Justification Of The Recent Fiscal Stimulus Announced By Labour

Chancellor Alistair Darling on Monday 24th Nov, had delivered his annual PBR (Pre Budget Report) speech & described many of the upcoming measures as “extraordinary response to extraordinary times”.

Among highlighted issues:

(a) VAT (Value Added Tax) reduced from 17.5% to 15% starting 1st December to end of 2009

(b) £3 billion worth of capital spending on public works projects brought forward from 2010/2011

(c) Further support £1.3 billion to help those who are unemployed to find work

(d) Tax relief for businesses making losses & deferral of rise in corporation tax rates for small businesses

(e) Tax rate for high income earner will rise from 40% to 45%

(f) Increase in NIC (National Insurance Contributions), something that small businesses claim as tax on jobs will increase 0.5% in 2011

(g) Increase in alcohol & tobacco duty

(h)) A 2p per litre increase in fuel duty

Judging the fiscal stimulus

(1) Preventing economic downturn. The increase in government spending & cut in tax is justified. By channeling £3 billion onto capital spending such as motorway building, council housing, schools & energy efficient projects, the Labour government will be able to create more employment. Also tax cut is an essential way to encourage people to spend into the economy, thereby avoiding a period of deflation. To be honest, deflation seems to be inevitable & yet it is an issue that is not thought off by many. Few months ago, people are worried about stagflation since oil price rose to $147 per barrel in July

(2) To earn more tax revenue. By engaging in ambitious borrowing, the government hopes to see UK economy to recover in a year or two. By then, tax revenue will increase & it can be used to patch the current fiscal deficit. On top of that, government may no longer need to spend so much on unemployment benefits in future. If the government does not start borrowing now, very likely recession will become worse. Unemployment will rise & more will be wasted for unemployment benefits payout. Therefore, government borrowing rise anyway

(3) Inevitable. National debt as % of GDP will rise, but this is expected in the period of recession. The logic is, as economy is slowing down, size of GDP shrinks but the level of debt increase. Do the math & you’ll get it

(4) Effective. Cut in VAT will relatively have a greater impact onto low income earners than those rich ones. As goods become cheaper, it means increase in the purchasing power, especially those poor consumers. Given that low income earners have higher marginal propensity to consume (mpc) & that is higher tendency to spend, this can give a good kickstart to economy. The rich has lower mpc as they have owned most of the goods. Therefore whenever there is an increase in income or purchasing power, they are likely to save huge portion of it

Meanwhile the loss of tax revenue can be recovered by increasing the income tax onto those high earners. For instance, from 2011 onwards those who earn £150, 000 will have to pay extra £3, 000 on tax while those with earnings of £200, 000 will pay extra £ 5,000. This is an increase of 40% to 45%

(5) The past is worse. Current UK’s national debt is just 43% of its GDP. We have seen worse one, 70% of GDP in 1970 & yet the government successfully brought it down

Problems

(1) Cutting VAT & other form of taxes may not work. Cutting these taxes may not even encourage people or firms to spend. Most of it could be saved to face future economic uncertainties. Some could be used to pay off debts. Also spending may not take place as the public knew that they will have to pay it back somehow in the future by the way of higher tax

(2) Chancellor Alistair Darling could be too optimistic. He often mentioned about UK economic recovery by end of 2009 or 2010. In my opinion, the economic recovery which may take place in a year or two, could be ‘postponed’. This is because as the economy is about to recover that time, workers & firms will be slammed with burdening tax, increase in NIC by 0.5% by 2011

(3) Worsening current account deficit. Cutting VAT may encourage people to begin spending on imported goods, thus worsening of the existing current account deficit. Also if imports outweigh exports, net exports (X-M) will fall, thus pulling AD down

(4) Fall in tax revenue. The top rate tax to 45% may actually cut government revenues rather than increasing it. This is because more rich people will have the incentive to evade tax. Although any increase in tax rates on incomes above £150, 000 affects only 1% of earners, this accounted for 25% of all income tax revenue.

So what do they do? For those very rich, they will move offshore & perhaps run their business from a tax haven. That is what many sports stars do

(5) The Japan case. The government has spent £80 billion this year, & yet it fails to lift the British economy out of recession. Therefore what is the justification that the bigger £118 billion next year will be successful? Japan is a good example. The government has tried spending itself out of depression & as a result their National Debt amounts to 194% of their GDP, yet the result is not there