Wishful thinking?
Tim Congdon
'Finance must determine expenditure; expenditure must not determine finance.' The remark was one of the keynotes of Sir Geoffrey Howe's first Budget speech. As a warning that in future the Government's Spending plans must not run ahead of the nation's ability to pay for them, it is what one would expect from a Chancellor who has many times stated his commitment to sound money. But does this really mean that the halfhearted, pragmatic monetarism of Mr Healey has been replaced by a new undiluted and cold-blooded monetarism? Can we assume that from now on the budget deficit and money supply growth rate will be reduced progressively and without inter ruption?
The short answer is `no'. Ironically, the clue to the problem is given by Sir Geoffrey's fine words about finance and expenditure. The trouble is that they omit any reference to taxation and so sidestep an inconsistency in the present Government's economic philosophy. On the one hand, the Conservatives believe that the tax burden must be reduced to help incentives. The public sector borrowing requirement is to be £81 billion, but only after £1 billion of sales of public sector assets. The true, unembellished PSBR figure is therefore £91 billion, since marketing British Petroleum and Ferranti shares is as much a drain on institutional cash flow as equivalent sales of gilt-edged securities. But Mr Healey pledged that the Labour government would have held PSBR to in billion. In other words, in their first financial year the Conservatives are envisaging a PSBR Li billion higher than their predecessors. The reason, in terms of arithmetic, is that the direct tax reductions — with three pence off the standard rate and substantial upward adjustments to tax allowances — are bigger than the indirect tax increases. Despite the newspaper headlines about 15 per cent VAT and what it will do to prices in the shops, most people's spending power has been increased by this Budget. It is a strange anomaly that the Government should have decided on this when consumer spending is already buoyant — and an even stranger anomaly that some observers should have described the measures as 'tough'.
Treasury officials knew that the £9i billion PSBR was higher than the City wanted. They also remembered how the financial markets reacted last year to a PSBR of £13i billion — sterling tumbled and official gilt sales came to an end as investors gave an unfavourable verdict to the Labour Government's financial strategy. To forestall any possible hostile criticism and loss of confidence on this occasion, they advised Sir Geoffrey to hoist Minimum Lending Rate from 12 to 14 per cent. The move is blatant over-kill; in its resemblance to the increase in MLR from 10 to 121 per cent last November, it is establishing a new and predictable tactic in monetary management — to raise interest rates more than anyone predicted.
As a Pavlovian response, the pound immediately rose 11 cents against the dollar. The gilt markes, on the other hand, collapsed, with prices of long-dated stocks being marked down by 4 points initially. The obvious interpretation is that the Bank of England is trying to create an opportunity for another massive gilt selling exercise and thereby to make the 7 to 11 per cent growth target for sterling M3 more certain of attainment. If in the meantime there are wild gyrations in interest rates and gilt-edged prices, that is, to recall the title of Trollope's novel on Victorian financial excesses, just part of 'the way we live now'.
Will it succeed? Is the slippage on the financial objectives going to be justified by the benefits from improved incentives? On the issue of how much harder people work because of lower tax rates, most empirical studies are agreed. The effects are difficult to measure; when they are measured they are usually small; and, although small, they can sometimes be perverse. If the government is hoping that industrial production will suddenly jump because tax rates are lower, it is about to face its first economic disappointment.
Indeed, it is not altogether clear what the Government intends to gain from the income tax cuts. The reduction in the top rate to 60 per cent was long overdue and sensible — and so were the increases in allowances at the lower end which will take 1.3 million people out of tax. But changes in the standard rate will do nothing of much importance.
This is particularly true as they are offset by the increase in VAT. The attitude of the average taxpayer to his work should be quite unaffected. He receives more in his pay packet, but the prices of the goods and services he buys have risen by an equivalent amount. If he is induced to put in a little more effort or stay at his factory for a longer time, he is plainly subject to an illusion. It will not be long before he realises what has happened.
There is an advantage to switching the weight of taxation from direct to indirect taxes — or, to put it in different terms, away from taxing income to taxing expenditure. It is that saving is encouraged, because the post-tax returns to investment are improved. But this is a long-term gain — it is also questionable if it matters much when most personal saving is performed through pension funds and life assurance policies because of their substantial existing tax privileges.
The 30 pence in the pound standard rate is only the first step. Sir Geoffrey Howe promised a 25 pence in the pound standard rate as the eventual objective, to be achieved presumably within the life-time of the present Parliament. But next year it will be more difficult to raise indirect taxes to pay for another penny off the standard rate and in the following year it will be harder still.
Instead, the hope is that economies in public expenditure will enable further tax cuts to be made without endangering the goal of a lower PSBR. The steps announced so far in this direction are aggressive and radical. In particular, the adherence to the original cash limits, despite much higher than expected inflation, implies a big real cut in expenditure. The three per cent projected fall in public sector manpower is bold — although scepticism about the realism of this aim when confronted by belligerent civil service unions is considerable.
Doubts are reinforced when the outlook for the next and subsequent financial years are considered. The economy will enter a recession in late 1979 and early 1980, creating an environment in which it will be much more difficult either to trim public expenditure or to raise the overall burden of taxes. How, then, will the PSBR be lowered?
The absence of specific and quantitative medium-term financial targets, relating to the PSBR and the money supply, is the major defect of Sir Geoffrey's approach. It is perhaps churlish to say that this Budget, with its radical changes in the structure of taxation, contains soft options. But it does. In particular, to reduce the net tax burden now is popular — almost as if the Chancellor were trying to catch votes four years and eleven months before the next election. Its economic purpose is to promote incentives, but the economic effects are likely to be trivial. Its cost is that it postpones the reduction in the PSBR which is the most essential component of a sound financial policy. For that reason, monetarists would be justified in a little dissatisfaction.
Finance may come to determine expenditure decisions in the next few years, but it is hard not to feel that wishful thinking has determined tax rates in this Budget.
Previous page
