Tag: real and nominal GDP

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Tax cuts or tax rises? The issue of fiscal drag

The UK Chancellor of the Exchequer, Jeremy Hunt, delivered his Spring Budget on 6 March 2024. In his speech, he announced a cut in national insurance (NI): a tax paid by workers on employment or self-employment income. The main rate of NI for employed workers will be cut from 10% to 8% from 6 April 2024. This follows a cut this January from 12% to 10%. The rate for the self-employed will be cut from 9% to 6% from 6 April. These will be the new marginal rates from the NI-free threshold of £12 750 to the higher threshold of £50 270 (above which the marginal rate is 2% and remains unchanged). Unlike income tax, NI applies only to income from work (employment or self-employment) and does not include pension incomes, rent, interest and dividends.

The cuts will make all employed and self-employed people earning more than £12 750 better off than they would have been without them. For employees on average incomes of £35 000, the two cuts will be worth £900 per year.

But will people end up paying less direct tax (income tax and NI) overall than in previous years? The answer is no because of the issue of fiscal drag (see the blog, Inflation and fiscal drag). Fiscal drag refers to the dampening effect on aggregate demand when higher incomes lead to a higher proportion being paid in tax. It occurs when there is a faster growth in incomes than in tax thresholds. This means that (a) the tax-free allowance accounts for a smaller proportion of people’s incomes and (b) a higher proportion of many people’s incomes will be paid at the higher income tax rate. Fiscal drag is especially acute when thresholds are frozen, when inflation is rapid and when real incomes rise rapidly.

Tax thresholds have been frozen since 2021 and the government plans to keep them frozen until 2028. This is illustrated in the following table.

According to the Institute for Fiscal Studies, the net effect of fiscal drag means that for every £1 given back to employed and self-employed workers by the NI cuts, £1.30 will have been taken away as a result of freezing thresholds between 2021 and 2024. This will rise to £1.90 in 2027/28.

Tax revenues are still set to rise as a percentage of GDP. This is illustrated in the chart. Tax revenues were 33.2% of GDP in 2010/11. By 2022/23 the figure had risen to 36.3%. With neither of the two changes to NI (January 2024 and April 2024), the OBR forecasts that the figure would rise to 37.7% by 2028/29 – the top dashed line in the chart. After the first cut, announced in November, it forecasts a smaller rise to 37.3% – the middle dashed line. After the second cut, announced in the Spring Budget, the OBR cut the forecast figure to 37.1% – the bottom dashed line. (Click here for a PowerPoint of the chart.)

As you can see from the chart, despite the cut in NI rates, the fiscal drag from freezing thresholds means that tax revenue as a percentage of GDP is still set to rise.

Articles

Information, data and analysis

Questions

  1. Would fiscal drag occur with frozen nominal tax bands if there were zero real growth in incomes? Explain.
  2. Find out what happened to other taxes, benefits, reliefs and incentives in the 2024 Spring Budget. Assess their macroeconomic effect.
  3. If the government decides that it wishes to increase tax revenues as a proportion of GDP (for example, to fund increased government expenditure on infrastructure and socially desirable projects and benefits), examine the arguments for increasing personal allowances and tax bands in line with inflation but raising the rates of income tax in order to raise sufficient revenue?
  4. Distinguish between market-orientated and interventionist supply-side policies? Why do political parties differ in their approaches to supply-side policy?
  5. What is the Conservative government’s fiscal rule? Is the Spring Budget 2024 consistent with this rule?
  6. What policies were announced in the Spring Budget 2024 to increase productivity? Why is it difficult to estimate the financial outcome of such policies?
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Inflation and fiscal drag

Since 2019, UK personal taxes (income tax and national insurance) have been increasing as a proportion of incomes and total tax revenues have been increasing as a proportion of GDP. However, in his Autumn Statement of 22 November, the Chancellor, Jeremy Hunt, announced a 2 percentage point cut in the national insurance rate for employees from 12% to 10%. The government hailed this as a significant tax cut. But, despite this, taxes are set to continue increasing. According to the Office for Budget Responsibility (OBR), from 2019/20 to 2028/29, taxes will have increased by 4.5 per cent of GDP (see chart below), raising an extra £44.6 billion per year by 2028/29. One third of this is the result of ‘fiscal drag’ from the freezing of tax thresholds.

According to the OBR

Fiscal drag is the process by which faster growth in earnings than in income tax thresholds results in more people being subject to income tax and more of their income being subject to higher tax rates, both of which raise the average tax rate on total incomes.

Income tax thresholds have been unchanged for the past three years and the current plan is that they will remain frozen until at least 2027/28. This is illustrated in the following table.

If there were no inflation, fiscal drag would still apply if real incomes rose. In other words, people would be paying a higher average rate of tax. Part of the reason is that some people on low incomes would be dragged into paying tax for the first time and more people would be paying taxes at higher rates. Even in the case of people whose income rise did not pull them into a higher tax bracket (i.e. they were paying the same marginal rate of tax), they would still be paying a higher average rate of tax as the personal allowance would account for a smaller proportion of their income.

Inflation compounds this effect. Tax bands are in nominal not real terms. Assume that real incomes stay the same and that tax bands are frozen. Nominal incomes will rise by the rate of inflation and thus fiscal drag will occur: the real value of the personal allowance will fall and a higher proportion of incomes will be paid at higher rates. Since 2021, some 2.2 million workers, who previously paid no income taxes as their incomes were below the personal allowance, are now paying tax on some of their wages at the 20% rate. A further 1.6 million workers have moved to the higher tax bracket with a marginal rate of 40%.

The net effect is that, although national insurance rates have been cut by 2 percentage points, the tax burden will continue rising. The OBR estimates that by 2027/28, tax revenues will be 37.4% of GDP; they were 33.1% in 2019/20. This is illustrated in the chart (click here for a PowerPoint).

Much of this rise will be the result of fiscal drag. According to the OBR, fiscal drag from freezing personal allowances, even after the cut in national insurance rates, will raise an extra £42.9 billion per year by 2027/28. This would be equivalent of the amount raised by a rise in national insurance rates of 10 percentage points. By comparison, the total cost to the government of the furlough scheme during the pandemic was £70 billion. For further analysis by the OBR of the magnitude of fiscal drag, see Box 3.1 (p 69) in the November 2023 edition of its Economic and fiscal outlook.

Political choices

Support measures during the pandemic and its aftermath and subsidies for energy bills have led to a rise in government debt. This has put a burden on public finances, compounded by sluggish growth and higher interest rates increasing the cost of servicing government debt. This leaves the government (and future governments) in a dilemma. It must either allow fiscal drag to take place by not raising allowances or even raise tax rates, cut government expenditure or increase borrowing; or it must try to stimulate economic growth to provide a larger tax base; or it must do some combination of all of these. These are not easy choices. Higher economic growth would be the best solution for the government, but it is difficult for governments to achieve. Spending on infrastructure, which would support growth, is planned to be cut in an attempt to reduce borrowing. According to the OBR, under current government plans, public-sector net investment is set to decline from 2.6% of GDP in 2023/24 to 1.8% by 2028/29.

The government is attempting to achieve growth by market-orientated supply-side measures, such as making permanent the current 100% corporation tax allowance for investment. Other measures include streamlining the planning system for commercial projects, a business rates support package for small businesses and targeted government support for specific sectors, such as digital technology. Critics argue that this will not be sufficient to offset the decline in public investment and renew crumbling infrastructure.

To support public finances, the government is using a combination of higher taxation, largely through fiscal drag, and cuts in government expenditure (from 44.8% of GDP in 2023/24 to a planned 42.7% by 2028/29). If the government succeeds in doing this, the OBR forecasts that public-sector net borrowing will fall from 4.5% of GDP in 2023/24 to 1.1% by 2028/29. But higher taxes and squeezed public expenditure will make many people feel worse off, especially those that rely on public services.

Videos

  • Fiscal drag

    • Sky News Politics Hub on X, Sophy Ridge (22/11/23)

  • Fiscal drag

    • Sky News Politics Hub on X, Beth Rigby (22/11/23)

Articles

Report and data from the OBR

Questions

  1. Would fiscal drag occur with frozen nominal tax bands if there were zero real growth in incomes? Explain.
  2. Examine the arguments for continuing to borrow to fund a Budget deficit over a number of years.
  3. When interest rates rise, how much does this affect the cost of servicing public-sector debt? Why is the effect likely to be greater in the long run than in the short run?
  4. If the government decides that it wishes to increase tax revenues as a proportion of GDP (for example, to fund increased government expenditure on infrastructure and socially desirable projects and benefits), examine the arguments for increasing personal allowances and tax bands in line with inflation but raising the rates of income tax in order to raise sufficient revenue?
  5. Distinguish between market-orientated and interventionist supply-side policies? Why do political parties differ in their approaches to supply-side policy?
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Rethinking central bank targets

At present, the Bank of England has an inflation target of 2% CPI at a 24-month time horizon. Most, other central banks also have simple Inflation targets. But central bankers’ opinions seem to be changing.

Consider four facts.
1. Many central banks around the world have had record low interest rates for nearly four years, backed up in some cases by programmes of quantitative easing, officially in pursuit of an inflation target.
2. The world is mired in recession or sluggish growth, on which monetary policy seems to have had only a modest effect.
3. Inflation seems to be poorly related to aggregate demand, at least within an economy. Instead, inflation in recent years seems to be particularly affected by commodity prices.
4. Success in meeting an inflation target could mean failure in terms of an economy achieving an actual growth rate equal to its potential rate.

It’s not surprising that there have been calls for rethinking monetary policy targets.

There have recently been two interesting developments: one is a speech by Mark Carney, Governor designate of the Bank of England; the other is a decision on targets by the Fed, reported at a press conference by Ben Bernanke, Chairman of the Federal Reserve.

Mark Carney proposes the possible replacement of an inflation target with a target for nominal GDP (NGDP). This could be, say, 5%. What is more, it should be an annual average over a number of years. Thus if the target is missed in one year, it can be made up in subsequent years. For example, if this year the actual rate of nominal GDP growth is 4%, then by achieving 6% next year, the economy would keep to the average 5% target. As Stephanie Flanders points out:

Moving to nominal GDP targets would send a signal that the Bank was determined to get back the nominal growth in the economy that has been lost, even if it is at the cost of pushing inflation above 2% for a sustained period of time.

In the USA, Ben Bernanke announced that the Fed would target unemployment by keeping interest rates at their current record lows until unemployment falls below a threshold of 6.5%.

Until recently, the Fed has been more flexible than most other central banks by considering not only inflation but also real GDP when setting interest rates. This has been close to following a Taylor rule, which involves targeting a weighted averaged of inflation and real GDP. However, in January 2012, the Fed announced that it would adopt a 2% long-run inflation target. So the move to targeting unemployment represents a rapid change in policy

So have simple inflation targets run their course? Should they be replaced by other targets or should targeting itself be abandoned? The following articles examine the issues.

Articles
UK
Mark Carney hints at need for radical action to boost ailing economies The Telegraph, Philip Aldrick (11/12/12)
George Osborne welcomes inflation target review The Telegraph, Philip Aldrick and James Kirkup (13/12/12)
Monetary policy: Straight talk The Economist, R.A. (12/12/12)
New Bank of England governor Mark Carney mulls end of inflation targets The Guardian, Larry Elliott (12/12/12/)
Carney’s trail of carnage Independent, Ben Chu (12/12/12)
Mark Carney suggests targeting economic output BBC News (12/12/12)
A new target for the Bank of England? BBC News, Stephanie Flanders (14/12/12)
Should the UK really ditch inflation target? Investment Week, Katie Holliday (14/12/12)
BoE economist Spencer Dale warns on Mark Carney’s ideas The Telegraph, Philip Aldrick (12/12/12)

USA
Ben Bernanke Outlines Fed Policy for 2013 IVN, Alex Gauthier (14/12/12)
Fed gives itself a new target BBC News, Stephanie Flanders (13/12/12)
Fed to Keep Easing, Sets Target for Rates CNBC, Jeff Cox (12/12/12)
Bernanke calls high unemployment rate ‘an enormous waste’ Los Angeles Times, Jim Puzzanghera (12/12/12)
Think the Fed has been too timid? Check out Britain and Japan. Washington Post, Brad Plumer (13/12/12)
Inflation Targeting is Dead, Long Live Inflation! The Market Oracle, Adrian Ash (14/12/12)

Speech and press conference
Guidance Bank of Canada, Mark Carney (11/12/12)
Transcript of Chairman Bernanke’s Press Conference Federal Reserve Bank, Ben Bernanke (12/12/12)

Questions

  1. Which of the following would meet an NGDP target of 5%: (a) 5% real growth and 0% inflation; (b) 5% real growth and 5% inflation; (c) 5% inflation and 0% growth?
  2. What are the main arguments in favour of an NGDP target?
  3. What factors would need to be taken into account in deciding the target rate of NGDP?
  4. What are the main arguments against an NGDP target?
  5. Is it possible to target two indicators with one policy instrument (interest rates)? Explain.
  6. Explain what is meant by Taylor rule?
  7. Is having an unemployment target a type of Taylor rule?
  8. Why may the rate of inflation (whether current or forecast) be a poor indicator of the state of the real economy?
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Getting real with GDP (update)

Just how large is the UK economy and how rapidly is it growing? These were questions we asked, back at the turn of the year, in Getting real with GDP when reviewing economic data for the third quarter of 2010. We update this blog in light of the latest Quarterly National Accounts release from the Office for National Statistics.

The latest Quarterly National Accounts release estimates the value of our economy’s output during Q1 of 2011 at £375.3 million. When measured across the latest four quarters, i.e. from the start of Q2 2010 to the end of Q1 2011, the total value of our economy’s output was £1.472 trillion. Across calendar year 2010 the UK’s GDP is estimated to have been £1.455 trillion.

When analysed in terms of the total expenditure on the goods and services produced in the latest four quarters, household final consumption contributed £931 billion of Gross Domestic Product. In other words, household expenditure over these four quarters was equivalent to 63% of GDP, almost exactly in line with its average since 1948. This demonstrates the importance of spending by households for short-term economic growth. Households help to shape the business cycle.

Another important expenditure-component of GDP is gross capital formation. This is capital expenditure by the private and public sector and is estimated to have been £219.6 billion over the latest four quarters, equivalent to 15% of GDP. As well as affecting current levels of GDP, gross capital formation also affects our economy’s potential output. In other words, changes in capital expenditure can impact both on the demand-side and the supply-side of the economy. Interestingly, the long-term average share for gross capital formation in GDP is around 18% and so about 3 percentage points higher than is currently the case.

So far we have looked at the level of economic activity measured at current prices. But, what about the rate at which the economy is growing? When analysing the rate of economic growth economists look at GDP at constant prices. By doing this economists can infer whether the volume of output has increased. This is important because in the presence of price rises, an increase in the value of output could occur even if the volume of output remained unchanged or actually fell. For instance, in 1974 the volume of output or real GDP fell by 1.3%, but because the average price of our domestic output – the GDP deflator – rose by 14.9%, GDP measured at current prices rose by nearly 13.4%.

The latest ONS figures show that in the first quarter of 2011 real GDP grew by 0.5% (nominal GDP grew by 1.7%). This follows a 0.5% fall in real GDP the final quarter of 2010 (nominal GDP grew by 1.2%). Compared with Q1 2010, the volume of output of the UK economy in Q1 2011 is estimated to have grown by 1.6%.

Exports were the fastest growing component of aggregate demand in Q1, rising in real terms by 2.4%, while import volumes decreased by 2.4%. Export volumes in Q1 were 9.3% higher than a year earlier. In contrast, capital expenditures contracted sharply in the first quarter, falling by 4.2%. This follows on the back of a 0.6% fall in the final quarter of last year. This has reversed much of the strong capital expenditure growth seen during the earlier part of 2010.

We finish by looking at the growth in household spending. In the first quarter of the year real household spending fell by 0.6%. This follows a 0.2 fall in Q4 2010 and zero growth in Q3 2010. This helps to explain some of the difficulties that particular retailers have faced of late. Some context to these disappointing consumption numbers is provided by patterns in household sector disposable income. The sector’s disposable income fell by 0.8% in Q1 2011 which follows on from a 0.9% fall in the last quarter of last year. The result of this is that the household sector’s real disposable income in Q1 2011 was 2.7% lower than in Q1 2010. This was the fastest annual rate of decline since the third quarter of 1977.

Articles

Household incomes sees biggest fall since 1977 BBC News (29/6/11)
UK service sector sees biggest fall for 15 months BBC News (28/6/11)
UK economic growth revised down BBC News (29/6/11)
Service sector output slumps Guardian, Phillip Inman (29/6/11)
Household raid savings as income squeezed Independent, Sean O’Grady (29/6/11)
Poor GDP numbers add pressure on Osborne Guardian, Phillip Inman (28/6/11)
UK economy suffers blow as tepid growth confirmed Telegraph (28/6/11)
Service sector slumps deals heavy blow to economic recovery hopes Scotsman, Natalie Thomas (30/6/11)

Data

Latest on GDP growth Office for National Statistics (28/6/11)
Quarterly National Accounts, 1st Quarter 2011 Office for National Statistics (28/6/11))
ONS Time Series Data Office for National Statistics
For macroeconomic data for EU countries and other OECD countries, such as the USA, Canada, Japan, Australia and Korea, see:
AMECO online European Commission

Questions

  1. What do you understand by the terms nominal GDP and real GDP?
  2. Can you think of any other contexts in which we might wish to distinguish between nominal and real changes?
  3. The following are the estimates of GDP at constant 2006 prices:
    Q1 2011= £330.724bn, Q4 2010= £329.189bn, Q1 2010= £325.360bn
    Calculate both the quarterly rate of change and the annual rate of change for Q1 2011.
  4. What would happen to our estimates of the level of constant–price GDP in (3) if the base year for prices was 1996 rather than 2006? What if the base year was 2011? What would happen to the quarterly and annual growth rates you calculated in each case? Explain your answer.
  5. Explain how gross capital formation could have both demand-side and supply-side effects on the economy. How significant do you think such supply-side effects can be?
  6. How important for short-term economic growth do you think household spending is? What factors do you think will be important in affecting household spending in the months ahead?
  7. What factors do you think help to explain the 2.7% annual rate of decline reported in Q1 2011 in the household sector’s real disposable income?
  8. The real annual rate of decline in household spending reported in Q1 2011 was 0.5%. Would you have expected this percentage decline to have been the same as for real disposable income? Explain your answer.