THE BUDGET

Mr Clarke's first unified budget is politically highly astute. He has skilfully defused the household fuel VAT row. As we predicted in the October Economic Outlook, he has taken advantage of lower inflation and the public pay freeze to cut public spending with tough curbs on social security. This, together with the absence of measures against the pensions industry, has pleased the markets. But it will prove hard, though not impossible, to hit the new public spending targets beyond next year, particularly if inflation picks up. The further reduction in mortgage tax relief, the modest extension of the tax base, the action on tax avoidance and the introduction of road charges all make good economic sense, though the absence of measures to give the Bank of England more freedom for manoeuvre in monetary policy is disappointing. There is still the risk that the large tax increases on consumers bequeathed by Mr Lamont will slow recovery in 1994, but overall this is a budget that is good for the economy and good for Mr Clarke. It paves the way for further interest rate cuts of ½-1%. In this forecast release we consider the details of the Budget, dissect the Treasury forecast, and consider the plausibility of the spending targets, especially in later years.     

The monetary policy dilemma: Will interest rates have to rise?

UK interest rates are now at their lowest level for more than two decades, and the government is hoping that interest rates can be kept at a low and sustainable level comparable to the 1960s. Indeed, some commentators are calling for still lower interest rates to offset the risk that the £12bn tax increases and cuts in government spending that will come into effect in the next financial year will lead to stagnant consumer spending and a stalled recovery. Against this must be weighed the risk that the recent very good run of inflation figures will prove temporary. Both headline and underlying inflation will be pushed up by indirect tax increases and there is the possibility that wages will follow too, as employees seek to maintain their living standards in a tightening labour market. That risk would point to a much more cautious monetary policy stance and the possibility that the government may need to raise rates from their present level if it is to achieve its inflation objective. The Chancellor faces a clear dilemma. In this Viewpoint, we assess the evidence available to guide him in his decisions and draw out the implications for the future path of interest rates.     

Measuring the effects of fiscal policy

Measuring the effects of discretionary fiscal policy is both difficult and controversial, as some explicit or implicit identifying assumptions need to be made to isolate exogenous and unanticipated changes in taxes and government spending. Studies based on structural vector autoregressions typically achieve identification by restricting the contemporaneous interaction of fiscal and non-fiscal variables in a rather arbitrary way. In this paper, we relax those restrictions and identify fiscal policy shocks by exploiting the conditional heteroscedasticity of the structural disturbances. We use this methodology to evaluate the macroeconomic effects of fiscal policy shocks in the U.S. before and after 1979. Our results show substantive differences in the economy׳s response to government spending and tax shocks across the two periods. Importantly, we find that increases in public spending are, in general, more effective than tax cuts in stimulating economic activity. A key contribution of this study is to provide a formal test of the identifying restrictions commonly used in the literature.     

Indirect taxation with shadow cost of public funds in mixed oligopoly

We adopt a mixed oligopoly model, where a state-owned welfare-maximizing public firm competes with a profit-maximizing private firm, to compare the welfare effects of the specific and ad valorem tax in the presence of the shadow cost of public funds. Following the assumption of most previous literature that total output is constant under specific and ad valorem taxation, we find that, when the shadow cost of public funds exists, the tax policy must be adjusted according to the privatization level of the public firm; if the privatization level is low (medium, high), the government needs to adopt ad valorem (specific, ad valorem) tax. Moreover, the private firm will earn a higher (lower) profit under ad valorem tax than under specific tax, if the public firm is not fully privatized and the shadow cost of public funds is high (low).     

The London Business School with Gower Publishing

The knives are out for the Chancellor whose opinion poll ratings are at a record low level. He is being personally blamed for the Conservatives' poor showing in this month's elections and, according to newspaper reports, is certain to lose his job in a Cabinet reshuffle, probably in the summer. Mr. Lamont has presided over the UK economy over a difficult period - though many of his policies and problems were inherited from his predecessor (Mr. Major) - and arguably he should have resigned last September following the failure of the ERM policy and the huge cost of intervention. Since then Mr. Lamont, probably on the advice of his Treasury officials, has followed a determinedly non-populist approach, notably on public spending last autumn, interest rate cuts earlier in the year and tax increases in the Budget. But, as economic recovery becomes better established, and the focus turns to the structural problems of the British economy, it is evident that some very tough choices will have to be made. Over the medium term the balance of payments and public sector deficits are going to have to be tackled which means devoting resources in the first place to exports and investment, not to consumption. This means no more interest rate cuts, higher taxes and public spending cuts, which Mr. Lamont has already shown he is willing to implement, and requires a Chancellor who is able to stand up to the more populist and erratic approach of the Prime Minister. The danger would be that a new Chancellor, seeking to court popularity in a way that Mr. Lamont has not, opts for the easy alternative in the short run - to the longer-term detriment of the economy. Almost by definition, certainly in the absence of either an independent Bank of England or an external exchange rate constraint, only the Treasury can take the tough line and so the Chancellor has to be unpopular - Nigel Lawson's best received Budget, that of 1988, is now universally damned. Mr. Lamont may be about to be buried but he should be praised for taking the non-populist line.     

Implications of productive government spending for fiscal policy

The standard assumption in macroeconomics that government spending is unproductive can have substantive implications for tax and spending policy. Productive government spending introduces a positive feedback between the tax rate, the productive capacity of the economy, and tax revenue. We allow marginal tax revenue to be optimally allocated between productive subsidies to human capital and utility-enhancing government consumption and calculate Laffer Curves for the US. Productive government spending yields higher revenue-maximizing tax rates, steeper slopes at low tax rates and higher peaks. The differences are particularly pronounced for the labor-tax Laffer curve. The use of tax revenue is an important determinant of the actual revenue that a tax rate increase generates.     

The London Business School with Gower Publishing

In the last month there have been three major items of economic news. First there was Mr Healey's package of 26 October; then there was the announcement on 31 October that the Government's exchange rate policy would change; finally on 1 November there was the news that the miners had rejected the National Coal Board's pay offer. In terms of our view of the outlook for the longer-term development of the economy, the most significant change is the move to free the pound. The effects of Mr Healey's package upon total output are to leave 1977–78 much where it would have been had the Treasury's original public expenditure plans been realised; the shortfall in spending has been made up by tax reductions and, in turn, consumer spending increases.     

Policy uncertainty and aggregate fluctuations

This paper estimates the impact on the US economy of four types of uncertainty about (i) government spending, (ii) tax changes, (iii) public debt, and (iv) monetary policy. Uncertainty about government debt has a large and persistent effect on output, consumption, investment, consumer confidence, and business confidence. Uncertainty about tax changes also has detrimental consequences for real activity but the effect of spending and monetary policy uncertainty appears to be small. About 25% of output fluctuations are accounted for by policy uncertainty, with government debt making the largest contribution at longer horizons.     

Forecast in detail

Recent months have seen a significant shift in the UK fiscal backdrop. Statistical changes have caused a significant upward revision to the level of borrowing last year, while muted growth in tax receipts and faster‐than‐expected rises in public spending have pushed up the deficit in 2019–20 to date. Moreover, the political climate has shifted against austerity, with both Conservative and Labour party pledges implying a rising deficit for the foreseeable future.     

Monetary and fiscal policy under deep habits

Allowing habits to be formed at the level of individual goods – deep habits - can radically alter the fiscal policy transmission mechanism as the counter-cyclicality of mark-ups this implies can result in government spending crowding-in rather than crowding-out private consumption in the short run. We explore the robustness of this mechanism to the existence of price discrimination in the supply of goods to the public and private sectors. We then describe optimal monetary and fiscal policy in our New Keynesian economy subject to the additional externality of deep habits and explore the ability of simple policy rules to mimic fully optimal policy. We find that the presence of deep habits at empirically estimated levels can imply large externalities that significantly affect the conduct of monetary and tax policy. However, despite the rise in government spending multipliers implied by deep habits, government spending is barely used as a stabilisation tool under the optimal policy.     

How economic integration affects the vertical structure of the public sector

This paper investigates the impact of economic integration on the vertical structure of the public sector within a country. To tackle this issue we set up a model of fiscal federalism, where economic integration is assumed to affect central government tax revenues. The main findings are that when an increase of the impact of economic integration brings about a reduction in central government tax revenues, under certain conditions: (a) it reduces central government expenditure; (b) it reduces general government expenditure; (c) it increases local taxation; (d) it increases the degree of public sector decentralization. Quite interestingly, these results are consistent with different patterns of local public spending and grants to local government.     

Environmental taxes in a differentiated mixed duopoly

Beladi and Chao (2006) and Bárcena-Ruiz and Garzón (2006) considered the role of environmental policy on the decision whether to privatize a public firm in different market structures. This paper re-examines whether privatization improves (or deteriorates) the environment in a mixed duopolistic framework with differentiated product and pollution abatement. It is shown that, due to privatization, less attention is paid to pollution abatement by all the firms coupled with less environment taxes levied by the government in a differentiated duopoly, and the environment is more (less) damaged when the product is less (more) substitutable. When the product is highly substitutable, industry profits increase because this softens the intensity of the product market, but social welfare deteriorates accompanied with the path of privatization because the loss of consumer surplus and tax revenue exceeds the increases in profits, even if the environment is less damaged.     

Summer Budget: calculated risk or reckless gamble?

• The Chancellor had created the expectation that his Summer Budget would be radical and he did not disappoint. The ‘rabbit from the hat’ was a compulsory ‘living wage’, expected to reach £9 per hour in 2020, which Mr Osborne hopes will help to compensate the lower paid for the slashing of in‐work benefits. This has effectively transferred responsibility for supporting low‐income households from the government to employers. The OBR expects this to have a relatively muted impact on employment, but this view looks pretty optimistic and the policy represents a major gamble.
• The reduction in welfare spending, plus an easing of the near‐term fiscal squeeze, has helped to smooth the public spending ‘rollercoaster’. But with a plethora of giveaways failing to disguise a net increase in the tax burden, the Budget is likely to weigh on growth prospects, even if the Chancellor's big gamble pays off.
• Alongside the Budget the Chancellor announced a new fiscal mandate, which will require governments to run a budget surplus in “normal times”. But meeting this mandate will require a fiscal stance very far from the historical norm and it will also force other sectors to move into deficit to compensate. It will also mean a looser monetary policy than would otherwise be the case. So a policy presented as creating room for fiscal policy to respond to future economic shocks could potentially narrow the scope for the more potent weapon of interest rate cuts.

     

Fiscal news and macroeconomic volatility

This paper analyzes the contribution of anticipated capital and labor tax shocks to business cycle volatility in an estimated New Keynesian business cycle model. While fiscal policy accounts for about 15% of output variance at business cycle frequencies, this mostly derives from anticipated government spending shocks. Tax shocks, both anticipated and unanticipated, contribute little to the fluctuations of real variables. However, anticipated capital tax shocks do explain a sizable part of inflation fluctuations, accounting for up to 12% of its variance. In line with earlier studies, news shocks in total account for about 50% of output variance. Further decomposing this news effect, we find permanent total factor productivity news shocks to be most important. When looking at the federal level instead of total government, the importance of anticipated tax and spending shocks significantly increases, suggesting that fiscal policy at the subnational level typically counteracts the effects of federal fiscal policy shocks.     

EDITORIAL: TAX REFORM AND SIMPLIFICATION

Major tax reform to simplify the UK tax system is possible. Merging income taxes, social security taxes and corporation tax into only a single flat-rate of tax on all incomes would be a radical start. Avoiding taxes on income and expenditure which are 'too high' requires major reductions in government spending, mainly on the welfare state. Given the political will, over a period of years we really can hugely improve the UK tax system.     

Democratic transition and fiscal policy in the Arab world

This paper investigates the relationship between democracy and public debt in the Arab world over the period 2002–2013. The results show strong evidence of an inverted U-shaped relationship between democracy and public debt. This means that democratization is associated with lower debt only when a certain level of democracy is reached. In an attempt to explain these findings, we assume that the effect of democracy on public debt operates mainly through its impact on government spending and government revenue. Our results show that the inverted U-shaped relationship between democracy and public debt stems from the inverted U-shaped democracy-government spending path and the U-shaped democracy-government revenue pattern. This implies that, at the earlier stages of democratization, democracy is associated with an increase in government spending and a decrease in government revenue, which stimulates public debt. However, beyond a certain level of democracy, further democratization reduces government spending and enhances government revenue, leading to lower levels of public debt. Hence, achieving some level of democracy is a key prerequisite to improve the effectiveness of public spending, enhance tax compliance, and thereby control public debt.     

The First Unified Budget What Should Mr. Clarke Do?

Mr. Clarke has the distinction of presenting the first Unified Budget, an innovation introduced by his predecessor. He does so against a subdued inflation outlook and a recovery from recession that has been proceeding since the first half of last year. But he is also aware that there are risks to this favourable outlook: European recession may slow growth, and there is the worry that underlying inflation may breach the Government's 4 per cent ceiling. III this Viewpoint, we argue that the Chancellor should go further that his predecessor in curbing public borrowing, aiming for a reduction of sonic £4-5bn; this fiscal contraction could be accompanied by a further 0.5 per cent reduction in interest rates, or more if the recovery shows signs of faltering. A rebalancing of monetary and fiscal policy in this way reduces the risks associated with a high level of public borrowing, can help in reducing the excessive level of consumption (private and public) in the UK economy, and offers the best means of maintaining a competitive exchange rate without inflation. A curious feature of the first Unified Budget is that, having moved tax decisions to the autumn, the Chancellor appears to have ruled out further government spending cuts beyond those agreed by the Cabinet before the summer: with more favourable inflation arid the public sector pay limit, there would seem to be scope for a further reduction in the Control Total. On the revenue side, the Chancellor should seek to raise revenues in such a way that does not adversely affect incentives. Here he has several options: to extend the VAT net; to eliminate income tax allowances or reduce them to the 20p rate of tax; or to introduce new user charges. There is also the opportunity, one year on from the UK's exit from the ERM, to restate the basis for a sustainable macroeconomic framework. This should include a rebalancing of monetary and fiscal policy, and a move to enhance the powers of the Bank of England but with parliamentary accountability.     

Will Labour’s Economic Programme Work?

If Labour is elected to government on 1 May, it will inherit the lowest inflation of any incoming government over the last fifty years but the highest unemployment. At the same time, public borrowing is running at an unsustainable high level. In this article, Andrew Sentance examines Labour's plans to expand employment while reducing public borrowing and containing inflation. He argues that Labour's economic programme could work but a number of pitfalls need to be avoided. Monetary policy will need to be tightened after the Election and the fiscal squeeze implied by Conservative spending plans maintained – if necessary through higher taxes. The benefits from Labour's employment policies could also be undermined by a high minimum wage, particularly if applied to young workers.     

Optimal fiscal and monetary policy with occasionally binding zero bound constraints

This paper studies optimal fiscal and monetary policy when the nominal interest rate is subject to the zero lower bound (ZLB) constraint in a stochastic New Keynesian economy. In the baseline model calibrated to match key features of the U.S. economy, it is optimal for the government to increase its spending when at the ZLB in the stochastic environment by about 60 percent more than it would in the deterministic environment. The presence of uncertainty creates a unique time-consistency problem if the steady state is inefficient. Although access to government spending policy increases welfare in the face of a large deflationary shock, it decreases welfare during normal times as the government reduces the nominal interest rate less aggressively before reaching the ZLB.     

Managing the Public Debt: The Optimal Taxation Approach

This paper examines research on public debt management, focusing on debt structure by denomination, indexation features, and maturity. The optimal taxation approach is reviewed and its policy implications are related to the trade-off between minimization of the expected cost of debt servicing and minimization of budgetary risk. Strong arguments are provided for debt instruments which yield low returns when output and hence revenues are lower and public spending higher than expected. This debt design minimizes tax distortions and provides flexibility in conducting fiscal policy. The exact characterization of the debt composition which supports efficient taxation depends on the stochastic structure of the economy. Long-term nominal debt is a hedge against supply shocks affecting revenues and inflation and makes the government budget insensitive to interest-rate risk. However, at high levels of debt, the extent of insurance or flexibility that governments can obtain by issuing long-term nominal debt is limited by the need to maintain the credibility of the anti-inflation stance.