Economic Theory

Why there really aren’t any magic money trees

There is an old and often very useful adage that “if it sounds too good to be true, then it probably is.” But that hasn’t stopped some people from arguing that the next government can ramp up spending without worrying about where the money will come from, because the additional spending will somehow pay for itself.

To be fair, it is not just Labour-supporting economists who seem to believe in magic money trees. The Conservatives have confidently asserted that a stronger economy will deliver a substantial increase in funding for the NHS and other social priorities, with no further explanation.  Whereas the Labour manifesto arguably had too many numbers on both spending and tax, the Conservative version fell conspicuously short.

Let’s start, however, with three points of agreement. First, it is not always necessary – or even desirable – for a planned increase in public spending to be exactly offset by an equivalent increase in taxes. This is what the author and commentator Ann Pettifor (among others) refers to the ‘household fallacy’ – that government budgets are like household budgets and must always balance.  It is a point we have made at the IEA too. There may be times, for example, when the economy could benefit from a fiscal stimulus financed by a temporary increase in borrowing. And governments, unlike households, can get some of their spending back in the form of tax revenues or lower welfare payments.

Second, the short-term boost from an increase in public spending will generally be larger in a weak economy with plenty of under-employed resources, when interest rates are low, and when firms are struggling to get finance. This is because increased demand from the public sector is then less likely to crowd out demand from the private sector. Indeed, the initial boost to incomes, spending and confidence could be magnified as it ripples through the economy. (Hat tip to Professor Keynes.)

One way to express this is the ‘fiscal multiplier’, which is the ratio of the change in overall economic activity to the change in budget deficit. A fiscal multiplier of 1x, for example, would mean that a £100bn increase in public spending financed by borrowing would be expected to increase GDP by £100bn. Many studies have found that fiscal multipliers are usually below 1x during expansions but between 1x and 2x during recessions. What’s more, even a ‘fiscally neutral’ package could boost the economy if it redistributes income from the ‘rich’ towards people who are more likely to spend it. (In the jargon, they have a higher ‘marginal propensity to consume’.)

Third, spending on investment, such as infrastructure, can be thought of differently from ‘current’ spending on day-to-day items such as wages and benefits. This is because investment spending may create assets which boost the long-run potential output of the economy and help finance the borrowing required to pay for them. Some forms of current spending could also have investment characteristics. For example, spending on NHS salaries may improve the quality of care, allowing people to work longer and more productively, while free university tuition may help to raise the average skill level.

So far, so good. However, some economists have stretched these principles to breaking point – and beyond. For example, there is (in my view) a decent argument for paying nurses more to address staff shortages in the NHS. But Dr Pettifor appears to have gone further and suggested that an increase in spending on public sector wages could be entirely self-financing, because of the resulting boost to economic activity and tax revenues. For this to be true, the fiscal multiplier would have to be implausibly high (at least 3x, assuming a tax/GDP ratio of 35%). And if this were the case, the government would have nothing to lose from awarding 100% salary increases across the board.

What’s more, those making the macroeconomic case for debt-financed investment usually assume a high fiscal multiplier (at least 1x), so that the burden on future taxpayers is offset by stronger growth. This might have made sense when the economy was only just emerging from the recession and when interest rates were anchored near zero. (And no-one could seriously argue that ‘austerity’ has been anything other than a disaster for Greece.) Nonetheless, the UK is now close to full employment, global monetary policy is set to tighten, and the financial sector is lending again. Public debt is also much higher, increasing the risks from adding even more.

At this point, somebody usually observes that the current high levels of employment have only been achieved at the cost of sluggish growth in real wages. This sluggishness is partly due to Conservative policies (including the ongoing public sector pay freeze), as well as the drop in the pound following the Brexit vote. But the fact remains that there are now many fewer people looking for work and little spare capacity in the economy as a whole. As a result, a large fiscal stimulus is still more likely to feed through into higher inflation than higher economic activity – unless you believe that additional government spending can magically boost the UK’s productivity overnight. Interest rates are now far more likely to rise too.

Any boost from government spending will also depend on the money being spent wisely. The track record is not good, either in the UK or elsewhere, particularly in respect of large infrastructure projects. The lack of a clear economic rationale for Labour’s plans to renationalise the railways, utilities and Royal Mail is not very encouraging here.

A final area of disagreement is the fallout from higher taxes. Some Keynesian economists, including (the widely respected) Simon Wren-Lewis, have criticised the likes of the Institute for Fiscal Studies for focusing too much on the ‘micro’ aspects of fiscal policy. Or, as Professor John Weeks has put it, ‘bean counting’.

However, the pendulum can also swing too far the other way (‘mainly macro’ becomes ‘only macro’). The danger is that those pointing their telescopes only at those benefitting from increased government spending end up ignoring the costs of higher government borrowing (including the ‘crowding out’ of private investment) and of increased taxation.

For example, people being asked to pay higher taxes will also alter their behaviour and in ways which are likely to harm the economy and reduce the revenues raised. Companies in particular are not the ‘magic money tree’ that many assume. Corporate taxes are ultimately paid by people too – whether shareholders (in the form of lower profits), customers (higher prices), or employees (lower wages and fewer jobs). It is true that more of the burden of corporation tax tends to fall on higher-income groups (it is at least a relatively ‘progressive’ tax). But it is also easier for companies to reduce their tax bills by relocating abroad.

Indeed, most economists and (more importantly) most governments recognise that corporation tax is a relatively inefficient tax. Fifteen other members of the OECD group of advanced economies have joined the UK in cutting corporation tax since 2010 and only five have hiked it – including Greece and Iceland. The US and France are now proposing to cut corporate taxes too. The upshot is that raising corporate taxes now – even just back to the OECD average – would buck the global trend and send a particularly negative signal in the run up to Brexit. (Similar points apply to Labour’s other tax plans, including large increases in income tax for higher earners, which are unlikely to raise as much revenue as they project.)

Of course, any additional government spending might still provide a temporary boost to growth, especially if deficit-financed. After all, most observers raised their forecasts for US GDP following the election of President Trump, partly in anticipation of a substantial fiscal stimulus, and whatever their feelings toward the man. (Mr Corbyn’s team may not appreciate the comparison.) But few expected the benefits to be sustained. And unlike the Trump administration, Labour is committed to more taxes and regulation, not less.

Overall, then, both the Conservatives and Labour can be criticised for peddling fantasies about where the money will come from to finance their spending plans. Labour politicians and supporters at least deserve credit for being open about the issues and setting out a clear agenda. But this welcome clarity also means that the potential problems are plain to see.

Julian Jessop is an independent economist with over thirty years of experience gained in the public sector, City and consultancy, including senior positions at HM Treasury, HSBC, Standard Chartered Bank and Capital Economics. He was Chief Economist and Head of the Brexit Unit at the IEA until December 2018 and continues to support our work, especially schools outreach, on a pro bono basis.

4 thoughts on “Why there really aren’t any magic money trees”

  1. Posted 06/06/2017 at 14:36 | Permalink

    We still have over 1 million unemployed in Uk. 12% of this is youth unemployment. We cannot continue with this level of underclass. How do your ideas address this?

  2. Posted 06/06/2017 at 19:22 | Permalink

    “It is true that more of the burden of corporation tax tends to fall on higher-income groups (it is at least a relatively ‘progressive’ tax).”

    Is that true? I thought the majority of the incidence fell on employees and particularly those whose productivity was determined by capital applied.

  3. Posted 08/06/2017 at 08:19 | Permalink

    “We still have over 1 million unemployed in Uk. 12% of this is youth unemployment. We cannot continue with this level of underclass. How do your ideas address this?”

    Gee, do you think barriers to employment such as minimum wages and another regulations might have an effect on employment?

  4. Posted 15/08/2019 at 15:35 | Permalink

    Maybe with the better skills gained by free university places, we could actually start making sellable items, thus increasing exports and raising capital.

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