The Big Lie #2 (Part 2): Small Govt = Higher Growth

In my previous blog post I outlined some of my criticisms of the neoliberal stance against Big Government, and in particular the spurious arguments that are generally advanced in support of the concept of low taxes and the small state; arguments such as the Rahn curve. This is not to say that the Rahn curve is wrong per se. I doubt than many would argue that there should be no upper limit on government spending, or that politicians should always aim to make the public sector as large as possible. The real problems with the Rahn curve are twofold. 

Firstly, it implies that the only variable that matters in determining economic growth is the quantity of government spending, and not what the money is spent on, or other factors within the economy such as levels of investment (public and private), education, consumer demand or inequality. 

Secondly, it implies that there exists a single unique value for the ratio of government spending to GDP that is optimal for all countries irrespective of their size, their stage of economic development or their range of economic diversity. 

For example, there are many developing countries with smaller governments and much larger growth rates than the UK: China, Brazil, India for example. But even if all developing countries with smaller governments than the UK have larger growth rates, that does not mean the UK would increase its own growth rate by following suit and reducing the size of the State. These countries have higher growth-rates than the UK because they are playing catch-up. They don't have to "re-invent the wheel" because other countries have already done that for them. Their growth is not constrained by the limited demand of their own consumers because they can piggyback on the higher spending capacity of consumers in more developed countries. And their governments are small because the disposable income of their citizens is small and so their tax base is small. Therefore the economies of these countries contain no lessons from which we in the UK can learn. 

Instead much of the analysis tends to centre on comparisons between countries with advanced economies, particularly those in the OECD. Yet even here there is much subjectivity in the comparative analysis. 

For example, last year Martin Wolf of the Financial Times analysed the growth rates of the 18 most advanced OECD countries over the 22 year period from 1989 to 2011 and published them on his blog. The 16 OECD countries he ignored were: Chile, Czech Republic, Estonia, Greece, Hungary, Iceland, Israel, South Korea, Luxembourg, Mexico, Norway, Poland, Portugal, Slovak Republic, Slovenia and Turkey. 

The results (shown above) indicate that there is very little evidence that low tax economies yield higher growth rates. Martin Wolf's interpretation of the data was: 

 The first conclusion is that there is no relation between the share of government revenue and the rate of growth of real output per head (that is, productivity) over the 1989-2011 period. The “regression line” is flat. 

I disagree. If you discard the data points for Ireland and Spain for the reason that their growth over the period was artificially inflated by transfers from wealthier EU nations (Martin Wolf also discounts the Irish datum as being an "outlier"); and also those of Australia and Canada because they atypically have economies based on mining and agriculture rather than industry, banking and services (so their growth is not endogenous but is inflated by rises in commodity prices driven primarily by growth in China); then the data actually points to a positive correlation between Big Government and higher growth. The regression line through the remaining data points is linear and has a distinct upward slope. In fact the rise in growth rate is about one percentage point for every 28% of GDP spent by government. Not bad! Not bad at all in fact! 

Of course there are many other studies by right-wing economists and think tanks that claim to prove the opposite by selectively using different baskets of countries (often ones with wildly dissimilar economies and questionable political systems) or dubious statistical averages. The approach taken here by Ryan Bourne and Thomas Oechsle at the right-wing Tory/Thatcherite think tank, the Centre for Policy Studies (CPS) is a case in point and one that I find particularly dubious for reasons that I might discuss in a future blog post. 

One way to avoid the complication of comparing different countries is to stick to the same country but then compare its performance under different macroeconomic conditions. The history of economic growth in both the UK and the USA over the last 150 years is a good example. Over this period both countries experienced periods of small government (before 1929) and large government (after 1950). The neoliberals would have you believe that the earlier period, when government was small, was a period of dynamic and rapid growth, with the animal spirits of the entrepreneur freed from the later suffocating bureaucracy of the State. What rubbish!

The graph above illustrates the growth in real GDP per capita in the UK from 1850 to the year 2000 (green curve) together with the size of government (black curve). I have highlighted two distinct regions. The blue region is the period of small government where government spending was generally less than 15% of GDP (with a slightly higher blip during the 2nd Boer War). The pink region is the period of Big Government where government spending was generally above 35% of GDP. The period from 1915 to 1950 has been discarded from the analysis because the economy over this time period was dominated by war spending for the First and Second World Wars. Yet the contrast in GDP growth between the blue and pink periods is stark. 

Firstly, GDP growth was more unstable in the blue period than it was in the more recent pink period. There were more recessions and those recessions were deeper. The twenty year rolling average of GDP growth (as indicated by the red curve) also shows two distinct patterns of behaviour. This data is shown again on the graph below for greater clarity. 

Before 1940 the twenty year rolling average of GDP growth never rose above 1.3%. After 1950 it rarely fell below 1.5%. The average growth rate over the 65-year long blue period 1850-1915 was only 0.94% per annum. For the post-war pink period of 1950-2000 it was more than 2.2% per annum. These are striking differences! 

And yet they are not just confined to UK economic performance. Exactly the same trends are to be seen in the economic data of the USA over the same periods. 

When one looks at the economic data of the USA for the 25 years immediately prior to the 1929 crash one sees that US government spending averaged less than 10% of GDP. For the 25 years before that the average was even lower at barely 3% of GDP. In contrast, over the period 1950 to 2000 the average was closer to 35% of GDP. 

For the period 1879-1929 real GDP was 5.5 times larger in 1929 than it was fifty years earlier. That equates to an average annualized growth of 3.47%. Yet for the fifty years after 1950 the factor was 5.6 and so the growth was actually slightly higher at 3.50%pa. However this neglects the effects of population growth. 

Between 1880 and 1930 the US population grew by 150% whereas from 1950 to 2000 it only grew by 86%. So the annualized growth rates in real GDP per capita for the two periods are actually 1.6% and 2.2% respectively. Once again that is a big difference, particularly when continued over fifty years, although the difference is not as stark as in the UK. This difference over time can be seen in the plot of the 20-year rolling average of GDP growth in the graph below. 

However the benefits of higher public spending don’t end there. They are also seen in the volatility of the growth rate and the frequency and severity of the ensuing recessions, just as in the UK case. The striking thing about the GDP growth rate over the period 1879-1929 is its extreme volatility. One year growth could be over 10% and a couple of years later GDP is contracting by just as much. This happened repeatedly over that period. As a result the average growth rate was 3.6% but the standard deviation in this value was even greater at 5.2%. 

Contrast that with the second half of the twentieth century where the average growth rate was 3.5% but the standard deviation was actually much smaller at 2.3%. Not only that but this period also experienced recessions that were mild by historical standards with contractions in GDP of typically only 1%-2% each time. The period 1879-1929 on the other hand was blighted by repeated recessions where GDP contracted by 5%-10% or more. 

What this demonstrates is the stabilizing effect of high government spending (plus of course the added benefits of a Federal Reserve Bank and deposit insurance instead of a system of free banking which existed for most of the 19th Century). It is easy to see why. If government spending is high and generally fixed, then the capacity for the economy to contract during a recession is reduced. So recessions are less severe, less capital investment is lost due to business failures and so when the recovery begins less new capital investment is needed to replace what was lost in the recession. Thus the economy functions more efficiently with higher overall growth rates. 

Moreover, even in boom periods Big Government aids growth because it provides the private sector with guaranteed markets. That improves business confidence and therefore raises long-term investment. Not only that, but Big Government also increases the level of redistribution within the economy, thereby reducing inequality and raising aggregate demand, which also boosts investment confidence and growth. 

So for those still hankering after small government I suppose the BIG question is this. Which type of economy do you really want to live in? 

(i) An economy with more government that offers better public services, higher growth, fewer recessions, greater economic stability and security, less inequality and few if any depressions? 

 Or: 

(ii) An economy with inadequate small government that can only offer poor public services, low growth, more recessions, greater economic instability with little long-term security, more inequality and regular massive depressions? 

Wow! What a tough choice.

Why is Labour afraid of a 'Mansion Tax'?

Is there a causal link between the British obsession with property ownership and the reluctance of our government to tax it? I can only think there must be, because I can't come up with any other reason why a Labour government would have failed to endorse Vince Cable's proposal for a 'Mansion Tax'.

Ever since Vince Cable announced his proposal it seems as though it has been subjected to a barrage of venomous criticism from all sides. Not surprisingly, most of this criticism has emanated from the small sect of people that would have the most to lose from this tax: those that make up the wealthy core vote of the Tory party and their cheerleaders in the right-wing press. Nor is it perhaps surprising that many Lib Dems also appear rather bewildered by it, given that it totally contradicts and undermines their currently stated opposition to that other established property tax: the Council Tax. What I really don't understand, though, is why those on the Left, and particularly most of the Labour Party have not enthusiastically embraced this tax policy. After all, it goes to the heart of what most socialists believe in and are striving for: a fairer and more equal society with a fairer and more even distribution of wealth. It targets extreme wealth, inherited wealth, and the idle rich. Moreover, because it targets fixed assets it is impossible to avoid. People and businesses can move between countries and tax jurisdictions: property can't. Personally, I only have one problem with this tax: it doesn't go far enough.

The tax Vince Cable proposed was originally going to be set at a rate of 0.5% on the excess value of any property above a threshold of £1 million, and was expected to yield over £1bn in revenue. Unfortunately, Vince then appeared to lose his nerve and watered down his proposal by raising the threshold to £2 million. Presumably the Lib Dems were worried that the original proposal might lose them too many votes in their key marginal constituencies in and around London. As a result the tax is now worse than useless. Like Labour's 50% income tax band that I slated in my last post, this proposal doesn't raise sufficient revenue to make it politically worthwhile. It won't fill the fiscal black hole that we are currently staring into, nor will it either help rebalance the property market or contribute anything significant towards promoting greater wealth redistribution and a fairer system of taxation in this country.

Instead of a 0.5% tax above £2m, the tax rate should be set much higher and the threshold set much lower (and closer to the current Inheritance Tax threshold). In short, it should be set at a minimum of 2% on excess property values above £500k. Now that would be truly radical, and it would yield almost £10bn for The Treasury. If the tax were also to be levied on all second homes and buy-to-let properties below £500k, and all commercial land not already covered by business rates (such as speculative land banks etc.), the total could be closer to £20bn. Not only would such a proposal be both radical and progressive, it would also allow the Government to address the problem of the budget deficit without cutting services or raising taxes on income and consumption that could damage the fragile economic recovery.

Of course those that would be hit by this tax would claim it was both unfair and arbitrary. In fact it is neither. The rate at which this tax is set is consistent with existing property taxes. It is, therefore, the absence of this tax that is unfair. To understand why, we need to consider the other main property tax that is levied on the populus: Council Tax. It is the iniquity of this tax that demands the introduction of the Mansion Tax, and also helps determine the rate and threshold that should be imposed.



The average Council Tax in the UK is now nearly £1500, compared to the average property value of about £165k. For most people, this equates to a 0.9% tax on the asset value of the property they live in, irrespective of whether they actually own that property or not. Yet this tax is not levied in proportion to the actual house price, nor even the price back in 1991 when the last valuation took place. In fact, as the graph above illustrates, the relative burden of this tax falls disproportionately on those occupying houses valued in the lower bands (A-E) who would also be expected to have lower incomes and net wealth, while the rich end up paying a much lower rate of tax when measured either as a proportion of their income or their wealth (i.e. property value). This cannot be fair, and goes against all established principles of progressive taxation. It is because of this iniquity that the Mansion Tax is needed.

This then is the rationale behind such a tax. Currently most Council Tax payers (or at least those in bands A-E) are paying approximately 1% of the asset value of their property in tax each year. Yet coincidentally, this equates almost exactly to the amount they would pay in extra income tax (at 20%) from the typical maximum rental income (about 5% of asset value) that they could reasonably be expected to derive from that property. In other words, they are in effect being taxed on the potential income that the equivalent property investment might yield. So, applying the same principle to those living in more expensive properties (bands F-H), who are also likely to be higher rate (i.e. 40%) income tax payers, means that their tax rate should be 40% of the rental value (which in turn is 5% of the asset price), and this then equates to a property tax equal to 2% of the asset value. As for the level at which the threshold for this tax is set, well that should be determined by the point on the graph above at which the tax rate under the current system plateaus off in favour of the rich. This occurs at about band F/G, or 1991 property values of about £160k. Today these properties are valued at about £500k.

There are two main objections that critics of this tax usually try to raise to demonstrate, either its unfairness, or its impracticality.

The first objection is that the tax will prove far too difficult to collect because it is just not possible to value each property accurately enough, or the property values will change with time. If this were true, though, then surely the same problems should apply to the collection of Council Tax and inheritance tax, shouldn't they? So how is it that these taxes appear to work perfectly well? If it is possible to value a property for the purposes of levying Inheritance Tax upon it, then it should be equally possible to value the same property for the purpose of this Mansion Tax. Remember - the Inheritance Tax threshold is currently below the level at which I would propose levying the Mansion Tax. So every property that would be subject to the Mansion tax in the future is already potentially subject to Inheritance Tax now.

The second objection is equally spurious. It is based on a belief that all taxes should be based on the principle of a person's ability to pay. This in itself is a noble and just position to take. Unfortunately, those that seek to oppose wealth taxes like the Mansion Tax presume that one's ability to pay, as they define it, is determined solely by one's income, and not by one's accumulated wealth. Thus they invent the hypothetical case of a little old lady living alone in a vast mansion, with little or no income to support her, other than maybe her paltry widow's pension. This is supposed to highlight the gross unfairness of the tax. With little or no income, how can she pay the tax? An equally valid question though is, with no income how can she maintain the property at all, irrespective of whether it is taxed or not? How will she be able to pay for the roof to be mended, or the electrical wiring replaced, or the boiler repaired?

The fact is that this hypothetical old lady is just that: hypothetical. She doesn't exist because no-one with an ounce of common sense would ever take on the responsibility of the upkeep of such a property without having sufficient excess capital to maintain both the property and their own lifestyle. If though, by some one-in-a-million chance this old lady did exist then there would still be many ways for her to pay. She could sell her home, and downsize, by acquiring a smaller and cheaper property. The capital profit could then be used as income. Alternatively she could re-mortgage and use the capital lump sum to fund her lifestyle.

In effect this argument against this Mansion Tax actually reduces to one in favour of the landed gentry being allowed to live beyond their means. Contrast that with the outcry that would emanate from the same right-wing voters if a group of penniless squatters were to take over a property and expect to live in it tax-free.

The plain fact is that this Mansion Tax is both fair and necessary. With the UK's wealth now estimated to be in the region of £6 trillion, and an astonishing 55% or more of that accounted for by unproductive residential property, it is obvious that we need to rebalance our economy. We need a taxation regime that encourages people to invest in productive assets, not unproductive ones, and the Mansion Tax would do just that if its scope were extended to cover buy-to-let investments and other private property portfolios.

To put it simply, the Mansion Tax is the missing link in our tax system that would do far more to reduce inequalities of wealth than the 50% income tax rate or Inheritance Tax will ever do. It will also raise far more revenue than both these taxes combined, and could even replace them. It is also supported by both Polly Toynbee of The Guardian, and Martin Wolf of The Financial Times.

If we are serious about trying making Britain a more equal and less economically divided society, then the issue of wealth inequality in this country needs to be addressed. With the wealthiest 10% of Britons now owning more of this country's assets than the remaining 90% put together, and with that disparity widening further with each passing year despite the efforts of the current government, something needs to change. Up until now government tax policy has focussed obsessively on revenue raised from income and consumption. Yet, as I pointed out in my previous post, by using higher tax bands for income tax as its preferred method of wealth redistribution, this government actually risks damaging the wider economy by reducing the amount of entrepreneurial activity within the economy. Rather than taxing liquid wealth, the government would be better served by taxing accumulated idle wealth, and by far the largest and least-taxed component of that wealth is property.

Moreover, this tax, unlike many others (such as the recently announced disastrous rise in National Insurance or the abolition of the 10% income tax band) has no electoral downside for Labour. It will have no impact on Labour's core vote, and it will be invisible to swing voters in marginal constituencies, as neither group will be targeted by the tax. Nor does it have the negative economic consequences that recent rises in National Insurance and Income Tax could have, particularly in the midst of a deep recession, by reducing consumption and demand within the economy, and thereby endangering jobs and the speed and scale of the recovery. Instead it targets dead money: money that would otherwise either remain idle and unproductive, or would be used to boost speculative asset prices such as property values; i.e. the same asset prices that caused this very recession in the first place. In fact this tax would target the ill-gotten gains of those that made the most money during the last credit boom, and whose earnings and increase in wealth we now know were both in large part undeserved because they were based on fictitious or inflated profits in the financial sector during the economic boom years.