A tale of two transAtlantic budgets

Policy Monitor, March 15th 2021

By Sam Ashworth-Hayes

This month fiscal policy was re-set on both sides of the Atlantic, in ways that set two different courses for post-pandemic economic policy. On one side, President Joe Biden’s huge “American Rescue Plan”, worth $1.9 trillion or about 10% of US GDP, places a bet on achieving rapid economic growth without inflation, on establishing a permanently larger role for government and on the politics remaining favourable for a further big public spending programme on infrastructure later this spring. By comparison, Britain’s annual budget took an apologetic approach, more in line with those of its European neighbours: it is smaller (about 3% of GDP), and while extending what has been one of the world’s most generous programmes of emergency fiscal support, the budget promised to retrench and to reduce public debt as soon as possible.

First, the context. Both countries entered 2021 after a rough year. In the UK, GDP dropped 9.9% in the past 12 months, one of the biggest slumps among rich countries, as lockdowns and voluntary distancing took effect. The USA, having taken less stringent measures to combat the virus, saw a correspondingly smaller reduction in activity of 3.5%. Unemployment in the USA peaked at just under 15% in April 2020 before dropping to 6% in February, while in the UK furlough schemes avoided significant rapid increases, with unemployment rising from 4% to 5% over the year.

Yet both find themselves in similar fiscal positions. By the end of 2020, US federal government debt had reached 100% of GDP, and even before the new stimulus had been on course to blow past the previous debt-to-GDP records set in the aftermath of the second world war. The UK’s public debt is on course to hit 100% of GDP later this year. While this does not however place them near the top of public debtor rankings – that crown is worn by Japan, with more than 260% – it is far higher than either country has previously felt comfortable with.

Britain and the USA also share longer-term economic headwinds; aging populations and increased dependency ratios are predicted to reduce tax revenues while placing greater demands on the state in terms of health and social security spending. While the COVID response constitutes a one-time blow to public finances, the longer-term trends would have seen debt-to-GDP ratios increase significantly anyway; even discounting the pandemic, government spending in both countries is on a path that is likely to lead to significant fiscal risk. Britain’s Office for Budget Responsibility projected last July that if UK policy remained unchanged, then by 2069 public debt would reach 418% of GDP, and interest payments almost 18% of GDP. America finds itself better off in the mid term at least, with debt rising to 200% of GDP by 2051 and interest payments 7% of GDP.

Second, the policy responses. Both countries face a tricky balance: they need to think about those long-term fiscal challenges while also facing urgent needs to support their populations while the pandemic lasts while remedying the societal shortcomings that the pandemic has exposed, notably inequalities of income and job security, and inadequate public health systems. Meanwhile, more than half an eye needs to be cast on the decarbonisation of society to meet climate targets. Not easy. How has the task been tackled in these budgets?

The Economist summed up the approach of Britain’s Chancellor of the Exchequer, Rishi Sunak, as “St Augustine’s economics”: as the saint said in his Confessions, “O Lord make me chaste, but not yet”. This implies that the British view is that fiscal virtue remains politically and economically vital and that taking risks with debt sustainability against a background of an economy also adjusting to Brexit would be politically and economically imprudent. The Biden package took a much bolder approach: against a more favourable economic background than Britain’s, it placed a bigger bet on generating short-term growth but also on building support for a long-term recasting of the role of government, and, crucially, for an ambitious public infrastructure plan. Fiscal virtue barely got a look in.

Start with Britain’s more conservative approach. Chancellor Sunak’s budget can be split into two parts: the first is a commitment, the second a promise or prediction.

The commitment is that significant deficits are to continue to be run over the next two years in order to boost economic activity. He extended the furlough scheme until the end of September, along with other cash payments to the self-employed and jobless, and maintained value-added tax (VAT) at reduced levels for hospitality firms and the suspension of local business taxes (rates). His most innovative move was to try to persuade companies to make bigger investments in physical machinery by allowing deductions of 130% of the cost from their taxable income. What is unknown is whether this will simply bring planned investments forward or induce genuine increases, but either way it is stimulative.

Yet the promise is that from 2022 onwards Chancellor Sunak will begin to claw back money for the Treasury by raising taxes. He said that Corporation Tax will rise from 19% to 25% from 2023 onwards, and various personal and business tax thresholds will be frozen, allowing inflation to drive people into higher tax brackets. That is his promise to be virtuous, and thus fiscally austere. Little was revealed about any long-term strategy for economic growth or for reducing inequality.

The American approach is much more aspirational as well as adventurous. Taxation is notable in Biden’s stimulus plan by its absence. While $60 billion in tax increases is tucked into the bill for technical reasons, the bulk of the $1.9 trillion bill is financed by borrowing. Treasury Secretary Janet Yellen has indicated that future tax increases will be proposed later in the year, and if accepted would be likely to be phased in only gradually. Meanwhile, the Biden package hands out welfare support in the form of direct payments to individuals, extensions to unemployment benefit and, significantly, a renewal of a tax credit for children billed as capable of halving child poverty. While the direct payments and unemployment benefit extensions are unlikely to be repeated, there promises to be a big effort to make this temporary extension of the child tax credit permanent, thereby re-establishing broad-based welfare support following nearly 30 years of cutbacks.

Why these differences in emphasis? It could be explained by differing views of the sustainability of public debt. Yet on the headline measure of sustainability, the debt to GDP ratio, the US and UK are on similar short-term paths. As issuers of the world’s dominant reserve currency, the dollar, the US does enjoy what has been described as “an exorbitant privilege”, which the UK has not held for more than a century. Nevertheless, there is no outstanding concern over the UK’s short-run prospects. The cost of servicing the government’s debt has hit historic lows even as the total reaches near record highs, while long term borrowing rates are astonishingly low. While future rises in interest rates would increase repayments accordingly, the prospect of full-blown fiscal meltdown looks remote. That there will need to be changes to tax and spending over a longer-term horizon to handle an aging population similarly does not imply that changes need to be made today.

Instead, the gap appears to be largely one of political positioning and of attitudes to economic growth. The hallmark of British Conservative governments for the past decade has been one of attempting to distinguish themselves from their opponents in the Labour Party by claiming the mantle of fiscal responsibility. They have more than 3 years to go before another general election is due.

The hallmark of Joe Biden and the Democrats is that they ran in last November’s election on a platform of using government to remedy America’s ills, and know that in less than two years they face mid-term Congressional elections. This gives them a strong incentive to get the economy running hot and to get their long-term plans for public infrastructure spending presented to Congress while they still hold a (thin) majority. The Biden administration’s infrastructure plans have not yet been unveiled, but comments during the election campaign suggest they could amount to as much as the spending of $6 trillion over a 10-year period.

In the end, much will depend on economic growth in both countries during the post-pandemic years. Both have achieved quite well-advanced vaccination programmes thanks to public investment in support of vaccine production capacity and measures of vaccine nationalism. Relatively rapid lifting of restrictions on social interaction could stimulate the release of pent-up demand represented in unusually high personal savings rates. Subject to what happens to inflation, the best-case scenario is for rapid growth in tax receipts along with GDP to begin to reverse the course of the debt-to-GDP ratio.

If that happens, it could be that Chancellor Sunak’s pledged tax increases are never actually implemented, which would not be a first for a Conservative chancellor. The surprising gap in his budget was the lack of any plan or strategy for long-term growth, especially against the background of Brexit-related declines in the UK’s trade with its EU neighbours. It may not be too fanciful to expect the British government to watch carefully the infrastructure plans likely to emerge in Washington this spring and to start preparing its own. There is, after all, plenty of potential ways in which the currently low cost of long-term borrowing could be exploited for productive uses. Sunak’s prime minister, Boris Johnson, has always shown a penchant for grand projects such as airports and bridges. Given time, the British and American approaches could converge.