Ed Balls is calling for a temporary tax cut of £12bn for one year, ideally through a lower VAT rate but failing that lower income tax. This, I fear, is an example of how policy proposals are constrained by the Overton window.
I say this because such a cut would be only mildly stimulatory.
The IFS has estimated that a temporary VAT of £12bn would increase consumer spending by just over 1.2%, relative to what would otherwise be the case; in effect, all the cut would be spent. This sounds good.
But put this into another context. £12bn is around 0.8% of this year’s GDP. If employment rises proportionately to spending, it too will rise by 0.8% - equivalent to just over 230,000 jobs. Which is less than one-tenth of current unemployment.
And this probably overstates the employment impact. A lot of that rise in consumer spending would come simply because consumers pull forward spending from 2013 into 2012. It’s unlikely that employers would create permanent jobs in response to what they’d believe to be temporarily higher demand. More likely, they’d just work their existing employees harder. Productivity would rise, but not so much employment.
The effect of a temporary income tax cut would be even smaller. Knowing the cut to be temporary, households would respond by saving more or paying off debt; the permanent income hypothesis is about half true (pdf) . Consumer spending would thus not rise much. Alan Blinder has estimated (pdf) that temporary tax moves are only half as effective as permanent ones.
This poses the question: why isn’t Balls proposing more radical measures? I can think of two macroeconomic arguments:
1. Our economic weakness is only temporary and the economy should recover next year, so the stimulus should be withdrawn then. This would be the case if our present woes are due to business confidence being depressed by the euro area debt crisis, which might be resolved this year.
But this argument is not wholly convincing. It could be that the weakness is more permanent - say because of a dearth of investment opportunities. And the withdrawal of a fiscal stimulus should be state-dependent, not time-dependent; it should come when the economy recovers, not merely when time passes.
2. Bond markets would take fright at a permanent easing, and the subsequent rise in interest rates would offset the fiscal stimulus.
There are two competing replies to this. One would be that if market sentiment is so fragile, it might take fright at a one-off rise in debt too. The other is that the shortage of global safe assets - and failing that the power of the Bank of England to buy unlimited amounts of gilts - should keep rates low, in which case a “permanent“ expansion is feasible. It’s not clear to me that there’s much room for Balls’ midway position here.
Instead, I fear there’s another reason for Balls’ timidity. The coalition has successfully shifted the Overton window in favour of austerity so much that a call for fiscal expansion is no longer seen as “credible”; academic economists are powerless to prevent this shift. This puts Balls into an awkward position. As a member of the political class trying to appear “credible” to the media he cannot call for more radical policy action. But as a member of the Labour party, he cannot acknowledge either that this constraint (among others) means that policy-makers cannot offer anything close to full employment.