Category Archives: Public finances

The magic money tree

On Question Time this weekend, Theresa May was confronted by a nurse whose pay has been squeezed under the Coalition and Conservative governments. Her response to the nurse’s complaints was that “there isn’t a magic money tree that we can shake that suddenly provides for everything that people want”. Theresa May is of course right. There is, as far as we know, not a magic money tree. However, I fear that as an explanation for why nurses can’t have a pay rise, her statement is lacking.

That is not to say that there is no link between magic money trees and nurses’ pay. If there were indeed a magic money tree, then its harvest could surely be used to pay nurses more[1]. The absence of such a tree is a necessary condition for it being impossible to pay nurses more – but it is not sufficient. The reason for this is that there are types of money that are not magical and do not grow on trees. In failing to address the availability of this more mundane form of money, Theresa May has, not for the first time, not really answered the question.

A more charitable interpretation of Theresa May’s statement is that she is trying to argue that we can’t afford to increase government spending above current levels. Government spending is financed by taxes or debt, which must be repaid from future taxes, so the ability of a government to afford a given level of spending is dependent on its ability to raise taxes. One reason that some developing countries struggle to fund public services such as health care is that they have weak public institutions and so can’t raise taxes very effectively. The UK and most other rich countries are much better at collecting taxes and have larger public sectors. But their scope for public spending is not unlimited, for two reasons: high taxes and a large public sector might have a distortionary effect on the economy, discouraging economic activity and squeezing out the private sector; or democratic processes might limit the size of the state by voting out governments that raise taxes.

This is all very complicated and hotly disputed, but one way to understand whether the UK could conceivable have higher public spending is to look at how we compare to other countries. The chart below (based on OECD data) compares public spending as a share of GDP with GDP per capita, for all OECD countries where data is available[2].

On both measures, we are roughly in the middle. GDP per capita in the UK is about the same as Japan, France and Finland, higher than Spain and Italy, and a fair bit lower than most other Western European countries. Public spending (as a share of GDP) is lower than in most Western European Countries, but higher than Japan, Australia or the US.

It is also fairly clear that, as far as this dataset goes, there is no relationship between the two variables. Sweden, Austria and Denmark have much higher public spending than the UK, but this doesn’t stop them having much higher economic output. On the other hand, Australia and the US manage higher economic output with lower public spending. It seems that (within the range of this chart) pretty much any combination is possible. Of course, this doesn’t prove that higher taxes wouldn’t be bad for the UK economy. Perhaps our economy is so fragile that it would be crippled by any tax rises. But if you are going to argue this you are going to have to convince me that it is impossible for us to achieve what much of the rest of Western Europe can.

The political question is more difficult to analyse. Yes, other countries have larger public sectors, but they also have different political cultures. Perhaps the British are fundamentally different to our European neighbours and would simply not stand for the tax rises that are required to finance better health care and pay rises for nurses. Perhaps we are and will always remain a low tax country.

I don’t have a strong opinion on the optimal size of government, but I do wish we could have an honest debate about it. When someone says “we can’t afford it”, we need to be clear that this is nonsense. What they are really saying is that they do not think that we should raise the taxes required to pay for it. This is a debate that we need to have, but saying “we can’t afford it” is not the way to go about it.

The phrase “magic money tree” is even worse: it is designed to ridicule the suggestion that public spending should be increased. A nurse asking for a pay rise is as stupid as someone who believes that money grows on magical trees. Repeating this phrase whenever anyone suggests spending public money on something is not only nonsensical but frankly offensive.

 


[1] This statement is not the main point of this post and I don’t want to hear from any macro-economists about the inflationary effects of magic money trees.

[2] Excluding Ireland and Luxembourg, whose results are heavily distorted by their role as tax havens.

The UK does not spend a disproportionate amount on benefits

OK, I know I’m a bit late to this party, but even by the standards of government publications, this paragraph from George Osborne’s recent Summer Budget (section 3.4) is a stinker:

However, despite progress during the last Parliament there is still more to do. Taxpayers are still being asked to pay for welfare expenditure that remains disproportionately high. 7% of global expenditure on social protection is spent in the UK, despite the fact that the UK produces 4% of global GDP and has only 1% of the world’s population. As chart 1.14 shows, spending on working-age welfare has increased significantly in real terms over the last few decades. Too many families continue to be trapped on benefits. The Budget sets out the next stage of welfare reform, delivering on the government’s commitment to save £12 billion from the working age welfare bill.

I’m not sure where these figures came from, but there are very plausible. It would in fact be surprising if the UK did not spend a “disproportionate” amount on social protection (broadly speaking, public pensions, social care and benefits) when compared to the whole world. Many people living in developing countries are in desperate need of social protection, either because they are too ill to work, there are no jobs available, or for any number of other reasons. But they don’t have access to it. The governments of these countries may be corrupt and not care about the needs of large proportions of the population, or they may simply lack the infrastructure needed to collect enough taxes to provide meaningful social protection. Western countries are much richer than the world as a whole and have much stronger institutions, so they are able to spend more than the global average on social protection. This is a good thing.

So it is a nonsense to compare the UK to the global average. This is the wrong comparator group and sets a laughably low ambition for what a government can do to enhance the welfare of its citizens. It makes more sense to compare the UK to other OECD countries.

Spending on social protection as a % of GDP in OECD countries

The figures look rather as you would expect. The UK spends a smaller share of its wealth on social protection than almost all other rich European countries. If we are spending a disproportionate amount on this, spare a thought for the poor French! The Summer Budget figures imply that they account for 11% of global social protection spending and only 4% of global GDP.

There is one country that clearly bucks this trend. The US is a very rich country (GDP per capita is nearly 50% higher than in the UK) but it spends relatively little on social protection. However, while the US is a great country that UK would do well to emulate in many areas, it is not a leading light in the field of social protection. To take a random example, women in the US get precisely zero paid maternity leave.

To summarise: the UK does not spend a disproportionate amount on social protection. In fact, we spend less than most comparable countries in Europe. Nonetheless, the US shows that it’s possible to spend a smaller proportion of GDP on these things, but we might have to become 50% richer and cancel maternity leave to achieve it.

Reasonable arguments can be made for reforming parts of our benefits system, but this is one of the weakest and most disingenuous I have seen. While it is careful to stop short of telling an outright, falsifiable lie, its purpose is clear: it is seeking to mislead the reader. Although it removes the risk of that gotcha moment when a full-blown lie is exposed, seeking to mislead is morally equivalent to lying and politicians should be called out for it more often.

The other referendum and the future of local democracy

So farewell then, Eric Pickles, one of the surprise casualties of the post-election cabinet reshuffle. His time in charge of the Department for Communities and Local Government (DCLG) was characterised by a combative approach towards local authorities, and nowhere is this more evident than in the squeeze that he put on their finances. So there was a certain irony in the fact that only a day before he was relieved of his duties he scored a significant victory in his battle with councils when the people of Bedfordshire voted against increasing council tax to pay for extra police officers.

To understand the significance of this, we need to back up a little and get our heads around how local government finance works in England. It’s a horrendously complicated system, so we’ll save the full story for another time, but here’s the short version.

Councils get some of their funding from council tax. They set the level of this tax, collect it from residents and spend it locally. This accounts for about 40% of their funding. Councils also collect business rates from commercial properties in their area, but they don’t set the level of this tax and they don’t get to keep the money, which goes instead to the Treasury [i]. The rest of their funding comes from central government in an ever-shifting range of grants, mostly paid by DCLG.

Over the last parliament, these grants were cut back severely. The IFS estimates that between 2009-10 and 2014-15, central government grants to local authorities were reduced by 36.3%. That means that the 60% of council funding that comes from central government fell by more than a third [ii]. In times past, councils could have raised council tax to offset these cuts. Of course, there were limits to this, since they would have to answer to their voters at the next local elections. That’s how local democracy works. Or rather, that’s how it used to work.

You see, Eric Pickles was determined that councils wouldn’t be able to raise council tax to compensate for his department’s cuts. Right or wrongly [iii], he viewed councils as wasteful, overly bureaucratic and in need of a bit of fiscal discipline. To make sure that this discipline was not undermined by council tax rises, he decided to neuter councils’ revenue-raising powers with a combination of carrot and stick.

The carrot was the council tax freeze grant. Councils that agreed to freeze council tax in nominal terms (i.e. a real terms cut) would receive a grant from DCLG to compensate them for some of the cost of doing this [iv]. The stick came in the form of council tax referendums. Any council that wanted to raise council tax by 2% or more (in nominal terms, so usually that would only just keep pace with inflation) is now legally required to hold a referendum. Pickles was presumably calculating that such a referendum – where a council asks its population whether they want taxes to rise – would be difficult to win. Voters understandably favour lower taxes and better public services, which is why politicians often pretend that they can deliver that heady combination by “eliminating waste”, “reducing bureaucracy” or even “cracking down on tax avoidance”. Few politicians dare to go to the polls on a platform of raising taxes, even if they know they will have to do so once they are in office.

Councils seem to agree with this calculation, since despite huge cuts to their budgets and pressures to deliver better social care and collect bins more often, not one council has triggered a referendum by trying to raise council tax by 2% or more [v] – until now.

All of which brings us, finally, back to this week’s referendum result from Bedfordshire. The referendum was triggered because Bedfordshire’s Police and Crime Commissioner Olly Martins wanted to raise £4.5 million to put an extra 100 police officers on the streets. This would have meant increasing the police’s council tax precept (not council tax as a whole, just the police bit of it) by 15.85%. When asked whether they wanted council tax to rise, the people of Bedfordshire said no. Naturally, they preferred for the extra police officers to be funded by eliminating waste, reducing bureaucracy and cracking down on (council) tax avoidance.

There may be other reasons why this rise was voted down. Kelvin Hopkins, MP for Luton North, blamed it on the wording of the ballot paper, which is set by DCLG. The ballot paper asked people about a 15.85% rise, but Mr. Hopkins thinks that “if it had said ‘would you be prepared to pay 18p a week extra for 100 extra police officers’ people might have said yes”. Whether or not that’s true, any other council that braves a referendum will face the same wording restrictions and the result in Bedfordshire will make them even less confident of victory. In effect, councils can no longer make decisions on levels of taxation and expenditure, reducing them to managers administering the budgets allocated to them by Whitehall.

This curtailing of council power seems perverse when viewed alongside this week’s third notable piece of local government news. In a speech on Thursday, the Chancellor outlined plans for greater devolution to cities that are willing to elect a mayor, starting with Manchester. This “radical devolution” will give local government the “levers to grow their economy”, including transport, planning, housing, policing and public health, but no new revenue-raising powers.

So even under these plans, while councils will be given additional managerial responsibilities, they will remain at the mercy of central government for their funding. As Mr. Pickles’ time in office demonstrates, central government can and will use this as a stick to beat them with. Devolution should be about a transfer of power (actual power that is, not just “powers”) from central government to the local level, but Whitehall is offering to give up precious little power here. Local government will remain relatively unimportant, and since voters recognise this, local democracy will remain weak and participation levels low.

The experience of other countries shows that it doesn’t have to be like this. US states have significant revenue-raising powers, although since the country is much larger than ours this may not be a fair comparison. European examples may be more relevant. In Germany, the sixteen Länder have significant powers; and Swedish municipalities – the lowest level of government – set and collect taxes on income.

Council tax is a poorly-designed and regressive tax that badly needs reforming (for example, it could be replaced with a progressive levy on property values). But control of a reformed council tax should be handed back to councils, without forcing them to undergo unwinnable referendums just to keep pace with inflation. Local governments should be elected for a period then allowed to do their jobs until they face the voters again at the next election – just like central government is. Along with devolution measures of the sort proposed by the Chancellor, this would help to create stronger local democracy that people actually care about and which makes a real difference to their lives.


Notes

[i]
DCLG recently introduced a “business rates retention” scheme, which allows councils that increase their business rates take (by having more businesses in their area) to keep a bit of the money. But since the Treasury still controls the overall level of non-council tax money going to councils, this amounts to a zero sum game between different authorities. If you grow your business rates, but everyone else grows them by more, you actually lose money. Perhaps more on this another time, but for now it’s enough to note that this hardly counts as a revenue raising power.

[ii]
In fact, this proportion varies across the country. Councils that have a small council tax base (relative to their assessed funding need) get more than 60% of their revenue in central government grants. These councils (which tend to be in more deprived areas) feel the effects of grant reductions much more sharply. The IFS estimates that between 2009-10 and 2014-15, council spending per person fell by an average of 23.4% in real terms; but spending in Westminster fell by 46.3%, while spending in North East Lincolnshire fell by just 6.2%. This system is frankly nuts and in dire need of reform. Perhaps more on this another time.

[iii]
As always with local government issues, the answer is probably that some councils are wasteful and others are efficient. It is worth noting however, that central government has no way of identifying the wasteful councils, let alone targeting spending cuts on them.

[iv]
It seems to me that councils would be mad to take up this offer, since the grant is not recurring but the losses from freezing council tax are (unless they are willing to brave a council tax referendum to play catch-up). But in fact, a majority of councils took this offer up, at least in the early years.

[v]
A number of councils raised council tax by 1.99%, the maximum that would not trigger a referendum and just about keeping pace with inflation. Pickles branded these councils “democracy dodgers”. This tells us a couple of things about Pickles’ view of democracy. First, he is implying that traditional local democracy, where councils are elected and are accountable for their actions (and which mirrors national democracy), is not real democracy. Second, he is saying that voters should be consulted when council tax is raised, but not when it is cut. In fact, he is saying that voters should be consulted if council tax is raised in line with inflation – i.e. if it stays the same in real terms – but not if it is cut.

How to draw public finances

Here’s a chart from the OBR that I really don’t like:

Total public sector spending and receipts (OBR)

The OBR's chart showing UK government spending and receipts

I don’t mean to attack the OBR here, which I think generally does decent work. I’ve seen this sort of chart reproduced by all sorts of otherwise reputable people. But it is horribly misleading. It’s not that there is anything wrong in the chart. It’s just that the way it’s constructed and the patterns that jump out at you feed a narrative that is both wrong and pervasive.

Try looking at the chart without reading any of the text. What do you see? A blue line and a yellow line that jump around a lot but sort of follow each other; and two points where the blue line shoots up. And what’s that blue thing that shoots up? Public spending.

Except public spending didn’t actually shoot up. These two points are the biggest recessions in modern history, and while recessions do lead to increased spending thanks to automatic stabilisers, they mainly lead to lower GDP. That’s kind of the definition of a recession.

The chart shows the ratios of spending and receipts to GDP. In many situations this is the best way to think about spending and receipts, but in this case it leads to a visual representation of the right data that tells the wrong story. The blue line shoots up even though spending doesn’t; and the yellow line stays the same even though tax receipts have collapsed.

This may sound obvious and, of course, the people who make these charts know all of this. But when the government and large sections of the media are pushing a narrative that public sector spending was and is out of control, communicating the facts clearly is important.

So how could we do this better? Something along these lines would be a good start:

UK public finances and GDP

A better way to draw the UK's public finances

This chart shows spending, receipts and GDP in real terms (13/14 prices), as well as total public debt as a share of GDP[i]. This shows three important things about the recent financial crisis that we can’t easily get from the OBR chart.

  1. Although spending rose a bit relative to trend when the financial crisis hit, the much more pronounced effect was that receipts collapsed. This was a more important cause of the deficit.
  2. The reason for the collapse in receipts was a collapse in GDP. Receipts broadly follow GDP, since government policy pretty much directly sets what proportion of total output is collected in taxes. Spending policy (at least in the short term) is set in pounds, so it doesn’t follow GDP as closely.
  3. Public debt was a lower proportion of GDP on the eve of the financial crisis than it was a decade earlier when Labour came to power.

This stuff is all pretty basic, but this narrative is largely missing from the mainstream media and instead confined to economics blogs. Maybe this is because of media bias or ignorance. But maybe it’s also partly because we aren’t doing a good enough job of presenting the data that we have.

[i] As I said, it’s usually a good thing to think about public finances as a share of GDP, except when it’s not.