This is a guest post by Michael Burke. Michael works as an economic consultant. He was previously senior international economist with Citibank in London. He blogs regularly at Socialist Economic Bulletin. You can follow Michael at @menburke
The Fine Gael/Labour Coalition government has announced its overall tax and spending plans for 2016, which seems set to be an election year. It is a reactionary Budget in two key respects. First, it prioritises tax cuts over investment, which has actually been cut. This is to repeat the economic failures of the so-called ‘Celtic Tiger’ years and will damage the long-term growth prospects of the economy. Secondly, within the tax cutting measures it provides a much larger benefit to the higher-paid and the rich than it does on lower incomes.
Investment and Consumption; Proportions and Growth Rates
The purpose of all economic policy is, or should be, the optimal sustainable improvement in the living standards of the population. Primarily that means the rising consumption of goods and services, either individually or collectively through public provision. This should be the framework in any government policy, especially formulating a Budget.
However, this rise in consumption cannot be achieved directly through boosting consumption. It can only be achieved by boosting investment. As all production is necessarily either consumed or invested, this means that the greater the proportion of output (GDP or another measure) devoted to investment, the greater the growth rate of output will be and from this the greater the growth of consumption.
This can be illustrated in a number of ways. Take the case of a farmer who retains 10 per cent of the crop as seed corn for next year’s harvest in order to reproduce this year’s crop yield. If those ratios remain the same she can only ever expect the same yield (all other things being equal) and there can be no growth and no improvement in her consumption. Suppose instead she retains 12 per cent of the crop as seed corn. This is a reduction in her level of consumption from 90 per cent to 88 per cent of the total. But her investment in the seed crop rises from 10 per cent to 12 per cent. All other things being equal, she should expect a crop yield of 120 the following year (as the seedcorn has increased by 20 per cent so should the yield), which she can divide between increased consumption and increased investment.
This is also the record of modern economies. The chart below illustrates the US economy, the Western economic model. It shows the proportion of GDP devoted to household consumption versus the annual growth rate of household consumption. From the 1970s to the current period household consumption has formed an increasing proportion of US GDP. But the growth rate of household consumption has slowed dramatically. This is a general pattern observable in most Western economies and in the OECD economies as a whole.
To smooth out the volatility of annual changes, especially in the growth rate of household consumption, Table 1 below shows the proportion of US GDP claimed by household consumption and the average annual growth of household consumption by decade.
The pattern is one in which there is a rising proportion of GDP claimed by household consumption, yet the growth rate of household consumption is declining. The exception to this pattern is the 1990s where household consumption continued to rise as a proportion of GDP and yet there was a marginal increase in its growth rate from 3.1% to 3.2%. But this would be accounted for by the surge in household debt to finance consumption in the 1990s which was a key factor in the economic slump in the later part of the 2000s. This slump, the Great Recession of the 2000s, also showed a more marked decline in the growth rate of consumption, even as its proportion of GDP continued to rise.
All output can only be consumed or invested. In addition, as household consumption is only one portion of total consumption (which also includes Government and other sectors) then a more accurate and systematic way of expressing the same relationships as above is to focus on investment and the growth of consumption.
This is done in Table 2 below, which focuses on the Irish economy. This is derived from domestic demand data, which excludes the distortions of the overseas sector data.
The same general pattern is true as with the US economy. But from this (and more detailed data) it is possible to refine the proposition that the higher the proportion of GDP devoted to consumption, the slower the growth rate of consumption. This can now be modified and restated; the higher or rising proportion of output devoted to investment, the greater the growth rate of consumption.
The mass of the population does not care what proportion of the economy is available to it for consumption. Justifiably it only cares whether its material well-being (consumption) is rising or falling. The method to achieve the optimal sustainable rise in consumption is to increase the proportion of investment in the economy.
Framing a Budget
The distinction between investment and consumption, and the understanding that only the latter can provide sustainable growth, should provide the framework for all economic policy including Budgets.
The current Fine Gael/Labour government is in a better position than the farmer of our earlier example. The economy is currently growing and so there are already additional resources. There is no need to temporarily reduce consumption in order to increase investment. Without any policy changes the department of Finance says that tax receipts are expected to rise from €44,637 million in 2015 to €47,242 in 2016. These are likely to be underestimates in both cases as the DoF seems to have little understanding of the scale of the impact of growth on government finances.
If the proportions between investment and consumption in the economy are unaltered then so too will the rate of growth of the economy. The Coalition has chosen to cut taxes and increase cut its own investment. Tax giveaways of just under €1 billion are accompanied by a nominal cut in voted capital expenditure of €700 million, a cut in GDP terms from 2.7% in 2015 to 2.25% in 2016. In this way, the Government’s Budget increases consumption and reduces the proportion of investment in the economy.
This economic failure is compounded by the tax changes themselves being distributed towards the higher paid and the rich. This deepens inequality and social divides, and reduces funds available for necessary consumption for middle and lower income workers and the poor, while increasing the funds available for luxury consumption and speculation in housing by the high paid and the rich.
A progressive, reforming Budget would broadly do the opposite of this reactionary one. It would primarily focus on increasing investment, to raise the genuine economic growth rate and make it sustainable by investing in the productive economy, housing, transport, infrastructure and education. It would prioritise social provision such as childcare and healthcare. And it would address the needed support for those on middle and lower incomes by increased revenues from business, the higher paid, and taxes on speculation and luxury consumption. There should be growth and fairness through boosting investment, not speculation and injustice through boosting consumption.
Footnote
Some supporters of Labour’s new leadership in Britain have been debating the role of borrowing for consumption versus borrowing for investment. There are a number of contributions here, here, here and here as well as others.
As Ireland has a much more highly developed political culture than Britain, the Irish debate on these questions is much clearer. Here a reactionary government is using its fiscal leeway to increase consumption. On the other side, the progressive forces, including Sinn Féin, many in the trade unions, social justice campaigners and others all argue (with different emphases) that the priority should be investment, not tax cuts primarily for the higher paid.
As the world economy slows and economic and social problems mount, these debates on the alternatives are likely to intensify.
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