COMMENTARY.

Weale, Martin ; Young, Garry

Introduction

The early Autumn has brought two issues into focus, the taxation of motor fuel and the question of old age pensions. The debate on both of these has been coloured by the widow's cruse of the government budget. Despite the fact that government spending is rising the current account is in large surplus and the buoyant revenue shows no sign of diminishing. We predict a continuing surplus on the current account of the public sector of [pound]l9bn in the current fiscal year, falling only slowly next year. With rapid growth in public sector investment, the public sector cash surplus, having been swollen in 2000/2001 by sales of broad-band spectrum licences, is expected to be [pound]7bn next year and thereafter to settle close to zero.

This picture, of course, leads to the view that the money is there to reduce fuel taxes and increase pensions and that such changes are in some sense 'costless' instead of being at the expense of higher taxes or lower spending elsewhere. There are two immediate observations which follow. First of all, from a macroeconomic point of view, the state of demand in the economy is such that significant tax cuts or pension increases should be expected to lead to a higher interest rate at a time when some people feel already that monetary policy is too tight and, in consequence, that fiscal policy is too slack. Secondly, it is always the case that public spending or lower taxes have a cost. The government does not have to balance its budget in any one year, but a lower surplus now means higher taxes in the future, possibly at a time when revenue has lost its current buoyancy.

Pensions

The issue of pensions is complicated and for a number of reasons. There is pressure on the government to target help at poor pensioners but at the same time it is objected that this penalises people who save. On the other hand, to raise the basic pension for everyone, or to resume earnings indexation is expensive. The logic of the position is that 'targeting' of help amounts to a high effective tax rate, either on the investment income of people of modest means or on their capital. One can reasonably question why a government which thinks it inappropriate to levy a tax rate of more than 40 per cent at the top end of the income scale, should think it appropriate to impose much higher tax rates on much poorer people. These high tax rates act as a disincentive to save which is mitigated only by the complexity of the benefit structure serving to mask its true nature. However their effect is to increase wealth inequality (Sefton, Dutta and Weale, 1998). People of modest means are discouraged from saving, while tho se with more resources see benefit withdrawal as a lump-sum tax which does not affect their marginal decisions.

In the short term there is little that the government can do except muddle through. Most of those currently retired did so after the link between pensions and earnings ended twenty years ago and have had the opportunity to provide for their retirement, although there is a case for paying more to very old people who retired before the end of the earnings link or had only a few years to adjust to the changed circumstances. There is also a question whether the government did enough to inform people of the consequences of breaking the earnings link at the time the link was broken; this might also justify some increase now. In the longer term the key question that the government needs to address is the appropriate balance between means-tested benefits paid to old people and means-tested pension contribution credits paid to people of working age. The former discourage saving while the latter reduce the incentive to work. For any overall level of support to pensioners it is necessary to strike a balance between thes e two disincentives. As yet it is too soon to offer any precise guidance on this issue; a project studying the trade-off funded by the ESRC begins at the National Institute next year. On the other hand we can note that the government has additionally discouraged private saving in pension schemes by reducing the 'carry forward' of private pension contribution entitlements from seven years to one year. This greatly reduces the flexibility of private pension schemes and is bound to discourage their use as compared to other forms of saving (see Sefton, 2000).

One should not lose sight of the effect of paying larger pensions to old people out of current revenue. It amounts to a permanent transfer from the young to the old; those drawing pensions at the time of the increase receive a benefit that they have not necessarily paid for. As the population ages the proportion of old voters increases and it becomes more and more likely that governments will bow to pressure from the elderly. But at the same time, as the balance of the population ages, the burden imposed on those of working age by any particular pension increase is all the greater. It should also be noted that young people are typically wealth-constrained; on average their incomes rise at least until their forties. In consequence the level of spending that they can afford out of their life-time income is likely to be higher than their current income. Lack of access to borrowing means that their consumption is held below its optimum level in the first part of their working lives, rising above it in the second part. To impose further taxes on young people so that they receive extra pension benefits when they are old worsens the impact of this wealth constraint.

The cost of any pension increase is, of course, compounded by ageing of the population As the population ages there are more recipients and fewer taxpayers. It is therefore a mistake to assess the cost of any permanent increase in terms only of current year costs. The most sensible question to ask is what permanent change in the tax rate is needed to finance a permanent change to pensions, although this means that initially the extra tax collected will be more than adequate to meet the pension increase because there are relatively fewer pensioners at the start of the period. On page 15 we set out some calculations from the National Institute's generational accounts. These suggest, for example, that a resumption of earnings indexation would take the standard rate of income tax about 5p higher than it would otherwise have been.

Fuel tax

There are also a number of microeconomic arguments which suggest that the Chancellor of the Exchequer would be wrong to respond directly to the pressures he is facing to reduce fuel taxes. At present fuel tax is the best means that we have of charging for road use. It is a blunt instrument which might eventually be replaced by proper charging mechanisms, but until these exist one has to rely on fuel tax. The degree of congestion in urban streets makes it seem that fuel taxes are more likely to be too low than too high. In the long term the problem could be allieviated by urban road building, but it is doubtful that there is a consensus for building urban motorways on any significant scale. Secondly, the government has agreed targets to limit emissions of carbon dioxide. Taxation of motor spirit, as a means of discouraging car use and encouraging people to buy fuel-efficient cars is an important means of delivering these targets. More generally, there can be no doubt that the best means of keeping oil prices i n check would be for the oil-consuming countries to levy a substantial tax on the use of oil. This is bound to be more effective than exhorting OPEC to raise output but there are obvious difficulties in explaining and implementing it, particularly in the United States.

Against these arguments for continuing and increased taxation, we have seen pressure from the producer interests of farmers and road hauliers making a number of arguments which are ill-founded or reflect vested interests. Both groups complain, rather oddly, that they are unable to pass on cost increases, despite the fact that fuel price rises affect their competitors as much as themselves. UK hauliers competing with foreign truckers have the same access to foreign fuel sources as do their competitors. Hauliers observe that they face 'unfair' competition from competitors from Central Europe who use lower-paid drivers while farmers complain of low prices which make farming uneconomic. In both of these cases it is worth pausing to consider the consumer interest. If goods can be delivered more cheaply in Britain by foreign hauliers, that surely is in the public interest and particularly so at a time when the labour market is tight. Similarly, if food, like coal, can be bought from overseas without the subsidies o r inflated prices that are paid to British farmers and were paid to British coal mines, that too must be in the taxpayer's interest. The solution floated to hauliers' problems, that foreign truckers should be taxed for driving on UK roads is equivalent to an import tariff with clear adverse effects on consumer welfare. [1] As so often in these debates, the producer interests are focused, while the consumer interests are dispersed making it all too likely that governments succumb to producer pressure at the consumers' expense. Skillful producers may even succeed in generating public sympathy at the same time as they burden consumers with the costs of subsidies or protection from foreign competition.

The international environment

In our forecasts of the UK and world economies we discuss the question of fuel prices from a number of perspectives. First of all we look at the impact on the world economy of different oil prices. We note that there is some sensitivity to the oil price, in that an increase of the oil price of 50 per cent depresses output in the UK, the Euro Area and the United States by 1/2-3/4 percentage points by 2002 and leads to a price level which is up to 1 per cent higher. Monetary policy responds to the increased inflationary pressures, so that interest rates are raised by up to 1/4-1/2 percentage points by 2002.

The other international development of some importance is the concern that the US is showing about the strength of the US dollar. This led to intervention to support the euro in September. However since then the dollar has risen to an even higher level against the euro. Exchange rates are notoriously unpredictable, but a forecast requires some assumption. Our forecast is based on the premise that exchange rates remain close to current levels, although it shows some recovery of the euro from the very low levels reached recently.

The world economy remains very exposed to the risks that world stock markets, and in particular the US market, will fall back to more normal levels. Such falls are likely to have more of an impact on aggregate demand than was the case in the crashes of 1973/4 and 1987 because stock market wealth is a more important component of people's portfolios than it was then. Savings ratios, particularly in the United States, are likely to rise in response to falling stock markets, with a consequent reduction of aggregate demand. This stock market risk may be aggravated by fears that banks have lent too heavily to telecom and information technology firms, raising the possibility of new liquidity problems for the banking sector.

The UK economy

At a more domestic level, the result of the Danish referendum must make it less likely that Britain will join the Euro Area in the short or medium term. On the other hand this now has few implications for our forecast. We take the view that exchange rate movements are generally best indicated by interest rate differentials. The term structures of interest rates in sterling and the euro suggest that, after a modest decline of sterling to [epsilon]1.65 in 2002-3, the exchange rate is expected to be stable. For long maturities sterling yields are lower than euro yields. We take the view that this is because the minimum funding requirement creates an artificial demand for UK government stocks and do not assume that the difference implies that the euro is expected to fall against sterling in the longer term.

As we reported in July, our projection does not suggest that the exchange rate at this level will cause severe problems for the British economy, although its structure will obviously be different from that suited to a much lower exchange rate. The buoyancy in manufacturing reported in the August data is perhaps the first explicit signal that the economy is developing a structure suited to the level of the exchange rate. The argument becomes even stronger when one looks at the export performance of manufactures. Manufacturing exports were in 2000Q2 more than 10 per cent above their value a year earlier and the buoyant growth has continued into the third quarter of the year. Thus, with most of the estimate for the year based on data rather than a forecast, we expect that, in the year as a whole manufacturing exports, growing by 12.5 per cent over 1999, will have grown more than manufacturing imports and also faster than world trade as a whole. We expect that, with the exchange rate close to current levels, manu facturing exports will continue to grow broadly in line with world trade.

There is, however, one risk we should mention. This is that the rapid growth of manufacturing exports reflects the outcome of decisions to raise manufacturing capacity made at a time when either the exchange rate was lower than it was now or in the belief that the high exchange rate would prove short-lived. If this is the case there is a risk that manufacturing capacity, and therefore manufacturing exports, may fall in the future. Manufacturing investment gives a mixed signal about this. In 1999 investment fell back to the 1996 level from a record in 1998. Our estimate for 2000, again based partly on data, is that there has been a recovery from the low levels of last year, but that investment remains below its 1997 and 1998 figures. Indeed the modest growth we project in 2001 and 2002 is not sufficient to lift manufacturing investment above its 1998 level. On the other hand non-manufacturing business investment, which is much the larger part of overall business investment, is now one third higher than it was in 1997 and is expected to remain buoyant.

This generally buoyant picture leads us to forecast a growth rate of about 3 1/2 per cent for next year falling to about 3 per cent in 2002. Manufacturing output overall is expected to grow faster next year than in 2000. From the demand side both government spending and fixed investment are expected to show rapid growth. We anticipate some recovery of the household saving ratio, so that household consumption will grow more slowly than GDP. Plainly, if this recovery of the savings ratio does not occur, then GDP growth will be even faster with a major risk of overheating.

If the growth rate does not rise above the level we have forecast, we expect the inflation rate to remain within the government's target. However, our analysis is predicated on the assumption that a period of relatively rapid productivity growth is now possible. As we explained in July, unless this happens it will prove very difficult for the economy to accommodate the Chancellor's spending plans without being overwhelmed by inflationary pressures. It will also become increasingly difficult for the economy to compete satisfactorily in world markets.

But with our forecast of productivity growth of close to 3 per cent per annum for the whole of the economy in 2001 and 2002, and remaining above 2 per cent per annum until 2007, inflation remains in check with interest rates not far above today's level. With claimant count unemployment at just over 1 million, the scope for continuing falls is plainly limited. The labour market is likely to remain tight, and we expect earnings growth of over 5 per cent per annum during 2001.

This time last year we expressed the view that the Monetary Policy Committee had changed interest rates far too frequently with rather little impact on the inflation rate (see National Institute Economic Review, No. 170, p. 12). A number of members of the Monetary Policy Committee publicly disagreed with this view although there are no official estimates of what has been achieved by monetary policy activism. But the interest rate has now remained unchanged since February and our view is that a rise would be prudent and consistent with our forecast for GDP growth. We have assumed that the base rate will rise to 6 1/4 per cent per annum by the end of this year, with a further rise to 6 1/2 per cent per annum early next year.

NOTE

1 The only case where a levy can be justified is if UK road fund taxes are higher than those collected elsewhere. It makes sense to equalise these charges by imposing a levy on foreigners to match that imposed on UK firms.

REFERENCES

Sefton, J., Dutta, J. and Weale, M.R. (1998), 'Pension finance in a calibrated model of savings and income distribution of the UK', National Institute Economic Review, 166, pp. 97-107.

Sefton, J. (2000), 'The demand for personal pensions', paper presented to INQUIRE conference, September.