Less than a week ago, I wrote in a post on my blog: “So there is something we can do with fiscal policy, without increasing government debt. Why does hardly anyone talk about this?” Two days ago Ian Mulheirn from the Social Market Foundation published a detailed proposal exactly along these lines. (There is also a short piece in Monday’s Financial Times.) A coincidence of course, but very welcome.
This proposal involves bringing forward by four years £15 billion of tax increases pencilled in for after 2015, and using that money for temporary infrastructure spending in those four years. This is a specific example of a more general idea, that you can stimulate demand through additional but temporary increases in government spending financed by temporary increases in taxes. The proposition that this will stimulate aggregate demand is a pretty robust bit of macroeconomic theory. In fact we can go further, and say that the benchmark multiplier for such a policy will be at least one. This suggests that this proposal, by using OBR figures, may be rather conservative in its estimate of the impact on UK growth.
The multiplier will be one if consumers are of the simple Keynesian type who consume some constant fraction of their current income. Higher taxes will reduce their income, but as long as their propensity to consume is less than one, there is a net positive effect on demand, which gets translated into higher output and higher income. But higher income leads to higher consumption, and we get the famous ‘balanced budget multiplier’ of one which every first year undergraduate learns how to prove. However, as Professor Michael Woodford has recently shown, we get exactly the same multiplier of one if consumers are much more sophisticated, and look at their entire lifetime income when planning their consumption. The basic intuition here is that any temporary tax increase gets smoothed over their lifetime, so the impact on current consumption is small. As the simple Keynesian case shows, any short term impact there is will be offset by higher incomes generated by higher government spending.
This all assumes an unchanged level of real interest rates. Higher aggregate demand should lead to some increase in expected inflation. If the Bank of England keeps nominal interest rates unchanged (which, with inflation falling, they should), then real interest rates will fall, which will provide an additional stimulus to demand. That is why the benchmark multiplier will be at least one. If the government spending is in the form of useful infrastructure projects, this has the additional bonus of increasing future supply.
Why have tax financed temporary increases in public investment not been part of the austerity versus stimulus debate so far? For those who oppose austerity, I think the problem is a (correct) belief that debt financed increases in spending would be even more effective at stimulating demand (because ‘Ricardian Equivalence’ does not hold), and that the short term dangers of increasing debt are vastly overblown. While I think this line is right in principle, I fear this debate is unwinnable so long as the Eurozone crisis continues, and the media obsesses about ratings agencies. We can argue till the cows come home that the Eurozone is different, because these countries do not have their own central bank, and that the market takes no notice of ratings agencies, but these arguments are drowned out by the daily news about Greece and other Eurozone economies.
On the other side, among those who favour austerity, I think there is a reluctance to consider policies that increase the size of the state, even though this would only be for a few years. There is also the obvious unpopularity of tax increases. However there is now a real danger that by the time of the next election UK unemployment may still be rising and the recovery will be modest. It is going to be very hard to win an election with this record. (I do not think Argentina will distract attention again as it did in 1982!) The great advantage of tax financed increases in spending is that they stimulate the economy without going back on the austerity pledge. Indeed, because they stimulate growth, they reduce headline budget deficit figures and so increase the likelihood that austerity will be successful in bringing down the ratio of debt to GDP.
So these proposals from the Social Market Foundation are very welcome indeed. They show that something can be done to stimulate the economy without increasing debt. Of course there is a great deal of discussion still to be had on what taxes to increase, and what investment to fund. However from a macroeconomic point of view most combinations will succeed in stimulating the economy. With unemployment continuing to rise, there is still time to act. It is imperative that we do.
Have you seen the recent Liam Fox op-ed in the FT, arguing for what sounds like the opposite of your proposal: http://www.ft.com/cms/s/0/2ee5b8de-5c8d-11e1-8f1f-00144feabdc0.html#axzz1n3UcQLfu (should this be called balanced budget contraction?)? I wonder if we can infer anything about the current government’s thinking on these issues from Dr. Fox’s piece?
I was initially quite enthusiastic about your balanced budget expansion proposals in the current austerity climate – this would also allow to correct for some income inequality by increasing the taxes on the rich.
But now I wonder if it is equally ideologically unpalatable to the current government because it involves tax increases and increasing the size of the state, which is quite contrary to the conservative ideology. And Dr. Fox’s piece indicates the same focus on deregulation and reducing the size of the state (I’m not sure what his truly odd comment about “currency debauchery” is about).
I'd also like to thank you for a great blog, one of the few economics blogs I keep coming back to regularly - hope you keep up the good work!
Arguments presumably work a fortiori in a climate of liquidity constraints
What about investmenat financed by "printing money" ? Or how about debt-financed investment, but with the Bank of England using QE to put a ceiling on any interest rate rise - limit the interest rate on gilts to,say, the long-term inflation target + a real 1 or 2% return, i.e. 3 or 4% ?ReplyDelete
You can't discuss macroeconomic policy without acknowledging political realities. Even if we accept that economics is a science, when making policy recommendations economists are entering the field of politics (just as climate scientists who advocate certain energy policies, or doctors who call for higher taxes on alcohol are doing).ReplyDelete
The idea of raising taxes is a hard sell at the best of times, and in the current circumstances is absurd. If Labour were in power, there would still be zero chance of a balanced budget expansion, because it's bad politics. As you correctly observe, the Conservatives are ideologically opposed both to higher taxes and government spending, so they would be even less likely to take this approach than Labour.
If there is to be a fiscal expansion, it must be through tax cuts. Ed Balls clearly gets this, which is why he is arguing for a cut in VAT. This is certainly a defensible position, although I don't think all these changes in VAT have been healthy. If the coalition is ever going to support a fiscal expansion, it will be because they rediscover an appetite for tax cuts that exceeds their appetite for spending cuts. I think Nick Clegg's proposal to increase the tax threshold to £10,000 would be a good place to start (I would make it retroactive, so households get a rebate for last year). This could be packaged with an end to the 50% rate to keep the conservatives happy. The tax cuts would work by overcoming liquidity constraints, encouraging supply, and boosting confidence.
“Why does hardly anyone talk about” expanding fiscal spending without increasing debt? I “talked about it” in the letters column in the FT yesterday:ReplyDelete
To judge by his article in the FT on Monday, Mulheirn has no grasp of macro whatever. I set out reasons for thinking this here:ReplyDelete
It looks like that article was a shortned version of “Osbornes’ Choice” (the Social Market Foundation’s recently published work). So I am very strongly tempted not to read “Osbornes’ Choice”.
It does seem like the interesting debate in the FT continues:ReplyDelete
Tim Harford takes Liam Fox to task: http://www.ft.com/cms/s/0/03bc635a-5e23-11e1-8c87-00144feabdc0.html#axzz1n3UcQLfu
Gavyn Davies is quite supportive of the Social Market Foundation proposals: http://blogs.ft.com/gavyndavies/2012/02/24/boosting-growth-without-raising-budget-deficits/#axzz1nDUNwArS
If the object of the exercise is to “stimulate demand” what is the point of “increases in taxes”? The effect of the latter is DEFLATIONARY.ReplyDelete
To “stimulate demand” why not just have the government / central bank machine create money and spend it (and/or cut taxes)? And if inflation looms, do the opposite: raise taxes and extinguish the money collected.
The whole “balanced budget” idea confuses macro with micro. Micro entities MUST balance their budgets, i.e. they have to avoid making a loss. In contrast, government is a macro entity: it can create money from thin air and spend it ad infinitum, or it can do the opposite – rein in money and extinguish it.
I think you've missed the point, Ralph. The increase in tax may be deflationary when applied in isolation, but if the government were to spend the income from the tax increases now, then there would be an expansionary effect. Why? Because the increase in tax leads to a small fall in consumption (small because consumers smooth their income over their lifetime), so the increase in government spending outweighs the small fall in consumption. Moreover, a falling real interest rate (the expansion leads to higher inflation, thereby reducing real interest rates) would lead to further expansion. Output therefore grows, and we have an expansionary effect. It is simplistic to suggest increases in taxes are always deflationary without assessing what the tax revenues are used for.Delete