Wednesday, 24 March 2010

How well did Mr Darling do?

Chancellor Alistair Darling today presented what is probably his last budget speech. It must be noted that this was not a “real” budget since the Conservatives have promised to quickly produce their own budget if they win the election and should Labour win they will almost certainly wish to “supplement” what is continued in the budget. Instead the budget should be seen as part of setting out Labour’s stall for the next election.

Some weeks ago I predicted that the Chancellor would address the following themes:-

1. The general state of the UK economy
2. UK public finances and changes to taxation and public spending
3. Supporting businesses
4. Helping people in need
5. Improving public services

How did I do? Well I think I hit the button on four out of five.

Regarding the UK economy, the Chancellor started by recognising the economic problems faced by the UK as part of the global recession. The Government did not accept any blame for this situation preferring to blame financial problems in the USA but he insisted that the Government had made all the right decisions to protect the economy while claiming the Conservatives were prepared to do nothing. He then insisted that the economy was now improving quoting economic growth, reducing unemployment and increasing tax receipts. However, he also noted that the economy was still fragile and care had to be taken in cutting public expenditure too quickly which could damage the economy.

The Chancellor spent some time talking about the UK public finances. Better than expected tax revenues had meant a smaller than expected borrowing requirement. However, even in 2014/15 the Government still expects to borrow a staggering £74bn and this may not be enough to satisfy the financial markets that the UK public finances are under control. In his response to the budget David Cameron repeatedly hammered this point. Changes in taxation were not a huge issue in this budget. He froze inheritance tax, changed thresholds on stamp duty and announced improved measures to prevent tax avoidance. There were the usual increases in alcohol and tobacco duty but all of a sudden he announced there were no more tax changes. However, this situation will probably change after the election – whoever wins. The chancellor also provided some detail about how a package of £20bn efficiency savings would be achieved but no real detail on the major cuts in public sector spending needed after the election.

Mr Darling spent a lot of time outlining measures that would support and improve the UK economy and UK businesses. There are changes to corporation tax to encourage investment and various funds are to be created to support UK businesses including one that would promote the development of green technologies.

Also he promised support to certain groups in society - measures which would get support from Labour’s core vote. Examples here included changes in child tax credit, help for first time house buyers and people who have been made unemployed and who have mortgage repayment problems/

Mr Darling appeared to say little about improvements in public services other than to promise more money to undertake repairs on motorways and other roads.

This was a budget strong on politics but light on economics and finance. Overall Mr Darling seemed to be trying to achieve three main objectives. Firstly to portray to the voters an aura of economic competence and a Government that has steered the economic ship through stormy waters. However the ship is not yet in port and he emphasized care is needed. Secondly to differentiate Labour from the Conservatives on key policy issues such as targeted support for key industries not an across the board reduction in corporate taxation. Thirdly to introduce measures that will appeal to Labour’s core vote such as increased stamp duty on properties over £1million and enhanced tax avoidance measures. However, the size of the public sector borrowing requirement is something that will be repeatedly thrown at the Government throughout the election campaign. David Cameron made the wounding charge that all Labour governments leave office leaving the country in a financial mess.

Public sector pay versus public sector jobs

We can be certain that the Chancellor’s budget speech on 24th March will talk much about the public sector budget deficit but say little specific about what should be done to remedy it. In the debate about what to do about the sorry state of the UK’s public finances, the issue of public sector pay almost always crops up. While the Government is in favour of tight public sector pay restraint others talk about a pay freeze or even a pay reduction. Typically public sector workers will object to this saying why should they have a pay freeze when the bankers have got away with millions of pounds of bonuses after having been bailed out by the Government. However, this is a somewhat pointless argument since the total number of bankers who benefited from such bonuses is relatively small and in reality a report by the Institute of Fiscal Studies suggested that pay in the private sector actually fell in early 2009 by some 2-3% as a consequence of economic recession. One might ask whether public sector pay should reflect the financial and economic condition of the public sector in the same way as seems to have happened in the private sector.

Another issue is the link between public sector pay and public sector jobs. Whichever party wins the general election it is inevitable that, sooner or later, there will be substantial reductions in public expenditure and in public sector jobs. In this situation, it seems almost inevitable that there will be a trade off between pay increases for public sector workers and loss of jobs in the public sector. While the precise nature of this linkage is unclear, a high level analysis of the latest data on public sector pay and employment suggests some interesting results. If we assume that three quarters of the costs of any public sector pay increases would be funded through job losses and all of the savings from a public sector pay reduction would be used to protect existing jobs then my rough calculations suggest the following:-

• Compared to the level of job losses under a pay freeze, a 2% across the board public sector pay increase could result in the loss of an additional 83,000 public sector jobs (42,000 jobs lost for a 1% pay increase) compared to the level of job losses under a pay freeze.
• Compared to the level of job losses under a pay freeze, a 2% across the board reduction in public sector pay levels could result in the saving of 110,000 public sector jobs (55,000 jobs for a 1% pay reduction).

Clearly, these are crude calculations and also involve some broad based assumptions. Nevertheless, the magnitude of the results deserves some reflection.

Having a pay freeze or pay reduction could have a major impact on public sector employment levels at a time of high unemployment and a lack of alternative jobs. However, many will argue that having such a pay reduction or pay freeze will mean they will have a reduction in their personal standard of living. This is indeed true but that is what economic recession is about. A reduction in GDP of a country inevitably means that there will be a reduction in living standards and the only issue is how that reduction is to be shared out among different parts of society. In these circumstances both public and private sector employees will have to share the consequences.

However there could also be wider economic benefits from having a pay freeze/pay reduction policy. Public servants who lose their jobs are certain to make drastic reductions in their personal expenditure which would have a detrimental effect on their local economy. On the other hand, public servants who received a pay increase would be more than likely to save a large part of their increase thus providing no economic stimulus.

However, it is likely that public sector trade unions would fiercely resist such proposals since part of the raison d’ĂȘtre of trade unions is to boost members earnings. Given the close links between the present Government and the Trade Unions (and the history of the 1978/79 Winter of Discontent) this could explain why the Government seems luke warm about the idea of a public sector pay freeze.

Will the Chancellor mention the idea of a public sector pay freeze in his speech? Not a chance – too many public sector workers are core Labour supporters. However, the individual public sector employee faced with a choice between a tiny pay increase and keeping their job may well choose the latter course of action.

Friday, 12 March 2010

Who wants a hung Parliament in the UK?

The UK general election is looming and looks set for 6 May. This election will take place in a situation where the condition of the UK economy and its public finances are dire. In spite of this, recent opinion polls suggest that the two main political parties are neck and neck and thus we face a real possibility that no party will gain an overall majority and a “hung” Parliament will ensue. A number of views are put forward which need to be discussed.

Firstly there is a view put forward that the electorate wants a “hung” Parliament and that this is why the polls are the way they are. This is clearly fantasy since it implies some form of mass conspiracy by the electorate to “fix” the opinion polls such that they point towards a “hung” Parliament. I suggest that the current economic situation in the UK is such that most people do not want a “hung” Parliament but want a government with a clear mandate to sort things out. The issue is that the electorate is completely divided about which party is best placed to do that.

The second issue concerns the effectiveness of a “hung” Parliament in dealing with the UK’s severe economic problems. The key question seems to be whether the appropriate response to these problems should be:-
• immediate and significant reductions in public spending in order to stabilise exchange rate and credit ratings, or
• more gradual reductions in public spending to avoid destabilising the fragile economic recovery which might make the overall situation worse, and require even more painful reductions.

This is a very delicate balancing act and it seems the parties are divided. The Labour Government would seem to support action to deal with the budget deficit but gradually over a two Parliament period. The Conservatives having taken a stronger line on the need to address the level of public sector deficit quickly hesitated over the advice of some notable international bodies like the IMF, arguing that too quick a reduction would create greater recessionary impact, but latterly seem to have returned to the need to cut the deficit more quickly than their opponents.

The “hung” Parliament model is often postulated as the best option since it would encourage all parties to “work together in the best interests of the country”. In my view, this analysis is false. Firstly, even if the Parliament is “hung”, there is no guarantee of any form of coalition government appearing. In the 1974 election, Harold Wilson the then leader of the Labour Party had the largest number of seats but no overall majority. Wilson decided not to have a coalition but to take power as a minority government. Secondly, the absence of fixed term Parliaments in the UK means that all parties would know that another general election would be imminent once the then Prime Minister decided the signs were positive for his party. In 1974, Wilson called a second general election seven months after the first one and won with a small majority. The consequences of a “hung” Parliament today are probably that between the inevitable two general elections, no party will want to be held responsible for any decisions which would be unpopular and would come back and haunt them at election time. Contrast this with Germany where a grand coalition governed, reasonably effectively, for a four year period between 2005-2009 because of fixed term Parliaments.

In the current economic and fiscal climate and the nervousness of the financial markets, I suggest the last thing the UK wants is a “hung” Parliament. Both the financial markets and the electorate would probably agree that what is wanted, first and foremost, is clarity about the direction of travel.