdogs around the world. They have 5 main roles: Economic and Fiscal forecasting, evaluating performance, sustainability and balance sheet analysis, evaluation of fiscal risks, and scrutinising tax and welfare policy costing.

5. The last time the UK government ran a budget surplus:

In 2000/01, the UK ran a budget surplus of £17bn or 1.7% of GDP.

6. Osborn’s budget in “normal times”:

  • “With our national debt unsustainably high, and with the uncertainty about what the world economy will throw at us in the coming years, we must now fix the roof while the sun is shining,”
  • He was in favour of enforcing austerity in order to ‘balance the books’ and run a budget surplus in “normal times”.
  • However the target was criticised and referred to as ambitious. The savings were to come from a £12bn cut to the welfare bill mainly from cuts to tax credits, housing benefits and a lower welfare cap.
  • The BBC was required to make cuts to its own budget as well as take on the annual £650m bill for providing the over 75s with free TV licenses.
  • He said that this is “A Budget that sets out a plan for Britain for the next five years to keep moving us from a low-wage, high-tax, high-welfare economy; to the higher wage, lower tax, lower welfare country we intend to create”.
  • He pledged to make Britain the richest economy in the world by the 2030s under his plans, suggesting that he would bring in his budget surplus rule once he is nearly finished with his cuts.
  • His idea was: in the good times we stay in surplus – raising more money than we spend and using that to pay down our debts,” Osborne said. “And when the bad times come, the Government will have to set out a clear plan to get back to health.”

7. Taxes in the UK:

According to the Institute for Fiscal Studies (IFS), the proportion of national income that is taxes in the UK is approximately 33% and the total tax receipts in 2017–18 are forecast to be £690 billion. By 2019–20, tax receipts are forecast to be at their highest share of national income (34.4%) since 1981–82. Total government receipts, which include interest, dividends and gross operating surplus, are forecast in 2019–20 to be at their highest level (37.2%). A study by the think-tank the Centre for Cities found that London generated almost as much tax as the next 37 largest cities combined and increased its share of “economy taxes” underpinning the Treasury’s finances to 30%.

In Scandinavian countries Finland, Norway of the Netherlands, taxation make up a larger proportion of national income and these societies are often referred to as being more ‘equal. On the flipside countries such as the UAE or Saudi Arabia who are oil rich, depend less on tax income with many people exempt from paying any income tax at all, as majority of their national income is from oil.

8. Proportion of national income that is government spending:

Government spending as a proportion of national income in the UK is at a similar level to that in Germany but is considerably higher than in Switzerland, Australia and Ireland. Government spending is also somewhat higher in the UK than in Canada, the US and New Zealand. Before the First World War, government spending was about 10 per cent of national income. By 1920, the figure was 20 per cent; and by 1937, it was 30 per cent. Now it is around 46% of national income.

9. Tax system in the UK:

The UK has a progressive tax system. This means that the rate of tax increases as income increases. The US also has a progressive tax system and essentially it reduces the burden on people who can least afford to pay them. These systems leave more money in the pockets of low-wage earners, who are likely to spend all of their money and stimulate the economy. Progressive tax systems also have the ability to collect more taxes than flat taxes or regressive taxes, as tax rates are indexed to increase as income climbs. Progressive taxes allow the people with the greatest amount of resources to fund a greater portion of the services all people and businesses rely on, such as roads, first responders etc. Critics of progressive taxes consider them to be discriminatory against wealthy people or high-income earners.

10. Examples of countries with a proportional or flat rate tax system:

Romania-16%    Russia-13%     Hungary-15      Jamaica-25%

11. Government’s objectives for direct taxation (income) and indirect taxation (VAT):

  • Finance government expenditure & infrastructure
  • Prevent Concentration Of Wealth In A Few Hands- Progressive systems-prevents wealth being concentrated in a few hands of the rich i.e. narrowing the gap between rich and poor.
  • Redistribute Wealth For Common Good- the wealth of the rich is redistributed to the whole community.
  • Promoting economic growth, stability and efficiency-The government controls or expands the economic activities of the country by providing various concessions, rebates and other facilities. The effective tax system can boost the economy. Similarly, taxes can correct for externalities and other forms of market failure (such as monopoly). Import taxes may control imports and therefore help the country’s international balance of payments and protect industries from overseas competition.
  • Reduce Structural Unemployment-The government can reduce the unemployment problem in the country by promoting various employment generating activities. Industries established in remote parts or industries providing more employment are given more facilities.
  • Remove Regional Disparities-Regional disparity has been a chronic problem to the developing countries. Tax is one of the ways through which regional disparities can be minimized. The government provides tax exemptions or concessions for industries established or activities carried out in backward areas. This will help increase economic activities in those areas and ultimately regional disparity reduces to minimum.

12. Reasons for public expenditure:

  • Improve Public Services-Higher government spending can lead to improved public services like health, education and transport. These are important for increasing the quality of life and economic well being.
  • Increase Productive Capacity of Economy-Some types of government spending, can help to overcome market failure. For example, education can help increase labour productivity and reduce structural unemployment; if the education spending is well targeted it can help to increase the long run trend rate of growth. However, not all government spending is guaranteed to actually increase government spending, it may be subject to government failure and inefficiency.
  • Expansionary Fiscal Policy-Increased government Spending without higher taxes is likely to increase AD. It will cause a budget deficit, however, the increased government spending is an injection of spending to the economy and could help to increase the rate of economic growth. Some monetarists argue increased government spending will just cause crowding out, and therefore it will not increase AD.
  • Reduce Inequality-A significant % of government spending is spent on social security. This includes benefits, such as; unemployment benefit, income support, child benefit and housing benefit. The majority of these benefits are means tested; this means they are targeted to those on low incomes. The aim is to reduce relative poverty and inequality.

13. Key Principals of Taxation:

Adam Smith developed his four famous ‘canons’ of taxation:

  • Equity: The amount payable by taxpayers should be equal, by which he meant proportional to income.
  • Ability: The taxpayer should know for certain how much he will have to pay.
  • Convenience: There should be convenience of payment.
  • Economy: Taxes should not be imposed if their cost of collection is excessive.

Other principals include:

  • Adequacy: taxes should be just enough to generate revenue required for provision of essential public services.
  • Broad Basing: taxes should be spread over as wide as possible section of the population, or sectors of economy, to minimize the individual tax burden.

14. UK Current level of:

  • Corporation Tax- 19%
  • VAT- 20%
  • Top Rate of Income Tax- 45% (over £150,000)
  • Tax Free Allowances- up to £11,850 (increase from £11,500-announced in this year’s budget-in line with inflation).

15. Examples of goods exempt from VAT:

Charity shops – selling donated goods, lottery ticket sales, education, water supplied to households, children’s clothes and books.

16. Difference between a cyclical and structural deficit:

Cyclical budget deficit-A cyclical budget deficit takes into account fluctuations in tax revenue and spending due to the economic cycle. For example, in a recession, tax revenues fall and spending on unemployment benefits increases.

Structural deficit-This the level of the deficit even when the economy is at full employment.

17. Examples of how government spending and taxation can influence the pattern of economic activity:

  • In a recession e.g. the 2008/09 crash, consumers may reduce spending leading to an increase in private sector saving. If government spending is increased it may create a multiplier effect e.g. the unemployed gain jobs, they will have more income to spend leading to a further increase in aggregate demand. (e.g. construction workers employed by government increase spending in pubs and transport, causing other sectors of the economy to benefit from the government spending). Some economists would argue increasing government spending through higher taxes would lead to a more inefficient allocation of resources, as governments tend to be less effective in spending money.
  • Increasing taxation perhaps to finance the growing budget deficit would leave consumers with less disposable income and is likely to reduce AD.

18. Factors which could put pressure on public finances over the next 10 years:

  • Healthcare-NHS
  • State Pensions (growing and ageing population)
  • Immigration-increased demand for education, welfare benefits, housing etc. However a ‘Hard Brexit’ i.e. with no free movement of people and a move to a ‘points based system’ may offset this.

Sources Used:

https://www.economicshelp.org/blog/2731/economics/impact-of-increasing-government-spending/

https://www.ifs.org.uk/publications/9178

http://uk.businessinsider.com/budget-2017-live-chancellor-philip-hammond-brexit-tax-borrowing-schools-tech-2017-3

https://www.gov.uk/guidance/rates-of-vat-on-different-goods-and-services

https://www.britannica.com/topic/taxation/Principles-of-taxation

http://www.economicsdiscussion.net/india/public-expenditure/public-expenditure-causes-principles-and-importance/17462

http://www.investopedia.com/terms/p/progressivetax.asp

http://www.telegraph.co.uk/finance/budget/11726259/Budget-2015-George-Osbornes-speech-in-full.html

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