The Role Of The State: Part 1

The Christmas break finally allowed me to read various books that I knew were going to require some clear days, a rich diet, plenty of sleep and a deep sense of panic about our economic plight.

Amidst the pile were Warwick Lightfoot's Sorry, We Have No Money and Richard Murphy's The Courageous State. I read them in that order, but I also think the first provides a better context for the second, so I'll get to Richard's book in my next post.

Warwick Lightfoot's book provides a very helpful overview of public sector finances, reflecting his previous economic advisory roles at the heart of government.  It also explains a key problem that is destroying regional competitive advantages. 

First, it's worth extracting some basic fiscal rules that have emerged through economic experience:

• Public expenditure needs to be paid for through taxation, either directly in the short term or indirectly by repaying public borrowing over the longer term. Tax is a 'deadweight cost' or inefficiency in the economy, so countries should aim to limit public spending to around 30 - 35% of GDP (more on GDP shortly). Try to tax/spend more than that, and the economy slows down and reduces the absolute amount of tax actually raised;
• Tax receipts in the UK have averaged around 38 per cent of GDP over the last twenty years and have never exceeded 40%.
• A deficit of up to 2.5% of GDP can be financed sustainably;
• Govt borrowing competes with private sector borrowing and can crowd it out or drive up borrowing costs. As a result, the US Office of Management and Budget, for example, requires any new spending proposal to generate benefits at least 25% greater than the explicit financing costs involved. 

"GDP", or gross domestic product, is worth a separate explanation. It's the market value of all final goods and services produced within a country in a given period. There are 3 methods of determining it, which should all reach the same result. But it's worth considering that the figure is gross, so it includes wasteful or otherwise harmful expenditure, as Tim Harford explains in The Undercover Economist - like shoddy building work that needs to be repaired. So, I guess a fall in GDP due to a decline in harmful output could be seen as a good thing, but the economy is still smaller. Therefore we should still reduce the absolute amount of public expenditure by keeping it below 35% of GDP.  

Warwick Lightfoot explains that, above 35% of GDP, the marginal benefit from extra public spending drops sharply. I wonder whether this helps to explain why the EU, and Eurozone in particular, appears to be struggling to derive benefit from increasing EU public expenditure? It would seem tough to mirror the success of, say, the US when the timing of US federation meant that it's taxpayers captured the upside of the surge public sector spending from quite low levels during much of the 20th century, whereas EU came in after member states had already exhausted the marginal economies.

At any rate, how do the UK's finances stack up?

In 2009 public expenditure reached 48% of GDP from a low of about 37% in 1997-99. The structural or permanent budget deficit was about 7% of GDP and public borrowing was about 11% of GDP in 2009-10. The current government had aimed to bring public spending down to just under 40% and public borrowing down to about 1% in 2015-16.  Public spending of just under 40% will still be too high, and continue to act as a drag on economic growth. Further work will be needed to remove structural inefficiencies in the years beyond. Unfortunately, public sector productivity fell between 1997-07, while private sector productivity increased. The public sector faces fewer penalties for failure and has few effective incentives to use capital efficiently. None of the many efficiency measures of the past 30 years has worked.

It's important to understand that public expenditure is also a critical factor in local and regional development, and helps explain why local production capacity has been lost to other regions and countries. New Labour's solution to regional decline was to decentralise government, increasing the share of public sector expenditure as a share of the local economy - well beyond the proportion of 48% of national GDP.  That differential is largely explained by the fact that staff have been employed on wages and salaries agreed on a national basis with public sector unions (which account for 60% of public sector workers). That union activity has ensured that public sector workers enjoy a 14% pay and pension premium nationally. But the difference is disproportionately larger in communities outside London and the South East. So regional private sector employers face overwhelming competition for employees from the public sector. To compete on pay, private businesses have to charge more for their products, which means they lose out to competitors who don't face the same pay costs. Higher regional public sector pay also has local inflationary effects that mean it's less attractive for private sector workers to live and work in the regions. Inevitably, the regional private sector businesses close and those who wish to work in the private sector head to London and the South East - or to overseas production centres. Warwick Lightfoot estimates that public sector pay and pensions should be reduced by 2% of GDP nationally - about £30bn or 17% overall. But clearly this needs to take place on a regional or local basis if regional competitiveness is to be restored.

Meanwhile, social security payments put benefits recipients on a par with low income earners. So-called 'working' tax credits are paid to people who work 16 hours a week, but is progressively withdrawn for additional hours worked, so people don't take the perceived risk of working longer hours. Centrally determined tax credits also work harder against regional or local employers. Potential savings in remedying this situation are estimated at £30bn from a social security budget of £195bn (however, spending on older people also needs to be given higher priority, as we have no additional tax-raising capacity to fund our 'pay-as-you-go' liabilities on an ageing population).

So to restore regional - and therefore national - competitiveness, Warwick Lightfoot suggests that public sector remuneration and social security must be reduced in line with local costs and labour market conditions. Shifts towards local rather than national taxation would also enable localised competition.

The last time we were in this mess, in the 70's, public borrowing peaked at 9% of GDP, but none of the factors like high inflation, North Sea oil or public asset sales are there to help us now. My conclusion from Warwick's book is that reducing public sector pay and pensions and social security to working people in line with local pay and cost of living is one of the few options left to us to deliver the cuts needed to boost inward private investment that will power us out of the current malaise and set up a sustainably high standard of living.