On red boxes and helicopters

George Osborne
George Osborne and his case

George Osborne, the Chancellor of the Exchequer, will present the next Government’s budget tomorrow. Although it is not official yet, this year’s Budget has already triggered a general outcry given the various alleged tax increases that have emerged in the press, including an increase in fuel duty, and has raised fears about the return of ‘austerity policies’ – which Mr. Osborne’s interview video below will not alleviate. We will have the opportunity to discuss the key measures once they have been made official. In the meantime this post presents the difficult conundrum Mr. Osborne has to confront.

Firstly, Mr. Osborne bets a large chunk of his political credibility on this budget. After hinting a fiscal surplus – a result that has rarely been achieved in the past -, boosted by promising economic prospects in sight, the Chancellor got caught by the real world and a disappointing economic recovery in the UK, whose 2015 GDP has been revised downwards by £18bn in December 2015. And yet, an apathetic economic activity translates into lower tax receipts for the government – up to £50bn over the course of the parliament. In order to partly offset this unexpected ‘black hole’, Mr. Osborne has to rely on a mix of public spending cuts and tax increases. The first lever will consist of “50p [of cuts] from every £100 the government spends” by 2020. The second lever will be further detailed tomorrow but, beyond the fuel duty increase we mentioned above, tax on insurance premiums and banks are also on the agenda. Mr. Osborne nonetheless proved his political instinct by softening the bitter pill with an announced reduction in income tax – the most visible and universal

Historical UK general government deficit as a percentage of GDP. Source: ONS.
Historical UK general government deficit as a percentage of GDP.
Source: ONS.
brexit1
Credits: www.abceconomics.com

Secondly, the looming Brexit threat adds uncertainty to the state of the UK economy at least for the year to come. In the short-term, this uncertainty translates into deferred investment decisions (‘sit and wait’) and ties the hands of the Chancellor, who has been publicly urged by David Cameron not to do anything that could complicate the referendum campaign. This phenomenon would however become marginal if the country decided to leave the EU. In that case, there is little doubt that the road to a fiscal surplus would significantly steepen.

Credits: www.moneymetals.com
Credits: www.moneymetals.com

Lastly, this political stance is challengeable from an economic perspective. Central Banks have struggled to revive inflation despite injecting thousands of billions of pounds/euros/dollars in the economy. The result has been mixed to say the least – inflation in 2015 in the UK will end up close to 0% – and has conducted some economists to bring the notion of ‘helicopter dropback in the spotlight. This measure consists in giving money directly to households in an attempt to encourage private spending. This decision would be a sensible way for the ‘fiscal stimulus’ to reach individuals, given that, as accurately diagnosed by Joseph Stiglitz, banks prefer to leave cheap money sleeping on their accounts – even if it means paying for it – and that companies have benefited from the low interest rates to buy financial assets – including their own shares – instead of investing.

Are helicopter drops the ultimate solution? They could be, provided that households are confident in the future enough to spend part of this gift rather than piling cash in the bank. By putting ‘skin in the game’ itself, the State could facilitate individual decision-making by highlighting trustworthy investments. Higher taxes – leading to lower disposable income – and lower public spending both go in the other direction.

Unfortunately, as we see today, the political agenda is too much focused on short-term deficits to account for longer-term economic benefits. This difficult (and inefficient) trade-off could have been avoided, at least partly, if governments had been bold enough to implement structural cost-cutting reforms in good times. This has not been the case, as the chart below shows. Another thing to think about for the Maastricht Treaty advocates.

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Correlation between UK GDP growth and UK budget deficit as % of GDP. Sources: ONS, World Bank.

To understand what will happen tomorrow you can watch the video below extracted from the UK Parliament website.

Update (16/03): The US banking industry body called for a rate rise yesterday, arguing that the key root cause of the current poor economic conditions was more the lack of business confidence than the availability of funding.