UK needs more creative destruction

Allister Heath
IT was Joseph Schumpeter, the great economist, who first understood that capitalism is a process of creative destruction. Every day, new firms are born with fresh ideas, talent and technologies; old firms die when they become unable to meet customers’ needs efficiently and fail to make a better use of resources than their rivals. Competition combined with the discipline of profit and loss is an astonishingly powerful driver of innovation, capital accumulation, economic growth and rising living standards.

A successful economy is one which incubates lots of new firms and ideas – and which allows them to grow, raise funds and blossom into the corporate giants of tomorrow. Such an economy makes it easy to shut down failing firms and to reallocate capital and labour. America, thanks to its open society, tradition of relatively free markets and long-established rule of law, has long enjoyed the world’s most finely tuned process of creative destruction: that is the reason why the likes of Google, Facebook and Apple are all US firms. Britain, by contrast, has lagged behind; we do have plenty of young firms but few reach their full potential. Too many struggle to tap into the right investment or to find the right staff with the right mindset, skills and knowledge; others get bogged down in red tape, a flawed culture (and tax system) which no longer values work and effort, and the general difficulties of operating in the UK; and all too often, rather than reaching for the skies, as their American counterparts are want to do, British entrepreneurs end up selling out too soon. That is the biggest challenge facing the UK today; if it wants to make a lasting mark on Britain, the coalition must urgently begin to tackle the barriers that prevent so many of Britain’s entrepreneurs from becoming truly great.

Yet more evidence that spending cuts would do less damage than tax rises, this time from Oxford Economics, the well-known consultancy. Given the latest round of reductions from Danny Alexander yesterday – grants agreed in the dying days of the Labour government to firms in the north of England were among the casualties – it is worth taking a look at the study’s findings.

Its key point is that spending cuts would do less damage to the private sector – the part of the economy that suffered all of the damage during the recession – than tax rises and in some sectors would actually promote stronger growth.

The report compared the impact of a £10bn cut in government current spending with a £10bn increase in government revenues, achieved through an increase in the standard rate of VAT, currently at 17.5 per cent. A cut in public spending would obviously reduce employment in public services; but any effect on output could be mitigated by eliminating waste. However, reduced government borrowing as a result of the cuts would bring lower interest rates and a drop in sterling. The benefits would be enjoyed by the most internationally-exposed (and thus pressurized) parts of the private sector: manufacturing, business services and retail, distribution and hotels.

In contrast, a VAT increase would impact almost exclusively on the long-suffering private sector. The biggest losers would be retailers, hotels and restaurants, but other sectors would also suffer from weaker intermediate and final demand. The lesson is clear: Tuesday’s budget needs to focus on cuts while doing all it can to avoid tax hikes.