I will not go into the details of the budget. A lot of people are much better qualified to do that than I am. But one thing I always recommend to people interested in the budget announcement is to focus not just on the inevitable bad news in the form of higher taxes or spending cuts, which clearly hurt economic growth, but also on what the money is being spent on.
The orthodoxy among low-tax conservatives has always been that higher taxes reduce growth and lower taxes increase economic growth. Sometimes they even claim that growth is increasing so much that tax cuts will pay for themselves. Nothing could be further from the truth. Depending on the tax, economic growth can slow or increase in response to a tax increasebut in general, it’s a good rule of thumb that tax changes don’t change long-term economic growth, either for the better or for the worse. And I have shown here that tax increases or decreases do not matter at all for the stock markets. So don’t buy or sell stocks because you think taxes will go up or down. That will inevitably fail. If you want to know why stock market returns and tax increases or decreases are not correlated: here is an earlier post on the underlying dynamics.
As I show in that post, how tax revenues are used is as important to the impact on growth as how many taxes are raised. That brings me to the tax multipliers. Budget multipliers measure the value for money of government expenditure and revenue measures. A budget multiplier of 0.5 means that for every pound of revenue raised, GDP will shrink by 0.5 pounds. A budget multiplier of 1.5 means that for every pound the government spends, GDP will increase by 1.5 pounds.
So, here it is the tax multipliers used by the OBR based on empirical findings for the UK economy (fiscal multipliers differ from country to country and where we are in the business cycle):
- Tax Multiplier: The OBR uses a simple tax multiplier of 0.33 in the first year after tax increases or decreases are announced. It is therefore assumed that for every pound of tax collected, GDP will shrink by £0.33 in the first year (and then by less in subsequent years, but I’ll get to that).
For capital investments (so-called ‘capital Departmental Spending Limits’, or CDEL), the OBR uses a tax multiplier from the first year. So raising revenues through higher taxes and then investing that money in infrastructure, for example, will produce a net increase in GDP of 1.0 -0.33 = £0.67 for every pound of taxes collected.
For regular expenditure (so-called ‘resource Departmental Spend Limits’, or RDEL), the OBR uses a budget multiplier of 0.34. This money is mainly spent on education, the NHS and defence, but also on the police and the judiciary.
Finally, for other annual managed expenditure (AME), which is essentially social expenditure, the OBR uses a budget multiplier of 0.6 in the first year.
The graph below shows how these budget multipliers decrease over the years. What you can see is that tax increases slow down growth, and if the government uses that money to spend on the civil service, or on running the NHS, schools, etc., it won’t change UK GDP at all. In this case, the government has effectively lost an opportunity to stimulate growth through investment.
Budget multipliers of government spending measures over time
Source: OBR
Using tax increases to increase capital investment or social spending will certainly boost growth, not reduce it. Suppose we add the cumulative budget multiplier over the first three years in the graph below. In that case, we can see how large the opportunity cost is of spending tax revenue on running the civil service, schools or hospitals (but not on investing in infrastructure and other productivity-enhancing measures).
Cumulative budget multipliers of government measures in years 1 to 3
Source: OBR
Over three years, investing one pound of public money in improving hospitals, schools, roads, power supplies, etc. will add 2.26 to Britain’s GDP. Funding this entirely through tax increases reduces this growth stimulus by £0.86 over three years, equating to a net increase in output of £1.4.
Similarly, investing one pound in infrastructure investment by reducing government consumption by one pound has much the same effect. But by investing one pound in infrastructure while cutting social spending by one pound, we only have a net gain of 2.26 – 1.9 = 0.36 pounds of extra output over three years.
So when you hear the announcements later today, I hope you will worry a little less about the tax increases and spending cuts, and think a little more about how much the increase in spending will offset this. You can even use the figures above to get a quick and dirty estimate of the net effect on GDP in Britain.
#budget #day #Britain