1 May 2019

The trouble with Labour’s voodoo economics

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While local council elections are, as the old adage goes, only really about potholes and bin collections, that hasn’t stopped the political parties from shoehorning bigger issues into their campaigns. True to form, the Labour Party have modelled their campaign around reversing government spending cuts – as encapsulated in a campaign video published this week.

The video is a thought experiment on how best to stimulate the economy: pay rises and other subsidies to “ordinary people”, or tax cuts for billionaires?

As you’d probably expect, Labour are keen to make the case for the former. Those with even the most basic understanding of economics will recognise that what they are promoting is a straightforward case of the multiplier effect, made famous by economist John Maynard Keynes in the early 20th century.

If the multiplier is to be believed, when governments spend money, they create demand, which oils the wheels of the economy. This creates more employment, begets even more demand, and a virtuous circle is born, leaving the economy in a better state than it was previously.

A nice theory, but, sadly for the Labour Party, one that doesn’t quite stack up in the real world. Because what Jeremy Corbyn and John McDonnell are arguing for is a long way from Keynesian doctrine. They propose a massive injection of government spending in the economy, despite the UK experiencing unprecedented levels of employment and (admittedly rather anaemic) growth. Keynes, by contrast, argued for counter-cyclical fiscal policy.

Of course, the money would have to be found from somewhere: either in existing budgets, or levying new or higher taxes, or through quantitative easing, or additional borrowing. I’ll take each of these in turn.

Should the money come from current government spending, Labour’s plan is thus merely to redistribute wealth, not create more of it. Shunting money from person A to person B does not magically expand the productive capacity of the economy as Labour would like us to think. True, one person may derive more utility from a given amount of money than another, but the economy remains the same size as before.

Should the money come from new taxes, then the policy is somewhat self-defeating – once again, the government will simply be giving with one hand while very much taking with the other. As I’ll explain later, this will also have a host of perverse impacts, all of which will likely shrink, not swell, the size of the economy.

Should the money come from quantitative easing, where the government prints more money to finance its spending, inflation will likely kick in – eroding the value of everyone’s income and savings, diminishing their purchasing power. Given the past record of command economy’s grasps on sensible monetary policy (see: Venezuela), this option is perhaps most frightening of all.

But what about funding spending increases through borrowing? Virtually everyone will have borrowed money at some point – whether for a house, new car, or university tuition. We do so because we expect the thing we took on debt for will either save or make us money in the future. Therefore, Labour could be onto something if its spending – financed by borrowing – is focused on investments which actually makes the economy more productive in the long run.

However, this model only makes sense if governments are more strategic in deploying resources than private firms and individuals. And, as failed socialist experiment after failed social experiment has shown, there is no evidence to suggest that is the case. Indeed, it is telling that in Labour’s own video, one sees very little purchasing of the capital goods which ultimate drive productivity in an economy.

So if extra spending isn’t the answer, what about the other proposal that Labour introduce at the top of the video – the tax cuts for billionaires? The track record of the private sector is certainly better than the government’s when it comes to allocating resources effectively.

If I had to pick between increased spending and tax cuts for the rich, I’d plump for the latter. However, I’d be minded to borrow Labour’s own mantra of “for the many, not the few”, and cut taxes for everyone.

While there are plenty of holes in the argument that extra government spending actually increases the meaningful size of the economy, tax cuts have invariably shown themselves to do just that. With respect to firms in particular – the nation’s engines of economic growth – lower and better-designed taxes can help bring forward investment in capital equipment and machinery which increase productivity, the essence of long-run economic growth.

Cutting taxes on corporations has the additional benefit of making the country more competitive on the global stage. This might incentivise foreign companies to set up shop here, providing a lucrative source of jobs and tax receipts. Ireland, for example, has a famously low rate of corporation tax, so it is not surprising that it plays host a string of profitable multinational firms’ European headquarters.

For individuals, lowering taxes – either by reducing marginal rates, or the point at which they start paying them on something like their income – will encourage them to work longer hours, as they’ll keep more of the additional money they earn, and increase the incentives of those out of work to find employment. All this additional money will likely be ploughed back into the economy through higher consumption, leading to exactly the sort of boost to activity described in Labour’s film.

The story does not stop there. Reducing (or even abolishing) other taxes, such as transaction taxes, which serve little purpose other than to generate income for the government and put the brakes on certain markets, would encourage more business activity and more efficiently match resources to their most valued ends. Accordingly, the economy should flourish, leaving people better off.

It’s often remarked that if something’s too good to be true, then it probably is. Labour’s voodoo economics are no exception to this. If they really want to stimulate the economy, they should be celebrating, not denigrating the real way to foster genuine economic growth: tax cuts and other supply-side reforms.

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Eamonn Ives is a Researcher at the Centre for Policy Studies.