The deficit: It’s a labour market thing

More from the Resolution Foundation’s report on public finances. (See yesterday’s post.)

All the projections for deficit reduction could be thrown off course by tax revenues – or the lack of them. The importance of even fairly small variations in the tax take is illustrated on this chart. If revenue growth turns out to be one percentage point higher than the OBR forecast, then things start to look much better. Whichever path the next government chooses, the current surplus is achieved a year earlier than planned. If, on the other hand, revenue growth comes in one percentage point lower than the OBR forecast, the chances of achieving a surplus by the end of the decade are pretty much scuppered.

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This shows how much of the fiscal plans of all parties are dependent on developments in the labour market. Despite recent economic growth, tax receipts have fallen well short of what the government expected. This chart from the recent ONS report on long-term public finance trends shows the extraordinary effect of having a growing economy and poor tax revenues. Both spending and revenues are falling as a proportion of GDP but the gap between them remains, giving the Chancellor his continuing deficit headache. (Ben Chu has an excellent summary here.)

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If wages continue to stagnate, the tax revenues will undershoot and the welfare bill will overshoot. Economic growth needs to create pay growth if the deficit is to be reduced. Research by the Joseph Rowntree Foundation found that two-thirds of those who moved from unemployment to employment last year earned less than the £7.85 living wage.

What this suggests is that a large chunk of this year’s in-work poor were last year’s workless poor. Given that only one-fifth of low-paid employees have left low-paid work completely ten years later, they may be next year’s working poor too.

Many of these will have gone from job seekers’ allowance to working tax credits, exchanging one benefit for another and paying very little tax.

In its report on public finances published last week, the Social Market Foundation pointed out that “if we remain stuck in the same pattern of growth that we’ve had since 2010 then all parties in Westminster will need to go back to the drawing board.”

Unfortunately, this is just what the EY Item Club predicted yesterday.

Upgraded forecasts for economic growth are likely to be where the OBR’s good news ends as, despite the economy growing at a faster pace than had been anticipated, this has not been reflected in an improvement in the public finances. Indeed, at first glance the figures for the first seven months of fiscal year 2014-15 suggest that fiscal consolidation is not just in danger of stalling, but of going into reverse.

In our view the causes of the undershoot are two-fold. Firstly, earnings growth has continued to disappoint – we expect average earnings1 to grow by just 0.5% in 2014-15, well below the OBR forecast of 2.4% – with the shortfall causing far more damage to revenues than the boost coming from surprisingly strong employment growth. Secondly, the damage to revenues from successive large increases in the income tax personal allowance appears to have been significantly worse than the OBR had anticipated.

The OBR’s forecasts for income tax growth, says the Item Club, keep shifting to the right.

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The growth outlook has actually improved over the past couple of years while revenues have continued to disappoint, so the persistent shortfall in revenues cannot solely be a function of softer economic growth. In our view, the shortfall in income tax revenues is also a function of a combination of persistent over-optimism on wage growth and low revenues for a given level of earnings growth – which we attribute to a shift towards lower paid jobs and an underestimation of the impact of successive large increases in the income tax personal allowance.

If job growth comes in the low-tax or no-tax brackets, then there won’t be much revenue to show for the jobs miracle. EY expects this taxless recovery pattern to continue and suggests that the OBR should build it into its projections:

The OBR could try to address these issues once and for all and adopt weaker forecasts for income tax receipts throughout the forecast period; their existing projections, which show income tax receipts growing by 6.3% a year from 2014-15 to 2018-19, certainly look optimistic in light of the experience of recent years.

The OBR has already said that it would look at the impact of low earnings growth on tax revenues before making its forecasts for tomorrow’s Autumn statement. It is likely, therefore, that they will contain some disappointing news for the Chancellor. Last week, the TUC calculated that HMRC will need to collect £8.5 billion more than it did last year between Novermber and next March. Without the long hoped for self-employed tax bonanza in January, this looks unlikely.

Another £48 billion in public spending cuts over the next four years isn’t going to help. State spending supports a lot of workers beyond those directly employed by public bodies. Cuts on the scale proposed by the government will hit grant-funded charities, outsourced service providers and suppliers as well as civil servants, council workers and NHS staff. A shift from publicly funded employment into low wage jobs or marginal self-employment will simply convert more people from taxpayers to in-work benefit claimants.

Without an improvement in wages, tax revenues will stay low and social security spending will stay high, meaning the gap between spending and revenue will stay large. The deficit, then, is as much a labour market problem as a public spending one. Unless the pay and employment situation improves, whoever wins the next election will have to rip up their deficit reduction plans and start again.

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10 Responses to The deficit: It’s a labour market thing

  1. SK says:

    Parties should focus on wealth and not income.
    The ridiculous wealth gained from housing must be taxed while income must be taxed less.

  2. TickyW says:

    So the increase in the income tax free threshold has not produced an increase in tax revenues?
    Nor the reduction of the 50 pence rate to 45 pence?

    Well, I’ll be blowed!

    Did not Mr Laffer say tax receipts should rise if tax rates were reduced? Surely, Mr Laffer could not have been talking rubbish, could he? Who’d have thought it !

    • ChrisA says:

      Ticky – Laffer did not say that lowering tax rates would increase tax revenues, he merely pointed out that there must be a maximum in the tax rate/tax revenue curve. This undoubtedly true – at zero tax rate there is zero tax collected, and at 100% tax rate there is also zero tax collected (as who would invest if the entire profit was confiscated). Therefore somewhere in between there must be a maximum. Laffer used this argument (presented on a napkin) with Reagan to suggest that the very high marginal tax rates currently then prevailing in the US (close to 90%) be lowered. And indeed, if you look at the amount of tax collected from the upper income brackets, it did increase. But, to take an extreme example, Laffer would not argue that lowering tax rates from 10% to 0.5% would increase tax revenues. And of course you have to be very careful to distinguish marginal from average tax rates, and also tax rates on different segments of the population. So in Britain we could have an average tax rate of say 30%, but this average could hide that for poor people, as they lose benefits at a very high rate as their income increases, could face marginal tax rates of more than 70%. This is probably the wrong side of the Laffer curve I believe and in the long run I would expect if we lowered this high marginal tax rate eventually we will get more tax due to more people being in work.

      Unfortunately, this belief by myself is being tested. Tax revenues remain low despite more people being in work than ever before. As explained by Rick and others this is due to the tax credit system which has been expanded by this Government to deal with the high marginal tax issue. However I believe that there are significant long term benefits to having people in work, as compared with the European approach of very high unemployment. This is true even if it results in less tax revenue. But I remain hopeful that longer term, as hopefully we continue the expansion, people will move up the income ladder and the tax revenues will return and Laffer will be proved right again in this case. Hopefully also the state will reduce in size back to the Major days and the need for tax revenues will also fall.

      • TickyW says:


        I accept my comment re Laffer was simplistic. But no more simplistic than Osborne and many Tweeters who categorically assert, without nuance, that reducing income tax rates will increase the government’s tax take. Indeed, Osborne cut the top rate of 50% to 45% on the spurious assertion that the income tax take would increase as a consequence. HMRC studies, post cut, do not confirm Laffer effects.

        On a general point about Laffer: Joining two points (at 0% and 100%) with an arc is simplistic. To base policy on such a simplistic assumption owes more to ideology than to evidence. There are several other shapes that I can think of which may more accurately join those two points. Not pretty shapes, I grant you, but then human behaviour rarely follows pretty mathematical functions or equations.

        • guthrie says:

          The last I read, the actual Laffer curve for the USA had been calculated a few years ago, and the lower point was a marginal tax rate of something like 70 or 80% on the richest taxpayers, instead of the 10 or 20% that actually prevails.
          Oddly enough that hasn’t led to calls for higher taxes…

          • ChrisA says:

            Gutherie – a country’s economic strategy should not be to maximise tax revenues…..

          • guthrie says:

            But it can be to increase tax revenues from the places that have the money in order to support the places that don’t. A marginal rate of 80 or 90% being compatible with the curve means we can certainly go higher than 45% without doing any damage.

      • ChrisW says:

        Also ChrisA, I’d quibble with both endpoints:

        – At 0%, people would continue to donate money to charity. The charities will effectively function as a skeletal government.

        – At 100%, a government might purchase goods and distribute them to the public. People may still invest because e.g. it’s fun; there’s a social hierarchy; it’s a hobby; feeling of public duty or patriotism; etc.

      • Bob says:

        Only on some taxes. Tax income at 100% and you destroy the economy. Tax land values at 100% and there is no dead weight loss as the supply of land is fixed.

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