UK Fiscal Policy and the Economics of the Tooth Fairy

My six-year old grandson’s schoolfriend Joshua was so impressed by the two pound coin he received under his pillow for the loss of his first tooth that he started mass-producing fake teeth, which were cut out of paper, embellished with felt tips and again placed under his pillow, in the expectation of receiving an unlimited shower of coins from the tooth fairy.

What is interesting to an economist is that, given the initial premise that the tooth fairy existed and could be bamboozled, young Joshua’s actions were entirely consistent with the concept of the ‘rational economic man’ widely used in economic analysis.

Unfortunately, the political and media debate about UK fiscal policy has taken on distinct tooth fairy characteristics in recent years with a widespread belief on the part of both the current and previous Conservative administrations – let alone the Labour Party, Liberal Democrats and Scottish National Party – that there was no upper limit on the share of government expenditure in national output, that no adverse economic consequences resulted from big government and that a compliant central bank would always take on the tooth fairy role by buying up ever more government debt.

The purpose of my new Politeia paper, Britain’s Taxable Capacity: Has it Reached the Upper Limit?, is the equivalent of young Joshua’s parents explaining that the tooth fairy did not exist and that every two pound coin had to be paid for by the hard work of his parents who had only a finite supply of such coins. To be more precise, my paper examines the share of general government expenditure in the factor cost measure of Gross Domestic Product (GDP) and the share of non-oil taxes in non-oil GDP using well over a century’s annual figures up to 2019 (2020 figures will not appear until next year) and quarterly data up to the third quarter of this year. The latter provide the first ‘fix’ on the economic consequences of Lockdown I and its subsequent amelioration.

The main findings from the detailed analysis are that:

  • Over the decades it has been difficult to get the non-oil tax burden to stay above 39 per cent of factor cost GDP for any length of time, despite massive changes to the structure of taxation and the various key rates of tax.
  • The upper bound of sustainable general government expenditure as a share of the factor cost measure of GDP is around 45 per cent, a figure derived by adding to the 39 per cent historic top limit on tax revenues 3 per cent to allow for non-tax receipts, plus a further 3 per cent to allow for ‘acceptable’ government borrowing.
  • Prudent governments should keep spending below the 40 per cent to 45 per cent ‘danger zone’, which has often triggered sterling crises or other adverse events in the past. However, even before Covid-19, the UK general government spending ratio had seemed stuck at between 44 per cent and 45 per cent between 2016 and 2019.
  • On the market-price measure of GDP preferred by officialdom, which includes indirect taxes and gives noticeably lower numbers as a result, the upper limit to the sustainable tax and spending burdens, would be 34½ per cent and just under 40 per cent, respectively.

In the event, the government spending ratio using the historically consistent factor cost measure rose from 43.4 per cent in 2019 Q4 to 45.2 per cent in 2020 Q1, when lockdown was introduced on 23rd March, before leaping to 61.3 per cent in 2020 Q2 when Lockdown I was at its peak, before easing to 53.6% in 2020 Q3. These figures compare with the 52 per cent top annual cost of World War I, recorded in 1917, and the not quite 77 per cent peak recorded in 1944 during World War II.

Since modern governments have almost no resources of their own, and government cannot gain real economic resources by taxing itself, the burden of funding these spending levels inevitably falls on the rump private sector of the economy – either through today’s taxes or tomorrow’s – unless the government chooses to default, either explicitly or implicitly through high inflation.

So the main policy conclusions ahead of Rishi Sunak’s Spending Review due to be delivered on Wednesday 25th November are as follows:

  • Even before the Covid-19 crisis, the UK government spending to GDP ratio was high by historic standards, while the tax burden appeared to be close to the historic upper limit of sustainability in 2019 before the pandemic.
  • As a result, the UK’s public finances were an accident waiting to happen well before the iceberg Covid-19 ripped the side off Britain’s fiscal ship of state. As the Office for Budget Responsibility has pointed out, this reflected both the spending decisions of Theresa May in June 2018 and Rishi Sunak’s Spring Budget this year.
  • The concern now is that the recent UK growth trend of around 1½ per cent each year will collapse to zero, or remain negative, even after Covid-19 has burned itself out. This would have horrendous implications for social and political stability, as well as the public accounts and the wider economy.
  • It is hard to be positive about the longer-term fiscal and economic prospects given the Conservatives’ unwillingness to forewarn the populace about the longer-term consequences of ‘spend, spend, spend’. Here, it is necessary to emphasise a key finding of the extensive fiscal stabilisation literature that any attempt by the Government to tax its way out would massively backfire economically and worsen the public finances, not improve them.
  • Enhanced fiscal parsimony – accompanied by politically “brave” rhetoric to explain the fiscal facts of life to voters – will be required if the UK is not to become a permanently stagnant and low- or negative-growth economy. Chancellor Sunak should employ his ‘bully pulpit’ on Wednesday to that end.
  • Finally, there is now a massive policy inconsistency between the liberalising measures required to minimise the costs of, and maximise the gains from, Brexit and the Edward Heath-style Big Government approach of Boris Johnson’s administration. It would be ironic if Brexit became discredited in the eyes of the populace, not because of its own failings, but because one of its foremost proponents pursued policies in other areas that almost guaranteed that it would go off at half cock.

David B. Smith

David B. Smith is a City economist who worked as a macroeconomic modeller and economic forecaster, predominantly in banks (including the Bank of England) and security houses (1968-2006). He was subsequently a Visiting Professor in Economic and Business Forecasting at Derby Business School, chaired the IEA’s Shadow Monetary Policy Committee (2003-2014) and was the Chief Economist working on the TaxPayers’ Alliance 2020 Tax Commission report published in 2012. He maintains his own macroeconomic forecasting model at Beacon Economic Forecasting. His Politeia publications include The Brexit Settlement and UK Taxes (2018), Banking on Recovery: Towards an accountable, stable financial sector (as co-author, 2016) and The UK Government Spending Ratio: Back to the 1930s? (2015).

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