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Britain is not bust. It is rich and could get even richer – here’s how

We are not doomed to slow growth or indefinite fiscal austerity.

When the government published its spending review in 2010, the promise was of an early return to healthy growth. The forecast then was that the UK would grow by about 3.5 per cent over 2011 and the first half of 2012. Since then, the economy has shrunk. The latest estimates from the Office for National Statistics show that the UK economy contracted by 0.7 per cent in the second quarter of 2012 – a third consecutive fall – while the year-on-year drop in GDP of 0.8 per cent was the steepest since the end of 2009.

This continued gloom fits a convenient narrative for analysts on all sides. It vindicates the arguments of those who, like me in these pages a year ago, argued that the government’s misguided macroeconomic policies would choke off recovery. But it also supplies ammunition to those who want yet more spending cuts beyond those already planned. They can continue to point to high deficits – higher than were forecast before the government’s plan was announced – as justification. There may be no economic logic to this position but rhetorically it is a powerful point. Despite the present gloom, we are not doomed to slow growth or indefinite fiscal austerity. There are three overlapping varieties of economic pessimism but there is little evidence to support any of them.

Glass half-empty

First, there are the “supply-side pessimists”, who think that, even in the short term, the economy isn’t capable of generating much growth. The Office for Budget Responsibility (OBR) claims that although output is about 4 per cent below its peak, we haven’t got much room to grow. It thinks that spare capacity in the economy is only about 2.5 per cent. Looking a little deeper, this is very difficult to believe. The OBR’s estimates imply that firms have no spare capacity at all, given the levels of employment. That is, that everyone in work is pretty much fully occupied. Even the International Monetary Fund finds this implausibly gloomy.

Second, there are the “permanent austerians”, who argue that the deficit is so large and the fiscal forecasts so dismal that we will have to keep on cutting, not just until 2015, as per the original plan, but until 2020, as the Prime Minister has suggested. Yet recent history suggests thata proper recovery would quickly render these forecasts obsolete. In 1993-94, the budget deficit was only slightly lower than it was last year. In sharp contrast to the current administration, the then government adopted the sensible policy of not trying to cut the deficit until recovery was established. The result was strong growth and rapidly falling deficits. In four years, the deficit had been almost eliminated and only three years after that we had the largest surplus in modern times.

Both these arguments are used by those who want to stick with current economic policy despite the dismal results; they argue that changing course wouldn’t make things much better. This is a self-fulfilling prophecy. If we set fiscal and monetary policy on the basis that we are doomed to low growth, that is exactly what we will get. Moreover, as the long-term unemployed drift away from the labour market and new firms find it difficult to start or expand, long-term growth really will be damaged. But the underlying health of the UK economy is much better than the OBR forecasts suggest. Over the past two decades – up to and including the recession – GDP per capita grew faster in the UK than in all our major comparator economies, as the chart below shows.

Nor was this an unsustainable boom. The chart shows GDP per capita, so the growth wasn’t driven by immigration pushing up the population and GDP without raising overall prosperity. There is no obvious bubble in 2006 and 2007 but consistent good performance throughout the period. While a small part of that reflects the growth of the financial sector, some (but not all) of it illusory, the vast majority was because of improvements in the UK labour market, a more skilled workforce and a more competitive economy. None of those has gone away. In the short term, “growth pessi­mism” is self-fulfilling; sensible macroecono­mic policy, both here and in the eurozone, could make things much better quite quickly.

How the UK economy has grown
GDP per capita (1995=100)

Long-term government borrowing is as cheap as it has been in living memory. We have unemployed workers and plenty of spare capacity. The UK is suffering from creaking infrastructure and a chronic lack of housing supply. So there is ample scope for investment and growth. The third and more substantive argument is made by those who point out that there is a serious question as to the sustainability of present policies in the long term. The OBR’s long-run fiscal sustainability report points to a substantial gap between projected tax reven­ues and public spending. As the books have to balance in the long run, something must give; policy must change.

Reasons to be cheerful

As a matter of arithmetic, this is correct – but to translate this into “Britain is bust” is absurd. The truth is the opposite. Britain is rich and will get richer. The same OBR report says that income per head in 2060 will be substantially more than double what it is today. As countries grow richer, people want more and better health and education and spend less of their increased income on necessities such as food. That is both inevitable and desirable.

It so happens that the British want good-quality health and education, largely provided free at the point of use by the public sector; decent state pensions and social care, and for old people to be able to leave their houses to their children, not to have to sell them; and they don’t want to pay the taxes necessary to fund all this. This combination doesn’t add up and poses a significant political challenge; but that doesn’t make us any poorer, let alone bust. These are the problems of success in a rich, ageing, developed economy. There is plenty to worry about. We are still stuck in the longest period of stagnation in recorded economic history, thanks to damaging and unnecessary policy failures, both here and globally. But things could and should be better, if policymakers would only act. Over the longer term, there are – from a purely economic perspective, at least – reasons to be cheerful.

Jonathan Portes is director of the National Institute of Economic and Social Research and former chief economist at the Cabinet Office.

This article first appeared in the 30 July 2012 issue of the New Statesman, The London Issue

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Q&A: What are tax credits and how do they work?

All you need to know about the government's plan to cut tax credits.

What are tax credits?

Tax credits are payments made regularly by the state into bank accounts to support families with children, or those who are in low-paid jobs. There are two types of tax credit: the working tax credit and the child tax credit.

What are they for?

To redistribute income to those less able to get by, or to provide for their children, on what they earn.

Are they similar to tax relief?

No. They don’t have much to do with tax. They’re more of a welfare thing. You don’t need to be a taxpayer to receive tax credits. It’s just that, unlike other benefits, they are based on the tax year and paid via the tax office.

Who is eligible?

Anyone aged over 16 (for child tax credits) and over 25 (for working tax credits) who normally lives in the UK can apply for them, depending on their income, the hours they work, whether they have a disability, and whether they pay for childcare.

What are their circumstances?

The more you earn, the less you are likely to receive. Single claimants must work at least 16 hours a week. Let’s take a full-time worker: if you work at least 30 hours a week, you are generally eligible for working tax credits if you earn less than £13,253 a year (if you’re single and don’t have children), or less than £18,023 (jointly as part of a couple without children but working at least 30 hours a week).

And for families?

A family with children and an income below about £32,200 can claim child tax credit. It used to be that the more children you have, the more you are eligible to receive – but George Osborne in his most recent Budget has limited child tax credit to two children.

How much money do you receive?

Again, this depends on your circumstances. The basic payment for a single claimant, or a joint claim by a couple, of working tax credits is £1,940 for the tax year. You can then receive extra, depending on your circumstances. For example, single parents can receive up to an additional £2,010, on top of the basic £1,940 payment; people who work more than 30 hours a week can receive up to an extra £810; and disabled workers up to £2,970. The average award of tax credit is £6,340 per year. Child tax credit claimants get £545 per year as a flat payment, plus £2,780 per child.

How many people claim tax credits?

About 4.5m people – the vast majority of these people (around 4m) have children.

How much does it cost the taxpayer?

The estimation is that they will cost the government £30bn in April 2015/16. That’s around 14 per cent of the £220bn welfare budget, which the Tories have pledged to cut by £12bn.

Who introduced this system?

New Labour. Gordon Brown, when he was Chancellor, developed tax credits in his first term. The system as we know it was established in April 2003.

Why did they do this?

To lift working people out of poverty, and to remove the disincentives to work believed to have been inculcated by welfare. The tax credit system made it more attractive for people depending on benefits to work, and gave those in low-paid jobs a helping hand.

Did it work?

Yes. Tax credits’ biggest achievement was lifting a record number of children out of poverty since the war. The proportion of children living below the poverty line fell from 35 per cent in 1998/9 to 19 per cent in 2012/13.

So what’s the problem?

Well, it’s a bit of a weird system in that it lets companies pay wages that are too low to live on without the state supplementing them. Many also criticise tax credits for allowing the minimum wage – also brought in by New Labour – to stagnate (ie. not keep up with the rate of inflation). David Cameron has called the system of taxing low earners and then handing them some money back via tax credits a “ridiculous merry-go-round”.

Then it’s a good thing to scrap them?

It would be fine if all those low earners and families struggling to get by would be given support in place of tax credits – a living wage, for example.

And that’s why the Tories are introducing a living wage...

That’s what they call it. But it’s not. The Chancellor announced in his most recent Budget a new minimum wage of £7.20 an hour for over-25s, rising to £9 by 2020. He called this the “national living wage” – it’s not, because the current living wage (which is calculated by the Living Wage Foundation, and currently non-compulsory) is already £9.15 in London and £7.85 in the rest of the country.

Will people be better off?

No. Quite the reverse. The IFS has said this slightly higher national minimum wage will not compensate working families who will be subjected to tax credit cuts; it is arithmetically impossible. The IFS director, Paul Johnson, commented: “Unequivocally, tax credit recipients in work will be made worse off by the measures in the Budget on average.” It has been calculated that 3.2m low-paid workers will have their pay packets cut by an average of £1,350 a year.

Could the government change its policy to avoid this?

The Prime Minister and his frontbenchers have been pretty stubborn about pushing on with the plan. In spite of criticism from all angles – the IFS, campaigners, Labour, The Sun – Cameron has ruled out a review of the policy in the Autumn Statement, which is on 25 November. But there is an alternative. The chair of parliament’s Work & Pensions Select Committee and Labour MP Frank Field has proposed what he calls a “cost neutral” tweak to the tax credit cuts.

How would this alternative work?

Currently, if your income is less than £6,420, you will receive the maximum amount of tax credits. That threshold is called the gross income threshold. Field wants to introduce a second gross income threshold of £13,100 (what you earn if you work 35 hours a week on minimum wage). Those earning a salary between those two thresholds would have their tax credits reduced at a slower rate on whatever they earn above £6,420 up to £13,100. The percentage of what you earn above the basic threshold that is deducted from your tax credits is called the taper rate, and it is currently at 41 per cent. In contrast to this plan, the Tories want to halve the income threshold to £3,850 a year and increase the taper rate to 48 per cent once you hit that threshold, which basically means you lose more tax credits, faster, the more you earn.

When will the tax credit cuts come in?

They will be imposed from April next year, barring a u-turn.

Anoosh Chakelian is deputy web editor at the New Statesman.