The financial crisis and associated deterioration in the UK’s public finances foreshadows a bleak period for the UK economy, even when the green shoots of economic recovery appear and blossom. HM Treasury is forecasting massive government deficits, even with optimistic forecasts about future rates of economic growth.
It is now very clear that after the next General Election there will have to be the largest fiscal tightening in UK history. This article presents the 10 key principles that, in the IoD’s view, need to inform future policy decisions:
1. Lower public spending instead of higher taxation
Reduction of the budget deficit must be weighted overwhelmingly on lower public spending, as opposed to higher taxation. Public spending has surged since 2000 - from 36.3 to 47.6 per cent of GDP - and must now fall as a proportion of GDP from 2010 onwards. Private sector companies reduce their cost base significatly when expenditure exceeds revenue. The public sector must also face up to this reality.
Interestingly, over the 1997-1999 period public spending was very tight and UK productivity performance was strong. Maybe this suggests that public spending restraint can yield supply side gains to the economy which crowd-in the private sector and boost productivity. Graeme Leach, IoD Chief Economist & Director of Policy, outlines 10 key principles on which the UK’s economic recovery and future prosperity should be founded.
2. Real terms spending increases to be funded by productivity gains
In broad terms, the Government is projecting a real terms freeze in public spending for the duration of the next Parliament. In contrast, the IoD is calling for a real terms freeze in spending for 10 years from 2010-11 onwards. This would provide the opportunity for a very sharp fall in the ratio of public spending to GDP – to around 35 per cent by 2020. A fall of this magnitude would transform the public finances for the better. Real terms increases in public spending would have to be funded by productivity gains.
3. Tight fiscal policy and loose monetary policy
Very tight fiscal policy will suck demand out of the economy and in order to maintain trend GDP growth and the inflation target, monetary policy will be required to remain loose. If a very tough fiscal adjustment is introduced, interest rates could then be maintained at very low rates.
4. Reverse proposed tax increases
Tax policy must be set to maximise long-term GDP growth, by stimulating the supply-side of the economy. Tax increases that damage the supply side of the economy and the incentives to work, invest and take on employees – such as the proposed 50 per cent top rate of income tax and national insurance increase – must be reversed.
5. Ring-fence infrastructure spending
Public spending on infrastructure (transport, energy etc) is productive and helps improve the supply side of the economy. For this reason the easy political option of cutting infrastructure spending must be avoided. Indeed, we would argue that infrastructure spending should be ring-fenced and protected from cuts.
6. Redistribute taxation from direct to indirect
The deterioration in the public finances is so great that any tax cuts will have to be funded from spending cuts or tax increases elsewhere. The IoD proposes that the rate of VAT is increased in order to fund a reversal in the proposed increases in taxation by the Government. In the long term, deeper tax reductions would need to be financed by reductions in public spending.
7. Pursue tax cuts where the supply side gains are greatest
The supply side gains from reductions in taxation are greatest for corporation tax, top rate income tax and national insurance contributions. Resources released from higher indirect taxes and lower public spending should be targeted on those taxes where the incentive effects will be most powerful, since this will help to boost the supply side of the economy and raise underlying GDP growth.
8. Radically reform public sector pensions
The private sector should not have to fund generous public sector pensions it can’t afford for itself. Radical reform of public sector retirement ages and the level of employee contributions are required. However, most significant of all would be a shift from defined benefit to defined contribution public sector schemes. It will not be sufficient to merely apply these changes to new entrants.
9. Root and branch reform of the public sector
Realising productivity gains will not be sufficient to bring the ratio of public spending down to a level that is world class from a competitive perspective. There will also need to be a root and branch appraisal of what the public sector should or should not be doing. Canada went down this road – to some extent – in the 1990s and the UK will have to be even more determined in pursuing this approach. At a regional level there will also have to be a root and branch appraisal because of the very large shares of public spending in regional economies of the UK, outside the South East.
10. Regulatory culture change
There should be a moratorium on regulation during the recession, followed by a sustained reversal in the regulatory burden over the coming decade. Civil servants should be given personal incentives to reduce regulation. At present, civil servants do not have an incentive to reduce regulation, quite the opposite in fact. Personal incentives (with monetary rewards) provide an opportunity to transform the regulatory culture.
Article reproduced from www.iod.com.
