October Budget 1: can economic growth end austerity?

 

The October Budget will tell us a great deal about how Rachel Reeves will act as Chancellor during this Labour government. As a result, before the Budget I intend to write a number of posts setting out the main macroeconomic issues as I see it. This first sets the scene, by questioning the idea that improvements in public services will come from better economic growth.

In her 2024 Mais lecture Chancellor Rachel Reeves said that

“it is through growth and only through growth that we can sustainably resource strong public services, raise living standards, and compete internationally.”

During the election, when Labour was pressed on how it would find money to improve public services while at the same time ruling out raising taxes on working people, the fall back position seemed to be that this would come from growth.

At first sight this idea is straightforward, and can be encapsulated in the following sentence. Higher real growth means rising real incomes, and higher income brings in higher taxes at existing tax rates, providing the finance for extra government spending, which allows the employment of more doctors, nurses, teachers and so on. However this simple intuition can be very misleading. To see why, consider the following very similar sentence. With higher inflation, higher nominal growth means rising nominal incomes, and higher income brings in higher taxes at existing tax rates, providing the finance for extra government spending, which allows the employment of more doctors, nurses, teachers and so on. The only change I have made to the original sentence is to replace the word ‘real’ with ‘nominal’, but the idea that inflation helps fund additional public sector jobs sounds wrong.

It is wrong, if by inflation we mean price and wage increases across the board, including wages in the public sector. Higher taxes in nominal terms are mainly going to pay for higher wages in the public sector, and there is little or nothing left over to increase public sector employment. But exactly the same point can apply if we are talking about real growth, depending crucially on where that growth is coming from. The most obvious example is real growth due to an increasing working population. More people earning incomes will raise total tax revenue, and those additional taxes can pay for more doctors, nurses, teachers etc, but the number of doctors, nurses or teachers per working person will be much the same.

The more interesting example is where economic growth comes from higher private sector labour productivity. This normally leads to higher private real wages, and therefore higher taxes. But if real wages in the public sector keep pace with those in the private sector, then these higher taxes mainly pay for higher real wages for public sector workers rather than for more doctors, nurses or teachers. [See postscript for a bit more explanation.]

This point is very familiar to economists since the 1960s, when William Baumol argued that rising real wages in jobs that saw productivity growth would lead to higher real wages in service sector jobs, particularly public sector services like health and education, where productivity growth was much harder to achieve. Baumol suggested that this kind of unbalanced growth, with productivity in service sectors lagging behind productivity elsewhere in the economy, was the typical pattern in all economies.

Of course the benefits of real or nominal growth in terms of higher wages may be unequally shared. Public sector workers may have their wages reduced relative to those in the private sector, which will leave some money to be spent on additional public sector workers. That is exactly what the last Conservative government did, except some of that money went on tax cuts rather than higher public sector employment. But Labour have made it clear that for the moment at least that is not a strategy they will follow, for the very sensible reason that it is not sustainable. Reducing the relative pay of public sector workers creates both industrial unrest and staff shortages, which is why Baumol assumed it wouldn’t be the norm.

The only way growth gets you significantly more doctors, nurses and teachers is if labour productivity gains are spread throughout the economy, including the public sector. But the idea that, for given levels of expenditure, better public sector productivity will allow the employment of more doctors, nurses and teachers is both simple and obvious. If that is what people mean by growth delivering better public services, why not mention public sector productivity directly?

The same reasoning shows why data showing trends in public sector spending can be a very misleading indicator of changes in the quality of public service provision, even when that data is shown in real terms. Higher real spending on education, for example, may reflect a combination of higher real wages for teachers combined with little productivity growth, rather than more teachers being employed.

This is why, whenever I look at trends in public spending over time, I try to look at public spending relative to GDP, and how that measure has changed in the past. That controls for inflation, but it also controls for real growth that is spread across public as well as private sector workers. As a result, public spending relative to GDP gives you a better idea of whether public services are getting better or worse than numbers that only control for inflation.

While public spending relative to GDP is a better measure of the provision of public services than either real or nominal spending levels, it still may give a misleading picture. In education, for example, it is important to look at changes in the total population of pupils. In health, as I have noted many times, factors like an ageing population mean that spending relative to GDP tends to rise over time in almost all OECD countries, so a constant level of health spending relative to GDP (as we saw from 2010 to 2019) is consistent with a deterioration in service provision, leading to increased waiting times for example.

If the idea that growth naturally helps end austerity is misleading, there is a more subtle sense in which it may enable it. To put it at its most simple, it may be politically easier to increase tax rates when real incomes are growing strongly compared to when they are stagnant. In terms of resources, higher taxes moderate the growth in private sector spending relative to increases in productivity, which frees up labour that can then be diverted to providing better public services.

However, using growth in this way to end austerity appears to have been ruled out by the Chancellor with her pledge not to raise taxes on working people. Instead she will have to rely on increasing more minor (in terms of revenue raised) taxes. In my next post on the October Budget I will look at how much taxes have to rise to achieve in any meaningful sense an end to austerity.

Postscript (22/08/24)

Feedback suggests I should have added something to make this clearer. Suppose, for simplicity, that all public spending goes on the wages of public sector workers, and that total taxes = total public spending. Now imagine an X% increase in private sector productivity, which leads to an X% increase in private sector wages. Public sector wages rise by X% to keep relative wages unchanged. For higher growth to pay for additional doctors, nurses or teachers, taxes would have to rise by more than X%. They might do so at the margin because of real fiscal drag, but the great majority of the tax increase will pay for higher public sector wages.