Implementing the unthinkable Fiscal policy and the crisis

Implementing the unthinkable: Fiscal policy and the crisis Robert Chote DEE Conference, Cardiff, 10 September 2009 © Institute for Fiscal Studies

Outline • The IFS and our experience with graduate economists • Three policy issues raised by the crisis – The evolution of the public finances – The temporary VAT cut – The 50 p income tax rate © Institute for Fiscal Studies

The IFS and our use of economists • Independent research institute: not linked to a university but with similar funders (e. g. ESRC, charitable foundations) • We hire c. 3 graduate economists a year from 200/300 applications • We aim to combine world-class academic work with policy analysis of use/relevance for government, civil society and media • Combination of analytical and quantitative skills with ability to write and explain for non-technical audiences © Institute for Fiscal Studies

Some unscientific feedback • People don’t want to do more econometrics while at college, but wish they had done more when they leave • More emphasis on practical econometrics and computer skills (introductions to STATA and MATLAB) would be helpful • Balance between quantitative and written/oral skills hard to achieve – we find wide variation in people’s ability to write well • Students hard to motivate in areas where work is complex (!) and lack of consensus around what we know and what we don’t © Institute for Fiscal Studies

The evolution of the public finances • Green Budget – 2009: www. ifs. org. uk/publications/4417 – 2010: Wednesday February 3 rd • Britain’s fiscal squeeze: the choices ahead – Briefing note due for publication on September 16 – www. ifs. org. uk/ • Response to the Pre-Budget Report – Later this year; date as yet unfixed © Institute for Fiscal Studies

The problem: more borrowing, mostly structural Public sector net borrowing in Budget 2009, excluding PBR and Budget policy measures Sources: HM Treasury; IFS calculations; figures may not add due to rounding. © Institute for Fiscal Studies

Why has the structural deficit risen so much? • Long-term productive potential of economy assumed 5% lower – Increases structural deficit by roughly 3. 5% of GDP (£ 50+ billion) • Long-term whole economy price level lower – Reduces tax revenues in cash terms, but has less impact on spending • Falls in long-term level of house prices and share prices • Long-term fall in financial sector profitability • Tax gap assumption locks in losses from higher VAT debts © Institute for Fiscal Studies

Debt set to explode without fiscal tightening © Institute for Fiscal Studies Note: Excludes unrealised losses on financial interventions. Sources: HM Treasury; IFS calculations.

The goals of the policy response • Support economic activity in the short-term – Impaired monetary policy strengthens case for fiscal stimulus – International action makes leakages less of a concern – Much debate on multipliers: what is the counter-factual? – Robert Lucas: “I guess everyone is a Keynesian in the foxhole. ” • Return government debt to sustainable path in long-term – Big budget deficits current cheap to finance – But sharp rise in rates would exacerbate economic and fiscal problems – Concerns: gilts auctions, rating agencies, Asian-style contagion • Key choices: size, timing, speed and composition © Institute for Fiscal Studies

The response: giveaway followed by takeaway © Institute for Fiscal Studies Sources: HM Treasury; IFS calculations.

Policy measures limit debt rise to a generation © Institute for Fiscal Studies Note: Excludes unrealised losses on financial interventions. Sources: HM Treasury; IFS calculations.

The stimulus • UK stimulus small and short-duration by international standards • Didn’t realise depth of recession in PBR; Mervyn King ‘blocked’ more in Budget • Only G 20 country bar Argentina not to have stimulus still in place in 2010 • But increase in borrowing between 2007 to 2010 biggest in G 20 bar Russia • Do we risk moving from stimulus to tightening too soon (risk of 1937)? • Discretionary tightening 2% of GDP in 2010, but cut in borrowing only 0. 5% of GDP as structural and cyclical deficits widen. And what about monetary policy? • Link between size of stimulus and credibility of tightening? © Institute for Fiscal Studies

The tightening • Rising to 8% of GDP over 8 years from 2009– 10 • Too quick for recovery or too slow to reassure markets? • No clear guide to when debt path too risky. Sustainability fundamentally a political rather than an economic question • Opposition parties might wish to get tightening over in a single term if economy up to it – easier to blame their inheritance • Pace of tightening will help determine composition © Institute for Fiscal Studies

Two parliaments of pain © Institute for Fiscal Studies Sources: HM Treasury; IFS calculations.

Spending Review 2010: 2011– 12 to 2013– 14 • Budget 2009 plans – Current spending: real growth of 0. 7% a year – Investment spending: real cuts of 17. 3% a year • “move to 1¼ per cent of GDP in 2013– 14” in Darling-speak – Total spending: real cuts of 0. 1% a year • Lowest since 1996– 97 to 1999– 00 © Institute for Fiscal Studies

Cutting the shrinking cake in Spending Review • Given plausible assumption on debt interest, social security and other ‘annually managed expenditure’, Budget implies real cut for public services and admin of 2. 3% a year or 6. 7% after 3 years – Equivalent to £ 26 billion a year real cut comparing 2013– 14 to 10– 11 – Sharpest real decline since IMF squeeze in late 1970 s • Parties have things they would like to protect (health, aid, schools, defence), increasing necessary cuts elsewhere • Is this plausible? • More tax increases, especially if tightening accelerated?

The temporary VAT cut • Symposium in Fiscal Studies July 2009 – http: //www 3. interscience. wiley. com/journal/117977097/home • Green Budget 2010 © Institute for Fiscal Studies

The policy. . . • Standard rate of VAT cut from 17. 5% to 15% from Dec 1 st 2008 to Dec 31 st 2009 – Government estimates the cost to be £ 12. 4 billion – This is about £ 440 per household • Standard rate of VAT applies to about 55% of total consumer expenditure • If fully (or near fully) passed on, average consumer prices would fall by about 1. 2% © Institute for Fiscal Studies

… is not getting rave reviews… “The VAT cut has been an unbelievable and expensive failure. This government, that lectured us about prudence, has spent £ 12. 5 bn of our money, and wasted it. ” (David Cameron, Conservative leader) “Temporarily cutting VAT, a measure that was adopted in Great Britain, does not seem to me to be a good idea – 2% less is not perceived by consumers as a real incentive to spend. ” (Olivier Blanchard, IMF chief economist) © Institute for Fiscal Studies

… but you can take a more positive view • Temporary VAT cut has, potentially, two impacts: – Income effect – lower prices mean with unchanged purchasing patterns you have more money left in your pocket – Substitution effect – lower prices today relative to tomorrow may encourage you to bring forward spending • Changes in relative prices a bit like cut in interest rate (1%+) – Unlike cut in interest rates doesn’t hurt savers • Temporary cut in Income Tax or NI has only an income effect © Institute for Fiscal Studies

How will people respond? Unconstrained consumers • If not subject to credit constraints substitution effect is key – Income effect small as base spending on lifetime ability-to spend – But prices are 1. 2% lower in 2009 than 2010 and thereafter • Studies: 1. 2% fall in prices this year relative to next boosts purchases by 0. 6 -1. 2%. We think towards top end: – VAT is largely payable on ‘luxuries’ – VAT is focussed more on ‘durable goods’ (e. g. TVs, fridges) • Purchase 1. 2% more things 1. 2% more cheaply leaving amount they spend unchanged © Institute for Fiscal Studies

How will people respond? Credit-constrained consumers • For those subject to credit constraints the substitution effect cannot operate – only an income effect – The 1. 2% fall in prices means their money goes 1. 2% further – As they would like to consume more they spend these savings • Normally few people constrained – more important group now? • Luckily response of similar magnitude © Institute for Fiscal Studies

Overall impact of VAT cut • If there is full (or close to full) pass through expect people to purchase 1. 2% more things 1. 2% more cheaply • As less of this (unchanged) expenditure is paid in VAT, retailers keep more of it • Suppose pass through actually only 2/3: – Prices fall by 0. 8% and purchases increase by 0. 8% – £ 4. 1 billion retained by firms (bolster margins) • Cannot compare shopper numbers or purchases with last year • Compare purchases now with what they would have been now without the policy © Institute for Fiscal Studies

Could VAT be used for further stimulus? • Original timing designed to boost activity in 2009, even at the cost of weakening it somewhat in 2010. But recession now worse. • If extend the tax cut consumers may believe 15% rate is permanent – But then no incentive to bring consumption forward • Instead increase VAT to 18. 5% from the beginning of 2011? – Makes 2010 purchases cheaper relative to 2011 – People may save now to pay for future tax rise – But credit constrained households can’t respond • So not much room for using VAT as additional stimulus • But VAT remains favourite as future revenue raiser © Institute for Fiscal Studies

The 50 p income tax rate • Briefing note: Can more revenue be raised by increasing income tax rates for the very rich? – http: //www. ifs. org. uk/publications/4486 • Mirrlees Review chapter – http: //www. ifs. org. uk/mirrleesreview/press_docs/rates. pdf © Institute for Fiscal Studies

Income tax changes over the past year • PBR 2008 – Personal allowance to be withdrawn in two c. £ 6. 5 k bands (above £ 100 k and £ 140 k), giving 60% marginal rates and raising £ 1. 2 bn – Tax rate above £ 150 k to be 45% in 2010– 11, raising £ 1. 6 bn • Budget 2009 – Personal allowance to be withdrawn in one c. £ 13 k band (above £ 100 k) , raising £ 180 m more than the PBR proposal – Tax rate above £ 150 k to be 50% from 2010 -11, raising £ 800 m more than the PBR proposal – Tax relief on pension contributions to be reduced gradually from 50% at £ 150 k to 20% above £ 180 k, raising £ 3. 1 bn © Institute for Fiscal Studies

Income tax schedule, 2011 -12 © Institute for Fiscal Studies

Income tax relief on pension contributions, 2011 © Institute for Fiscal Studies

Overall revenue impact • Total income tax and pension package to raise £ 7 bn a year • From relatively few, relatively well-off people – Roughly 2% of adults (750 k) have incomes above £ 100 k – Roughly 1% of adults (350 k) have incomes above £ 150 k • Part of larger tax package affecting more people

How much will the 50% rate raise? • HM Treasury says £ 2. 4 bn • But huge uncertainty about how much people will reduce their taxable income in response – Work less, retire earlier, emigrate, contribute more to pension or charity, convert income to capital gains, incorporate, invest in tax avoidance, … – This is vital for the effect on revenues – Government’s assumption not unreasonable • £ 2. 4 bn also ignores any effect on consumer spending – Even if HMT are right about responsiveness of income, indirect tax revenues could fall by up to £ 1. 5 billion – May show up elsewhere in revenue forecasts, but what use is direct costing? • This reform alone could actually cost money – But cutting tax relief on pension contributions makes 50% rate harder to avoid © Institute for Fiscal Studies

Assessing the impact • Brewer, Saez and Shepherd try to estimate taxable income elasticity of top 1% (i. e. by how much their taxable income falls when the effective marginal tax rate rises) • Look at how the income share of the top 1% changed in response to changes to top marginal tax rates in the 1980 s, compared to income share of next richest 4% who were less affected by them • Very uncertain. Much has changed that may affect behavioural response in both directions (e. g. ease of avoidance, pension tax relief changes in the Budget). May also confuse response to policy with underlying factors increasing income inequality at the top. • Best we have to go on. • BSS get slightly bigger behavioural response than HMT. © Institute for Fiscal Studies

Revenue raised by income tax rates above £ 150, 000, excluding effect on indirect

Revenue raised by income tax rates above £ 150, 000, including effect on indirect

Conclusion • Public finances – Problem: Recession and big rise in structural deficit – Is timing of transition from stimulus to tightening sensible? – If we change it, what does that imply for composition? • Temporary VAT cut – Disparaged, but sensible response to problem as perceived in PBR – Need to judge against counterfactual – lots of Ph. Ds in this • 50 p income tax rate – Practical illustration of the Laffer curve – Even if Treasury right, more symbolic than substantive response to the need for revenue? © Institute for Fiscal Studies