In defence of the IFS, and why it cannot tell the whole story

Our own fiscal council, the OBR, is very restricted in what it is allowed to say by the party that created it. As a consequence, it is absolutely essential that we have widely respected bodies, principally the IFS but I would also include the Resolution Foundation and the National Institute (NIESR), that are able to provide good quality economic advice at all times, but particularly before General Elections.

A good example is the Conservative manifesto published last Sunday. Without the IFS, it is quite possible that it would have made extravagant promises on public expenditure and it would have also included some tax cuts. But because the media treats the IFS as authoritative and impartial, this year they will have judged that the political costs of a manifesto like that exceeded the benefits.

So the IFS or something like it is essential. But that does not, of course, mean that it is beyond criticism. Indeed it is essential that such criticisms are made (no one is perfect). There are two types of criticism. The first are specific criticisms: it got this piece of analysis or this particular statement wrong. The second is generic: it is often wrong because of a general failing of some kind. Let me take each in turn

A specific criticism I would make is that Paul Johnson’s initial reaction to Labour’s manifesto was ill-judged in the language he used. He used three words that you will not find in the IFS’s written assessment: colossal and not credible. On ‘colossal’, the written text uses the more neutral words ‘very substantial’. More seriously, he said claims that all the tax would be raised from companies and those earning over £80,000 were not credible.

That gave the media an easy headline. For example The Times wrote “Jeremy Corbyn’s plans to raise a “colossal” £83billion in extra taxes to fund an unprecedented public spending spree are “simply not credible”, the Institute for Fiscal Studies has warned.” The Mail wrote “Jeremy Corbyn's hard-Left spending splurge is 'simply not credible': IFS ridicules Labour leader's claim he can raise £83BILLION in extra tax to fund 'colossal' giveaways JUST from the rich - warning EVERYONE will have to pay”. The Guardian wrote “The Institute for Fiscal Studies, the non-partisan tax and spending thinktank, said that it does not believe Labour’s claim that it will be able to achieve everything it plans with 95% of taxpayers not having to pay any extra in tax”

There are two issues here. The first is about the direct incidence of tax which is how everyone, apart from those with some economics, understands by the question who pays tax. It is just not clear from their initial assessment whether the IFS are claiming that Labour’s numbers on revenues are wrong in any serious way. They don’t dispute the initial figures for corporation tax (I will talk about the longer run later), and welcome the measures for capital gains and dividends tax. Yet most people reading the phrase ‘not credible’ would think otherwise.

There is of course a legitimate question mark about the final incidence of corporate tax. As I note in my earlier post, the empirical evidence on this is all over the place. True, shareholders include pension funds. But none of this in my view justifies the phrase ‘just not credible’ to the tax plans in Labour’s manifesto, particularly as Labour pledge was about initial incidence. Now interviews, particularly in the age of 24 hour news and the resulting requirement for instant reactions, are hard to get right. But nevertheless I think it is fair to say that Paul Johnson, on this particular occasion, didn’t get it right.

Is there a generic problem that the IFS are biased towards the right, or against any kind of radical manifesto. Certainly many on the left think so, but then many on the right think the IFS is in the pay of the EU because it thinks Brexit will do what pretty well all economists think Brexit will do. How you feel also depends on your perspective. If a government in a situation you think is intolerable decides to do nothing, which is a fair characterisation of the current Tory manifesto, the IFS has little to say by way of headlines besides it being ‘remarkable’ (although, as with Labour, they should have mentioned Brexit). On the other hand, the IFS is almost bound to criticise some aspect of any radical plan of the type Labour are putting forward. This just illustrates that the IFS has a very limited remit, and cannot dela with everything that influences social welfare. 

Having said that, I should note some of the things that the IFS did not say about Labour’s plans. They made comparisons with the past when talking about the size of the state under Labour’s plans, but did not (as the Resolution Foundation did do) compare that to other countries. This matters, because the IFS will know more than anyone that with any country with a state run health service the size of the state is very likely to grow over time. In addition in discussing revenue raised from Labour’s tax plans, they failed to discuss the potential Remain bonus which they had already analysed for the LibDems.

Another generic criticism is that the IFS are just bean counters. This is nonsense. For example their point about the incidence of corporation tax is not bean counting. I think the problem is more about how others use the numbers the IFS produce. For example, if you listen to the presentation of both parties’ budgets from 2017 by Carl Emmerson, you will see that they think Labour’s tax projections are too optimistic, but they still meet their fiscal rule with room to spare. Guess which number the media talked about and which they ignored. You could respond that the IFS should take that into account, but how could they do that?

A more credible generic criticism of the IFS is that they do not do macroeconomics. I have in the past made this point. If you listened to the 2017 presentation I linked to above, you will see some discussion (13.02 minutes in) of the supply side of each party’s policies. Labour have a plus (more infrastructure spending) and according to the IFS negatives (higher minimum wage, higher corporation tax, more bank holidays), and the Conservatives have a negative (less immigration), so they assume both parties will have no long run impact on output! Now it is just possible the plus and minuses for Labour cancel out, but just one negative for the Conservatives cannot equate to zero. They also assumed the multiplier from a balanced budget fiscal expansion is zero. They clearly don’t want to do macro.

Does this matter? Yes for two reasons. First sometimes macro has a critical influence on their overall assessment of plans, and as my illustration in the previous paragraph suggests it is not good enough to wish them away. Another example is in their analysis of Labour’s 2019 manifesto, where higher public investment under Labour will almost certainly outweigh any impact of higher corporation tax on investment. It is better to be humble about ignorance than pretend to take it into account and then do nothing, and better still to do something more rigorous on macro. Second, as the media takes the IFS as definitive, it means macroeconomic aspects tend to be ignored, which - as with 2019 - is very unfortunate.

The IFS have a real problem here. Their basic funding is for microeconomic analysis of tax and spending changes, and not for macro. For the Green Budget this year they teamed up with Citi who did the macro analysis. In an ideal world they would team up with a respected think tank that is known for its macro analysis, like the National Institute (NIESR). In the meantime we need to look to the Resolution Foundation, that clearly has macro expertise.

In 2019, many of the key issues are macro, or are not addressed by the IFS analysis. To see that, read the letter in the Financial Times yesterday from scores of economists. Issues of stagnant productivity, lack of real wage growth, regional inequalities, the state of public services and the need for a green transformation of the economy are all key issues influencing peoples’ welfare, are addressed by Labour’s manifesto but are not part of the IFS’s analysis. That does not mean what the IFS does should be ignored - as I suggested at the start it is vital work they do - but just that what they do is not everything that matters to peoples’ wellbeing.

Postscript (28/11/19)

The IFS's full analysis of each party's plans, released today, avoids some of the criticisms I make above. One chart below illustrates exactly the key point I'm making, which is that there are many more important things about each party's plans than whether their tax plans match their spending plans. In this case its Brexit, and it is to the IFS's credit that they showed this.

The chart shows that even though Labour's large investment programme raises debt, as it should do, this is dwarfed by the impact of a possible/likely Conservative No Deal Brexit. 

Is Labour’s economic plan credible?

Labour have a huge set of spending proposals, many of which are unequivocally good like extra spending on the NHS, some are open to debate like abolishing student loans, and only one that I think is foolish (keeping the state pension age at 66). It would be good if all the debate was about these spending pledges. However the standard excuse for why you cannot have these things has always been about paying for them.

There are actually two issues here. The first concerns current spending, around £80 billion each year or about 4% of GDP, and public investment, expected to rise by about £50 billion a year or over 2% of GDP. Labour's current spending increase is financed £ for £ mainly by higher taxes on corporations, capital gains and high earners, while the investment is financed through borrowing. Let me take each in order,

The figure for the increase in current spending and taxes is large. I personally would not call it colossal but it is large. I would argue that reflects the extent of the squeeze we have seen on the public sector since 2010. But what about the argument that it makes the share of government current spending in GDP the highest since the 1970s? A much better comparison is to look at other countries, as the Resolution Foundation has done here.

What Labour’s plans do is to move the UK from the bottom of the league table in terms of the size of the state to somewhere around the middle.

I think this is a key part of the Corbyn project. Under Thatcher, but particularly since Cameron and Osborne, the UK has pretended it can have a state only a bit bigger than the US. But of course the US does not have a universal health service free at the point of delivery. So a key goal of this manifesto is to move us from the bottom to the average in terms of size of states. Another way of putting it is that the UK will become closer to the European average, and further away from the US/Canada level.

The reason why comparisons with the UK’s past are misleading can be summed up with three letters: the NHS. For reasons I have talked about in the past, spending on health has been increasing as a share of GDP since WWII. Every time the Conservatives try to halt this we get growing waiting times. That means that the share of the state in GDP is bound to rise over time, unless there is some offsetting component of public spending. In the 90s there was - lower military spending following the end of the Cold War - but now there is nothing. So the size of the state is bound to rise over time.

Who is going to pay for getting us to the average of European countries. Under Labour’s plans it is the rich and corporations. I think Paul Johnson in his initial TV comments on the manifesto confused two things, and as a result said some things which were very open to misinterpretation. (Initial reactions to complex documents are often hard to get right,) There is no ‘black hole’ in Labour’s costings. The IFS say the corporation tax numbers are realistic, and I know Labour have tried hard to make them so. Johnson’s point is that companies are not people, and some people will pay this tax. The question is who.

On this issue it has to be said that there is no settled view from the empirical evidence. At one end you have the studies presented in a recent IPPR report (p11). This suggests that most of corporation tax changes fall on shareholders. Now some of those shareholders will indeed be pension funds, but that might influence those who hold those funds rather than those who hold none. Other evidence suggests a 50/50 split between shareholders and workers, and some suggest workers end up paying an even greater share. The honest answer is we do not know what the incidence will be.

There also seems to be a legitimate difference of opinion over the longer term impact of higher corporation tax. The IFS say it will reduce investment and therefore profits. My own view is that corporation tax plays a pretty small roll in investment decisions. The most important factor for investment in non-traded goods is the future level of demand, and here Labour’s strategy is very positive. For exporting firms that are more mobile, factors like the skill base, ease of exporting and political stability play a big role, which is why leaving the EU is so costly.

I have no doubt that a few of the tax increases proposed by Labour will not yield as much as they hope. But most analysis misses the elephant in the room, and that is Brexit. I think it is highly likely Brexit will not happen under Labour, and even if it did it would be far less costly than either the Tories plans, or the effects embodied in the OBR base numbers that many people use. For this reason the LibDems have talked about a ‘Remain bonus’ (in the incredible event they could form a majority government). Labour will also get this bonus.

As to the investment part of the programme, the key issue is once again whether the investment is needed and well spent. We should not be talking about whether it is safe to borrow it. There is virtually no chance that this money will not be available at low long term real interest rates. No one should be scared of investing in the future of our economy and the planet, whether its by adding 2% or more to the deficit.

Much more interesting than the ‘do the numbers add up’ question is thinking about the macroeconomic impact of Labour’s plans. If you read some people there will be an immediate run on sterling as capital takes its money out of the UK. Of course if enough people believe this nonsense it might happen, for a day or two. But the one area where Labour are not radical is macroeconomic policy design. We will have Bank of England independence and a solid state of the art fiscal rule. As soon as that becomes clear any depreciation will be more than reversed, and I suspect there will be an appreciation from day 1. Sterling will appreciate on the expectations of an end to a hard Brexit and rising interest rates.

Why will interest rates rise? The large increase in public investment alone represents a large fiscal expansion. So does the increase in current spending, because a lot of the tax increases will come out of personal or corporate savings. A big injection of demand in the economy will require an increase in interest rates to prevent inflation rising, although the appreciation in sterling will provide some temporary cushioning.

An appreciation in sterling is likely to raise the real wage of every worker in this country. Is an increase in interest rates a problem? For some it may be, but of course for every borrower there is also a saver. From a macroeconomic point of view an increase in interest rates is long overdue. It is a sign that that after a wasted decade we are finally getting the economy moving. You thought the economy was already strong? Just more Conservatives lies. 2010 to 2018 has been the weakest period in terms of growth in GDP per head since the 1950s.  

In the unlikely event of a majority Labour government a stimulus of this scale might lead to shortages of skilled labour that would mean some plans may be delayed. More realistically that problem would be less severe in a minority government where some of the manifesto might be blocked by coalition partners. But either way, a Labour government implementing all or the major part of this manifesto will mean the economy as a whole will end a decade of low output and wage growth that has stifled UK innovation and productivity growth.

We should ignore the tired old discourse about whether we can pay for it, and focus on the benefits each individual spending increase or investment project might bring, and on the revitalisation of the economy that this manifesto will generate.

Conservative Contradictions: the limits on Red Tories

There has been much talk of Re-leavers: those who voted to Remain but are now voting for Theresa May to get the best Brexit deal. I had talked about something similar long before the term arose (see here and the previous linked post), so I do not think this is just an artifact of particular poll questions. But I’m also sure that this is not the only reason many Remainers will vote Conservative.

Some, as Ian Dunt suggests, just believe that Brexit is inevitable (as you would based on most of the MSM [1]), and that May would be better at negotiating our exit than Corbyn. Others always vote Conservative because they belong to particular groups in society, and they are sure that party will - whatever happens - protect their interests over others. Think the typical Times reader for example. If we are talking about what you might call the affluent middle class, their assumptions have a solid empirical base.

This becomes important once you recognise the dismal economic outlook that faces the UK over the next decade. Productivity growth has virtually stopped. That means that, on current policies, growth in output per head is likely to be pretty slow. In addition, the Brexit depreciation will reduce real incomes, a process that has already begun. Finally May seems determined to reduce immigration as far as she can, which if it happens will damage the public finances.

Think of both the Conservative's core support and these dismal economic prospects in trying to decide how seriously to take the interventionist proposals in Theresa May’s first manifesto. (For good background discussion on this written before the manifesto was published, see Rick here and Geoffrey Wheatcroft here.) The words in the manifesto are certainly different: for example

"We do not believe in untrammelled free markets. We reject the cult of selfish individualism. We abhor social division, injustice, unfairness and inequality. We see rigid dogma and ideology not just as needless but dangerous."

Furthermore some of the proposals would have been condemned as socialist nonsense in certain quarters if they had been made by another party. For example a cap on energy bills, worker ‘representation’ on company boards, more council housing, a ‘modern industrial strategy’, and of course more measures to discourage (and maybe control) immigration. Now not all of these measures require serious money, but a lot of them do if they are to be meaningful. And, unlike the Labour or LibDem proposals, the Conservative’s plans are completely uncosted.

As a result, it becomes imperative to ask how much each measure will cost, and where the money comes from, because that will reveal a basic contradiction between rhetoric and reality. It is extremely difficult if not impossible to tackle social division and inequality if you want to protect your core supporters and are not increasing the size of the cake. You could find the money by raising taxes on business, but given Brexit the Conservatives are unlikely to reverse their cuts in corporation tax. (Not so much because of their economic effects, but to preserve the support of the business community which has become strained by Brexit.) You could find the money by raising taxes that largely impact on the better off, but that risks losing your core support. You could put fiscal rectitude to one side, but that would seriously tarnish the brand.

Given these contradictions, the rhetoric above is only likely to be accompanied by token gestures in reality. The most obvious thing May could have done to help the just managing family was to scrap the proposed cuts to in work benefits, and she did nothing. To be able to address inequality and social division without taking away from the better off you need a growing economy. The tragedy for Theresa May is that her insistence that Brexit means controlling immigration ensures [2] that is very unlikely to happen, and it is not clear she realises this.

But surely the change in rhetoric must mean something? The start of a Red Tory era, or the re-emergence of pre-Thatcher Conservatism, or at least the death of neoliberalism in the UK? I will start to believe those things when the IFS starts expecting falls in child poverty, rather than the - policy induced - increases they project. I will start to believe it when the pledge to introduce inequality enhancing Grammar schools is dropped. Until then, I suspect all we may be seeing is the same grasp of economics May has always displayed in government: she wants everyone to have more, while implementing policies that impede economic growth. I fear this Red Tory may be another symptom of the disease that hit the UK with Brexit. We are in the 'have your cake and eat it' era, an era that through its own contradictions cannot last.    

[1] The MSM where I fear the idea that the current fall in real wages is down to Brexit is now a ‘contested view’, thanks to recent remarks by the Prime Minister.

[2] Both directly through the impact of lower immigration on the public finances (uncontested by the Conservatives, perhaps because it comes from the OBR), and indirectly because it means we have to leave the Single Market.

But do the numbers add up?

The (official) launch of Labour’s manifesto saw mediamacro on display in all its unabashed pre-Keynesian ignorance. The idea that we could spend more on health and education by raising taxes on companies and high earners was so novel and (to many) attractive, the broadcast media collectively decided there had to be something wrong. The manifesto appeared to have increases in current spending exactly covered by increases in taxes, so surely there had to be some mistake.

Step forward the Institute of Fiscal Studies (IFS). Now I have huge respect for the IFS and the way it is run. Over the years it has established itself as the organisation of choice from where the media can get unbiased assessments of the size of individual fiscal measures or fiscal packages like budgets and election manifestos. But with this influence comes responsibility. Paul Johnson will freely admit that the IFS does not do macroeconomics. For many years before 2008 the IFS could get away with that, but no longer.

The IFS quite rightly said that tax estimates were uncertain because people can take measures to avoid tax increases or new taxes. The manifesto had made an allowance for this, but presumably the IFS thought it was not enough. In the media framing of measures having to ‘add up’ that suggested a potential problem with Labour’s figures. What the IFS did not say (or at least were not reported as saying) is that - when interest rates are at their lower bound - a tax funded spending increase would provide a much needed boost to activity, which itself would raise taxes. This is the famous balanced budget multiplier, which still holds in state of the art New Keynesian models when rates are stuck at their lower bound.

The IFS said raising corporation tax would cut investment, but did not note that raising demand would have the opposite effect. Because the IFS does not do macro, these points were simply not made. No one made the point that increasing public investment when real interest rates were about zero not only made good economic sense, but would also boost the economy, probably raise productivity, and itself bring in more taxes. In other words the IFS were implicitly assuming that this package would have no impact on output. [1] When interest rates are at their lower bound that is highly unlikely to be true. Even if interest rates did rise to exactly offset the demand impact of the balanced budget expansion, the increase in public investment will have positive supply side effects. I’m afraid this is a case where not doing macro means that what the IFS says is hopelessly one-sided. It has been 7 years since 2010, which is surely time enough to learn a bit of macro.

But this was nothing compared to media incredulity over failing to ‘cost’ the various nationalisation measures. Again the media have had years of being told that privatisation saves the government money, so surely reversing privatisations must cost them money. Of course neither is true in a macro sense. As any business will tell you, if you borrow to buy an asset, you get a return which should pay for the borrowing. When the government has no problem selling its debt at around zero real interest, the question ‘how much will it cost’ is completely irrelevant. The issue is whether this industry should be a private monopoly or state owned.

I should record two caveats to this familiar complaint about mediamacro in the coverage I saw. First, the BBC’s economics editor Kamal Ahmed did give a 30 second slot to someone from the IPPR, who very succinctly made the macroeconomics case for both a balanced budget spending increase and additional public investment. It was a single ray of sunshine in an otherwise dreary day. Second, senior Labour politicians still seem unable to robustly defend their own position on this. You don’t respond to questions about why nationalisations have not been costed by saying you do not know what the share price will be. You say as long as we pay a fair price it does not matter what it costs, because the state is buying an asset that brings a return that more than pays for the borrowing.

Of course journalists should ask hard questions at a time like this. I just wish they would not persist with questions which show their own macroeconomic ignorance. (It is a problem that arises with Budgets just as much as with election manifestos.) As any macroeconomist knows, there is no reason why the numbers have to add up, and if they didn’t on this occasion that is actually a benefit given rates are at their lower bound. The media’s focus on adding up misinforms viewers, and is classic mediamacro. As any economist knows if this government buys an asset by borrowing at zero real interest rates it really does not matter how much you have to borrow. Ask Labour politicians why they think the industry would be more efficiently run under public ownership, not how much will it cost.

But let me end on a positive note. It is great to finally have at least one of the two main parties putting the case for a large increase in public investment when the government’s borrowing costs are so low. It is great to see one party prepared to raise taxes to stop the growing squeeze on the NHS and the new squeeze on education. It is great that Labour have a fiscal rule which tries to represent current macroeconomic understanding rather than the wisdom of the Swabian housewife. Let’s hope this lasts beyond this election.

[1] In principle that could influence the ‘highest tax take since 1940s' line, but the impact on GDP would have to be quite large to do that. (HT GT)