Ignore the backbenches

business and industry, economy, taxation

Author(s):  David Nash
Published date:  16 Mar 2012
Source:  Progress Online

Speculation over what the chancellor will announce in his budget is hotting up. Despite improved business survey data last month, George Osborne knows that growth-boosting measures are desperately needed. Grim industrial production figures released on Friday serve as a timely reminder that the recovery is far from secure. But what should he prioritise?

A chorus of Conservative backbenchers and commentators are urging the chancellor to go to town on the supply side, by lowering corporate taxes, scrapping the 50p income tax rate and pressing ahead with a bonfire of red tape. In a widely-read piece for the Financial Times, former defence secretary Liam Fox recently suggested that wholesale deregulation of the labour market would be a good way to boost growth. He claimed it is currently too difficult and expensive to hire and fire workers in the UK, and this is why companies are reluctant to recruit. It is an argument that goes down particularly well with fiscally prudent Conservatives, who say such a move would cost nothing to the Exchequer.

There is, however, little evidence to support these claims. According to the OECD, the UK has one of the least regulated labour markets among advanced economies. Its employment protection index – which measures the protection of permanent workers against individual dismissal, the specific requirements for collective dismissal and regulations on temporary forms of employment – shows only the USA and Canada have less regulated labour markets. Hiring and firing is already relatively easy in the UK.

What is more, as David Blanchflower has argued, there is very little correlation across countries between the level of employment protection and the increase in unemployment since the beginning of the recession. Countries with much higher levels of employment protection than the UK, such as Germany and the Netherlands, have seen smaller increases in unemployment since January 2008.

Those arguing for greater deregulation of the labour market also forget that workers are consumers too. The flip side of making it easier to fire workers is to reduce job security. And lower job security is likely to make some workers more cautious spenders, thus sucking demand out of the economy at a time when it is already weak. Slashing labour market regulation could therefore lead to weaker growth in the short term, lower tax receipts and – if employers take advantage of any new fast-track dismissal rules – potentially a higher welfare bill. Hardly a fiscally prudent step then.

Businesses became increasingly reluctant to take on extra workers during 2011 not because labour market regulations were being increased; they were not. They stopped hiring because the demand outlook for their products and services deteriorated markedly. As a result, companies found themselves hoarding huge cash piles, instead of investing funds in new equipment or on hiring workers. So long as demand remains uncertain, further cuts to corporation tax – another supply-side remedy favoured by those on the right – will be do little to increase investment, generate growth or create jobs.

The solution, therefore, lies not in tinkering with supply, but in boosting demand. According to the Office for Budget Responsibility’s ‘impact multipliers’, the most effective way of doing this would be through extra capital investment in areas such as infrastructure, which, as IPPR has previously argued, would not only boost growth but also add to the country’s long term productive capacity.

The next best option would be to support hard-pressed consumers to increase their demand by raising their disposable incomes through cuts to personal taxes. In an article for the Times, US economist and chairman of IPPR’s Growth and Shared Prosperity Commission, Eric Beinhocker recommends a temporary two-year cut to employees’ national insurance contributions – mirroring Obama’s middle class tax stimulus – which could largely be paid for over six years by a one per cent levy on the value of homes above £2m.

Given his reluctance to increase spending, a boost in infrastructure investment seems unlikely. But the chancellor may have no option but to bow to pressure – including from his Liberal Democrat coalition partners who are pushing hard for a higher personal allowance threshold – to stimulate consumer demand and relieve some of the pressure on squeezed middle-class families.  Many Conservatives would like him to pay for their favoured tax cuts by further cuts to public spending, but as the OBR points out cutting spending takes more demand out of the economy than cutting taxes by the same amount puts back in. For this reason it should be a non-starter.

For political balance, the chancellor may therefore choose to act on the desire of Fox and his backbench colleagues for comprehensive labour market deregulation. If he does, it is unlikely to make one positive iota of a difference to the UK’s growth prospects.