The long game: Increasing UK economic growth

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Growth is good

Growth has become a term, like fairness, that is often used but rarely understood. The “Occupy” movements are the latest groups to argue that the pursuit of growth is harmful because this means sacrificing social and environmental goals. But the opposite is true. Increasing economic growth plays an essential role in providing funds for spending on public goods and services, repaying government debt and reducing tax burdens.

For families growth helps puts food on the table. The practical importance of this can be shown by comparing different forecasts for GDP growth between 2010 and 2015:

• If the economy grows in line with the March 2011 forecasts by the Office for Budget Responsibility (of around 2.6 per cent between 2010 and 2015) then GDP per person would increase by £1,922 (in real terms).
• If the economy was to grow in line with Centre for Economics and Business Research forecasts (of average growth of around 1.3 per cent between 2010 and 2015) then GDP per capita would grow by only £579 (in real terms). GDP would be lower by £1,343 per person or £3,108 per family per year.

Austerity is the new normal

Growth has to be earned (it cannot be expected as a right) and the environment for improving growth is set to become more challenging. There is a view that the recovery from the financial crisis should have been largely instantaneous and painless. But this is clearly unrealistic. High levels of public and private debt meant that the UK economy was vulnerable to any downturn. Fiscal crises that originate in financial sectors tend to be severe and prolonged. Even under the best economic scenario a programme of austerity should be at least a two-term project with the first term emphasising deficit reduction and the second consolidating the gains.

The Coalition must avoid the temptations of quick fixes and inconsistency. An excessive emphasis on quick fixes (prioritising immediate wants while postponing hard decisions) is one reason the UK economy is in the mess it is in. Inconsistency increases uncertainty and greater uncertainty reduces confidence and firms’ incentives to invest and expand.

This does not mean that the UK necessarily faces a “lost decade”, in Christine Lagarde’s phrase. By playing its cards right, the UK could create a stronger and fairer economy. But this will require making tough decisions and being clear on where government can add value, and where it does not. After all, real growth will not come from government but from a dynamic, highly productive economy.

A dynamic, highly productive economy

The characteristics of a dynamic growth economy include:

• Sound public finances, characterised by on-going fiscal discipline that eliminates deficits and then reduces debt. “Plan A” is start.
• More flexible labour markets, including a greater openness to immigration of skilled labour.
• Higher private sector and public sector productivity growth, driven by the “creative destruction” of organisational success and failure.
• A more consistent and transparent tax policy.
• A more consistent and transparent regulatory policy. The overall regulatory burden must fall.
• Infrastructure, including energy infrastructure, justified by returns in the market.

Sound public finances

Some people argue that relatively slow growth since the financial crisis means that the Coalition should delay (or even abandon) their “Plan A,” i.e., the objective to eliminate the deficit in one Parliament. In fact the day-by-day unfolding of events, and not just in the Eurozone, show the importance of a credible fiscal plan. So far this year the ratings agencies have downgraded Greece, Portugal, Ireland, Italy, Spain, Japan and the United States among major countries. The speed of the increase in Italian government debt yields – up by 150 basis points in just four weeks (10 year debt) – shows how vulnerable governments can be to a change in market sentiment. By failing to prudently manage its public finances a country can lose control of its destiny.

Critics also say that the UK consolidation is large compared to other countries. In fact, for the two years which allow comparison (2011 and 2012), the Eurozone countries will reduce spending by 2.4 per cent of GDP compared to a reduction of 2.2 per cent in the UK. Comparisons for later years are difficult as very few countries have published credible fiscal plans for beyond 2013.

This does not mean, however, that implementing Plan A will be plain sailing. In fact it will be a real challenge because not only will growth be lower than planned but also the public service reform programme has been subject to delay. In the case of the biggest public sector budget, the NHS, reform has arguably gone into reverse, which is significant because the Chancellor’s figures include £10 billion in NHS efficiency gains by the end of this financial year. To keep Plan A on track, the Chancellor must look to reduce spending further in the less productive areas of government spending such as welfare and health.

Flexible labour markets

The Government is right to recognise that the burden of employment regulation has to be reduced. The employment law review is a good step and its aim should be to make it easier to hire and fire staff. For this reason the Government should be open to the ideas in the unpublished “Beecroft Review,” such as a weakening of unfair dismissal regulations. As the Department of Business, Science and Innovation has itself shown smaller firms are being deterred from making appropriate dismissals and fighting claims because of the costs of employment tribunals.

Equally, the Government has made such little progress on implementing Lord Young’s report, Common Sense Common Safety, published over a year ago. The result is a confused and inconsistent picture on health and safety.

The proposals for tougher visa restrictions on workers from outside the EU are likely to be an economic own goal. Immigration through the “Points Based System” can benefit the UK in a number of ways:

• It increases the working age population.
• It can offer skills not available in the native labour market.
• In can increase business innovation via the exchange of ideas.

The idea that migrants “take British jobs” (displace local workers) is based on the lump of labour fallacy. The amount of work is not fixed but reflects the underlying growth potential of the economy and increasing the productivity in the labour market can improve growth and the jobs available.

Success based on productivity not politics

The pursuit of growth does not mean that all job losses or business closures are (or indeed should) be avoided. Job losses and business closures are a feature of a healthy economy and reflect a process of “creative destruction”. Innovations that stimulate general economic growth simultaneously destroy specific jobs as emerging technologies replace older technologies.

This potential for economic growth to create losers, as well as winners, can lead to resistance to change. “Active industrial strategies” typically seek to protect certain industries. But the cost of individual protection is a loss of income for society as a whole. Business policy should reflect the interests of the whole economy with resources being aimed at improving the business environment, for example through greater competition, before providing targeted support.

The importance of the business environment can be shown in the case of the Great Depression. Research has shown that, rather than purely being a failure in markets, policies that reduced competition and labour market flexibility made the Depression longer and more severe. For example, the “New Deal” included a National Industrial Recovery Act (NIRA), that weakened competition laws and allowed industries to increase prices collusively, and a National Labor Relations Act that gave unions collective-bargaining power.

The Government has committed to promoting the interests of the small and medium-sized enterprises (SME). But this is an unhelpful distraction. Improvements must be made to the business environment facing all firms and, indeed, larger firms are important for productivity, growth and taxation:

• OECD data shows that small firms account for 26.1 per cent of value added in the UK, compared to 28.0 for medium-sized firms and 45.9 for large companies.
• Very few small firms actually grow. The 2010 Small Business Survey found that just 17 per cent of small enterprises employed more people than a year previously, while 21 per cent employed fewer staff.
• Despite making up 99 per cent of businesses, SMEs contribute just 14 per cent of tax revenue. Large companies, who made up less than 1 per cent of companies, contributed 86 per cent of tax revenue.

A consistent and transparent tax environment

The 50p rate is damaging to growth and should be abolished. This should not, however, be an immediate priority. The smarter thing to do would be to combine the elimination of the 50p rate with the integration of National Insurance and Income Taxes, reform of the system of personal allowances, and reform of the taxation of pension tax relief into a once-in-a-generation reform of the personal income tax system. The goal should be a system with lower marginal rates and that treats different types of income in a more consistent and transparent way.

In fact there may be a need for further tax rises to help address the deficit. Any tax changes must be done in the least economically damaging way possible. Revenue should be increased through broadening bases, in particular by eliminating the zero rates of VAT, and not increasing rates. With sufficient base broadening it may be possible to increase revenue and lower rates. (That said, it is wrong to assume that tax cuts will always and everywhere expand the tax base and be, at least partially, self-financing, as Professor Arthur Laffer has himself argued).

The Government has introduced some temporary tax incentives (to reduce employment taxes for certain types of workers) and the Opposition and the CBI would like these to go much further. Yet international evidence shows that temporary reductions in payroll taxes do not encourage firms to hire more as they “look through” the policy change (they know the tax reduction is temporary while the hiring decision is permanent). Temporary reductions in consumption taxes such as VAT can be complicated for retailers to introduce and have very little effect on the prices paid at retail level. In truths firms are already improving their financial positions, having doubled their lending to the rest of the economy from £33 billion in 2008 to £63 billion in 2010. They don’t need temporary cash injections which in truth bring little if any growth benefit.

The Government is absolutely right to commit to a more transparent and consistent tax system. The Office of Tax Simplification is a good start. Nevertheless its work has barely begun. 43 tax reliefs may have been abolished but over 1,000 remain in effect. Equally, it is self-defeating to aim to have the most competitive tax system in the G20 but then have surprise tax raids on certain sectors, such as the supplementary charge on North Sea oil revenue and the tinkering with the rate of the levy on banks’ balance sheets.

A consistent and transparent regulatory policy

Reducing the overall regulatory burden will increase economic growth for the following reasons:

• In the UK, 62 per cent of businesses believe that the overall level of regulation is an obstacle to their success. Businesses report that compliance with regulation is the third most challenging aspect of running a business (behind attracting and retaining customers, and the level of taxes imposed).
• It will increase the stability of the business environment. 72 per cent of businesses report that the most burdensome aspect of regulation is keeping up to date with new regulations.

The Government is seeking to reduce both the stock of regulation (through the Red Tape Challenge) and the flow of new regulation (through the One-In-One-Out process, or OIOO). These are the right objectives but, as the National Audit Office has shown, the OIOO reforms are unlikely to reduce regulation in the near future. The framework depends on being able to measure the cost of new regulation, which is not yet possible.

Realism on the contribution of infrastructure

The Government has committed to a greater number of infrastructure projects. Spending on infrastructure generally generates a higher economic multiplier than spending on less productive areas such as welfare and health. Yet the decision to begin or expand an infrastructure project is often a financially large decision and difficult to reverse once made. Decisions should be made within markets with strong competitive pressures and be based on clear cost benefit grounds.

Increased capital spending is unlikely to significantly and rapidly increase employment as modern infrastructure projects are less labour intensive and the labour that they employ is often skilled (the employment created may not match the areas where unemployment is currently highest). There is a need to bring private funds into infrastructure but recent criticisms of PFI have damaged investor confidence.

Energy is an especially important part of infrastructure. Although there is little use of renewables the UK energy system is relatively strong. The need for change is largely driven by environmental targets that have gone much further than many other countries. This approach risks locking the UK into a high-cost energy system and will provide no discernible economic benefit. An alternative approach (a fast follower strategy) should be followed.

An adult debate on banking regulation

The challenge facing the euro area and the fiscal consolidation taking place in the USA and Europe will place pressure on demand in the UK (especially through trade channels). Yet empirical evidence shows that the effect of the money supply is more important than the effect of changes in fiscal policy. The major constraint on further quantitative easing is the effect of inflation. A weaker currency will increase tradeable inflation and risk harming domestic demand and also exporters (given the import composition of exports).

The effectiveness of quantitative easing will be undermined if the government simultaneously pursues other policies that reduce banks’ preferences for holding non-cash assets. It is inconsistent to increase the money supply through quantitative easing while simultaneously introducing regulations that discourage banks from holding non-cash assets. This risks expanding the liabilities held by the Bank of England while doing little to expand the money supply.