The UK economy needs some Obama-style stimulus
According to the latest labour market figures, unemployment is up again. This is the eighth quarterly rise in a row and brings the jobless total to 2.67m, while the number of people in work fell by 44,000 over the last 12 months. Contrast this with the US, where unemployment has been on a downward trajectory since June last year and 2.5m new jobs were added to the labour market in the 12 months to February.
The latest OECD assessment finds clear evidence of an upswing in the US economy, but is much more tentative about the strength of the UK recovery.
One explanation for the divergent fortunes of the US and UK economies is that the less austere fiscal regime in the US has helped to drive up consumer spending, boosting growth and jobs. Most importantly, President Obama’s payroll tax cut injected $92 billion of stimulus into the US economy last year, adding $1,000 to the spending power of the average family. This contributed to a 2.2% increase in consumer spending last year, whereas consumer spending fell by 0.8 per cent in the UK.
Given the weakness of the UK recovery, the Chancellor should consider an Obama-style stimulus in next week’s budget. Rising unemployment combined with the political reality of fiscal restraint argues for two priorities in any stimulus package. First, it must be quick to implement. This favours tax cuts over higher infrastructure spending, which takes longer to come on stream. Second, it must be easy to reverse, delivering a temporary economic boost without damaging tax revenues in the long-term. A VAT cut fits both these criteria, but the Labour Party’s preference for this stimulus mechanism takes it off the table for this month’s budget.
The Chancellor’s Liberal Democrat coalition partners will be urging him to deliver a stimulus by going further in raising the threshold for income tax to £10,000, which would take some low earners out of income tax altogether. But a higher personal allowance in practice will represent a permanent tax cut (because no Chancellor will cut it again), weakening the UK’s tax base in the long-term.
A better option would be a temporary cut in the rate of income tax or national insurance, which can be quickly reversed after a year or two. Leading US economist Eric Beinhocker has suggested a temporary 2p cut in employee national insurance contributions to mirror President Obama’s payroll tax cut. This would deliver a direct stimulus of around £7 billion to the UK economy, and an extra £2-4 billion in additional economic activity.
IPPR analysis shows that cutting tax rates is more regressive than raising the threshold: the gains from a cut in tax rates rise with earnings, whereas a higher allowance gives taxpayers a flat rate amount. And neither directly helps the unemployed, who will not be paying tax. However, the need to maintain the UK’s tax base gives greater priority to measures that can be easily reversed. Increasing tax credits would help lower income families more than cutting taxes, but would be hard to reverse, permanently increasing government spending. Low take-up also reduces their effectiveness.
An effective stimulus would partly pay for itself through the higher revenues generated by extra growth and jobs. But the remaining cost still needs to be paid for - by raising taxes on those least likely to reduce their spending. One strong candidate is the much-discussed ‘mansion tax’. A 1 per cent levy on the value of properties above £2 million would bring in around £1.7 billion a year. Over six years, this extra tax would raise enough to pay for a two year national insurance cut in combination with the additional tax revenues that would be result from a stronger economy.
Obama’s payroll cut shows that a temporary tax cut for workers has the power to deliver a major boost to consumer demand, strengthening recovery and accelerating job creation. With unemployment at a 17-year high and rising, this month’s budget should do the same for the UK.