IT HAS been a tough week for Ed Balls. Many within Labour are said to be questioning his position as shadow chancellor following his disastrous response to George Osborne’s Autumn Statement. While Balls claims he “couldn’t give a toss” about the speculation, he needs to repair his party’s economic credibility, and fast.
That’s one reason why, in recent months, Balls has been pressuring Osborne to allow the government’s independent fiscal watchdog, the Office for Budget Responsibility, to audit manifestos of political parties. Balls calculates that confirmation from the OBR that his 2015 general election commitments add up would help assure voters that electing Labour would not risk the UK recovery.
For this reason, Osborne is likely to reject Balls’s request. But there’s another reason why the Conservatives should object: the OBR’s models are deficient in analysing tax changes.
Consider the Treasury study published alongside the Autumn Statement last week on the effects of corporation tax cuts. The government has lowered the main corporation tax rate from 28 to 20 per cent with the explicit intention of encouraging more business investment and attracting mobile international capital. Labour, in contrast, had a declared policy before the Autumn Statement of cancelling this year’s corporation tax cut and using the “savings” to freeze business rates on small businesses.
The research suggested that over the long-term, corporation tax cuts can have profoundly positive impacts on the economy. Using a computable general equilibrium (CGE) model, which examines the effects corporation tax cuts have on behaviour in much more detail than traditional Treasury analysis, the model found corporation tax cuts could result in a long-term increase in investment of between 2.5 and 4.5 per cent, as well as increased GDP and increased wages.
The message in these models therefore tends to be that the “costs” or “revenues” of tax policy changes in a static short-term sense offer a misleading picture on the dynamic long-term consequences – and usually with a bias against tax cuts.
It’s easy to think of other examples to show this. The last Labour government initially believed the 50p income tax rate would raise £2.5bn. Yet more recent analysis by HMRC suggested behavioural changes decreased the pre-behavioural yield by as much as 83 per cent. Likewise, PwC analysis on air passenger duty (using a CGE model) suggested that once increased activity and productivity gains are considered, by 2015/16 a complete abolition of the tax would raise overall net tax revenues by £230m. The cost implied by more traditional models would be £3.2bn.
Not only does the OBR lack the expertise to audit this dynamic modelling, but its previous work on second round effects has been described by experts as “feeble”. This has important implications if the OBR is to be granted auditing powers: if it restricts its auditing to traditional modelling (because it’s easier), the auditing will be insufficient and biased against tax cuts. On the other hand, if it does CGE analysis, it will clearly be more open to challenge, given its position, with political pressure resisting particular assumptions. Granting the OBR power to sign off manifestos could therefore risk undermining its other, more useful, functions by politicising it.
Ryan Bourne is head of economic research at the Centre for Policy Studies. @RyanCPS