Saturday, 16 October 2010

A new weapon in the anti-deflationary armoury

Michael Taft: One might expect a pre-budget submission in today’s climate to focus on how to ‘save’ money through a lengthy list of public spending cuts combined with tax increases that ‘broaden the tax base’ (that used to refer to high income groups who escaped liability through exploiting tax avoidance mechanisms; not anymore: low-income groups are now the main culprits). Such a submission would then tally up column A and column B and see if the difference brings down that danged deficit. And in the coda, the submission would don ceremonial robes and prostrate itself before the financial markets for fiscal blessing.

Thankfully, TASC produced its own pre-budget submission.

The temptation is to start listing off particular elements one likes or doesn’t like but that approach is not satisfactory. Progressive groups and individuals can produce pre-budget submissions until the end of the time which, while adhering to the same principles, will never agree on the details. As President Franklin Roosevelt said, ‘There are many ways to go forward, there’s only one way to stand still.’

It is far more helpful to stand back and look at the overall composition, the architecture. TASC’s submission rests on two broad pillars:

1. Drive budgetary consolidation through taxation – primarily, reduction of tax expenditures and a residential property tax. The total amount to be raised is €2.7 billion. The underlying principle is to break from the low-tax model and move, over time, to average EU taxation levels.

2. Drive economic growth, employment and, so, deficit reduction through a €3 billion Economic Recovery Fund to be financed from the National Pension Reserve Fund (NPRF).

This is complemented by a number of proposals to increase budget transparency and improve budget documentation. There are some well-considered public efficiencies (e.g. reduce subsidies to fee-paying schools, etc) amounting to €300 million.

So what would the effect of this be in terms of the economy and public finances? Let’s measure it using the ESRI multipliers and compare it with the Government’s original €3 billion package (the ESRI set up a stylised budget for measurement purposes as details of the package’s composition were, naturally, not available).

Just on the budgetary consolidation measures alone, the TASC package is superior. Indeed, it would work out better in practice. First, TASC is rightly aiming at high income groups which would prove less deflationary than ESRI estimates as these assume across board tax increases. This would therefore increase the deficit reduction. Secondly, ESRI warns that its numbers ‘do not take account of the significant positive supply side effects from public investment’. This suggests significant losses to the Exchequer in the medium-term, diluting the deficit-reduction in that category.

However, TASC goes further, transcending the narrow balance sheet mind-set; it actually acknowledges such a thing as the economy – the economy that is the basis for any credible fiscal consolidation process. Their Economic Recovery Fund of €3 billion would start to address our considerable deficits: credit availability, infrastructural capacity, R&D, human resources, etc.

Measuring these impacts is a little more difficult. Traditional multipliers measure investment, non-wage consumption, social transfers, tax cuts, etc. The TASC programme contains programmes such as loan guarantees – which would have a definite economic benefit. However, it is not easy to measure under headline multipliers. In order to draw a conservative baseline, I will include only the infrastructural and education component – acknowledging the remainder as part of a general upside risk, always a good thing to have when entering an uncertain period. When these are included we find:

This is a significant turnaround. Instead of the Government’s deflationary budget with significant downside risks, we have an expansionary one with significant upside risks. And with no extra borrowing. As a result the deficit reduction is much higher than what the Government is proposing.

There’s another significant advantage that TASC delivers: it might be called Deflationary Cascade Avoidance (DCA). By providing an alternative to the current deflationary approach, we may be avoiding what the Government is leading us into – and highlighted by Michael Burke in his analysis of the submission. Michael refers to the IMF finding that fiscal contraction in situations where there is no scope for reducing interest rates further, will suffer a double whammy. A 1 percent fiscal contraction could actually double the deflationary impact – from -1.1 to -2 percent.

Were this to occur, we may be entering into a long-term deflationary trough where growth is sluggish at best and there is no chance of halting the rise in debt and interest payments; stuck in the proverbial creek without a paddle or a boat on a moonless night with the sound of large predators on shore. TASC’s DCA ensures we can be at home, sleeping in our beds.

No doubt the cheerleaders for fiscal contraction will ignore all this. They will ignore the benefits of the TASC submission; they will ignore the ESRI finding that the current strategy will fail to repair public finances for a decade and more and drive up debt to 1980s level and beyond; they will ignore warnings from international bodies about the course we are heading on. If they get their way, we will all sleepwalk into IMF receivership and years of deflationary slump.

We can’t let this happen. We have to start fighting back sometime. Now is not too late.

And we have increased our chances of winning now that TASC has given us this new weapon in the form of the pre-budget submission.


Anonymous said...

Michael, can you explain how grabbing on average €1000 from each productive household (merely for the privilege of actually living in a house as opposed to a hovel) would be anything other than deflationary?

Those households would magically fund the extra tax out of savings, right? The very same savings they've already ploughed in financing the deposit and stamp duty on the house you now want to tax them on.

Despite the fact that many have already paid the equivalent of 20-30 years property tax upfront in the form of stamp duty.

Anonymous said...

Despite normally being a daemon for quantifying policy changes and modelling future impacts, you and your colleagues in TASC don't seem to have put much thought into the "Reduce support for fee paying schools" proposal.

No consideration at all to the percentage cut in funding, the upward pressure on tuition fees, the knock-on impact on enrollment, and the resulting redundancies among the teaching faculty?

Well let me do a few back-of-the-envelope calculations for you ....

Say the €100 mill is entirely spent on teachers' salaries, at an average rate of €50k, giving circa 2,000 teachers in the sector.

Say conservatively a pupil:teacher ration of 20:1, which would give us around 40,000 kids attending these schools.

Its hardly worth cutting funding by less than 50%, or €50 million gross, tops €30 million net after pension levy, income tax, supperannuation payments are taken into account.

Now the €50 million funding gap would require an average €1,250 increase in tuition fees. Say conservatively this leads to a 10% drop in enrollment in next year's first form intake. Within 6 years that translates to a 10% reduction in total numbers, requiring a 10% cut in teaching headcount. Bada-bing at least 200 redundancies ... do you want to tell the union brothers in ASTI, or shall I?

Now once you subtract the cost of at least 200 extra unfortunates on the dole, what's the remaining yearly savings?

Could it be that this isn't about saving money at all? One suspects the idea is to indulge the class warriors about this parish, rather than actually making a constructive policy proposal.

Anonymous said...

Hi Anon,

There is a middle ground between the financial argument for withdrawing funding from fee paying schools, and class warfare.

I believe that we should withdraw all funding to such schools.

I don't think the majority of the schools would respond by raising fees - I don't think the market could take the increase. Most would instead apply (with a heavy heart) to enter the free schools system.

This would increase the cost to the state of course, because there is a capitation fee of about €500 that goes with each student. i think the total cost to the state would be a little less than 10 000 000.

But presumably a few schools would survive and maybe even prosper - catering to the truly rich as opposed to comfortable. If only four or five of them stayed outside the free system, the savings to the state would be close to the same 10 000 000.

So it would be cost neutral, and there would be few if any redundancies.

But the inequitable effect of these schools on society - especially in Dublin - would be
diminshed. I don't see that as class warfare. I think we would all gain from a more equal society.

But your point is nevertheless well made. Whether or not this is something that should be done, there is no economic argument for doing it.

peter g

Michael Taft said...

Anon (the first one): I'm not sure I read anyone making the argument that a property tax wouldn't be deflationary. For clearly it would be. The ESRI estimates that €1 billion raised in property tax would deflate the economy by 0.2 percent of GDP, or approximately €320 million. But of course all tax increases and spending cuts deflate growth. It would have been far better had the Government taken the rational approach from the start and focused on shortening the duration and limiting the impact of the recession. Only when we had emerged from the recession, should serious fiscal consolidation commence.

Unfortunately, the Governmen took the course it did - measures that actually lengthened and deepened the recession. That resulted in the mess we're in - high deficits, spiraling debt and possible IMF receivership.

We probably have no choice, therefore, but to start consolidation now but TASC has at least taken the least deflationary approach. For instance, a €1 billion cut in Government consumption would deflate the economy by 0.8 percent or approximately €1.3 billion. That's four times worst than a property tax.

Michael Taft said...

To the latter 2 Anons - the TASC report presented their data in the same way as all other organisations, political parties and the Government does so I think it is somewhat unfair to criticise them on that score. That they didn't claim these proposals would reduce the deficit or borrowing requirement by a similar amount should be noted.

But I think both of you make important points re: all spending cuts. One has to go into each one, analyse their impacts, factor in those impacts and then find their true savings. Your exercises show very clearly why the McCarthy Report was so economically and fiscally defective and misleding - because though it claimed its proposals would 'save' €5.3 billion, in fact they would only cut that amount from their particular line items. When one factored in all the impacts, it would actually save a lot less and deflate the economy - meaning the deficit burden would fall by only a small amount.

It should be noted that TASC provided flexibility in its approach - by not assigning any particular amount to each item. Therefore, it might be - if a Minister for Finance followed their suggestions - after having taken into account the calculations, might only cut subsidies to fee-paying schools by 10%. This may not lead to 10% or anything like it closing down, realising full savings.

In any event, in the impact multipliers I used from the ESRI, the €300 million would only achieve a savings rate of approximately €99 million - or less than a third of the headline figure. Unfortunately, the ESRI data doesn't allow for more detailed estimates. But the Government could and should do so.

By the way, it is not class warfare to limit subsidies to free schools. It is class privilege to demand that fee-paying schools be subsidised by people for whom most couldn't afford to attend.

This would help reduce inequality in soceity and the economy. And there is a very strong economic argument for greater equality.

Anonymous said...

For instance, a €1 billion cut in Government consumption would deflate the economy by 0.8 percent or approximately €1.3 billion. That's four times worst than a property tax.

The impact of cutting government spending would surely be heavily dependent on what is actually cut.

Surely there would be totally different deflationary hits resulting from cutting hand-to-mouth welfare (e.g. jobseeker's allowance), or middle-class welfare (e.g. by means-testing the OAP and child benefit), or higher levels of public sector pay, or the legal fees paid by the state, or the pile of cash gifted to the medical profession and pharma industry via the various medical and drug refund schemes, or the buckets of money handed over to private landlords.

It stretches credulity that a single number could possibly capture the impact of the many and varied potential spending cuts.

But either way, my main objection to a property tax is based on fairness and equity as opposed to the deflationary impact. How could it be fair or equitable to penalize owners of one particular asset class, an asset that has declined precipitously in value, may have very large debt outstanding on it, has already been taxed to the hilt in the form of stamp duty, and the original purchase of which was simply intended to meet the most basic of human needs ... i.e shelter for oneself and one's family.

Apart from such high-falutin' concerns, once one gets into the meat of the TASC proposal, there are all sorts of lurking inequities. Occupants of social housing are completely exempt regardless of means, so a worker living living in a local authority house gets off scot free, despite having the cost of their housing already heavily subsidized by the state. A house just purchased would attract both stamp duty and property tax going froward, whereas a house purchased in 3 months time would only attract the property tax element. A fixed wage worker (e.g. a public servant) living in Dublin is already penalized by virtue of paying much more for their accommodation as compared to their rural colleague on the same salary ... now they would be doubly penalized in the shape of a much higher property tax liability, payable on what is probably a much smaller house. And the suggested cap of 7.5% of gross income? On these pages, blood and tears were shed over the 7.5% public service pension levy. Yet with the same level of income deduction is suggested with a straight face on a heavily indebted property!

Michael Taft said...

Anonymous - yes, each spending proposal must be examined on its merits. The model I quoted from, of course, can't do that. No macro measure can. It measures the impact on the economy as a whole, averaging out all the possible impacts. This is the same approach to measuring inflation and the CSO's basket of goods and services. The inflation rate won't hit everyone the same.

But the examples you raise are helpful. For insntace, the McCarthy Report states that cutting GMS payments to GPs through competitive tendering would save €370 million. But, of course, it wouldn't. As 50 percent of that at the margin is taxed, it would save only half that amount. And that's not counting any economic impact, though this would probably be minimal. Again, you have pointed out how the McCarthy report is economically and fiscally defective.