Britannia Radio

Despite the leaks all over the place (whatever happened to the rule 
that any budget leaks led to the immediate resignation of the 
chancellor?)  we should now wait patiently until Pandora's box is 
opened!

That doesn't stop constructive and intelligent thinking as in  this 
contribution from the respected think tank Policy Exchange.  I 
commend it

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CENTRE RIGHT -CONSERVATIVE HOME BLOG  24.11.08
The borrowing dilemma

By James Mackenzie Smith, Economics Research Fellow, Policy Exchange

We have been faced with the dilemma of "our economy needs a stimulus" 
but "we don't have any scope to do this because of the public finances".

Recent murmurings in the press have first hinted at a spending spree 
a-la-1970's, then a tax-cutting spree. But both of these however, if 
unfunded, would have the same effect on the public finances and both 
of these would have serious long term implications for the British 
economy: high debt, high long term interest rates and prolonged 
stagnation - exactly as what happened in the 1980's.

Britain's public finances are in a particularly perilous state, not 
least because of the 'off-the-balance-sheet' liabilities such as PFI 
and public sector pensions (not to mention the borrowing from the 
banking bailout), but also because the structural deficit is 
increasing at an astonishing rate and could exceed 1970's and post-
ERM levels - above and beyond the effects of the automatic fiscal 
stabilisers.

Our research has looked at the theory that 'fiscal consolidation' - 
that is to say bolstering the public finances: in this case through 
cutting unproductive government spending - can actually have non-
Keynesian, positive growth effects, and there is plenty of academic 
research and evidence to support this. It works for three reasons. 
First, higher expectations of future wealth can have expansionary 
effects if the government is seen to be getting the fiscal situation 
into a sustainable manner.

Second, the capital markets will be more inclined to lend to the 
government for a lower coupon rate, given the associated lower risk 
premium, thus lowering long term interest rates. Third, a sustainable 
fiscal policy can encourage international investment. Our research 
has focussed on nine studies quoted in an ECB investigation, all of 
which show that as long as the consolidation focussed on unproductive 
spending cuts and not tax rises, the credibility effects outweighed 
the traditional 'Keynesian multiplier' effects, especially if there 
was an initially perceived fiscal problem.

Finally, if any cuts in government spending were to be used to 
finance tax cuts, which taxes should be targeted? Recent OECD 
research has prioritised the "most damaging to growth" taxes as 
corporation, then income, then consumption tax (VAT).

The logic here is that we should be using any tax cuts to target 
unemployment; a cut in employers' National Insurance is one effective 
way to do this. Any income tax cuts should be directed towards the 
lower earners, not least for the social reasons, but also due to 
their higher marginal propensity to spend.

A 2.5% reduction in VAT will merely have a token effect, yet at a 
huge extra cost to the public finances. The 5% increase in the top 
rate of tax is also an admission that Britain's public finances are 
not well equipped to deal with the problem, though it does not go 
close to making up the future (and current) shortfalls.