Fiscal Management in the United Kingdom - Essay Example

?Fiscal management in the United Kingdom The United Kingdom’s declared fiscal policy framework is sound public finance that is flexible “to respond to changing economic circumstances in the short term” under a regime of “significantly enhanced levels of transparency” (HM Treasury 2008, p. 3). Consistent with the framework, the United Kingdom’s fiscal objective over the medium term is to ensure that spending and taxation are distributed fairly across generations (HM Treasury 2008, p. 3). Over the short term, however, the UK government’s fiscal policy supports UK monetary policy so “automatic stabilizers” can smoothen the path of the economy (HM Treasury 2008, p. 3). Towards meeting the objectives, the UK government adopted two fiscal rules (HM Treasury 2008, p. 3). The first rule is “the golden rule” that holds government must borrow only to invest and not fund current spending (HM Treasury 2008, p. 3). The second rule is described as the “sustainable investment rule” and requires that the “public sector as a proportion of GDP would be held over the economic cycle at a stable rate and prudent level” (HM Treasury 2008, p. 3). In general, under the second rule, “net debt would be maintained below 40 per cent of GDP over the economic cycle” (HM Treasury 2008, p. 3). The Economist Online Magazine reported January 20th this year that an important component of UK’s fiscal management is the UK government’s policy of “opening up the public services to competition and private providers to much greater extent than any of its predecessors”. As shown by the graph captured by Figure 1, however, despite opening up the public services to competition and private providers, both the real and nominal value of public services have been on the rise in the United Kingdom since 1996. Thus, the UK government’s reliance on the private sector for the source of public of public goods that may be cheaper compared to government-produced public goods appears to be one of the cornerstones of the UK’s current fiscal policy. This implies that fiscal deficits need not be very large to finance increasing nominal and real values of public goods. Figure 1. Real and nominal value of public services, 1996 to 2008 Source: The Economist, 2011 Did the UK perform something extraordinary in its fiscal policy? According to Adam et al. (2010, p. 2), UK taxation in the last thirty years is not much different from the policies that other countries have implemented worldwide: government has increased the share of value added taxes but reduced both specific and income taxes. Yet at the same time, Adam et al. (2010, p. 2) described the UK taxation has been unusual to some extent in the following respects: UK imposed zero VAT to many goods compared to other countries. UK abolished tax relief for mortgage interests. UK has only a small share of tax revenues from social security contributions. UK has an “unusually” large share from recurrent taxes on buildings. Even if indeed there was redistribution in favour of the poor through taxation, Adam et al. (2010, p. 3) were unsure if inequality in the UK has decreased. This observation appears indicative that reduction of inequality does not constitute to be a main cornerstone of the UK’s tax policy in the UK’s fiscal framework. According to Adam et al., the redistribution in favour of the poor that has taken place was done to strengthen financial work incentives before anything else (2010, p. 3). In summarizing the main tax reforms from 1978 to 2008, Adam et al. (2010, p. 11) pointed out the following: The basic rate from income tax was reduced from 33% to only 20% The top rate of 98% from unearned income and 83% of earnings was reduced to a significantly low 40%. The higher value-added tax higher rate of 12.5% was abolished but the standard rate increased from 8% to 17.5% (recall however that there are relatively many item that are zero-rated in terms of VAT taxes). Capital gains taxes returned to a flat rate. Inheritance taxes replaced capital transfer taxes. Corporate main taxes were reduced from 52% to 28%. Tax rate on small companies was reduced from 42% to 21%. The lower tax rate was ultimately reduced. Variable local business tax rates were replaced by national rates. In the opinion of this writer, another way of summarizing the tax reforms enumerated by Stuart et al is in this form: the tax reforms from 1978 to 2008 attempted to reduce tax distortion but it may have created new distortions and retained some of the old ones. One possible evidence for this is that despite a movement to reduce price distortions, there were items that were VAT zero-rated and this may have created the price distortions. The zero-rated items in terms of value added taxes are in most food, construction of new dwellings, domestic passenger transport, international passenger transport, educational materials, water and sewerage services, prescription drugs and medicines, and charity supplies (Stuart et al. 2010, p. 63). It seems strange that some ships and aircraft above a certain size were also included in the items subject to zero-rated VAT (Stuart et al. 2010, p. 63). In addition to the zero-rated value added tax are items exempted from VAT and these are the rent on domestic dwellings, rent on commercial properties, private education, health services, postal services, burial and cremation, finance and insurance, betting, cultural admissions, and some of the business registrations (Stuart et al. 2010, p. 63). It seems very important to review the UK VAT structure in the interest of reducing further the price distortions that the variable tax rates may have created even as the concern for reducing the impact of VAT taxes on the poor and lower income groups is a valid and a pragmatic policy. It is a valid and pragmatic policy because tax policy has to bow down to public inputs or pressures or else policy may become unsustainable and even unimplementable given the lack of political support. Key political interests can override short-term efficiency considerations in tax policy. For instance, because of the concerns on climate change and global warming, tax policy has to respond to political inputs calling for tax rates intended to discourage the production of greenhouse gases believed to exacerbate global warming and climate change. In line with this point, Stuart et al. (2010, p. 66) noted that the UK government’s domestic goal is for a 20% reduction in carbon dioxide emission between 1990 and 2010 (Adam et al. 2010, p. 66). Meanwhile, assessing fiscal management can be difficult because of the debates between the classical and Keynesian perspectives (or New Classical and New Keynesian perspectives) on the matter. The Classical perspective fundamentally argue that discretionary fiscal policy that allows deficit spending is basically unsound while Keynesian approaches call for the use of fiscal policy either to move the economy towards full employment or simply to affect aggregate demand. We are also aware, of course, of the perspective of Giammaroli et al. (2009) on how fiscal soundness should be assessed. The simplest version of the Giammoroli et al. perspective (2009, p. 8-1) calls for the use of indicators to assess fiscal soundness. One indicator, for instance, is intertemporal sustainability gap that is discussed in Giammoroli et al. (2009, p. 8). For lack of space, however, we do not discuss the concept here. Besides these, I hereby point that there can be a simple way of assessing fiscal soundness. I propose that, at minimum, the soundness of fiscal policy must be assessed based on two points. One important criterion for assessing fiscal soundness is whether deficits are being avoided and if they are not, whether the deficits are being incurred in a manner that future generations are not sacrificing so much for the frivolities of the earlier generations. However, this is difficult to answer as well and I propose a more simple or simple or proxy analysis on the matter, we compare instead how the UK has been managing her fiscal arena compared with her peers. Of course, another criterion that can be devised to assess soundness of fiscal policy is to find out whether distortions or new distortions are being introduced in the economy. Distortions in resource allocation can happen if price the price signals are distorted by a tax system and our earlier discussion has indicated that this is probably the case. Let us tackle this point: is the UK managing her fiscal arena in a comparable manner with her peers? In May 2010, Standard Chartered Global Research called the attention of the United Kingdom along with the United States and Japan to address their “fiscal crisis” by maintaining monetary policy loose enough to offset the tighter fiscal policy that results from crisis (p. 10). Further, Standard Chartered Global Research attributed the “fiscal crisis” of developed countries, including the United Kingdom, to “profligacy in the good times, deep recession and only moderate growth prospects” (p. 1). According to the Standard Chartered Global Research, the International Monetary Fund suggested that the United Kingdom need to cut its “primary deficits by 13ppt of GDP” or by 13 percentage points of the gross domestic product (2010, p. 1). The Standard Chartered Global Research warned that if develop countries, the United Kingdom included, move slowly to address their crisis, there can be an overall economic crisis (2010, p. 1). Figure 2. Structural debt, net debt, financial debt and gross debt of UK compared with OECD countries Source: Standard Charted Global Research 2010, p. 3 According to the figures of the Standard Chartered Global Research, the United Kingdom or the UK is the country with the highest structural deficit at negative 10 percent of the GDP and net debt that is more than 50ppt of the GDP. This is shown by Figure 2, left panel. In addition, the UK has the largest financial deficit at more than 12 of the GDP and a gross debt of close to 100ppt of the GDP. This is shown by Figure 2, right panel. According to the Standard Chartered Global Research, IMF data suggest that the UK will let her debt rise to rise by about 40 to 50 ppt of GDP by 2014. Perhaps, what highlights the undesirable situation is that based on IMF figures and data cited by the Standard Chartered Global Research, the situation of the United Kingdom will be worst relative to the condition of the United States, Germany, France, the European Union as a whole, Canada, and many other countries. Based on forecasted data for 2010 to 2020 by the International Monetary Fund documented by the Standard Chartered Global Research, the United Kingdom has to make a fiscal adjustment that would result to primary balances adjustment equivalent to 12.8 percent of the GDP. Among developed countries, the Standard Charted Global Research echoed the IMF assessment that the UK is the second worst in managing her fiscal figures. The projected bad figures for 2010 to 2020 of the United Kingdom are surpassed only by Japan who has to make adjustments involving 13.4 percent of the GDP. The situation of the UK is worse than the figures for Ireland, Spain, Greece, United States, Portugal, France, Belgium, Austria, and Italy. This is indicated by Table 1. Table 1. IMF estimates of required adjustment in primary balances 2010-2020 Source: Standard Charted Global Research based on IMF data (2010, p. 3) Despite the large current and projected fiscal deficits of the UK, however, the UK is only a medium-scale public spender as a percentage share of the GDP. This is shown in Table 2. Table 2. UK as a medium-scale public spender Source: Dewan and Etlinger 2009, p. 5 More than anything else, Table 2 suggests fiscal management has been failing in the United Kingdom: large deficits are being incurred and, yet, the country is only a medium-scale spender in the OECD for public goods and services. Dewan and Etlinger (2009, p. 4) analysis of the financial imbalances for 2007 and 2010 confirm that the UK (together with the Ireland) are among the two OECD countries with prominent general government financial imbalances. This is shown in Figure 3. As indicated by the Figure, the United Kingdom has negative imbalance of 2.7 percent of the GDP in 2007 and this increase by so much to 14. 5% of the GDP in 2010. Note that in the figure, the UK and Ireland stand out and they are the two countries that deviate terribly far from the norm. Figure 3. Central Government fiscal imbalances of the UK compared with other countries Source: Dewan and Etlinger 2009, p. 4 Clearly, there is strong basis for the concern that the United Kingdom may not be soundly managing her fiscal arena because the country is performing poorly compared with her peers. Meanwhile, on the second point, on whether price distortions are being introduced by a taxation system, it should be pointed out that during our earlier discussion, we have noted from the material of Adam et al. (2010) that the VAT tax rate in the UK has many items in zero-rated and many other items are VAT exempt. In my opinion, this is adequate evidence to argue that, most likely, the fiscal policy of the UK has introduced many distortions to her economy. In sum, data indicate that the fiscal strategy of the United Kingdom does not lead the nation to sound fiscal management despite the United Kingdom’s current rhetoric of “sound finance” and “golden rule”. References Adams, S., Browne J., and Heady, C., 2010. Taxation in the UK. In: Stuart Adam et al. (ed) for the Institute for Fiscal Studies, Dimension of tax design. New York: Oxford University Press. Dewan, S. and Ettlinger, M., 2009. Comparing public spending and priorities across OECD countries. Washington: Centre for American Progress. Giammorioli, N., Nickel, C., Rother, P., and Vidal, J., 2007. Assessing fiscal soundness: Theory and practice. Occasional Paper Series No. 56. HM Treasury, 2008. The government’s fiscal framework. London: HM Treasury. Standard Chartered Global Research, 2010. Greek wake-up call for US, UK, Japan. Special Report, 14 May. Available from: www.standardchartered.co.jp [Accessed 4 April 2011]. The Economist, 2011. Where Thatcher feared to tread. Available from: [Accessed 4 April 2011]. Read More