The fairytale of fiscal multipliers

You cannot tax and borrow your way to prosperity

Dr Christopher Snowdon is the Head of Lifestyle Economics at the IEA

I like reading David Smith’s column in the business section of the Sunday Times. I don’t always agree with him but he is a reliable guide to the conventional wisdom. If this seems like faint praise, my point is that he is not a socialist and the Sunday Times is not a left-wing newspaper, but nor do either of them have an obvious commitment to free market capitalism. They are both, for want of a better word, centrist. This made it all the more disconcerting when I found him promoting the fairytale that public spending is the key to economic growth this weekend. Leaning on a blog post from a Keynesian economist, he wrote:

“Mark Cliffe, a veteran City economist who is now a visiting professor at the London Institute of Banking & Finance, has some ideas. In a blog post, “Instead of Tightening, Could Burnham Front-Load a Fiscal Stimulus?” for the National Institute of Economic and Social Research (Niesr), he suggests that the government could take more advantage of fiscal multipliers.

Fiscal multipliers determine the ‘bang for the buck’ in economic activity you get for additional public spending or tax cuts. Traditionally, and for the Office for Budget Responsibility (OBR), the biggest multipliers are for public investment, where 1 per cent of gross-domestic-product increase in spending results in an immediate 1 per cent increase in GDP, with tapering but significant effects in later years. This is followed by welfare spending, because people on welfare tend to spend what they receive, and on domestically produced essentials. Then comes spending on public services and, finally, tax cuts.”

There are a number of things to say about this. Firstly, getting £1 of GDP from £1 of spending is not an impressive multiplier. Strictly speaking, nothing has been multiplied. And since any extra spending in Britain today would most likely involve borrowing money from the bond markets at an interest rate of around 5 per cent, a 1:1 conversion rate does not seem like a particularly good deal.

Secondly, ‘public investment’ is a broad church. Some infrastructure projects genuinely produce a return on investment in the long run, but these are few and far between. Gordon Brown popularised the trick of describing all public spending as ‘investment’, thereby conflating teachers getting a pay rise with the Panama Canal being built. A review of the literature on government spending (in general) found that the multiplier effect was “generally within the range of 0.50 to 0.90” and was lower in countries like the UK which have a high debt to GDP ratio. A multiplier of 0.50 indicates that £1 of public spending adds just 50p to GDP.

Photo by Sarah Agnew on Unsplash

Thirdly, the category of ‘tax cuts’ is also a broad church. Ventriloquising the OBR, Smith writes that a £1 tax cut only adds 33p to GDP “because many people do not spend the extra income they receive from a tax cut and, for those that do, a lot leaks out into imports.” The focus here seems to be on income tax cuts or other tax cuts that leave consumers with more money to spend, but even if you accept the premise of the argument (and the mercantilist view of imports!), cuts to other taxes, such as Corporation Tax and business rates, can stimulate the economy by encouraging investment and entrepreneurship. There is more to the economy than consumer spending.

And that brings me to the final and most important point. If we take the OBR’s multipliers seriously, the best use of money - from the perspective of economic growth - is to have the government spend on ‘investment’. This is followed by spending by welfare recipients (because they have the highest marginal propensity to consume), followed by government spending on public services. And right at the bottom of the list is spending by ordinary working people. If true, the obvious implication would be for the government to tax ordinary working people more, give more money to those who do not work, and give more money to itself.

This feels intuitively wrong and history has repeatedly shown it to be wrong, not least in Britain since 2008, where successive governments have raised taxes and increased borrowing in a futile attempt to stimulate the economy.

The mistake is to focus on consumption rather than productivity. The Keynesian obsession with the marginal propensity to consume is unwarranted unless there is high unemployment and significant slack in the economy. Humans spent money for thousands of years without generating significant economic growth. For most of that time, the vast majority of the population were so poor that they spent every penny they had. Economic growth only arrived when people found ways of producing things in greater numbers and more cheaply. Facilitating greater consumption when there has been no improvement in productivity can only lead to inflation.

Swishing money around does not deliver growth, regardless of who its spending it. Successive governments have got us into £3 trillion of debt by chasing the chimeras of fiscal multipliers and Keynesian stimuli. But GDP is about productivity. The clue is in the name. You cannot tax and borrow your way to prosperity. You must create the conditions in which wealth can be created.

The good news is that the government can create the conditions for growth without spending a penny. The economy has been smothered by regulation, petty prohibition, targets, price controls and bureaucracy. Extensive deregulation might seem unlikely under Andy Burnham but it is our only way out of the woods. When he became Prime Minister, the IEA told him about eight things he could do at zero cost in his first 100 days. One of them has already become Labour policy. There are plenty more where that came from.