Sunday, July 05, 2015
Osborne must press the right buttons on tax and productivity
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Given the sheer unpredictability of events in Greece we cannot be sure that George Osborne’s first post-election budget, his seventh in all, will be the biggest economic story this week. But it will be important for all that.

One thing is clear. A budget that merely fills in the details of where the welfare axe will fall will not get the parliament off to a good start. As I wrote last week, there is plenty of scope for savings but they must be in the context of weaning people off welfare and into work, or into working more hours.

There are two other priorities. One is tax reform. Paul Johnson, director of the Institute for Fiscal Studies, is always worth listening to and his proposals for a tax reform programme for this parliament, beginning this week, make a lot of sense.

So the chancellor should begin the process of integrating income tax and national insurance, tackle absurdities such as the 60% marginal rate on earnings between £100,000 and £121,200 (tricky when the beneficiaries of any change are high earners) and reintroduce sensible indexation into taxation.

Johnson points out that we have a hotch-potch of indexation arrangements, with some parts of the system using the consumer prices index and others the now discredited retail prices index. More often, I would add, the decision to index or not, for example in the case of fuel duty, has become highly political. I have lost count of the number of times this chancellor has decided to “be kind to motorists” by not indexing fuel duty. Over time, these things add up to a lot of lost revenue.

The biggest failure to index, as the IFS director points out, is in the council tax system, where the system is based on valuations of nearly quarter of a century ago. This is bonkers.

The chancellor would make his life a lot easier if we were to return to the days when indexation, using a sensible inflation measure, was the normal thing to do. And there is no better time to do that when inflation is very low. If Osborne is to embark on sensible tax reform, not something that stood out in his first five years, now is the time to start. I am not clear that raising the inheritance tax threshold on main homes to £1m, paid for by reducing pension tax relief, is the kind of reform I would have in mind.

What else? Most chancellors, even those like Gordon Brown who introduced his own productivity agenda, have not had to worry overmuch about weak productivity growth.

New figures from the Office for National Statistics show that productivity – output per hour – rose 0.3% in the first quarter and is 1.3% up on a year earlier. They also show, however, how far there is to go.

In the first quarter productivity was just 5% up on its level 10 years earlier. The period straddles the crisis and recession but, even so, for productivity growth to average a little under 0.5% a year over a decade is remarkably weak. It was slowing even before the crisis hit.

For comparison, productivity rose by 22% in the previous decade; 1995-2005; 26% from 1985 to 1995, and 28% from 1975 to 1985. Roughly speaking, we have had a fifth of the productivity growth over the past decade that we should have had.

There are, as noted before, some special factors in that; the shift in the financial services sector from productivity driver to productivity drag and the decline of North Sea oil. Some sectors have bucked the trend. Manufacturing productivity has been up and down recently but is 18% higher than 10 years ago.

But productivity is a bigger problem for Osborne than for his predecessors. Hence the “productivity plan” we will see unveiled this week around the time of the budget.

There is no great mystery about what should constitute a productivity plan. Politicians cannot wave a wand and boost productivity though they can create the conditions under which the private sector can deliver improvements.

That means tackling the usual suspects, the productivity "drivers", though Osborne also appears to have in mind the dynamic drivers of productivity, the cities and other clusters in which those productivity drivers can trhive.

Of the traditional drivers, business investment has been improving recently but the single biggest explanation for why the output of British workers is below that of competitor countries such as France is that they invest more. So expect some modest investment incentives, notably an increase in the annual investment allowance.

A productivity plan means boosting education and skills, incentivising training and apprenticeships. Plenty is being done on this, though governments can probably never do enough.

It should also mean investing in and updating the infrastructure in a timely way and it is here that you realise that this productivity thing is not so easy. In presenting the findings of his Airports Commission Sir Howard Davies fired the starting gun, not on the diggers breaking ground for Heathrow’s third runway but on a prolonged period of argument, dithering and uncertainty.

The announcement a few days earlier of delays in what had been billed as the biggest rail investment programme since the Victorian era, including the postponement of at least one project pivotal to the chancellor’s northern powerhouse, confirmed that we do not do these things well. Anybody waiting for Transpennine electrification to deliver productivity improvements will be waiting a long time.

There is, of course, nothing new in Britain being bad at infrastructure, in business tending to under-invest and in more work being needed to improve education and skills. None of this, however, prevented good rates of productivity growth being achieved in the past.

If you were to put your finger on one big difference since the crisis, it is finance. Availability of credit, of funding for business growth is a factor most people can agree has significantly held back productivity. The process of creative destruction long ago identified by the Austrian economist Joseph Schumpeter has been held back. Banks have kept bad businesses alive while failing to finance new, creative and productive firms. It remains the case that bank lending to business is falling in year-on-year terms, six years into the recovery.

There have been plenty of initiatives in this area, and there are sources of finance, but it is still a problem. Osborne’s current priority is to get Lloyds and Royal Bank of Scotland back into the private sector. Maybe that will deliver stronger lending to business but probably it will not.

It is good that the chancellor has a productivity plan. It has some good elements as well as some familiar ones. But if productivity improves it will probably do so because of an easing of the effects of the crisis and a return to some kind of normality, not because of what will be announced in the next few days. If Osborne is lucky, his plan will coincide with an improvement in productivity. If not, it will be back to the drawing-board.