Category: Essentials of Economics: Ch 13

With an election approaching, there is much debate about recovery and cuts and about the relationships between the two. Will rapid cuts stimulate confidence in the UK by business and bankers and thereby stimulate investment and recovery, or will they drive the economy back into recession? The debate is not just between politicians vying for your vote; economists too are debating the issue. Many are taking to letter writing.

In the February 2010 news blog, A clash of ideas – what to do about the deficit, we considered three letters written by economists (linked to again below). There has now been a fourth – and doubtless not the last. This latest letter, in the wake of the Budget and the debates about the speed of the cuts, takes a Keynesian line and looks at the sustainability of the recovery – including social and environmental sustainability. It is signed by 34 people, mainly economists.

Letter: Better routes to economic recovery Guardian (27/3/10)
Letter: UK economy cries out for credible rescue plan Sunday Times, 20 economists (14/2/10)
Letter: First priority must be to restore robust growth Financial Times, Lord Skidelsky and others (18/2/10)
Letter: Sharp shock now would be dangerous Financial Times, Lord Layard and others (18/2/10)

Questions

  1. Summarise the arguments for making rapid cuts in the deficit.
  2. Summarise the arguments for making gradual cuts in the deficit in line with the recovery in private-sector demand.
  3. Under what conditions would the current high deficit crowd out private expenditure?
  4. What do you understand by a ‘Green New Deal’? How realistic is such a New Deal and would there be any downsides?
  5. Is the disagreement between the economists the result of (a) different analysis, (b) different objectives or (c) different interpretation of forecasts of the robustness of the recovery and how markets are likely to respond to alternative policies? Or is it a combination of two of them or all three? Explain your answer.
  6. Why is the effect of the recession on the supply-side of the economy crucial in determining the sustainability of a demand-led recovery?

After each Budget, the Institute for Fiscal Studies analyses its effects. Given the highly charged political environment, with an election looming and the prospects of considerable public expenditure cuts to come, dispassionate analyses of the Budget are hard to find. The IFS’s analysis is a major exception.

The IFS summarises the Budget as being largely neutral. As Robert Chote, Director of the IFS, says in the opening remarks to the Post Budget Briefing:

In a Pre-Election Budget, perhaps the most that we can expect of any Chancellor is that he should observe the key tenet of the Hippocratic Oath and “above all, do no harm”. Judged against that modest yardstick, the broadly neutral stance of this Budget passes the test.

But, the Budget avoided giving details of the cuts which are planned for the future. None of the political parties are saying just how they will achieve the necessary reductions to the deficit, although the Liberal Democrats have given some details.

Judged against the more testing yardstick of providing a detailed picture to voters and financial market participants of the fiscal repair job in prospect beyond the election, the Budget will have fallen short of many people’s hopes. There are an awful lot of judgements still to be made, or revealed, notably with regards public spending over the next parliament. This greater-than-necessary vagueness allows the opposition to be vaguer than necessary too.

The articles below look at the Budget and at the IFS’s assessment of it. There are also links to the sections of the IFS report. It is worth reading them if you are to be able to make the ‘cool’ judgements that economists can provide – even if they do not always agree!

Articles
Budget leaves questions unanswered – IFS Reuters (25/3/10)
Budget 2010: IFS warns transport and housing spending has to be cut Guardian, Phillip Inman (25/3/10)
Labour ‘has cost the rich £25,000 every year’ Independent, Sean O’Grady (26/3/10)
The pain to come The Economist (25/3/10)
Chancellor’s ‘difficult balancing act’ BBC Today Programme (24/3/10)
Pain deferred until the polls close Financial Times, Chris Giles (25/3/10)

IFS Report: Budget 2010
Links to the various supporting articles and the opening remarks can be found here.

Details of the Budget
See references in Darling and a case of fiscal drag? for details of the Budget measures.

Questions

  1. What do you understand by the ‘structrual’ deficit and the ‘cyclical’ deficit?
  2. Why do cyclical deficits rise during a recession?
  3. Why has the structural deficit risen during this recession? Is this an example of hysteresis? (Explain.)
  4. What is the Fiscal Responsibility Act and why does the government now expect to over-achieve the requirements of the Act?
  5. What elements of government spending are likely to be cut most? Is this a wise distribution of cuts?
  6. Use the links to the PowerPoint presentations from the IFS Budget Report site to (a) analyse the state of the public finances; (b) summarise the main tax changes in the Budget.

According to the Budget 2010 Report, public sector current receipts in 2010-11 will be £541 billion. With expected public sector expenditure of £704 billion this leaves a deficit of £163 billion. Of these receipts, £146 billion or 27% is expected to come from income taxation. Several notable developments in the income tax system for 2010/11 include: the freezing of personal allowances, an income limit for personal allowances for those under 65, and the introduction of an additional income tax band.

Personal allowances are amounts of income that can be earned without being liable to income tax. This amount is to be frozen in 2010/11 at the level of 2009/10 so that for an individual under 65, this limit will remain at £6,475. Allowances are typically raised each year in accordance with the rate of price inflation. This then helps to reduce, in part, what is called fiscal drag. Fiscal drag occurs when there is an increase in the proportion of income taken in income tax as a result of allowances not being adjusted for inflation or for the rate of growth in earnings. In other words, by not increasing the amount of income exempt from taxation in 2010/11, any individual whose earnings rise will pay a higher proportion of their earnings in income taxation.

Another change in 2010-11 is the introduction of an income limit on personal allowances for those earning over £100,000. For every £1 earned above this limit, 50 pence will be taken from the allowance. Hence, given the allowance of £6,475 an individual earning £112,950 or more (i.e. £12,950 over the limit) will, in effect, no longer receive any personal allowance.

Now consider changes to the tax brackets. In 2009/10, an individual with an income tax liability of up to £37,400 (i.e. earnings of up to £43,875, once the personal allowance has been taken into account) pays income tax at 20%. This is the ‘basic rate’ band. With a liability of over £37,400, the excess (i.e. the amount over £37,400) is subject to tax at 40%. This is known as the ‘high rate band’. From the 1st April 2010, there is to be an ‘additional rate’ of 50%. The 50% rate will apply to taxable income over £150,000, while taxable income up to £37,400 will continue to be taxed at 20% and that between £37,401 and £150,000 will be taxed at 40%.

Now, an illustration of how the changes for 2010/11 will affect two individuals. Firstly, consider somebody on £110,000. Their tax allowance is ‘reduced’ by £5,000 to £1,475 and so they have a tax liability of £108,525. Of this, they will pay £7,480 at the basic rate (20% of £37,400) and £28,450 at the higher rate (40% of £71,125). With a tax bill of £35,930, their average rate of income tax in 2010-11 will be 32.66%. In 2009/10, the total tax bill will have been £33,930 (20% of £37,400 plus 40% of £66,125) and so an average rate of tax 30.85%

Finally, consider an individual on £200,000. Their income tax bill in 2010/11 will be £77,520 (20% of £37,400 plus 40% of £112,600 plus 50% of £50,000) and so they will face an average rate of tax income tax of 38.76%. In 2009/10 the tax bill would have been £69,930 (20% of £37,400 plus 40% of`£156,125), an average rate of income tax of 34.97%

Articles

The £20 billion tax raid about to hit The Times, Lauren Thompson (27/3/10)
How to beat the new 50% top rate of tax The Times , Mark Atherton (27/3/10)
Budget 2010: Darling draws election battle lines BBC News (24/3/10)
High earners will feel like they have taken a pummelling The Scotsman, Jeff Salway (27/3/10)

Further information
For the full Budget Report, see Budget 2010: Complete Report HM Treasury, March 2010
(The above consists of the two elements, Economic and Fiscal Strategy Report and Financial Statement and Budget Report. It’s a fairly large pdf file and may take a few seconds to download.)
For the particular measures and their impact on government expenditure and/or revenue, see Annex A: Budget policy decisions of the Financial Statement and Budget Report.
See also Rates and allowances – Income taxation HM Revenue and Customs
(Note: from here you can also link to other tax rates.)

Questions

  1. Consider the efficiency and equity arguments for and against the income tax changes in 2010/11.
  2. What do you understand by the terms the marginal rate of tax and the average rate of tax?
  3. How will the changes to the income tax system in 2010/11 affect the marginal and average income tax rates? You could perhaps try plotting these in a chart for different gross incomes.
  4. How can fiscal drag occur even if personal allowances are raised by the rate of inflation?

A keenly awaited Budget, but what should we have expected? Chancellor Alistair Darling had warned that it wouldn’t be a ‘giveaway’ budget. The aim to cut the budget deficit in half over 4 years still remains and the UK economy is certainly not out of the woods yet.

You’ve probably seen the debate amongst politicians and economists over what should happen to government spending and it might be that the lower than expected net borrowing for 2009-2010 provides a much needed boost to the economy. With the election approaching, it seemed likely that some of this unexpected windfall would be spent. The following articles consider some key issues ahead of the 2010 Budget.

Budget 2010: Alistair Darling’s election budget BBC News, Stephanie Flanders (21/3/10)
Build-up to the Budget Deloitte, UK March 2010
Pre-Budget Report: What Alistair Darling has announced before Guardian, Katie Allen (9/12/09)
Budget 2010: Darling warns of ‘no giveaway’ BBC News (11/3/10)
FTSE climbs ahead of UK Budget Financial Times, Neil Dennis (24/3/10)
Bank bonus tax could net Treasury £2bn, E&Y says Telegraph, Angela Monaghan (24/3/10)
Alistair Darling set for stamp duty move BBC News (24/3/10)
Labour has run out of steam, says David Cameron Guardian, Haroon Siddique (24/3/10)
Ten things to look out for in the 2010 Budget Scotsman (24/3/10)
Sammy Wilson predicts ‘neutral budget’ BBC News, Ireland (24/3/10)
Do the right thing, Darling Guardian (24/3/10)
What do we want from the Budget? Daily Politics (23/3/10)
Budget boost for Labour as inflation falls to 3% TimesOnline (24/3/10)

Questions

  1. Why has the FTSE climbed ahead of the Budget?
  2. Why is there a possibility of a rise in stamp duty again? To what extent do you think it will be effective?
  3. Net borrowing for 2009/10 is expected to be lower than forecast. What should happen to this so-called ‘windfall’?
  4. What is expected from the Budget 2010? Once the Budget has taken place, think about the extent to which expectations were fulfilled.
  5. Why are excise duties on goods such as taxes and alcohol likely to be more effective than those on other goods?

Is there finally cause to celebrate? Government borrowing is lower than expected. Initially, public sector net borrowing for 2009-2010 was forecast in the Pre-budget Report to be £178bn, but official public figures have reduced this to £170 bn. The fall in government revenues has not been as big as predicted and as a result, borrowing this year is likely to be between £5bn and £10bn less than expected. But, let’s not crack open the champagne quite yet, as February’s figures for public sector net borrowing are still about 41% higher in 2010 than in the same month last year.

Whilst the UK is predicted to under-shoot its public-sector net cash requirement made in the Pre-Budget Report for 2009-2010, government borrowing remains at a record high and the level of the deficit is still a worrying 12% of GDP. It is, therefore, hardly surprising that the European Commission wants the UK to bring its deficit down faster than the current government plans – and the Commission is not alone. There is considerable debate at the moment between those who want the government to bring the deficit down quicker to appease the market and those who want the government to start taking strong measures only when the recovery is well established. Their fear, very much in the Keynesian school, is that cutting too soon, by reducing aggregate demand, would push the economy back into recession.

If government spending is to be restrained, can we rely on export-lead growth? The fall in the value of our currency over the past two years should have meant a boost for exports. With a weaker pound, export growth was expected to be strong and allow us to export our way out of recession. See the news blog Expecting too much from exports. However, with figures in January 2010 showing the biggest trade deficit since August 2008 (£3.8bn) and with the volume of exports down by 8%, this may not be the case. Whilst the credit rating of the UK remains at AAA, experts say that the government should be aiming to reduce the deficit more quickly in order to retain this rating. So, although there is some good news (government borrowing will only be £170bn!) and exports are likely to increase as the global economy recovers from recession, significant problems in the UK economy still remain.

Articles

Row over leaked EU deficit report AFP news (17/3/10)
Government borrowing less than forecast BBC News (18/3/10)
Borrowing update cheers Treasury Financial Times, Chris Giles (19/3/10)
UK trade deficit widens to biggest in 17 months BBC News, Stephanie Flanders (9/3/10)
Government borrowing: what the economists say Guardian (18/3/10)
Darling to use higher revenues to cut debt Financial Times, Chris Giles and Jean Eaglesham (19/3/10)

Data

Public sector finances. February 2010 Office for National Statistics

Questions

  1. Why have government revenues been falling?
  2. What is the difference between the public-sector net cash requirement and public-sector debt?
  3. Why is a weak pound good for exports?
  4. As the global economy recovers, UK exports should begin to rise. Illustrate this idea with a circular flow of income diagram for the UK and the rest of the world.
  5. What are the arguments (a) for and (b) against reducing the government deficit now?
  6. Should the Treasury be celebrating these latest figures, or is the UK economy still in a bad way?