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Time for a Radical Budget

March 19, 2012

“Maybe something will turn up.”

One of the classic stratagems of last resort in politics – and indeed for life in general.

I suspect Chancellor George Osborne’s tactical handling of the UK economy owes rather more than he might willingly admit to the Mr Micawber principle. After all, waiting for something to turn up is not always the ill-advised course of action. The accretion of time often does alleviate, and sometimes even solves, what seems an intractably difficult situation.

The fragile state of our domestic economy at the time of the 2010 General Election and the indeterminate election result meant that a mandate to take radical action on the economy was neither sought nor won by any political party. So in stark contrast to the first Thatcher government which front-loaded the economic pain, Osborne – whilst espousing a tough austerity message – has adopted a more pragmatic, steady-as-she-goes path.

His intention now, I have no doubt, is to maximise the coalition’s chances of re-election in May 2015 even if this results in the delay of essential longer-term structural reform. Equally it would be unfair not to recognise that the difficulties of coalition-building and maintenance, events in the Eurozone and the sheer weakness of the UK economy also persuade against a short sharp economic shock.

Nevertheless, the inability of the coalition to formulate a consistent programme for economic growth is having a chilling effect on our nation’s prospects. There is an overriding sense of progress every time the Chancellor declares the UK “open for business” when in Asia, South America or sub-Saharan Africa. Yet persistent talk of tycoon or mansion taxes, executive pay clampdowns and enhancement of employee rights, and the continued regulatory burden on SMEs, all proceed to run counter to this positive, global message.
So what should this budget herald? Let’s get one thing straight – there is zero veracity in Labour’s proposition that the government has cut “too far and too fast”. In the past twelve months UK government current spending has totalled £613.5bn – the highest figure in history. Borrowing this year will be at least £120bn, even if a little shy of what was predicted at the Autumn Statement.

However, over half of the deficit reduction plan was predicated on annual compound growth through this parliament of 2.7 to 2.9%. It is clear that for the first half of this parliament we shall struggle to achieve growth at one-third of this level – which is why we ought to view with suspicion likely forecasts that miraculously suggest growth of over 3% in 2014 and 2015.

Rather than responding to this deteriorating situation by imposing more savings, Mr Osborne has taken the path of ever more debt courtesy of the Bank of England’s Quantitative Easing Programme. The real purpose and impact of the UK central bank’s intervention has not been to ease the path for investment borrowing by small business. Instead it has mopped up a substantial proportion of the gilts being issued. This of course is where Mr Micawber comes into play – the actions of the Bank of England will not be sustainable in the longer term without a real risk of inflation. I suspect global conditions in the years ahead will make it less easy to finance deficits of this size. Which is why, in truth, we should urgently and aggressively be reducing public expenditure further.

In view of the stalling of both health and welfare reform programmes, however, I fear it will prove incredibly difficult to find the political will to execute even the planned level of spending cuts. The expansion of the European welfare model has for years served to make our continent less economically competitive. Unfortunately the solution is one the government and the public still cannot face – to start with a blank sheet and ask ourselves what we need instead of salami slicing against what we want.

It is for this reason that, to date, the fiscal constriction has owed far less to spending cuts than to tax increases, which have squeezed disposable incomes and consumption. However in spite of protestations from many of my Conservative colleagues, it is by no means clear that tax cuts would boost demand a great deal in the current economic environment. A fiscal giveaway today would in all likelihood be saved by most Britons. Once any economy is as over-leveraged as ours, demand is inevitably impaired. As such, tax cuts now make little economic sense if aggregate demand cannot be boosted.

Yet the process of deleveraging – within the public sector, banks and households – has barely begun. The irony is that of those three, the area boasting most progress – the financial sector – is the one in which deleveraging causes most damage to the economy as a whole. Banks’ aggressive strategies in this regard have dried up traditional lines of credit for enterprise and consumption. Yet even here the near zero interest policy of the past three years has enabled too much toxic property debt to remain on balance sheets rather than losses being crystallised and a sustainable recovery being allowed to commence.

Taking all these factors into account, I firmly believe that the Budget’s focus must now urgently rest upon a radical supply side reform in both the tax system and employment legislation.

It seems a long time ago, but when in Opposition the now Chancellor implored an overhaul of the UK economic model. His big idea then was to incentivise investment over consumption and equity rather than debt (let’s not ask savers how they feel right now as rates remain stubbornly below inflation). What this requires in the current environment is forensic attention being paid to the impact of high marginal rates of income tax and the disincentives that have crept into the system as a result of both the poverty trap for the low paid and the removal of some relief for higher rate taxpayers. If the latter process is to be extended to all pension tax relief (which appears the most favoured Liberal Democrat means of soaking “the rich”) we shall move further away from desirable reform.

A more serious potential conflict between the coalition parties is arguably the more urgent supply-side priority – namely legislation over employment rights. Once more the glad, confident morning of June 2010’s Budget has given way to starker reality. At that point the increasingly discredited Office for Budget Responsibility (OBR) predicted that unemployment would peak in tax year 2010-11. We now know that unemployment is likely to rise further in the next two years and remain stubbornly high for the foreseeable future. And still the UK continues to gold plate continental employment legislation and grant ever more generous paternity and maternity rights. Precious wonder that employers are reluctant to take on more staff.

It is instructive to witness how the US has shown signs of turning the economic corner. In simple terms it is easier to hire and fire staff there, which allows flexibility and supports rapid readjustment economically, especially as a recovery phase commences. Closer to home, Germany’s micro-businesses (i.e. those start-ups employing ten or fewer) are largely exempt from employment legislation. This type of enterprise is the engine for job opportunities, especially in innovative sectors employing the school and university leavers who have had such a raw deal. If we are really serious about getting people back to work we in the UK need to allow business to take on and let go of staff more readily. Alas I see only strife amidst coalition players if this is to be rectified, although surely the rights of the unemployed to get back into the workplace should now take precedence over the generous protections enjoyed by those with jobs.

Nevertheless, if the government insists on eschewing regulatory reform, how about we allow SMEs to take on any extra employees over the next two tax years without paying National Insurance? This might help stimulate growth without costing the Treasury too much. In fact better still an NI holiday might even be extended to all employees aged under 25. Let’s not forget that the UK’s SMEs account for over 13 million jobs in Britain and by most calculation two-thirds of all new employment creation.

I should also like to see the government think strategically about how we can promote, via the tax system, the sectors of our economy that actually have potential future growth. Lip service is paid to boosting traditional manufacturing, where we face enormously fierce competition. But what is our strategy when it comes to areas in which we continue to maintain a distinct reputation and competitive advantage such as the export of intellectual property?

The real weakness we need to rectify is the lack of domestic demand and an inability to appreciate that much of the growth in the last decade was illusory…little more than debt-fuelled borrowing in property, the public sector and financial services, none of which will be drivers of economic expansion anytime soon.

All the traditional macroeconomic levers that governments pull to promote growth have been tried, but all have failed. Interest rates have been near zero for three years, we have had fulsome benefit from being outside the Eurozone, the stimulus of QE and a 25% devaluation of sterling. We now need to look at microeconomic reforms.

If the UK can continue to convince the markets we have a serious deficit reduction plan (and a reliable tax base to pay back the ongoing debts in future) a slight relaxation to boost growth by selectively cutting taxes may do the trick. The legislative and regulatory burden on job-creating small and medium sized enterprises needs urgent reform. My overriding fear is that the Treasury has become complacent about the continued stagnation especially as the political polling figures seem so benign. Paradoxically if we were now 10 or 15 points behind Labour in the polls we might be more inclined to take the radical action I have proposed. Now is surely not the time to “wait and see” how things turn out.