Hamish McRae: Corrupt, tangled in red tape, with a failing legal system. Surely they don't mean us?

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The Independent Online

There are two completely different ways of thinking about the tax and spending policies of Gordon Brown, who presents his next pre-Budget report tomorrow.

The conventional way is to look at the accuracy of his economic forecasts, the viability of his tax and spending proposals, and the implications for us as taxpayers. There is nothing wrong with this; understanding how taxation and public spending is developing is the key to making a judgement on the performance of any government. Some thoughts about that in a moment.

But there is another approach, which is to look at the ways in which ideas about taxation and public spending in the developed world are changing and then seeing how this country fits into these wider patterns. What is really interesting here is that you can see how the UK was an early reformer, starting in the 1970s when Denis Healey was chancellor, but recently has gone into reverse when compared with most other countries. First, what is in store for us on Monday?

The initial thing to get out of the way will be the new economic forecast, which will show that growth this year will be around 2 per cent instead of the 3-3.5 per cent in the Budget forecast. Most independent forecasters, looking at present trends, think it will be only about 1.7 per cent but that figure may be revised upwards later. This matters not because it is embarrassing for Gordon Brown to be so wrong but because lower-than-expected growth undermines the fiscal arithmetic: revenues come in low and spending tends to rise.

The most recent evidence here is some really bad CBI survey numbers about consumer demand last week, which suggested retailers are more gloomy than they have been for the past 22 years. I can't quite believe things are as bad as that, given that one of the reasons for consumers to hold back - flat house prices - now seems to be recovering. But it is worrying because consumption is 70 per cent of demand and if it is flat growth could fail to recover next year.

The other new bit of information has been not-too-bad borrowing figures from the Government. Revenues are not good but they are not dreadful; and in the past month or so there seems to have been a squeeze on spending. The issue is whether or not the Chancellor can stick to his Budget forecast for borrowing. The City consensus is that he will overshoot the target of £32bn by at least £5bn.

What matters more is what happens next. Will there have to be tax increases to fund additional spending? Or will he manage to scrunch the spending down while maintaining that the public sector is getting the additional resources to pay for improvements in services?

The answer is probably a bit of both. Any tax increases will be minor, partly because it would be seen as a betrayal of trust and partly because it makes little sense to increase taxes when demand is slowing. But he will put pressure on the public sector, where productivity has been falling in recent years, pulling down the performance of the whole economy. He will argue that, had the public sector achieved its efficiency targets, it would have plenty of money to expand services. The whip-cracking in the poorly performing parts of the NHS has already begun.

The big picture as far as UK fiscal management is concerned? Strip away the stuff about golden rules, economic cycles and prudence and it looks OK, but not as good as it appeared three years ago. If the economy continues to slow, things will get somewhat worse in the future.

The other way of looking at UK policy is to see it in its global context. Since the 1980s nearly all developed countries have been reforming the way they operate, with the effect that the size of government worldwide is starting to fall as a percentage of GDP. The pattern has been to cut less effective spending on things such as industrial subsidies and focus on things such as education and health care.

A new study, Reforming Public Spending - Great Gain, Little Pain, by Ludger Schuknecht and Vito Tanzi, has just been published by Politeia. The authors have had practical experience of looking at governance internationally: Dr Schuknecht is at the European Central Bank, Professor Tanzi was until recently at the International Monetary Fund.

They look at trends in public spending and divide the different countries into early reformers and later reformers, and ambitious reformers and timid ones. Belgium, Ireland, the Netherlands and New Zealand are ambitious and early. Austria, Canada, Finland, Norway, Spain and Sweden are ambitious and late. Australia, Luxembourg and the UK are timid and early. And Denmark, France, Germany, Italy, Switzerland and the US are timid and late.This is all a trifle arbitrary. The UK ranks as timid not because it was timid in the 1980s but rather because some of the progress made then has been reversed. You can see that in the graph on the left. We came down from nearly 50 per cent of GDP being spent by the government in 1976 to some 37 per cent in 1999, but now spending is rising again. It is intriguing, politically, to see that both the start of the reduction and its end came under two Labour chancellors, though most of the process happened under the Tories.

The authors' take the fall from the peak year of spending to the level in 2002, the last year for which full data is available. Some results are shown in the bar chart in the right. These show the UK in a worse light than it should be, for the authors only use data back to 1982, so the UK peak is taken as 1984. The US also is shown in less than flattering light because the peak of spending there was much lower than in European countries - spending did not need to fall so much because it was lower in the first place. At any rate, you can see that the most ambitious reforms have taken place in rather surprising places. We all know that Ireland and New Zealand have been pretty radical, but the Netherlands and Belgium? What is clear is the extent to which the big three Continental economies, Germany, France and Italy, have lagged behind - countries that are struggling with slow growth now.

That leads to the core thesis of the authors. Countries that have reformed radically have made the greatest improvements in their growth. You would expect that. But they also have made greater social progress as well. The countries at the top of the reform table on the right also score towards the top of the human development league table.

The most surprising relationship is between public spending and what the authors call "institutional quality". They look at various scores for corruption, red tape, quality of the judiciary, legal structure, property rights and so on. They then compare these measures with trends in public spending. In countries where public spending comes down, there is a tendency for institutional quality to go up. So it is win, win.

The crude conclusion from all this would be that Gordon Brown has been making a grave error in expanding the state. That is a charge that he needs to answer, given the falling productivity. But there are more subtle conclusions which need to be looked at by both major parties. The score for the UK between 1990 and 2001 fell on several measures. We seem to have become significantly more corrupt, red tape has mounted and the quality of the judiciary is now deemed to be worse than in the Scandinavian countries, Canada, Australia, Ireland and Germany, among others.

The big question is whether the governments of the 1990s, under both parties, have undermined our civil institutions. One thing is sure: there is no room for complacency either from the Chancellor or from his next door neighbour.

The ECB is starting small - but it has higher hopes

So it is higher interest rates in the eurozone at last. Of course the rise is small and the rate low - 0.25 per cent to 2.25 per cent - but the direction matters, for this seems likely to be the start of a series of increases as the European Central Bank brings rates up to a neutral level. This would be about 3.5 per cent, a level where monetary policy was neither restricting growth, nor stimulating it.

There are two particular points of interest. First, the ECB president, Jean-Claude Trichet, refused to give any indication about future increases. Some took this to mean that there would not be any. The more rational response is that central bankers like to keep the markets guessing, so one should not take this comment to indicate movement either way.

Second, there has been some opposition to the increase on the ECB board. Some have taken this to suggest that Mr Trichet will find it difficult to sustain support for future increases. I think that is wrong too, partly because of the president's personal authority but also because the board has an obligation to meet its inflation target and has failed to do so. Now that eurozone growth has come up a bit it is very hard intellectually to sustain such a loose monetary policy.

So what happens next? Well, what really matters is whether the present modest rise in eurozone growth continues, and that depends on what happens in the big three economies. There is a case for waiting to see the impact of the policies of the new Grand Coalition on German growth before doing anything to interest rates. If these policies are even modestly well-received, then it will certainly mean higher rates. If not, then the dilemma remains: some countries do need higher rates to control inflation but the ECB is stymied by slow German growth.