Economics For Dummies

It’s nearly a year ago now that the leaders of the three main parties in the UK held those TV debates, but you will probably remember the talk of cutting the budget deficit, which was at that time approximately £150 billion. David Cameron was arguing that the deficit needed to be cut, while Gordon Brown was convinced that it should wait until the economy was growing healthily again.

I get the impression many people don’t really understand what is meant by a budget deficit.

A budget deficit is like running into the overdraft of your bank account, and instead of paying off its overdraft, the government was going £150 billion further into debt each year.

Like going into your overdraft, a budget deficit should be avoided as much as possible. It’s understandable that it might happen during difficult times like we’re in at the moment, but you want to minimise how long you spend in your overdraft because your bank charges interest on the money you borrow.

Here’s a graph that shows the state of the government’s bank account from 2002-2009:

The red bars show, very simply, how much the government borrowed each year between 2002 and 2009. The green line shows what those bars adds up to. That’s not the total debt, because it doesn’t include any debt accumulated before 2002, and neither does it count the interest the government owes to its lenders. But it’s clear that the Labour government was into its overdraft even before the recession, when times were good.

The government can’t go on borrowing indefinitely. At the moment we still have a pretty good reputation for repaying debts, so lenders are happy to trust us with their money, and they’re charging relatively little interest, but if we don’t start repaying that money at some point, that won’t last.

Students are worried about the prospect of being in debt for most of their lives having taken on a student loan, and yet many people seem oblivious to the government’s debt, and the interest building up on it.

Just to give you an idea how much debt we’re in, how much interest we’re paying (despite the relatively low rate), and how much better we could be using our money, here’s a quote from Nick Clegg:

“This year we’ll be spending over £43bn just on the interest on our debts.

That’s £830m per week. Just under £119m a day. For that money, we could build a new primary school every hour. We could buy a new Chinook helicopter every day. We could take 11 million people out of paying income tax. We could triple the number of doctors in our hospitals.”

If the government is going to start paying back its debt so we can start buying useful things rather than spending so much on interest, it will first have to make sure its income is greater than the amount it spends each year. This is what they mean by reducing the budget deficit; they need to turn it into a surplus.

There are two ways to work towards this. The government needs to either cut its spending, or increase its income, or both.

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First, let’s talk about cuts.

Ed Balls would argue that no cuts need to be made. He would claim that it is necessary to maintain spending to encourage the economy to grow, and that income will eventually catch up with spending so the debt can be repaid.

I will try to explain simply the folly of that idea.

There are two types of jobs in the UK:

A private sector employee works for a business that pays the employee’s wages out of its profits.

A public sector employee works for the government, which pays the employee’s wages out of the taxes it collects from the private sector.

Basically, Labour’s idea is that by giving people public sector jobs (i.e. they work for the government), those people will have money to spend, and if people are spending, the economy will grow.

The problem with this is, for the government to make a profit from one of its public sector employees, it needs more than 100% of the salary it’s paid to come back in taxes.

Let’s have a look at how plausible that is:

Think about what a typical employee spends their wages on: mortgage/rent, fuel bills, food, etc…

Take food for example: some of the price of the food is VAT, so the government gets a bit back there… the shop that sold them the food pays some tax, so the government gets a bit back there too… and the shop will have more money to spend on other things than it might have otherwise, so the government might get some more tax that way too… but these amounts are just ever decreasing fractions of the original salary paid out by the government, and the actual cost of the food or house or fuel never gets back to the government. The government is not going to get back more than it put in.

Government spending accounts for about half of our GDP, i.e. the government wants to spend about as much as the entire private sector.

But remember that the private sector ultimately has to pay the government’s bills as well as its own, so for the government to be able to afford to spend that much, it’s taking a huge amount of tax off the people and businesses that are actually creating wealth.

Obviously no one likes paying a lot of tax, but for many of these private sector companies – and hence for the government which is relying on them – a high tax rate actually causes serious problems.

It means that companies can’t afford to employ so many people, so they have to lay them off (or at least can’t take on as many as they would otherwise). Labour’s solution is to create more jobs in the public sector for those redundant people to do instead (who cares about efficiency anyway?). In order to pay these people a salary, the government needs to collect more taxes from the private sector, and a bigger tax bill makes it even more difficult for private sector firms to pay employees so they have to make more people redundant. It’s a vicious circle: raising taxes means people in the private sector lose their jobs; giving those people jobs in the public sector instead means the government has to raise taxes even higher to pay for them.

If you ever watch the BBC’s Question Time, you will have heard people questioning the Con-Lib representatives on whether the private sector will create enough jobs to make up for the losses from the public sector.

The simple answer is: it has to. Encouragingly “the number of private sector jobs rose by 428,000 in the year to December. Over that time, the public sector shed 132,000 jobs”, but whether that was already happening or not, the cuts need to happen.

The government needs money, and keeping so many people employed in the public sector will only make the situation worse. This seems very uncaring towards the people who will lose their jobs in the short term, but I’m afraid there is no other option, and in the short term, yes, it will be painful for many, I wish it didn’t have to be, but I will later go on to explain how the vicious circle will work in reverse.

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So how can the government increase its income?

I implied before that the answer is to raise taxes. Actually, I intend to show that the opposite is true.

This chart shows top tax rates in the US, compared with the income the government received from those taxes:

You can see that, whether the top tax rate was 90% or 40%, the amount the government received was basically the same. The idea that taxing the rich more gives the government more money is clearly not true.

In fact, with lower tax rates, private sector companies would be more able to afford to employ people, and more people in private sector employment would mean the tax bill is shared out between more people; so each person can pay less, while the total the government receives actually increases.

This is the vicious circle in reverse: lower tax rates means more private sector jobs, more private sector jobs means the government can afford to charge each individual a lower rate and still get more money than it did before. Everybody wins!

I know that the government is cutting some worthy causes in order to achieve this, but going on with a budget deficit is just not clever. When the debt has been repaid, then that money we’re currently paying as interest on our debts can be used for useful projects like those described by Nick Clegg in the quote above.

The alternative is to build up a bigger and bigger debt to pass on to future generations and let them worry about paying it back. That’s basically stealing from your children.

For Christians, of course we want to look after the poor, but the Biblical principle, from Ephesians 4:28, is to work to have to give, you don’t take from others in order to give more than you can afford.

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4 thoughts on “Economics For Dummies

  1. Did you do A-Level economics or do you just pick it up from reading blogs, etc.? You seem to have a pretty good command of it all, and your blog is well written and clear to understand 🙂

    A few things I wondered about…

    With your comments on public sector jobs, it is a bit of a simplistic view that assumes the jobs add no value of themselves, other than the injection of money into the pockets of employees. Any public sector job (although unfortunately this might not always be the case) should have a function and purpose and, whilst not all of those purposes will be economic and therefore have no economic gain, those roles will add to GDP and therefore increase the tax take. For example, if you employ tax collectors they will raise a lot more tax than what their wages are, or if you employ someone in the Treasury to close a tax loophole a similar effect will be had. More generally, if you employ another teacher, they can improve the education of a generation of children, themselves going on to pay income tax and other taxes, as well as becoming teachers, tax collectors and others things too. A similar thing with doctors and nurses who make the nation healthier so that they can work more and pay more tax, public transport planners helping make travel to work more efficient; the list goes on, and all are examples of how value is injected into the economy through public sector jobs, which increases GDP and with it the tax take. Obviously though not all jobs add so much value, which is why the Coalition are trying to cut ‘middle management’ and ‘back office’ jobs, but whilst I think that sounds good I’m wary that that could lead to more strategic and long-term work being cut because ‘police on the beat’, etc., sounds more important in the papers.

    With regards to your graph about tax rates it’s a bit misleading. Firstly, I think you should use a secondary axis. 1) because the scales are very different and it is hard to see the variation (which the 5 figures you give do show) and 2) you can’t use the same scale when they are percentages of different things (the first is the percentage of an individual’s income and the second is the percentage of a nation’s GDP). Secondly, by just using the top income tax rate this doesn’t tell us: 1) how many people were eligible for that rate/what real income level it was charged on; 2) whether they actually paid it or they avoided/evaded it; or 3) how many other tax rates there were. It may be better to say what the marginal tax rate of someone earning median income was. Thirdly, tax takes of a country are effected by things other than the income tax rate, so even with a median rate it is a difficult to know how much of a correlation there is between the two, and furthermore whether there is any causality.

    This analysis basically draws on the ‘Laffer curve’, a concept made up on the back of a napkin in a restaurant that was used to justify Ronald Regan’s tax cuts. I don’t necessarily disagree with the logic behind it, but I think there isn’t much evidence to support it.

    http://en.wikipedia.org/wiki/Laffer_curve

    The idea is that as you increase tax rates from 0% upwards the tax take will increase. However, once you get to a certain point the overall tax take will begin to dip as people will work fewer hours because there is no point in working if for every extra pound you earn you only keep, for example, 9p. The question is: where is the tipping point, which is the optimal tax rate? From your graph (and assuming this can be used reliably despite the concerns listed above) it would seem to be that a rate of between 70% and 50% would be optimal. Again, it is hard to tell if this is the case because lots of other things would have changed, plus it takes a while for firms and individuals to change their behaviour and for contracts to be renegotiated and new jobs created/made redundant.

    Overall though, I think your original graphic and comments are the most important. Having a deficit isn’t necessarily a bad thing in economics terms (although I’d suggest the country should be a positive example to it’s citizens and save rather than be in debt), however if you’re going to try and beat boom and bust you have to run a surplus when there’s a boom so that you limit the boom and than be in a position to support the economy through a deficit when the bust comes (thus getting sustained growth in GDP rather than wild peaks and troughs as time progresses). Instead, Labour (who inherited a surplus from the Conservatives – emerging from a recession – and only kept running a surplus because they promised to stick to Tory spending plans for their first term) decided to spend spend spend when times were good, meaning:
    1) The bubble became even bigger, meaning the fall was even worse than it would have been;
    2) The deficit was already bad, meaning it got much much worse after the credit crunch, and so it was even harder to keep the new amount under control; and
    3) The country’s debt was even bigger than it would have been, making it even harder to maintain the current level of spending, let along deal with the increased deficit when benefits payments go up and tax receipts come down.

    Hopefully your blog will help people to see that the deficit is a real problem and that Labour did contribute heavily to it (although there’s no guarantee other parties would have been greatly better, particularly as other parties backed Labour’s spending commitments prior to the credit crisis), as well as making us all think about how (and why) we create jobs, and what effect this has on the state of the country.

    1. Thanks Chris, I considered asking you to check this before I published it. I haven’t studied Economics, just a combination of a few blogs (I’m subscribed to Stephanie Flanders and Robert Peston’s BBC blogs), and, I think, common sense, although my idea of common sense may be a bit skewed by my Conservative, Accountant father.

      I was aware that I was being a bit simplistic, that’s due to a combination of wanting to keep it “for dummies”, not wanting to make the post longer than it already is, and being close to the limit of my understanding.

      I recognise that some public sector jobs will, directly or indirectly, add value, but the impression I got from Gordon Brown in those debates, and from people on Question Time, is that people don’t realise that ultimately the bill for all public sector salaries has to be paid by taxing the private sector. Is that fair?

      I was a bit nervous about using that second graph. Unlike the first one, I didn’t assemble it from figures I found myself. I should have referenced where I found it:
      http://www.twitlonger.com/show/93vqud
      I did think the logic was a bit questionable, and he was probably arguing more strongly than he could really justify from the figures, but I thought the 20% drop in tax rate corresponding to only 0.2% drop in revenue looked significant.

      But my argument was more based on the employers’ ability to afford taxes, which was more influenced by what I remember from watching this a while ago:
      http://www.channel4.com/programmes/britains-trillion-pound-horror-story/4od
      which is, again, probably too simplistic.

      I would be interested to find out if any causality can actually be demonstrated, but for now, somewhat vague correlation and a bit of “common sense” logic suggesting a link between low taxes and a strong private sector will do for me 🙂

  2. And here’s a link to a talk by Bill Gates, where the size of deficits is probably comparable and so too the observation that there is a big transfer from the young to the old. Once people work that one out the protests could become interesting!

  3. You state regarding that comparison chart, that “You can see that, whether the top tax rate was 90% or 40%, the amount the government received was basically the same.” Actually, this is a complete misreading of the data. Somewhat understandable because the chart is scaled in such a way as to make it LOOK like the tax receipts are relatively unchanged. But actually, you can still see from the chart that it peaked at a 70% tax rate in 1981, and is at the lowest at the end of the chart in 2010, at the 35% tax rate. The bottom line being the difference in receipts between the 70% tax rate and the 35% tax rate is (9.4-6.4) over 9.4, which is about a 32% drop– the tax receipts are actually 32% lower with the 2010 35% tax rate vs the 70% tax rate in 1981.

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