Category: Economics for Business: Ch 26

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Public spending and receipts: a pandemic displacement effect?

The COVID-19 pandemic had a stark effect on countries’ public finances. Governments had to make difficult fiscal choices around spending and taxation to safeguard public health, and the protection of jobs and incomes both in the present and in the future. The fiscal choices were to have historically large effects on the size of public spending and on the size of public borrowing.

Here we briefly summarise the magnitude of these effects on public spending, receipts and borrowing in the UK.

The public sector comprises both national government and local or regional government. In financial year 2019/20 public spending in the UK was £886 billion. This would rise to £1.045 trillion in 2020/21. To understand better the magnitude of these figures we can express them as a share of national income (Gross Domestic Product). In 2019/20 public spending was 39.8 per cent of national income. This rose to 52.1 per cent in 2020/21. Meanwhile, public-sector receipts, largely taxation, fell from £829.1 billion in 2019/20 to £796.5 billion in 2020/21, though, because of the fall in national income, the share of receipts in national income rose very slightly from 37.3 to 37.9 per cent of national income.

The chart shows both public spending and public receipts as a share of national income since 1900. (Click here for a PowerPoint of the chart.) What this chart shows is the extraordinary impact of the two World Wars on the relative size of public spending. We can also see an uptick in public spending following the global financial crisis and, of course, the COVID-19 pandemic. The chart also shows that spending is typically larger than receipts meaning that the public sector typically runs a budget deficit. .
If we focus on public spending as a share of national income and its level following the two world wars, we can see that it did not fall back to pre-war levels. This is what Peacock and Wiseman (1961) famously referred to as a displacement effect. They attributed this to, among other things, an increase in the public’s tolerance to pay higher taxation because of the higher taxes levied during the war as well as to a desire for greater public intervention. The latter arose from an inspection effect. This can be thought of as a public consciousness effect, with the war helping to shine a light on a range of economic and social issues, such as health, housing and social security. These two effects, it is argued, reinforced each other, allowing the burden of taxation to rise and, hence, public spending to increase relative to national income.

If we forward to the global financial crisis, we can again see public spending rise as a share of national income. However, this time the ratio did not remain above pre-crisis levels. Rather, the UK government was fearful of unsustainable borrowing levels and the crowding out of private-sector activity by the public sector, with higher interest rates making public debt an attractive proposition for investors. It thus sought to reduce the public-sector deficit by engaging in what became known as ‘austerity’ measures.

If we move forward further to the COVID-19 pandemic, we see an even more significant spike in public spending as a share of national income. It is of course rather early to make predictions about whether the pandemic will have enduring effects on public spending and taxation. Nonetheless the pandemic, in a similar way to the two world wars, has sparked public debates on many economic and social issues. Whilst debates around the funding of health and social care are longstanding, it could be argued that the pandemic has provided the government with the opportunity to introduce the 1.25 percentage point levy from April 2022 on the earned incomes of workers (both employees and the self-employed) and on employers. (See John’s blog Fair care? for a fuller discussion on the tax changes to pay for increased health and social care expenditure).

The extent to which there may be a pandemic displacement effect will depend on the fiscal choices made in the months and years ahead. The key question is how powerful will be the effect of social issues like income and wealth inequality, regional and inter-generational disparities, discrimination, poor infrastructure and educational opportunities in shaping these fiscal choices? Will these considerations carry more weight than the push to consolidate the public finances and tighten the public purse? These fiscal choices will determine the extent of any displacement effect in public spending and taxation.

Reference

Alan Peacock and Jack Wiseman, The Growth in Public Expenditure in the United Kingdom, Princeton University Press (1961).

Articles

Questions

  1. What do you understand by the term ‘public finances’?
  2. Why might you wish to express the size of public spending relative to national income rather than simply as an absolute amount?
  3. Undertake research to identify key pieces of social policy in the UK that were enacted at or around the times of the two World Wars.
  4. What do you understand by the terms ‘tolerable tax burden’ and ‘inspection effect’?
  5. Identify those social issues that you think have come into the spotlight as a result of the pandemic. Undertake research on any one of these and write a briefing note exploring the issue and the possible policy choices available to government.
  6. What is the concept of crowding out? How might it affect fiscal choices?
  7. How would you explain the distinction between public-sector borrowing and public-sector debt? Why could the former fall and the latter rise at the same time?
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Bounce back for the UK economy but with cloudy horizons

The OECD has recently published its six-monthly Economic Outlook. This assesses the global economic situation and the prospects for the 38 members of the OECD.

It forecasts that the UK economy will bounce back strongly from the deep recession of 2020, when the economy contracted by 9.8 per cent. This contraction was deeper than in most countries, with the USA contracting by 3.5 per cent, Germany by 5.1 per cent, France by 8.2 per cent, Japan by 4.7 per cent and the OECD as a whole by 4.8 per cent. But, with the success of the vaccine roll-out, UK growth in 2021 is forecast by the OECD to be 7.2 per cent, which is higher than in most other countries. The USA is forecast to grow by 6.8 per cent, Germany by 3.3 per cent, France by 5.8 per cent, Japan by 2.6 per cent and the OECD as a whole by 5.3 per cent. Table 1 in the Statistical Annex gives the figures.

This good news for the UK, however, is tempered by some worrying features.

The OECD forecasts that potential economic growth will be negative in 2021, with capacity declining by 0.4 per cent. Only two other OECD countries, Italy and Greece, are forecast to have negative potential economic growth (see Table 24 in the Statistical Annex). A rapid increase in aggregate demand, accompanied by a decline in aggregate supply, could result in inflationary pressures, even if initially there is considerable slack in some parts of the economy.

Part of the reason for the supply constraints are the additional barriers to trade with the EU resulting from Brexit. The extra paperwork for exporters has added to export costs, and rules-of-origin regulations add tariffs to many exports to the EU (see the blog A free-trade deal? Not really). Another supply constraint linked to Brexit is the shortage of labour in certain sectors, such as hospitality, construction and transport. With many EU citizens having left the UK and not being replaced by equivalent numbers of new immigrants, the problem is likely to persist.

The scarring effects of the pandemic present another problem. There has been a decline in investment. Even if this is only temporary, it will have a long-term impact on capacity, unless there is a compensating rise in investment in the future. Many businesses have closed and will not re-open, including many High Street stores. Moves to working from home, even if partially reversed as the economy unlocks, will have effects on the public transport industry. Also, people may have found new patterns of consumption, such as making more things for themselves rather than buying them, which could affect many industries. It is too early to predict the extent of these scarring effects and how permanent they will be, but they could have a dampening effect on certain sectors.

Inflation

So will inflation take off, or will it remain subdued? At first sight it would seem that inflation is set to rise significantly. Annual CPI inflation rose from 0.7 per cent in March 2021 to 1.5 per cent in April, with the CPI rising by 0.6 per cent in April alone. What is more, the housing market has seen a large rise in demand, with annual house price inflation reaching 10.2 per cent in March.

But these rises have been driven by some one-off events. As the economy began unlocking, so spending rose dramatically. While this may continue for a few months, it may not persist, as an initial rise in household spending may reflect pent-up demand and as the furlough scheme comes to an end in September.

As far as as the housing market is concerned, the rise in demand has been fuelled by the stamp duty ‘holiday’ which exempts residential property purchase from Stamp Duty Land Tax for properties under £500 000 in England and Northern Ireland and £250 000 in Scotland and Wales (rather than the original £125 000 in England and Northern Ireland, £145 000 in Scotland and £180 000 in Wales). In England and Northern Ireland, this limit is due to reduce to £250 000 on 30 June and back to £125 000 on 30 September. In Scotland the holiday ended on 31 March and in Wales is due to end on 30 June. As these deadlines are passed, this should see a significant cooling of demand.

Finally, although the gap between potential and actual output is narrowing, there is still a gap. According to the OECD (Table 12) the output gap in 2021 is forecast to be −4.6 per cent. Although it was −11.4 per cent in 2020, a gap of −4.6 per cent still represents a significant degree of slack in the economy.

At the current point in time, therefore, the Bank of England does not expect to have to raise interest rates in the immediate future. But it stands ready to do so if inflation does show signs of taking off.

Articles

Data, Forecasts and Analysis

Questions

  1. What determines the rate of (a) actual economic growth; (b) potential economic growth?
  2. What is meant by an output gap? What would be the implications of a positive output gap?
  3. Why are scarring effects of the pandemic likely to be greater in the UK than in most other countries?
  4. If people believed that inflation was likely to continue rising, how would this affect their behaviour and how would it affect the economy?
  5. What are the arguments for and against having a stamp duty holiday when the economy is in recession?
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Discretionary fiscal policy writ large: Biden’s stimulus plans

On 10 March, the House of Representatives gave final approval to President Biden’s $1.9tr fiscal stimulus plan (the American Rescue Plan). Worth over 9% of GDP, this represents the third stage of an unparalleled boost to the US economy. In March 2020, President Trump secured congressional agreement for a $2.2tr package (the CARES Act). Then in December 2020, a bipartisan COVID relief bill, worth $902bn, was passed by Congress.

By comparison, the Obama package in 2009 in response to the impending recession following the financial crisis was $831bn (5.7% of GDP).

The American Rescue Plan

The Biden stimulus programme consists of a range of measures, the majority of which provide monetary support to individuals. These include a payment of $1400 per person for single people earning less than $75 000 and couples less than $150 000. These come on top of payments of $1200 in March 2020 and $600 in late December. In addition, the top-up to unemployment benefits of $300 per week agreed in December will now continue until September. Also, annual child tax credit will rise from $2000 annually to as much as $3600 and this benefit will be available in advance.

Other measures include $350bn in grants for local governments depending on their levels of unemployment and other needs; $50bn to improve COVID testing centres and $20bn to develop a national vaccination campaign; $170bn to schools and universities to help them reopen after lockdown; and grants to small businesses and specific grants to hard-hit sectors, such as hospitality, airlines, airports and rail companies.

Despite supporting the two earlier packages, no Republican representative or senator backed this latest package, arguing that it was not sufficiently focused. As a result, reaction to the package has been very much along partisan lines. Nevertheless, it is supported by some 90% of Democrat voters and 50% of Republican voters.

Is the stimulus the right amount?

Although the latest package is worth $1.9tr, aggregate demand will not expand by this amount, which will limit the size of the multiplier effect. The reason is that the benefits multiplier is less than the government expenditure multiplier as some of the extra money people receive will be saved or used to reduce debts.

With $3tr representing some 9% of GDP, this should easily fill the estimated negative output gap of between 2% and 3%, especially when multiplier effects are included. Also, with savings having increased during the recession to put them some 7% above normal, the additional amount saved may be quite small, and wealthier Americans may begin to reduce their savings and spend a larger proportion of their income.

So the problem might be one of excessive stimulus, which in normal times could result in crowding out by driving up interest rates and dampening investment. However, the Fed is still engaged in a programme of quantitative easing. Between mid-March 2020 and the end of March 2021, the Fed’s portfolio of securities held outright grew from $3.9tr to $7.2tr. What is more, many economists predict that inflation is unlikely to rise other than very slightly. If this is so, it should allow the package to be financed easily. Debt should not rise to unsustainable levels.

Other economists argue, however, that inflationary expectations are rising, reflected in bond yields, and this could drive actual inflation and force the Fed into the awkward dilemma of either raising interest rates, which could have a significant dampening effect, or further increasing money supply, potentially leading to greater inflationary problems in the future.

A lot will depend what happens to potential GDP. Will it rise over the medium term so that additional spending can be accommodated? If the rise in spending encourages an increase in investment, this should increase potential GDP. This will depend on business confidence, which may be boosted by the package or may be dampened by worries about inflation.

Additional packages to come

Potential GDP should also be boosted by two further packages that Biden plans to put to Congress.

The first is a $2.2tr infrastructure investment plan, known as the American Jobs Plan. This is a 10-year plan to invest public money in transport infrastructure (such as rebuilding 20 000 miles of road and repairing bridges), public transport, electric vehicles, green housing, schools, water supply, green power generation, modernising the power grid, broadband, R&D in fields such as AI, social care, job training and manufacturing. This will be largely funded through tax increases, such as gradually raising corporation tax from 21% to 28% (it had been cut from 35% to 21% by President Trump) and taxing global profits of US multinationals. However, the spending will generally precede the increased revenues and thus will raise aggregate demand in the initial years. Only after 15 years are revenues expected to exceed costs.

The second is a yet-to-be announced plan to increase spending on childcare, healthcare and education. This should be worth at least $1tr. This will probably be funded by tax increases on income, capital gains and property, aimed largely at wealthy individuals. Again, it is hoped that this will boost potential GDP, in this case by increasing labour productivity.

With earlier packages, the total increase in public spending will be over $8tr. This is discretionary fiscal policy writ large.

Articles

Videos

Questions

  1. Draw a Keynesian cross diagram to show the effect of an increase in benefits when the economy is operating below potential GDP.
  2. What determines the size of the benefits multiplier?
  3. Explain what is meant by the output gap. How might the pandemic and accompanying emergency health measures have affected the size of the output gap?
  4. How are expectations relevant to the effectiveness of the stimulus measures?
  5. What is likely to determine the proportion of the $1400 stimulus cheques that people spend?
  6. Distinguish between resource crowding out and financial crowding out. Is the fiscal stimulus package likely to result in either form of crowding out and, if so, what will determine by how much?
  7. What is the current monetary policy of the Fed? How is it likely to impact on the effectiveness of the fiscal stimulus?
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The 2021 UK Budget: giving now and taking later

Rishi Sunak delivered his 2021 UK Budget on 3 March. It illustrates the delicate balancing act that governments in many countries face as the effects of the coronavirus pandemic persist and public-sector debt soars. He announced that he would continue supporting the economy through various forms of government expenditure and tax relief, but also announced tax rises over the medium term to begin addressing the massively increased public-sector debt.

Key measures of support for people and businesses include:

  • An extension of the furlough scheme until the end of September, with employees continuing to be paid 80% of their wages for hours they cannot work, but with employers having to contribute 10% in July and 20% in August and September.
  • Support for the self-employed also extended until September, with the scheme being widened to make 600 000 more self-employed people eligible.
  • The temporary £20 increase to Universal Credit, introduced in April last year and due to end on 31 March this year, to be extended to the end of September.
  • Stamp duty holiday on house purchases in England and Northern Ireland, under which there is no tax liability on sales of less than £500 000, extended from the end of March to the end of June.
  • An additional £1.65bn to support the UK’s vaccination rollout.
  • VAT rate for hospitality firms to be maintained at the reduced 5% rate until the end of September and then raised to 12.5% (rather than 20%) for a further six months.
  • A range of grants for the arts, sport, shops , other businesses and apprenticeships.
  • Business rates holiday for hospitality firms in England extended from the end of March to the end of June and then with a discount of 66% until April 2022.
  • 130% of investment costs can be offset against tax – a new tax ‘super-deduction’.
  • No tax rises on alcohol, tobacco or fuel.
  • New UK Infrastructure Bank to be set up in Leeds with £12bn in capital to support £40bn worth of public and private projects.
  • Increased grants for devolved nations and grants for 45 English towns.

It has surprised many commentators that there was no announcement of greater investment in the NHS or more money for social care beyond the £3bn for the NHS and £1bn for social care announced in the November Spending Review. The NHS England budget will fall from £148bn in 2020/21 to £139bn in 2021/22.

Effects on borrowing and GDP


The net effect of these measures for the two financial years 2020 to 2022 is forecast by the Treasury to be an additional £37.5bn of government expenditure and a £27.3bn reduction in tax revenue (see Table 2.1 in Budget 2021). This takes the total support since the start of the pandemic to £352bn across the two years.

According to the OBR, this will result in public-sector borrowing being 16.9% of GDP in 2020/21 (the highest since the Second World War) and 10.3% of GDP in 2021/22. Public-sector debt will be 107.4% of GDP in 2021/22, rising to 109.7% in 2023/24 and then falling to 103.8% in 2025/26.

Faced with this big increase in borrowing, the Chancellor also announced some measures to raise tax revenue beginning in two years’ time when, hopefully, the economy will have grown. Indeed, the OBR forecasts that GDP will grow by 4.0% in 2021 and 7.3% in 2022, with the growth rate then settling at around 1.7% from 2023 onwards. He announced that:

  • Corporation tax on company profits over £250 000 will rise from 19% to 25% in April 2023. Rates for profits under £50 000 will remain at the current rate of 19%, with the rate rising in stages as profits rise above £50 000.
  • Personal income tax thresholds will be frozen from 2022/23 to 2025/26 at £12 570 for the basic 20% marginal rate and at £50 270 for the 40% marginal rate. This will increase the average tax rate as people’s nominal incomes rise.

The policy of a fiscal boost now and a fiscal tightening later might pose political difficulties for the government as this does not fit with the electoral cycle. Normally, politicians like to pursue tighter policies in the early years of the government only to loosen policy with various giveaways as the next election approaches. With Rishi Sunak’s policies, the opposite is the case, with fiscal policy being tightened as the 2024 election approaches.

Another issue is the high degree of uncertainty in the forecasts on which he is basing his policies. If there is another wave of the coronavirus with a new strain resistant to the vaccines or if the scarring effects of the lockdowns are greater, then growth could stall. Or if inflation begins to rise and the Bank of England feels it must raise interest rates, then this would suppress growth. With lower growth, the public-sector deficit would be higher and the government would be faced with the dilemma of whether it should raise taxes, cut government expenditure or accept higher borrowing.

What is more, there are likely to be huge pressures on the government to increase public spending, not cut it by £4bn per year in the medium term as he plans. As Paul Johnson of the IFS states:

In reality, there will be pressures from all sorts of directions. The NHS is perhaps the most obvious. Further top-ups seem near-inevitable. Catching up on lost learning in schools, dealing with the backlog in our courts system, supporting public transport providers, and fixing our system for social care funding would all require additional spending. The Chancellor’s medium-term spending plans simply look implausibly low.

Articles and Briefings

Official documents and data

Questions

  1. Assess the wisdom of the timing of the changes in tax and government expenditure announced in the Budget.
  2. Universal credit was increased by £20 per week in April 2020 and is now due to fall back to its previous level in October 2021. Have the needs of people on Universal Credit increased during the pandemic and, if so, are they likely to return to their previous level in October?
  3. In the past, the government argued that reductions in the rate of corporation tax would increase tax revenue. The Chancellor now argues that increasing it from 19% to 25% will increase tax revenue. Examine the justification for this increase and the significance of relative profit tax rates between countries.
  4. Investigate the effects on the public finances of the pandemic and government fiscal policy in two other countries. How do the effects compare with those in the UK?
  5. The Joseph Rowntree Foundation looks at poverty in the UK and policies to tackle it. It set five tests for the Budget. Examine its Budget Analysis and consider whether these tests have been met.
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How values affect outcomes

Each year the BBC hosts the Reith Lectures – a series of talks given by an eminent person in their field. This year’s lecturer is Mark Carney, former Governor of the Bank of England. His series of four weekly lectures began on 2 December 2020. Their topic is ‘How we get what we value’. As the BBC site states, the lectures:

chart how we have come to esteem financial value over human value and how we have gone from market economies to market societies. He argues that this has contributed to a trio of crises: of credit, Covid and climate. And the former Bank of England governor will outline how we can turn this around.

In lectures 2, 3 and 4, he looks at three crises and how they have shaped and are shaping what we value. The crises are the financial crisis of 2007–9, the coronavirus pandemic and the climate crisis. They have challenged how we value money, health and the environment respectively and, more broadly, have prompted people to question what is valuable for individuals and society, both today and into the future.

The questions posed by Carney are how can we establish what is valuable to individuals and society, how well are such values met by economies and how can mechanisms be improved to ensure that we make the best use of resources in meeting those values.

Value and the market

In the first lecture he probes the concept of value. He explores how economists and philosophers have tried to value the goods, services and human interactions that we desire.

First there is ‘objective value’ propounded by classical economists, such as Adam smith, David Ricardo and Karl Marx. Here the value of goods and services depends on the amount of resources used to make them and fundamentally on the amount of labour. In other words, value is a supply-side concept.

This he contrasts with ‘subjective value’. Here the value of goods and services depends on how well they satisfy wants – how much utility they give the consumer. For these neoclassical economists, value is in the eye of the beholder; it is a demand-side concept.

The two are reconciled in the market, with market prices reflecting the balance of demand and supply. Market prices provided a solution to the famous diamonds/water paradox (see Box 4.2 in Economics (10th edition) or Case Study 4.3 in Essentials of Economics (8th edition) – the paradox of ‘why water, which is essential for life, is virtually free, but diamonds, which have limited utility beyond their beauty, are so expensive.’ The answer is to do with scarcity and marginal utility. Because diamonds are rare, the marginal utility is high, even though the total utility is low. And because water is abundant, even though its total utility is high, for most people its marginal utility is low. In other words, the value at the margin depends on the balance of demand and supply. Diamonds are much scarcer than water.

But is the market balance the right balance? Are the values implied by the market the same as those of society? ‘Why do financial markets rate Amazon as one of the world’s most valuable companies, but the value of the vast region of the Amazon appears on no ledger until it’s stripped of its foliage and converted into farmland?’ – another paradox highlighted by Carney.

It has long been recognised that markets fail in a number of ways. They are not perfect, with large firms able to make supernormal profits by charging more and producing less, and consumers often being ill-informed and behaving impulsively or being swayed by clever marketing. And many valuable things that we experience, such as human interaction and the beauty of nature, are not bought and sold and thus do not appear in measures of GDP – one of the main ways of valuing a country.

What is more, many of things that are produced in the market have side-effects which are not reflected in prices. These externalities, whether good or bad, can be substantial: for example, the global warming caused by CO2 emissions from industry, transport and electricity production from fossil fuels.

And markets reflect people’s biases towards the present and hence lead to too little investment for the future, whether in healthcare, the environment or physical and social infrastructure. Markets reflect the scant regard many give to the damage we might be doing to the lives of future generations.

What is particularly corrosive, according to Carney, is the

drift from moral to market sentiments. …Increasingly, the value of something, some act or someone is equated with its monetary value, a monetary value that is determined by the market. The logic of buying and selling no longer applies only to material goods, but increasingly it governs the whole of life from the allocation of healthcare, education, public safety and environmental protection. …Market value is taken to represent intrinsic value, and if a good or activity is not in the market, it is not valued.

The drift from moral to market sentiments accelerated in the Thatcher/Regan era, when governments were portrayed as inefficient allocators, which stifled competition, innovation and the movement of capital. Deregulation and privatisation were the order of the day. This, according to Carney, ‘unleashed a new dynamism’ and ‘with the fall of communism at the end of the 1980s, the spread of the market grew unchecked.’

But this drift failed to recognise market failures. It has taken three crises, the financial crisis, Covid and the climate crisis to bring these failures to the top of the public agenda. They are examined in the other three lectures.

The Reith Lectures

Questions

  1. Distinguish between objective and subjective value.
  2. If your income rises, will you necessarily be happier? Explain.
  3. How is the concept of diminishing marginal utility of income relevant to explaining why ‘A Christmas bonus of £1000 means less to Mark Zuckerberg then £500 does to someone on a minimum wage.’
  4. Does the use of social cost–benefit analysis enable us to use adjusted prices as a measure of value?
  5. Listen to lectures 2, 3 and 4 and provide a 500-word summary of each.
  6. Assess the arguments Mark Carney uses in one of these three lectures.