Fiscal policy & the Overton window

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 Our economic weakness is only temporary and the economy should recover next year, so the stimulus should be withdrawn then.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.

Comments

[Luis Enrique]

How does public opinion stand on this? I'm surprised there isn't more popular support for a program of state led investment and job creation, that I would have imaged a Labour politician eager to pander to

[JustAnotherTaxpayer]

Evidence of 2011 is that the MPC places significant weight on current headline CPI in their inflation target. The effect on AD of a TEMPORARY VAT change is likely to be amplified in both directions, and probably nets out to zero.

High headline CPI rate in 2011 nearly confused the MPC into tightening and it was only once the rate was clearly coming down (and the CPI forecast fell off a cliff... again... hello, 2008) that they felt justified to ease policy.

Lesson 1: where is the goddamned NGDP target already?

Lesson 2: under an inflation target, fiscal policy should avoid changing indirect taxes which affect the CPI AT ALL COSTS.

[Ralph Musgrave]

Chris, I don’t agree with your claim that a VAT cut would just “pull forward spending from 2013 into 2012” or that employers would not create jobs because employers would believe that the cut was temporary.

If government implements stimulus in 2012, and then imposes drastic deflationary measures in 2013 (and assuming there is no lag in the effect of those measures), then obviously spending is “pulled forward”. But why would government withdraw stimulus in 2013 or any other year if such a withdrawal was not warrented? It wouldn’t.

Alternatively, if there was a substantial rise in consumer confidence, that would boost demand and government could withdraw some or all the stimulus to compensate. But in that case the addition to demand would also be permanent, so there’d be no need for employers to treat the increased demand as temporary.

A similar criticism applies to your point about tax reductions.

[Account Deleted]

Luis, public opinion has not fundamentally shifted over the last 30 years. 2008 did not, as many expected, alter this. Instead of tackling systemic failure, we have been diverted to moralistic attacks on individuals, with bad bankers to the fore. Boo hiss.

There is still a perception that public expenditure is inherently inefficient (outside of the NHS), with too much being creamed off by special interests. Consider the current fuss over civil servants (and Moira Stuart) operating through personal service companies.

The PSC has actually been common throughout the private sector since the 80s, and remains one of the biggest tax dodges going, despite Labour's attempts to tackle it with the IR35 regulations in 2000. The bitter irony is that many of the freelance journalists who have written up the civil servant story are themselves beneficiaries.

This disguised tax break for the professional classes has gone hand-in-hand with increased casualisation at the bottom end of the jobs market. The difference is that these workers do not get the tax break. The benefit accrues to the agencies and gang-masters.

State-led investment at this point in the economic cycle makes sense in terms of both monetary and fiscal policy, which is an unusual conjunction: historically cheap borrowing and a dearth of private demand. As Chris suggests, the reluctance to consider this is ideological.

[Luis Enrique]

so ... do voters support state led investment / job creation or not? links to opinion poll appreciated.

[Account Deleted]

Luis, I don't have any polls to cite, but my interpretation is that voters are perfectly capable of holding conflicting views. We support state-led investment when it comes to specifics (e.g. Bombardier) but also insist that public debt must be reduced.

I imagine Labour have polled extensively on the issue and believe that support for a state-led programme would be vulnerable to the Tories casting it as "more reckless borrowing". If they had found stronger support, they'd presumably have announced the policy already.

[Student]

Dude, you're up and coming in the world. Google now auto fills " and mumbling" when I search stumbling, and Paul Krugmans linked to this post.

huzzah.

[billyblog]

For sure coming up in the world to be linked to by Paul Krugman, Rock Star!

Which causes me to ruminate on the sociology of knowledge fact that 2 years ago virtually no one except Krugman, Dean Baker, Thoma, and a very few others were pushing the Keynesean line. And, indeed, in Krugman's case, the concept of the Overton Window, though he wasn't using that term explicitly to characterize what he predicted would be a lost opportunity with the too weak Obama stimulus.

http://krugman.blogs.nytimes.com/2009/01/06/stimulus-arithmetic-wonkish-but-important/

Keep in mind that this Krugman piece was written on January 6, 2009, before Obama was even inaugurated! It reads now as if it were ripped from today's headlines. Read it and weep Ed Balls -- and Niall Ferguson.

Anyway, the boys on the South Side of Chicago thought they has long ago buried that goofy Keynesean economics.

But Krugman relentlessly pushed and pushed his view, and, as Stephen Colbert might put it, economic reality came around and adopted a Krugman bias. Now what PK says has become almost the new orthodoxy in both news stories and punditry circles.

Though in different flavors to be sure. Thus, there are those who:

1. Line up foursquare with Krugman, and acknowledge the source -- what I call the "honesty is the best intellectual policy" response;

2. Shift their previous position, materially line up with Krugman and acknowledge the source, but try to distinguish their new found wisdom with a graduate student like nitpicking point or two of differentiation to stake out their originality and save their amour propre -- what I call the "Stuart Smalley" response;

3. And by far the most common response, i.e., shift one's previous position and line up with the essential points that Krugman has been making all along, but not acknowledge the source and not even acknowledge that you were on the wrong side of history previously -- what I call the "Niall Ferguson" response. In terms of foreign affairs punditry this is also known as the "Tom Friedman" response.

Of course, there still remains the response of the unrepentant Very Serious People.

They continue to look for ways to twist stubborn facts on the ground from the standpoint of 30,000 foot ideology. In terms of politicians this is the "David Cameron" or “No Balls” response; or, for hackish and sycophantic pundits, the "David Brooks" response.

Note how some of these responses convert easily into verbs: "Ferguson" something, or perhaps "aNiallate" it? "Cameronize," “Ballsify,” "Brooksify."