Tuesday, February 05, 2008

Size Does Matter

Thatcher was a sharer too

Spending and growth are back in the news, with Shadow Chief Secretary Philip Hammond telling the FT:

"....the proposal that we should cut back the growth in public spending more harshly than Margaret Thatcher did is pretty odd... [the idea was] an extraordinary one last summer, it’s quite a barmy one now ... It’s not a sensible approach at this point in the cycle”.

Ah. There we were thinking Hammond was shaping up quite nicely, when he goes right back to political positioning ahead of economics. Even though, as ConservativeHome points out, the overwhelming majority of Hammond's own party members want to see much slower public spending growth.

Which is All A Bit Of A Shame.

The TPA's Corin Taylor explains here how Hammond is missing some key economic points. In particular, nobody's suggesting cutting spending growth alone- the idea is to cut spending growth to fund tax cuts. Because, as we've blogged many times, all the serious evidence now tells us that lower taxes mean faster growth.

And on that very subject (as Corin notes), the European Central Bank recently published its own paper , snappily entitled Government Size, Composition, Volatility and Economic Growth. It conducted a detailed econometric study covering 28 major economies over 35 years and concluded:

"Total [government] revenue and total expenditure seem to impinge negatively on the real growth of per capita GDP both for the OECD and the EU countries. In particular, a percentage point increase in the share of total revenue (total expenditure) would decrease output by 0.12 and 0.13 percentage points respectively for the OECD and for the EU countries."

0.12-0.13% pa may not sound much, but cumulatively it's huge. As Mr Stumbling and Mumbling explains:

"This implies that the rise in government spending we've had in the UK since 2000 (from 37.2% of GDP to 42%) would, if sustained take half a point off GDP growth, making us more than 5% worse off in 10 years' time than we would have been had spending stayed at 2000's levels."

So how does the ECB's conclusion stack up against the OECD econometric work we've blogged before (eg here)? As you will recall, the OECD said:

"Taxes...seem to affect growth both directly and indirectly through investment. An increase of about one percentage point in the tax pressure... could be associated with a direct reduction of about 0.3 per cent in output per capita. If the investment effect is taken into account, the overall reduction would be about 0.6-0.7 per cent." (The Sources of Economic Growth in OECD Countries, Section 2.3)

Following S&M, the extra 4.8% on government's share of GDP since 2000 might be expected to reduce per capita GDP in the long-term by about 3.3%.

In other words, this new ECB work suggests the size of government is even more important in determining our future incomes than previously thought.

Hammond isn't dumb, and has an economics backgound (well, PPE anyway). So he's surely familiar with the now overwhelming economic case for smaller government. And surely he can't really believe in fiscal fine tuning for a smallish open economy like ours.

So what gives?

Alas, it really is more of that key marginals, don't frighten the horses, trust us, we will downsize government one day, definitely, maybe stuff.

Meanwhile, for every extra 1% (£6bn) of public spending he allows, we can expect to be nearly 0.5% worse off in ten years time. He might have left the political stage by then, but we will still be here. Only poorer.

Footnote: The chart is ripped from the ever excellent IFS's paper on the Comprehensive Spending Review. It shows that even Thatcher shared the proceeds of growth, allocating around 22 pence of every extra pound generated by the economy to be spent by the public sector. Labour have so far allocated nearly 50 pence.


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