Warwick Lightfoot is Head of Economics at Policy Exchange.
What sort of Budget should the Chancellor present? Britain needs a confident and audacious economic policy to respond to the Covid shock and the economic stagnation of the last decade following the banking crisis and Great Recession. It needs to be based on realism about the constraints that limit effective policy and the opportunities for action.
It should recognise that both arms of macro-economic policy – fiscal and monetary policy – need to be used and the roles assigned to them need to reflect contemporary circumstances, in particular low interest rates. A Conservative economic agenda should encompass three arrows: an active fiscal policy to stimulate the recovery, a realistic monetary policy, and an ambitious supply-side agenda of tax reform and changes to regulation to improve incentives and the functioning of the economy.
As Policy Exchange has set out in a new report, What is to be done with the British economy?, we should not be afraid of allowing public borrowing to take the strain. The big question in public finance is how much is spent, not how it is financed. We are right to ditch the artificial fiscal rules that have been used since Gordon Brown that were at best economically irrelevant.
We should take advantage of three things: exceptionally low nominal and real interest rates, which remove the constraint of debt service charges on the use of fiscal policy as a stimulus; that in modern internationally-integrated global capital markets, government borrowing does not have the sort of crowding out effects it used to have; and that the UK is exceptionally well placed to take advantage of cheap long-term debt, and should lengthen the maturity of its debt.
The Government should continue to borrow to ensure a rapid recovery and minimum scarring. Preventing as much long-term damage to the economy as possible now will shore up future revenue from taxation and ensure the long-term health of the Government balance sheet.
As I highlighted to ConservativeHome readers in 2008 in the wake of the financial crisis, fiscal policy must in the current climate be used as a stimulus instead of monetary policy, and conservative economists in America at the time had already recognised this.
The opportunity to borrow coincides with the need for tax reform. One lesson I learned when I advised three Conservative Chancellors in the 1980s and 1990s is that it was a mistake to put so much emphasis on balancing the budget and more should have been done on tax reform.
The tax burden actually increased over this period and, as Lord Lawson recently advised the Chancellor, the Conservative party should not become the party of high taxes. The Chancellor should embark on an agenda of tax reforms to improve incentives by lowering marginal tax rates and creating a more coherent system overall.
In particular, he should end the Manhattan skyline of marginal tax rates across the earnings distribution, which means that some employees face marginal tax rates of around 60 per cent when they are earning between £50,000 and £60,000 and £100,000 and £125,000 due to the withdrawal of child benefits and personal allowances in these income brackets. These changes would create a simpler tax system that improves the incentives to work, save, and invest, for some of the most productive people in the labour market.
There is a risk of inflation given the disruption to supply chains constrained by Covid restrictions and rising oil and commodity prices. Although zero interest rates mean that monetary policy has been ineffective as a stimulus over the last decade, it has actually become stronger as a tool of tightening. The current environment of corporate leverage upwards means that tighter monetary conditions may be a more powerful instrument to curb economic activity than twenty years ago.
Despite the fact that a return to higher interest rates and a more normal bond market yield curve will push up the cost of servicing debt, it will improve the micro-economic functioning of money and credit markets. Looser fiscal conditions offset by tighter monetary conditions is undoubtedly a preferable macro-economic mix to that exercised over the last decade.
Reform of the planning system offers the greatest potential yield in terms of deregulatory reform, with particular benefits to the supply side of the economy and for renters trying to get onto the property ladder. Covid has only accelerated the need for planning reform, as the pandemic appears to have expedited trends in the use of technology, remote working and internet shopping.
This will result in a reallocation of capital and resources, meaning that there is changing demand for the location and nature of homes, business premises, office space and the use of buildings in city centres. Fundamental reform of the planning system will ease these shifts allowing for a more efficient and productive use of land and capital.
Regardless of what happens in the Budget tomorrow, it is vital that policy makers are nimble and responsive to changes in economic circumstances over the next year. Economic data over the course of the Covid crisis has been particularly unreliable, which means we are effectively flying blind.
The yo-yoing falls and rises of GDP are out of the parameters of the models to forecast the economy, the practical work of data collected by statisticians has been hampered, the weights employed in index numbers are distorted by changing behaviour, and Government interventions such as the furlough scheme have distorted our understanding of idle resources in the economy.
This has compounded issues in the collection of key data that was emerging before the crisis, such as the difficulty of measuring the effect of intangible assets on the economy. Economists and policy makers must therefore be particularly flexible in their approach to fiscal and monetary policy over the next year, a time frame in which we can expect to see huge shifts in production and consumption as we come out of the pandemic.
Although we do not know how strong the recovery will be, the Government must do all in its power to ensure we regain the full productive potential of the UK economy pre-Covid and stimulate future growth. While there are questions as to how much consumers will spend their accrued savings, the fact remains that interest rates are almost zero and there is slack in the economy that the public sector balance sheet should take up. Now is not the time to slam on the brakes and cut back on the use of fiscal policy as support.