Politics and Economics (and Pasties)

Looking back on 2012, I think it would be fair to say it was a fairly difficult year for the government’s economic credibility. No economic growth, no deficit reduction, a double-dip recession etc. There is one economic government policy however, that stands out from all of the rest and this is a blogpost about that one. Let’s begin.

At the start of 2012, the Conservatives and the Labour party were polling fairly closely but following the announcement of the government’s “Pasty Tax”, Labour shot into a massive lead, which they have held pretty consistently ever since.

If you are a regular reader of this blog, you might guess what my thoughts are on the “Pasty Tax” – yes, that’s right. In a year that the government spent creating and then stepping in huge economic cow pats, this one stood out for being… a good idea.

To see why I think it was a good idea and why it was ultimately scrapped we need to look at both the economics and the politics.

Economics

The phrase “Pasty Tax” was coined by the media to describe the closing of a tax loop-hole that meant certain foods were sometimes liable for VAT and sometimes exempt from VAT depending on the temperature at which they were stored in the shop or sold to the consumer. Under the previous policy if I had gone into a shop and bought a sausage roll, VAT would be charged as follows:

• If I bought it cold and heated it up myself – exempt from VAT
• If it had been cold when I went in and the staff heated it to order – exempt from VAT
• If it had been kept warm in a cabinet under heater lights – liable for VAT
• If it had been kept warm in a cabinet under heater lights but taken out of the cabinet when I ordered it and allowed to go cold before I bought it – exempt from VAT

I mean, seriously, whoever thought of that system? It is completely ridiculous. It is in no way unique though. In the UK VAT is charged on biscuits but not cakes – so the eternal question, “Is a Jaffa Cake a cake or a biscuit?” ended up in court. Wikipedia summarises it and links to the sources nicely:

In the United Kingdom, value added tax is payable on chocolate-covered biscuits, but not on chocolate-covered cakes.^[12] McVities defended its classification of Jaffa Cakes as cakes at a VAT tribunal in 1991, against the ruling that Jaffa Cakes were biscuits due to their size and shape, and the fact that they were often eaten in place of biscuits.^[13]McVities insisted that the product was a cake, and according to rumour produced a giant Jaffa Cake in court to illustrate its point.^[13] After assessing the product on eleven criteria, including “texture”, “attractiveness to children” and “consistency when stale”,^[14] the court found in McVities’ favour, meaning that VAT is not paid on Jaffa Cakes in the United Kingdom.^[12]

Now I can understand that there are often reasons for charging more or less tax on certain products. My job means I often have to fly somewhere in an aeroplane. Aeroplane travel is damaging to the environment though so I can understand the reasons that my flights incur a high tax. When the government taxes something then people will use it less, so the higher the tax is the less inclined my company will be to send me somewhere. They might decide that, given the costs involved, we should do a video conference instead.

The examples discussed above are in no way related to giving people sensible incentives though. Although it is cheaper for me to order my sausage roll and wait for it to go cold before paying for it, exactly what incentive is this policy trying to create? I have a cold sausage roll and the government has no tax revenue. Is that the outcome that the government is trying to engineer? No, of course not. Therefore closing this loop-hole was a good economic policy.

Let’s have a quick glance at VAT on heating your house. VAT on gas and electricity is 5% rather than the standard 20% applied to most other purchases. This makes heating my house much cheaper than it would be if gas and electricity were taxed at the standard rate. Using gas and electricity though is not something that we want to encourage so why in the world would we want to give it a tax break?

Let’s move on to the next subject.

Politics

It turned out that the government’s one good economic policy of 2012 was so unpopular that they quickly reverted to economic incompetence and abolished it. The Pasty Tax was scrapped and we retained the existing bizarre set of rules and incentives. But why was this?

The answer is that, although it was economically good, it was politically bad. The media got hold of the policy and reframed it as a tax by the nasty party on pasties, which were, as we learned, the quintessential sustenance of the working classes.

Now I doubt you will ever meet anyone who spends their free time being more disillusioned with politicians than me but even I found the next chapter in this story funny. First Ed Miliband and Ed Balls rushed down to the closest Gregg’s, news teams in tow, to show how much the Labour party liked pasties:

Ed & Ed out pasty shopping

I like this photo. Ed Balls has even taken off half of his jacket in order to look more working class.

Anyway. David Cameron and George Osborne then found that the only sensible political response was to show that they liked pasties even more than Ed and Ed. Cameron waxed lyrical over his last pasty – which it subsequently turned was from a shop in Leeds station that hadn’t existed for five years. Still, no better time to put things right:

I like pasties more than Ed Miliband

I like pasties more than Ed Balls

With no clear winner, the cabinet then challenged the shadow cabinet to a pasty eating competition to decide who liked pasties the best. Labour was initially bullish but their advisors then realised that they’d be taking on Eric Pickles and it would be akin to playing the cabinet at football with Lionel Messi as Foreign Secretary.

As it was then, we never found out which party liked pasties the best and shortly afterwards the government made a U-turn on their only sensible economic policy of 2012 and renounced the Pasty Tax.

Politics & Economics

What is actually going on here is a clash between politics and economics. The two often don’t agree and when they don’t the government always favours the former over the latter. Although economically it is far better to have a sensible VAT system without odd, unexplainable loop-holes; politically it is harder to explain. Predictably the policy was dropped.

Sometimes I meet someone and when we’re discussing things they say that they studied “Politics and Economics” at university and I think, “Shit! That must have been confusing.”

I imagine them in their finals, sitting down in the morning to their economics paper and seeing the question, “Should VAT be set at the standard rate for gas and electricity?” and them having to say “Yes!” then going to their politics exam in the afternoon, seeing the same question and having to say, “No! We’d kill all our pensioners!”

And I am sure that some of you reading this will be saying that this is all well and good but if we put VAT up on heating our homes we will kill all our pensioners. Well, this is where we can use economics to trump politics. If I get more tax revenue from everyone then I can use some of it to pay more in benefits to the poor and old. I can make it so that a pensioner’s increase in income is equal to what they lose on heating their home. By doing that the pensioner doesn’t lose anything and the government still gains overall.

I am in full-time employment but at the moment I pay 5% VAT if I switch the heating on and I pay 20% VAT if buy a jumper. This is not a tax policy that encourages sensible behaviour.

Sadly we live in a society where politically good things always better economically good things. It’s not just economics though, health, eduction, the environment and everything else is subject to politics over sensible policies.

So what should we do? I would like to live in a society where the government chooses to implement sensible policies and makes a big effort to explain why they were sensible so that we have a foil to the propaganda of The Sun and The Daily Mail and politics and sensible policies became aligned to the same things.

Sadly I see little prospect of that though, so while we wait we may as well munch on a couple of Jaffa Cakes. They’re tax free after all.

RedEaredRabbit

The Great Benefit Swindle

Tomorrow MPs will debate the real-terms benefits cuts proposed by George Osborne in his Autumn statement last month. (Was it Autumn last month?) Anyway, I’ve been wondering what all of this is about and have found some quotes from the government to shed some light on things.

…Conservative methods are not just good for the strong and the successful but the best way to help the poor, and the weak, and the vulnerable. David Cameron

Oh, that’s a relief – I thought they were going to do something nasty to poor people for a moment. Oh, hold on – here are some more quotes from the government about what it’s like to live on benefits.

Don’t get a job. Sign on. Don’t even need to produce a CV when you do sign on. Get housing benefit. Get a flat. And then don’t ever get a job or you’ll lose a load of housing benefit.David Cameron

…out of work for years, playing computer games all day, living out a fantasy because he hates real life… David Cameron

…it pays not to work. That you are owed something for nothing. David Cameron

…fairness is also about being fair to the person who leaves home every morning to go out to work and sees their neighbour still asleep, living a life on benefits. George Osborne

And all of this time I’d thought it would be quite unpleasant to have to live on benefits but actually having read those things, it sounds ace! They continue:

The system we inherited was not only unaffordable. It also trapped people in poverty and encouraged irresponsibility. Those within it grow up with a series of expectations: you can have a home of your own, the state will support you whatever decisions you make, you will always be able to take out no matter what you put in. David Cameron

…there was a stronger culture of collective responsibility in this country. But as I’ve argued for years, the welfare system has helped to erode that culture. David Cameron

Time and again people were not just allowed to do the wrong thing, but were actively encouraged to do so. David Cameron

So it would seem from the government’s position that over time, working-age benefits have become more and more attractive. That the welfare system has, over time, changed people’s incentives from wanting to work to not wanting to work. The one statistic used to back this up was presented in George Osborne’s Autumn statement but has been quoted many times in the press since:

…over the last five years those on out of work benefits have seen their incomes rise twice as fast as those in work. With pay restraint in businesses and government, average earnings have risen by around 10% since 2007. Out of work benefits have gone up by around 20%.

Well, no wonder people’s incentives are moving from wanting to work to wanting to live off benefits – the benefits are going up twice as quickly right? Hmmm.

Jonathan Portes immediately spots the slight of hand George used here. Although that stat is correct George has done some quite amazing cherry picking and completely discarded the vast majority of the useful data. As Portes notes:

The value of out of work benefits relative to average earnings (and more broadly the incomes of those in work) has fallen steadily over the past three decades, until the recent slight uptick resulting from the recession:

In 1979, unemployment benefit (the predecessor to Jobseekers’ Allowance) was about 22% of average weekly earnings; today it’s about 15%, a relative decline of about a third. What’s going on? Simple: JSA has been indexed to inflation. In normal times, earnings rise faster than prices, as workers become more productive and the economy grows; this chart shows the cash value of both JSA and average weekly earnings:

So indexing benefits to prices has been far from unsustainable, or “unfair” to working people, over the last 30 years. Indeed it has resulted in a substantial reduction in spending on out of work benefits as a proportion of GDP, compared to the alternative of indexing benefits to earnings.

The Austerity Fallacy

If you’ve been on a long-haul aeroplane ride in recent years you will no doubt be familiar with the fantastic invention of noise-cancelling headphones. Noise-cancelling headphones use a microphone to measure background noise and then cancel it out by transmitting the “opposite” noise through the headphones.

I use the word “opposite” a bit clumsily here. I don’t mean that if there is a “woof” in the background then the headphones transmit a “meow”. I mean that if there is a sound wave that looks like this:

Background noise

Then the noise-cancelling headphone produces a sound that looks like this:

Noise-cancelling effect

Note that the peaks of the background wave line up with the troughs of the noise-cancelling wave and vice versa, so when we add them together they offset one another. The noise-cancelling wave probably won’t be perfect and remove the sound completely but it will get rid of most of it resulting in a smaller version of the original background noise (the green line below):

Noise-cancelling wave

Essentially it works the opposite way round to a hearing aid. A hearing aid also has a microphone but instead of transmitting the “opposite” noise through the earpiece, it transmits the same noise – i.e. the peaks and troughs all line up. This time, rather than cancelling each other out, the waves combines to produce a bigger version of the original wave:

Amplifying Wave

Now you might wonder what all of this has to do with austerity. I’m coming to that but before I do let’s remember an important economic principal that I have mentioned many times before:

In the economy, my spending is your income and your spending is my income.

What I mean by this is that everyone’s income is a result of someone else spending money. If I buy a new pair of shoes then that gives income to the people who work in the shoe shop, people who work in the factory that produces the shoes, people who produce the raw materials such as leather, rubber, cotton, plastics etc that go to the factory, people who drive the lorries etc that deliver the raw materials to the factory, etc etc etc.

How did I get the money to buy the shoes? Someone else spent some money on the good or services that I help provide in my job. The point I am making here is that in the economy, spending and income are two sides of the same coin – you can’t have one without the other. Although this is the case, it is far easier to find a politician who says that we should all reduce our spending than it is to find a politician who says that we should all reduce our income. Politicians are a funny sort though. Anyway let’s talk about spending.

In the economy, at the highest level, we have two classes of spending – private spending and government spending. Private spending covers things like household spending, (such as the pair of shoes I bought) and the spending of companies. Government spending covers things like the NHS, state education, the armed forces, council budgets, roads – well, anything the government might want to spend money on.

The sum of private spending and government spending represent the total spending that is going on in the economy and therefore the total income. In order to maintain a healthy economy a healthy level of spending needs to be maintained but unfortunately the private sector is very unreliable in this respect.

The economy is sometimes good and sometimes not so good. When the economy is good the private sector wants to spend money – companies have lots of demand for their goods and services so they increase supply to meet the demand. This means employing more people opening new shops or offices or buying more raw materials from suppliers etc. When the economy is bad and demand for their goods and services is low they respond by reducing spending – making redundancies, closing shops, buying less raw material from suppliers etc.

So private spending over time might look a bit like this:

Private Spending

Those peaks are nice but those troughs are a problem. During those troughs, other things being equal, the economy as a whole is going to suffer from a lack of spending and a lack of income. Other things do not have to be equal though.

When the economy weakens, the government usually responds by cutting interest rates. This helps by making saving less attractive and borrowing and spending more attractive. More often than not this is enough to get the economy heading back in the right direction. In the case of the current financial crisis though it has not been enough to get things back on track. Interest rates were cut to near zero over three and a half years ago but the economy is still not recovering. Even with extremely low rates people would still rather save and pay down debt than borrow and spend.

So what are we left with? Remember that total spending is made up of private spending and government spending. We know that the private sector isn’t spending so we’re left with government spending. If the government keeps their own spending constant then overall spending will drop by the same amount that the private sector cuts spending. That doesn’t help.

The government could act as noise cancelling headphones though – increasing spending when private spending drops and cutting it when private spending rises. This might look like this:

Sensible Government Spending

You notice that when the government spends like this it helps to fill in the troughs and helps to stop overall spending (and therefore income) plunging by as much as it would if left to the private sector. (Note – we’re not asking the government to spend more overall – we’re asking the government to spend more when the private sector is not spending and less when the private sector is spending.) When interest rates can’t help then this is a very sensible fiscal policy – spending and income is to a large extend maintained.

Let’s look for a moment though at the opposite fiscal policy – what would happen if the government chose to cut spending at the same time as the private sector? (Essentially fitting a hearing aid when noise-cancelling earphones were required.) Now the government actually amplifies the effect of the private sector downturn:

Daft Government Spending

Bizarre as it might seem, this was the choice of the UK coalition government. Rather than act to offset the spending cuts of the private sector they chose to amplify them and instead of smoothing over the cracks they have opened them up.

This is the Austerity Fallacy – the widely held belief that cutting government spending when private spending is depressed will create economic growth. But your spending is my income and my spending is your income. The government has intentionally engineered a situation where no one in the economy is spending which bizarrely they expected to create growth.

Just in case I get the usual arguments in the comments on this post, I’ll address them now in a pre-emptive strike:

But government spending is what got us into this mess in the first place!

No it isn’t, I already covered that.

But if we don’t slash spending then the rates at which the UK government can borrow will become unaffordable!

No they won’t, I already covered that too.

Damn you! But we can’t spend more than our income forever! (Ha! I have you this time!)

You have not read this post properly. I do not say the government should increase spending forever. When the private sector is weak and unemployment is high then there are lots of spare resources in the economy that increased government spending can utilise. When the private sector is strong then the government can reduce spending safe in the knowledge that there are plenty of jobs being created in the private sector for people to move to.

I am definitely not advocating high government spending when the private sector recovers – quite the opposite in fact. We have long-term problems in the shape of the government’s commitments to pensions. With an ageing population our pension liability is increasing far quicker than our motivation to address it. I agree that we need to get on top of these things but to decide to try to do it in the middle of a depression is frankly very stupid.

When the economy is not working our government has an immediate obligation to fix it. When it is fixed we can go about tackling the long-term things but attempting to tackle them when the economy is depressed is self-defeating – both in theory and (thanks to the government) we can now see, in practice.

The government’s policy of choosing to amplify the downturn is not just a mistake, it is entirely negligent and is not just causing unnecessary hardship and unemployment today, it is creating problems that will negatively affect the economy and the lives of many for years to come. Middle-aged people who have worked all their lives are now amongst the long-term unemployed, their savings spent and the prospects for the second half of their careers in tatters. University students are graduating into an economy that has no use for them. Rather than take the skilled jobs for which they have trained they are forced to choose whatever is available and this will affect their prospects and their incomes and their spending and everyone else’s incomes for their whole lives.

Whatever we do now, the effects of Cameron’s and Obsorne’s austerity experiment will be felt far into the future and the Chancellor’s new policy of further cuts to welfare in order to pay for the backfiring of this experiment is almost beyond belief.

Every model of the current depression says that we will eventually recover. Even with the current government’s policy of amplifying the downturn, all models suggest we’ll get back to a sustainable economy eventually. But why didn’t we do something that would have brought us to that conclusion two years ago? Or failing that why don’t we do it today?

The government won’t do it though because it would be political suicide to admit that they had got things so wrong. Too late for that – better to plough ahead and hope they can convince the public to swallow The Austerity Fallacy for another two and a half years.

RedEaredRabbit

*In the UK The Bank of England were made independent in 1997 so it is now they who set interest rates rather than the government. If only we could find someone to take over fiscal policy too…