Hamish McRae: Ideas for alleviating grim fiscal realities

Economic View

So it will be Plan B – or at least Plan A done so much more slowly that it will in effect be a different plan. For a couple of months it has seemed likely that there will be some slippage in the coalition's deficit-reduction programme. Now it is clear that this is inevitable. That has macro-economic consequences and micro-economic ones. Let's take the macro first.

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The principal reason for believing the fiscal target will be missed is that, after five months of this financial year, the figures for government spending and tax receipts are way off. Spending is higher than projected and receipts are lower. The reason is partly, but not entirely, slower-than-expected growth. On spending, the Treasury has not been helped by retail price inflation reaching 5.2 per cent last September, its peak. This is the reference month for uprating most public pensions and other benefits. But the even greater problem is the shortfall in tax receipts.

You can see this in the graphs. On the left is the total revenue so far this financial year, plus the four main sources of that revenue: income tax, national insurance, VAT and corporation tax. If the big four are all right, then the government is OK. Two of them are and two are not. As you can see on the right, VAT and national insurance are up. This would be consistent with a growing economy, albeit a slowly growing one. But corporation tax and income tax are down. The former's shortfall is partly associated with lower North Sea revenues. But the big problem is the biggest revenue-raiser of all: income tax.

Since national insurance is up, consistent with higher employment, and overall earnings are up, the explanation must be that earnings at the top are down. Remember that the top 1 per cent brings in 28 per cent of all income tax, so you do not need a huge fall in their incomes to have a disproportionate impact. My own guess is that this is a lagged response to the 50 per cent top marginal rate – but it gives the Chancellor a huge problem. The deficit this financial year will be higher than last.

Sir Mervyn King tacitly acknowledged that by endorsing the view that if slower growth meant the government missing its budget-deficit deadline, that would be acceptable. The ultimate judge will be the markets because they have to remain convinced that the Government is serious about getting the national finances under control. But endorsement by the governor of the Bank of England probably reflects what the markets will accept.

There is however another implication of slower deficit reduction: that the squeeze on public finances will last for at least a decade, probably longer. But how do you achieve better social outcomes in a world where public spending must shrink? Three pointers have recently come up on my radar.

One was Ed Miliband's initiative on "predistribution". Essentially, he is saying that redistribution of incomes cannot solve all social problems, so you have to do something about the causes of inequality, rather than patch problems afterwards: "A fairer distribution of wealth before taxation, rather than after".

Quite how the state can nudge society in this direction is much more complicated. When you look at education, you would not just consider exams but also the soft skills people need in the workplace. When you look at health, you would look how the NHS might deliver services more effectively, but also at diet, exercise and lifestyles. And so on.

The second pointer was research conducted by Manchester and Southampton universities: they looked at two ways of encouraging people to change behaviour. One was nudge; the other think. As an example of the first, people were asked to give spare books to their local library. The researchers found that if people's names were published, responses shot up. For thinking, people were given information about a subject and then the opportunity to discuss it. That also affected behaviour, but the impact was smaller.

The study concluded that you use both methods – nudging and thinking. Common sense. But the bigger message is that simple changes in the way an idea is presented can have positive effects. We don't like being lectured, particularly by governments; but we will change if pushed gently in the right direction.

The third idea came from the National Housing Federation's conference last week. David Orr, the federation's chief executive, pointed out to me that housing associations had continuing relationships with millions of people, many of whom were disadvantaged. It seemed to him that there were many other ways in which the movement could help clients by taking on a wider social role. For example, a decade from now they might find themselves helping deliver healthcare.

This line seems to make a great deal of sense. Any country has to work with what it has got. What we will not have for perhaps a generation will be any spare state cash. That big expansion of spending of the past decade will not happen again. So we have to find other ways of achieving social objectives. It may well turn out that those ways are more effective – at least let's hope so.

Statistics give us reasons to be cheerful – but not for a while

There was a burst of "greenshootery" last week. The relentless gloom of the summer months flipped toward a cautious optimism at least, with the expectation of an upward revision of the GDP data this week, strong growth in employment and some forward indicators of improving business sentiment. Is the worst past?

For those of us who have argued that the economy has not been in recession but has been growing slowly all along, this might seem a vindication. It is true that the VAT and national insurance receipts that I mention above would suggest slow growth, and I expect eventually that will be seen to be the case. But, while slow growth is better than no growth, we need something much better to make any dent in the deficit.

Looking ahead, the risks seem evenly balanced. On the positive side, there is a reasonable expectation that inflation will fall to 2 per cent, hopefully below, by the end of the year. With average earnings running just under 2 per cent, that would mean that real incomes at last would start to rise and, once that happens, I think we will all feel more comfortable. If the experience of past cycles is any guide, people don't report any rise in consumer sentiment until quite a way into the recovery, so do not expect a feel-good factor for many months yet.

There is a complication: what will happen to energy prices? These are extremely important, because the oil price has a direct impact on monthly budgets through the price at the pumps, and an indirect one through industrial costs. Slower demand from China would be helpful; worsening conflict in the Middle East alarming. Both are utterly beyond our control.

That aside, the main negative risk comes from Europe, with exports to the eurozone already showing some weakness. The evidence of a mounting north-south continental split is growing: Germany is doing quite well, but even France is in the southern camp. This too is quite beyond our control.

Caution, please.