Patrick Nolan

Now is the time for reform

Now is the time for reform
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Throughout the country debates on the spending review have begun in earnest. Some of the most important questions in these debates will centre around the economics of consolidation, as I discussed on a recent radio show containing Professor Joseph Stiglitz. I also set out to discuss these issues at the launch of the Orwell Prize. In my remarks I focussed on the general case for eliminating the structural deficit within a Parliamentary term and less on the specifics of the approach that the Coalition has taken to achieving this goal (which I have outlined some thoughts on here). I made five key points.


First, consolidation is not based on extreme economic theory that has failed wherever it has been tried. This claim is not supported by the evidence in many countries. At Reform we have discussed the results of consolidation with figures from countries like Canada and New Zealand (and here), and indeed I was on Canadian TV earlier this week discussing the parallels between their reforms in the 1990s and those here. Ireland is sometimes used as a case against consolidation but the view of people involved in their reforms is that while their economy is going through a hard time things would have been even harder if they hadn’t taken their recent actions (as the cost of financing their deficit would have been higher). Problems with the Irish economy stem from a public finance system that was too pro-cyclical and from not having an independent currency. The problem is not consolidation.


Second, the UK did not go into the global financial crisis in a strong position. It is well known that the UK has the largest structural deficit in Europe, but what is less well known is that Europe as a whole is performing poorly in comparison to the rest of the world (which is not just the US). There also needs to be greater recognition that the government was running deficits even when the economy was experiencing strong growth (when other countries were “banking” their surpluses to prepare for future costs) and that comparisons of international debt levels should also include the poor household savings rates in the UK. The high level of economy-wide debt is one reason the economy was particularly vulnerable to the global financial crisis. Further, while comparisons are sometimes made with debt levels following World War Two these comparisons are anachronistic, as they must be seen in the context of other key economic factors, such as the age profile of the population. High debt levels and an expensive welfare state may have been affordable (although perhaps not wise) when the working age population was young and growing, but in the face of an ageing population this is not the case.


This relates to my third point. There are strong arguments for moving quickly. The costs of government entitlements in health and pensions are rising. The longer we wait to reform these systems the higher the costs of change will be. Even if the public finances were in a good state there would still be a need for reform. This is before we consider the rising costs of servicing debt, which have been well-outlined, and even under the current plans for consolidation the cost of servicing debt are forecast to rise from £43 billion now to £63 billion in 2014-15. The increasing cost of debt servicing is not sustainable.


My fourth point was the need to focus on the quality, and not just the quantity, of spending. We know that there are areas of government spending where the cost of the funds that pay for them is higher than the benefits they provide. It is nonsense to suggest that the government should borrow to spend money on projects that do not provide value – as we incur the costs of borrowing (and an opportunity cost) without gaining anything in return. One area where spending represents poor value for money is the expensive welfare money-go-round, where cash transfers and other benefits are provided to middle and higher income families from their own tax revenues. This churning of money comes at a cost of expanding bureaucracy and the harmful effect of taxes on the economy.


Finally, I noted that we should not confuse the inputs into public services (such as the money spent or the staff employed) with their outcomes. A phrase from New Zealand is “we don’t have the money, so we’ll have to think.” And this is precisely the challenge facing UK public services. Setting out to do what we currently do, and in the same ways, but on slightly lower budgets will be a recipe for disaster. What is needed is new ways of working, including a more flexible use of resources and a greater focus on what actually matters. We should not measure the quality of the health system by the number of nurses it employs, or the quality of an education system by the number of school buildings being built. We need new ways of thinking – and this is the real challenge facing the Coalition. It is relatively easy to cut budgets but it is much harder to change the way people think.


In the discussion following the presentations there was concern over whether the spending review would increase poverty – although there was also surprisingly little recognition of the importance of a growing economy for funding redistribution and the fact that the outcomes of changes in budgets are at least partly within our control (see my final point above). Among members of the audience, the debate was quickly reduced to the usual simplistic arguments about banks destroying the economy - banks did not double the health budget in real terms over the last decade or increase welfare spending by £100 billion in real terms since 1989 (even during times of economic growth and falling unemployment) - and the need to reduce tax avoidance.


On this second point I took the chance to ask an audience member whether she had seen the HMRC statistics on the tax gap (tax avoidance). She said yes. I then asked her to clarify which taxes were most prone to avoidance and who are the people who are most cheating the system. She couldn’t. I had the statistics with me and pointed out that the largest gap in the tax base relates to the VAT, that excise taxes like tobacco and alcohol are highly prone to avoidance (people importing these goods themselves) and that many small businesses engage in income-splitting to make multiple use of the personal income tax allowances. So the problem is not the behaviour of a few banks; it is broader than that. As Stephen Fry put it, a culture has developed where it is the norm to fiddle taxes and expenses.

A better approach would be for people to chip in and do their bit and accept that in times like these we should be willing to give up poor quality spending we receive (like Winter Fuel Allowances). Changing to this new approach will require changing the way that people think and this requires an honest debate, which has so far been lacking.

Patrick Nolan is Chief Economist at Reform