UK deficit cutting – lessons for the US

February 15, 2011

USA-BUDGET/The news that China is engaged in talks over the building of a rival to the Panama Canal ought to set alarm bells ringing in Washington – and not just because of its obvious geopolitical implications. It is yet another sign that the Chinese have finally woken up to the fact that relending their hoard of dollars straight back to the USA is not a very smart policy, at least not as long as the Federal Government carries on spraying out greenbacks like a tipsy GI on furlough, and without Chinese support, the outlook for the Treasury bond market looks threatening.

Those who argue that it is a bad time for imposing austerity should be ignored – in the good times there was no sense of urgency, and in any case deficit reduction has to be a multiyear project. The Federal deficit is running at over 10 percent of GDP and the projections for the coming decade on unchanged policies are too frightening to contemplate.

That is the background to the Obama budget – in qualitative terms, it is very similar to the scenario faced by Britain’s new Coalition Government when it came to power last May. What lessons can America draw from the UK experience?

One caveat needs to be made at the outset. Since the mills of government grind slowly, the full impact of Britain’s austerity budget is only just beginning to be felt, so some judgements may be a little premature. However, start with Britain’s mistakes. It was a gross error to ringfence any spending items – and the choice of the National Health Service and Overseas Aid as protected species was particularly perverse, not least because it left the defence budget to sustain a sizeable cut while the country is still at war. America should nominate no sacred cows. The burden of the cuts has to fall overwhelmingly on the big spending programs: social security, Medicare and Medicaid, and defence.

Politically, cuts in spending might be easier to achieve if they were set in the context of an overarching vision – something Britain’s Premier has tried to achieve with his so-called Big Society, which appears to mean encouraging voluntary organisations of one kind or another to take over the provision of a whole range of services from government, saving the taxpayer many billions of pounds in overheads, while at the same time proving far more responsive to local people’s needs and aspirations. It has to be said that, so far, this Big Idea has been greeted with cynicism bordering on contempt by Britain’s political class and with total indifference by the rest of the population, but only time will tell. It is hard to imagine a Democratic president wholeheartedly embracing this particular strategy of making a virtue out of a necessity, but given the emphasis on voluntary groups (especially churches) something along these lines might be popular with the Tea Party, and could form the basis of a deal on taxes, which is sorely needed.

The approach to taxation ought to follow UK in at least one respect. Faced with the need to raise revenue to cover at least a third of the projected turnaround in the fiscal balance, any significant rise in taxes on income was ruled out from the start. Instead, the Coalition raised expenditure tax (aka Value Added Tax) from 17.5 percent to 20 percent. Although the American situation is made more complex by the presence of local sales taxes, it still should be possible to raise revenue either by a federal expenditure tax or by an increase in the tax on gasoline, which could be presented as a step towards lessening the country’s dependence on imported oil and/or a green tax to appeal to Obama’s own supporters.

Ideally, just as the Bowles-Simpson deficit reduction commission recommended, the rise in indirect taxation would be combined with the long-overdue abolition of most of the direct (i.e. income) tax exemptions which do so much to narrow the tax base and, more importantly, distort spending and saving patterns – and which make the U.S. tax code a nightmare of complexity (matched, however, by Britain’s tax code).

Together, these reforms would make a major contribution to reducing the deficit, even if they are accompanied (as they should be) by a significant reduction in headline tax rates. The worrying thing is that this could be the last chance, because although a budget along these lines might be a hard sell politically right now, it is sure to be a lot harder in 2012 with the primaries about to start. The longer the delay in tackling the deficit, the greater the danger that the financial markets panic and force the issue.

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