For those of you who buried in the spending-tax-cuts and what-caused-the-deficit debate.
Policy Exchange have released a very stimulating document about tax options. It takes a number of striking positions, in particular a surprise attack on VAT as an income-tax equivalent that I hope to address later today, and an analysis of the idea of taxing debt more in order to reduce economic instability.
But before I start on that I would like to query (once again) their repeated claim that the deficit exploded because of a burst of excess spending. You can see the entire extent of their workings in Table 1.1. Revenues as a % of GDP fell 3%; spending rose 7%. Obvious, innit? Well no. Please consider this charming anecdote:
Imagine a small fishing community. Ten fisher-people bring in $20 of fish each year. 30% of this is taxed by the ‘government’. This $60 goes towards paying for domestic services – education, cleaning the huts, giving food to the young and old and infirm.
Now a storm comes and the boats are destroyed. The fisher people have to throw nets into the shallows, and now only gather $10 of fish each. With constant tax rates, the government now only has $30 of income. But – for now – it keeps paying the home carers and old people because they need that stuff done. (if you wonder how this can be done, there are other villages, and a ‘trade deficit’ emerges). The government starts running a $30 deficit.
The village policy wonk comes out and sees that the deficit has gone from a safe 0% of GDP to a worrying 30% of GDP. He pulls out a slate and works it out.
The villagers start clamouring about how they need to get the fishing started again – if they don’t, then their community is faced with ruin. But the fixer shows them the table, and tells them that clearly the problem here is a spending splurge. 100% of the deficit increase comes from the splurge, he says. So he convenes an immediate conference to discuss what to do about their mad spending habits.
Now it is obvious what is wrong with the way the wonk thinks. Dividing through by GDP invents ‘funny-currency’. In this case ‘Funny Currency’ means ‘One percent of what we gather in fish’, which by having such an elastic value distorts the picture of what has happened. Tax revenues have in fact halved – but they haven’t if you also divide through by something which has also halved. Try retelling the story with GDP falling to $50, $10, and you see the distortion much more clearly.
What should the villagers decide in their conference? It depends. At one extreme, the answer might be to bring spending down to $30 – if they think the income loss is permanent (the deficit is structural). Depending on their ability to borrow (they have assets) and the terms of trade with their neighbours, this may have to be quick or slow.
If they expect to return to $200 GDP, it may depend on how quickly they could get back up to those levels. Even if they are confident, they may decide that in future they need to tax $60, and spend just $50, using the surplus $10 to build up a stormy-day fund in case it happens again. Or they may realise they were not diversified enough, and need to invest in, say, irrigation in order not to be so fish-dependent.* This involves turning some of that social spending into investment.
Many of the answers to the village’s problem lie with reducing spending – there is no question of that. And given that we all know that storms happen from time to time, the government’s decision to spend all its income seems foolish, and has worsened the post-storm position. Its spending plans pre-storm were badly flawed – again, not question of that. The village elders should have anticipated fewer clear blue Mediterranean skies.
But these claims are different from claiming that the catastrophe itself was a spending issue. Some of the people in this debate are so concerned with making spending cuts a high priority that they accord sudden spending increases an unrealistically prominent part in our current difficulties. A balancing act tried to strike this balance: the fiscal crisis was largely about disappearing revenues; most of this is structural and so most of the answers lie in spending cuts. **
*Aditya’s Giant Panda theory, perhaps. In Iceland, interestingly, they moved from a fish-dependent economy to one dependent on hedge-fund carry revenues.
**Not that radical; in fact, the piece which won that award would scarcely merit a mention on a US blog, so obvious is the thesis – it was only the absence of such a sensible consensus last year that gave it ‘room’