Cutting business taxes won’t help economic growth. Instead George Osborne should focus on boosting consumer demand
Growth in the UK economy was disappointing in 2011. Real gross domestic product increased by just 0.8%. And 2012 is not shaping up to be any better. The average forecast for real GDP among the independent forecasters monitored by the Treasury is just 0.4%. It is not surprising, therefore, that the chancellor is coming under pressure to announce measures in the Budget on March 21 to boost growth.
Conservative backbenchers have called for the chancellor to cut taxes on business. He has already cut the main rate of corporation tax from 28% to 26%, and he plans to bring it down to 25% from April, and then to 24% in April 2013 and 23% in April 2014. They would like him to go faster and further – and to cut public spending to offset the lost revenues from cuts in corporation tax.
While it is good to see Conservatives coming round to the idea that the government can do more to boost growth, their policy prescription is wrong for two reasons.
First, cutting spending takes more demand out of the economy than cutting taxes by the same amount puts back in. The Office for Budget Responsibility published estimates of the multiplier effects – the impact on the economy – of changes in government spending and taxation in its June 2010 assessment of the economic and fiscal outlook. Although it did not consider changes in corporation tax, it said that the effects of changes in spending were two to three times larger than the effects of changes in taxation. Analysis by the IMF in 2009 reached similar conclusions.
Second, cuts in corporation tax are likely to be particularly ineffectual at the moment because companies are already sitting on huge cash piles, which they are choosing not to invest, or to spend on hiring extra workers. The problem facing companies is not too high taxes; it is too much uncertainty about the outlook for demand. The solution, therefore, is not to lower taxes, but to increase demand.
Similarly, Conservatives (most notably Liam Fox in the Financial Times) who have called for deregulation of the labour market as a way to support businesses and so boost growth are also wrong. Their argument is that it is too hard to hire and fire workers in the UK, and this is what is making companies reluctant to recruit. There is, though, little evidence to support this claim. Businesses became increasingly reluctant to take on extra workers during 2011 not because labour market regulations were being increased; they were not. They stopped hiring because the demand outlook deteriorated.
In fact, according to the OECD, the UK has one of the least regulated labour markets among advanced economies. Its employment protection index, which measures the protection of permanent workers against individual dismissal, the specific requirements for collective dismissal and regulations on temporary forms of employment, shows only the United States and Canada have less regulated labour markets. Hiring and firing is already relatively easy in the UK.
Those arguing for greater deregulation of the labour market also forget that workers are consumers too. The flip side of making it easier to fire workers is to reduce job security.
And lower job security is likely to make some workers more cautious in their role as consumers, so taking demand out of the economy at a time when it is already weak.
Cutting labour market regulation could therefore lead to weaker growth in the short term.
The problem facing the UK economy is weak demand because the government is cutting its spending and households’ spending power has been squeezed. If businesses are in a funk and not spending or recruiting, it is not because they have insufficient funds, it is because they do not believe there will be increased demand for their goods and services. The solution, therefore, is not to support businesses directly by cutting corporation tax or deregulating the labour market. It is to boost demand through extra infrastructure spending and to support consumers to increase their demand through tax cuts or tax-switching. The economy will then get a further boost when businesses respond to the better outlook for demand.
Tony Dolphin is senior economist at the Institute for Public Policy Research