Free Lunch (22 page)

We are thus reproducing in the world trading system, in the name of free trade but through free trade areas that spread discrimination against producers in non-member countries, the chaos that was created in the 1930s through similar uncoordinated pursuit of protectionism that discriminated in favour of domestic producers. In both cases, the preferred solution would have been non-discriminatory pursuit of freer trade.

Are high taxes good or bad for you?

One of the most enduring debates in economics is over the level of tax and government spending, and whether high taxes depress economic growth. In the previous chapter we encountered the American supply-siders, and the view that after a point high taxation not only did economic damage but was counter-productive in terms of its main purpose, that of raising revenue. It was an article of faith when the Conservatives were in power in the 1980s that lowering taxes on income boosted incentives (mainly for the better-off) and led to stronger sustained growth, for supply-side reasons. Tony Blair’s Labour government explicitly moved away from this line of thinking in the April 2002 Budget, raising National Insurance contributions, a tax on income, for all, for the purposes of boosting public spending. On average across the industrial countries, government spending has increased from about 11 percent of gross domestic product in 1870, when it was mainly concentrated on military expenditure, to just under 45 percent now, when it covers an array of public services, as well as the welfare state. In relatively recent history in Britain, the overwhelming majority of working people paid no income tax. Now the vast majority do so.

Yet the rise and rise of government spending, and therefore taxation, has been associated with more prosperity, not less. Where has the damage occurred, when real disposable incomes, after allowing for inflation and tax, have increased to record levels in spite of a rise in the government’s share of GDP? The puzzle becomes even greater when we look at comparisons between countries. At the time of writing both America and Japan have levels of tax of about 30 percent of GDP. America is a highly successful and dynamic economy while Japan, during the 1990s, appeared to have entered a state of permanent depression. One of the most successful economies in Europe, Finland, has government spending and tax of just under 50 percent of GDP while another, Ireland, has about 35 percent. On the face of it, there is no relationship between the level of tax and public spending and economic performance. How would an economist go about trying to solve this puzzle?

The answer is firstly to deconstruct some of the data. Yes, prosperity has risen strongly during a period in which the size of government has increased. It may be, however, that it would have risen a lot more if tax and public spending had remained lower, as some studies have shown. The second point is to recognize that the size of government is not the only factor at work at any time. If we take the Japan–America comparison, for example, one argument would be that Japan’s low tax advantage in the 1990s was swamped by other factors, most notably the prolonged effects of the abrupt ending of a huge speculative boom (the ‘bubble’ economy) and an ageing population. Not only that, but the response of the Japanese government to the difficulties of the 1990s was to increase public spending sharply, which could have added to the problem. More fundamentally, at the root of the tax-and-spending question is the motto of this book, there being no such thing as a free lunch. There is a cost to raising tax, for it means, in the case of individuals, that they will tend to have less incentive to work and less money to spend. Against this have to be set the benefits of government spending. A government that spends wisely and efficiently on health, education and other public services, with the full support of taxpayers, may do so in a way that not only offsets the economic costs incurred in taxation but also sometimes exceeds them. There is a net benefit, in other words, from raising taxes to increase government spending. Thus countries that spend taxpayers’ money efficiently can prosper with higher taxes than others. The settled societies of the Scandinavian countries, which at one stage increased government spending to 60 percent of GDP, appeared to be examples of this. Appropriately enough it was a Swedish economist, Knut Wicksell, who gave us the notion of the ‘Wicksellian equilibrium’, the level of tax and government spending that most closely reflected society’s preferences.

All this still leaves some economists uneasy. Surely there must be some kind of rule that can be laid down about optimal size of government, the level of taxation, even if there will always be exceptions to that rule. In general, studies show that government spending is quite efficient when it starts from a low level and, for example, introduces universal education, healthcare and a pension safety net. These things, particularly better education and health, contribute to economic growth. A major study by Vito Tanzi and Ludger Schuknecht,
Public Spending in the 20th Century: A Global Perspective
, as well as work by Robert Barro, conclude that the gains between 1870, when public spending in industrial countries averaged 11 percent of GDP, and 1960, by which time it was nearly 30 percent, were well worth having for those reasons. Beyond that, however, any gains are questionable. ‘We have argued that most of the important social and economic gains can be achieved with a drastically lower level of public spending than prevails today,’ Tanzi and Schuknecht wrote. ‘Perhaps, the level of public spending does not need to be much higher than 30 percent of GDP to achieve most of the important social and economic objectives that justify government interventions. However, this would require radical reforms, a well-working private market, and an efficient regulatory role for government.’

David Smith, a namesake of mine who works for the City firm Williams de Broë, has tried to calculate the effects on economic growth from boosting government spending’s share beyond 1960 levels. His work suggests that in all cases there has been a negative impact, although the impact varies. In America, where the spending boost has been smallest, growth has suffered an average 0.8 percent a year loss. In Britain, it is 1.1 percent. But in Sweden, where the size of government grew most rapidly, the effect was to depress growth by a huge 3.7 percent a year. At a time when the Labour government in Britain has embarked on a big increase in government spending, it is worth reminding ourselves that some things do not come free.

Is the euro a good idea?

There will be those who argue that taxation and government spending raise questions beyond economics, questions of philosophy and the freedom of the individual. And there are plenty of people who say that the European single currency raises profound questions of politics and sovereignty. If Britain were to throw in her lot with Europe by joining the euro – hot topic at the time of writing – some would say it would be the equivalent of signing up to a European super state. Whether that is true or not, it remains the case that economics should play a central role in any decision on joining the euro, as explicitly recognized by Tony Blair’s government. It set five
economic
tests for entry – whether it would be good for jobs, the City and investment, and whether Britain was sufficiently converged with Europe, as well as being flexible enough, to make a success of membership.

The question of euro entry lends itself perfectly to cost–benefit analysis, to assessing the arguments on either side. I say perfectly, but there will always be room for dispute among economists about the extent of those costs and benefits. There is, too, the matter of attributing risk. Suppose, as with any decision, there is the potential for a series of small gains but on the other side, a risk, perhaps a small one, of complete disaster. Correctly assessing the disaster risk is plainly pivotal to making the right decision. Anyway, what are the costs and benefits of the euro, and in particular of UK entry? Let me start with the benefits:

Joining the euro means certainty and stability for business, particularly exporters. In Britain, where firms have had to cope over the years with a highly volatile exchange rate, this could be a significant plus. Firms could plan long-term strategies for export markets on the basis of currency certainty, and invest accordingly.

It could lead to an increase in trade. Europe’s single market, free movement of goods, services, capital and people, officially commenced at the end of 1992, although it has yet to be completed in many of these areas. One argument is that having different currencies is itself a significant barrier to trade and until all fifteen (at the time of writing) EU members have adopted it Europe can never be a true single market, on the scale of, say, America. A single currency, in other words, is needed for a single market.

It lowers and in many cases removes transaction costs. Everybody knows the story, perhaps apocryphal, of somebody who starts in Dover with £100, changing into local currency each time he visits a different EU country (this is a pre-euro story). By the time he gets back the £100 has gone, not because it has been spent but because each time commission has had to be paid for changing the cash. As I said, this is a pre-euro story. Even so, UK individuals and companies dealing with Europe still have to go through the hassle and expense of changing currency. These costs are not high – removing them was calculated by the European Commission to be worth 0.3 to 0.4 percent of EU GDP annually – but they are not negligible either.

Interest rates are lower in the euro area, ‘euroland’. For a long time, not least when interest rates of 10 or 12 percent or higher were common in Britain, one of the most powerful attractions of the euro (which then was still a twinkle in the eye of European politicians) was that it would offer significantly lower interest rates. Britain, in a sense, could buy into Germany’s low-inflation credibility. Economists would say that Britain’s interest rates were high for a reason, notably because the economy was prone to high inflation, but to the extent that rates were high because of sterling’s recurrent vulnerability, there was a point. Joining the euro provided a huge boom for some countries. Italy, for example, found that it could fund its government debt at significantly lower interest rates, removing its budget deficit problem at a stroke. For Britain the argument has diminished as interest rates have come down, although it is still the case that short-term rates – those set by the Bank of England and European Central Bank respectively – tend to be slightly lower in Europe.