Pain ahead for the British economy

Allister Heath
WE simply don’t realise how painful the next few years are going to be – that, in a nutshell, was the message grim-faced analysts from the Institute for Fiscal Studies delivered yesterday. The Institute’s Green Budgets have become something of an institution in Westminster and the City; the reports are jam-packed with useful facts and projections, unlike the real Budget, which contains little more than propaganda and distortions.

Yesterday’s Green Budget demolishes the absurd idea propounded by the Treasury that Britain’s sustainable long-term rate of growth is 2.75 per cent a year. Michael Dicks of Barclays Wealth, the author of one of the chapters, is much more realistic. Britain’s average growth rate between 1972 and 2008 was a mere 2.2 per cent a year; it was also 2.2 per cent a year in 1996-2008 and just 1.5 per cent in 2001-08. The future will be little better, Dicks argues: growth will run at around 1.75 per cent over the next few years, partly because there is much less spare capacity in the economy than most people imagine. The natural rate of unemployment will rise from 6 to 9 per cent by 2015. All of the assumptions about the government’s long-term revenues are bogus; it also means that all businesses and investors based in the UK should cut their forecasts for returns, capital appreciation and revenue growth in the years ahead.

It is clear that the gilts markets will panic if the government fails to slash the deficit, sooner rather than later. A sustained five percentage points of GDP rise in the deficit tends to add over 1.5 percentage points to the cost of state borrowing (10-year gilts). A rise in the debt to GDP ratio from 55 to 75 per cent would double this impact – so the kind of debt explosion we are currently undergoing in the UK would imply a three percentage point jump in gilt yields. This will add a fortune to the UK’s interest bill. Others are even more pessimistic, suggesting the rise in yields could reach four per cent.

One way the government is trying to grab extra revenues is by hiking tax. Many readers of this newspaper earn £100,000 a year or more (and many of the remainder aspire to do so). Yet the income of these top earners is about to fall by a whopping 13 per cent on average as a result of already announced tax hikes – including the 50p rate, the phasing out of the personal allowance, reduced pension relief and higher national insurance – starting in April, the Institute calculates. Roughly 360,000 people will earn £150,000 or more in 2010-11; they will be hit the hardest.

It is a bizarre strategy for a government (and an opposition) that both claim to wish to encourage entrepreneurship, wealth-creation and aspiration to be introducing (and endorsing) such punitive taxes, especially given that no other country is following suit. As Fraser Nelson pointed out in a superb lecture to the Centre for Policy Studies last night, the evidence from all around the world shows that the best way to get the better-off to pay more tax is actually to cut marginal tax rates and encourage wealth-creation. It is an amazing paradox; John F Kennedy was one of the theory’s most successful proponents in the 1960s.

The only realistic way to bring down the deficit will be to slash spending. The Green Budget shows that all of Labour’s spending increases as a share of GDP will have to be unwound; it will be a befitting yet painful end to a bankrupt economic model based on an unaffordable spending binge.