Monday, 10 November 2008

Cleggy's Adventures in Wonderland

I don't envy any of the political parties at the moment. They each have to suggest ways to cushion the recession and/or steer a path to recovery, yet none of them can have any faith in the positions they put forward because we have never had a recession quite like this one. We have certainly had recessions in the post-war period which were a necessary adjustment for an asset price bubble caused by excessive credit, but previously there was not such a massive and rapid contraction of credit as now. Indeed, it has contracted so much that it is significantly below sustainable levels. In the past the banks have always had the capacity to continue giving support to essentially sound business suffering temporary cash flow problems whereas now even that modest amount of credit (which would be very good business for the banks) cannot be given because the banks themselves are in such dire straits.

Over the last couple of weeks many calls were heard for bringing forward infrastructure programmes to help the construction industry but that fell out of favour pretty quickly when it was realised it would help very few people directly, would take a long time to get started and could make things worse by imposing a massive call on public finances for very little tangible return.

I am not opposed to bringing-forward capital projects in principle. Many are content to attach the label "Keynesian" to such a measure and consider that sufficient to dismiss it out of hand, but I think the substance should be examined not the form. The principle behind building hospitals or roads now rather than in two or three years time is that it will allow large constructions companies to keep going. In effect, by placing work their way now rather than in the future the government would be acting like a bank which allows an extended overdraft to help a sound business through a difficult patch. I can see nothing wrong in principle with the government doing this provided the projects concerned have a pretty rapid effect on the viability of the construction companies and the amount spent in this way is modest. Pricing will have to be very tight so that the interest paid by taxpayers on the money borrowed to pay for the projects is actually paid, so far as possible, by the construction companies by way of reduced profit. After all, if your business is under threat and could collapse your first priority is to break even not to make a profit. If £1million in interest would have to be paid by taxpayers on the money borrowed to pay for a hospital it would be more than a little galling to find the builder making a profit of £1million pounds, in effect the taxpayer would be paying that profit when the interest should be treated like the interest the company would have to pay its own bank and should be part of the costs it must bear.

This week attention has shifted towards attempts to stimulate the retail market by reductions in tax. The LibDems kicked-off today with Nick Clegg giving a series of interviews in which he put a little flesh on the bones of previous policy announcements. It must be said that so little flesh has been added that even a sausage factory's mechanical recovery machine would find it hard to scrape off enough for one large spicy Cumberland. Nonetheless, the gist of it seems to be this: (i) cut income tax at the low end by up to 4p in the pound, (ii) close loopholes used by rich people and large companies to avoid tax, (iii) cut overall government spending by up to 3% and (iv) impose new "green" taxes.

As I understand it, this is meant to have no overall effect on tax revenues which necessarily makes the third item irrelevant. The second item could only increase tax revenues by a certain amount regardless of what happens to income tax and "green" taxes. Incidentally, the more income tax is reduced the less tax the rich will be avoiding, so additional revenues from closing so-called loopholes will be reduced. Whatever the net reduction in revenues from reducing income tax and squeezing the rich, new "green" taxes will have to make up the total to the same as under current rates. The more they cut income tax, the more "green" taxes will have to rise. And who will those "green" taxes hit? Surprise surprise, like all taxes they will hit the poorest hardest.

The purpose of the exercise is to give the least wealthy more spending money so that shops can keep trading merrily. It is hard to see how robbing Peter to pay Paul can achieve that to any significant degree. Who is going to maintain expenditure on non-essentials when they know any extra they receive from a reduction in income tax might have to go in "green" taxes. All "green" taxes are taxes on consumption. They might fall directly on the customer or they might add to the costs of the supplier, but either way they mean higher prices.

As always it is worth taking a quick look at the figures. Take someone on average-ish annual earnings of £25,000. He will pay £3,793 in income tax. Cut the tax rate by 2% to 18% and the total he pays will fall to £3,413.70. That is £7.30 a week. No doubt a welcome addition but hardly enough to push the boat out, especially when an unknown sum will have to be paid in new "green" taxes. Cutting the basic rate to 16% reduces income tax on £25,000 to £3,034.40, equivalent to an extra £14.59 a week, but more will have to be clawed back by the "green" demon, so it is anyone's guess how much extra will flow through the tills.

The biggest problem with the LibDem's idea is that they presume they can raise a significant sum by the squeeze on the rich. They plan to limit tax relief on pension contributions to the basic rate of tax and to close loopholes. We all know they can forget about closed loopholes raising more than a piffling sum, if it were as easy as he imagines it would have happened already. Limiting tax relief on pension contributions is more easily justifiable. He claims it will save £8billion a year. He is wrong, he will be lucky if it comes to half that. Voluntary pension contributions (such as all those made by self-employed people and top-up sums paid by the employed) fall at all levels of income in a recession. Nonetheless there is scope for saving some money there to help pay for a reduction in the basic rate of income tax.

None of it really works because the amount of extra spending money in people's pockets will be so small that it could only ever give a tiny cushion against recession to retail businesses. It also fails to take into account that an extra £5 or £10 is very likely to go towards credit cards debts in a vast number of households, thereby doing absolutely nothing for retail at all.

My biggest concern about Mr Clegg's latest adventure in wonderland is his desire to switch from direct to indirect taxation. Such a switch is a necessary part of replacing an element of income tax by "green" taxes. He might as well propose cutting income tax and raising VAT, his plan is almost as regressive as that. And what about pensioners and the unemployed? Many of them are barely above the tax threshold as it is. They will find savings of perhaps just a pound or two a week in income tax being dwarfed by the new "green" consumption taxes. It looks like an ill thought-out and potentially very nasty plan.

1 comment:

Mark Wadsworth said...

...even that modest amount of credit (which would be very good business for the banks) cannot be given because the banks themselves are in such dire straits.

Easily fixed. It's called debt for equity swaps, which would happen of their own accord if gummint made it clear that they will not bail out banks.