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So in the last election, there was a coalition between the Tories and Lib Dems. There were cutbacks, but some thing were stopped by the Lib Dems, such as tuition fees only going to £9000 instead of the proposed £16000; but still austerity measures were put in place.

Now we have a pure Conservative government which has imposed even more austerity measures. It seems every time I check the news I see the word "cutbacks", and hear about a new sector that is going to have cuts. My question is: where does all the money go that is saved from all these cuts?

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When Margret Thatcher cut tax, the top rate of income tax went from 83% to 60%, while the standard rate from 33% to 30%.

Over the next 10 years, the standard rate came down to 25%, and the top rate to 40%. (http://www.theguardian.com/politics/2013/apr/08/margaret-thatcher-political-phenomenon-dies)

VAT, or value added tax, jumped from 8% to 15%. (http://www.bbc.com/news/business-22064354)

Today, the british VAT rate is 20%.
So cumulatively seen, because VAT cuts low incomes far far more than high incomes, for which VAT is negligible, you have a tax rate of 45% on low incomes, and 40% on high incomes (degressive tax system).
So, in the short term, where do you think that money went ? [hint: vote Tory :( ]

On the long run, keeping services and lowering taxes creates a deficit that is financed by debts, which need to be repayed. In the case of the UK, mainly to Germany and Spain. Picture courtesy of the New York Times) P;G

Corp tax

GDP

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    What are the different curves? No explanation whatsoever? – clem steredenn Jul 23 '15 at 7:45
  • That might be true but I am not sure I see the relevance to the question. – Relaxed Jul 23 '15 at 12:14
  • @Relaxed: The relevance is: Where does the saved money go ? The answer is: Into reducing the structural deficit that was created when tax rates were cut. Or in other words, the money goes into paying for the tax reductions for the rich (since one percent of 100 millions isn't the same as 1% of 100'000). Because you can't afford to make debts forever, you have to cut services to "save" money. So John Doe ends up paying ever more tuition while Maggie's grandchildren pay less taxes (in percent) than John Doe, and have more for themselfs, aka. the rich get richer, the poor get poorer. – Quandary Jul 29 '15 at 14:53
  • @Relaxed: The underlying problem is, when everyone egoistically optimises for themselfs, you and up with 25% less for everyone overall. So while individually, it still can be profitable, it is a bad thing overall. – Quandary Jul 29 '15 at 14:56
  • @Quandary I am not sure I understand everything you are saying, but in any case, it wasn't an objection to your answer, I just think you could make it more explicit. – Relaxed Jul 29 '15 at 15:00
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The government does have plans to cut some taxes but most of the money is simply going nowhere, in the current conditions austerity is destructive. Because it keeps the economy operating under its potential, it makes everyone poorer. It's not always true but at the moment the government could very easily borrow more, spend more, make everyone richer and yet have a sustainable budget.

The key insight in all this is that a government is not like a household. If you reduces spending (say stop going to the restaurant), this has no effect on the economy so you are still earning the same income and you will have more money available, e.g. to pay your debts. So as long as everyone else is still spending and your job is not at risk, cutting on expenses is a good way to increase your savings.

But if the government reduces spending, it will have a big effect on its revenue as well so, depending on the conditions (specifically whether the economy is operating at its full potential or suffering from a shortfall of demand and whether the central bank can compensate the effect of budget policy through monetary policy, neither of which have been true recently in the UK), it's entirely possible that it would gain very little.

That's why beyond all considerations regarding fairness, unemployment, poverty, etc. recent austerity programmes in Europe even fail at what is ostensibly their main objective, namely reducing the weight of the debt (relative to the GDP). The only thing austerity achieves (and perhaps that's the objective) is to permanently reduce the size of the state. That's true both in the euro area (which has specific structural problems) and in countries like the UK or Sweden (which don't face the same constraints but have adopted austerity policies nonetheless).

See also this essay by Paul Krugman and this short note by Simon Wren-Lewis (both have been writing a lot on all this over the years).

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    Paul Krugman, the broken clock of economics. – user1450877 Jul 22 '15 at 10:13
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    @user1450877 It's a nice summary, which is why I quote him, but sarcasm notwithstanding, his ideas on this are not original in any way. It's actually pretty standard stuff. – Relaxed Jul 22 '15 at 10:20
  • Great answer and the essay of Krugman is REALLY interesting, if a bit long but still! Thanks for sharing! – Joze Jul 23 '15 at 13:28
  • I think your answer really need some references to back up your claims so it would read more as a well thought conclusion than an opinion(which it does to me now) – SoylentGray Jul 29 '15 at 17:12
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    @Relaxed I am thinking more specific and credible resources than Krugman and his idolators. – SoylentGray Jul 29 '15 at 18:42
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The government is currently deficit spending, meaning it has to borrow to spend because it is spending more money that it is bringing in from tax revenues.

Nothing is saved, less money is borrowed and when possible existing debt is retired.

  • This treats tax revenues as a constant, which isn't appropriate as they are negatively impacted by austerity measures. The reality is that nothing is saved or spent elsewhere but it's not even true that less money is borrowed. – Relaxed Jul 22 '15 at 7:12
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    At the moment, for the UK, it essentially is, yes but that wasn't my point. One way or the other, you need to account for the feedback loop between spending/taxes and economic growth. Sometimes borrowing money can be a very good idea, sometimes not, but intuitions like “if the state spends less, it will borrow less” are demonstrably false. – Relaxed Jul 22 '15 at 10:16
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    Maybe someone should tell Ireland, Iceland and Greece – user1450877 Jul 22 '15 at 10:51
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    Tell them what exactly? Greece is a case in point, they have been slashing spending more than anybody ever did and they still need to borrow vast sums of money and are not any better for it. And they know it, it's not them that did not get the memo. – Relaxed Jul 22 '15 at 10:56
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    @lazarusL I don't think that's a fair summary of the current state of economic thought at all but once again, my point here was much simpler, you can't simply assume that a decrease in public spending mechanically leads to a smaller deficit or a budget surplus, a reduction of the debt and less borrowing. You need some sort of model or macroeconomic argument, like those you just invoked. As it stands, it's this answer that treats the effect of austerity as a “solved question” and in the most naive way possible. – Relaxed Jul 22 '15 at 15:39
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Before Austerity, the UK was running a higher budget deficit than it is now. So each year the UK government is borrowing less money. The obvious answer is that the money went to not generating as much debt rather than into another program. However, since government spending can have an effect on the economy it makes sense to look at the broader effect of austerity. Obviously we cannot know what would have happened if the government had not engaged in austerity. There are two forces at work.

  1. Government deficit spending in recessions stimulates the economy since aggregate demand is depressed. Basically there's a shock to people's wealth which makes everyone poorer(see housing price collapse of 2008/9). Then because wages are 'sticky' and don't adjust down to accommodate the reduction in demand people have to be fired, so the economy shrinks. In this case deficit spending can come in to increase demand, increasing prices again and allowing people to be rehired. The basic version of the story is here. If this force is dominant, then gdp and tax revenues would have increased and the deficit could have been as small as it is now depending on the magnitude of economic growth stimulated by the deficit spending. In this case, Relaxed's answer is correct and the austerity merely made the British economy smaller.

  2. Government deficit spending crowds out private investing. If this force is dominant, then investors would have bought safe government debt in times of recession instead of investing in companies. Without austerity fewer start-ups would have been funded and established companies wouldn't have had as easy a time borrowing or selling equity to expand. Thus the reduction in government spending allowed for private companies to have access to capital and grow the economy. In this case, the money from austerity went to creating economic growth in the private sector. Since my summation of this force has proved to be a contentious point, let me cite a mainstream economics textbook treatment of the subject. "Some economists argue that crowding out can totally offset the expansionary effect of fiscal policy, so the net effect is zero or even negative, since they consider private spending to be more productive than government spending... The result is that potential output does not increase as much as it otherwise would and thus deficits lead to slower growth." David C. Collander.Economics 7th edition. McGraw Hill Irwin:2008.Page 716.

Since a large number of states have not allowed economists to randomly assign them to the deficit spending vs non deficit spending categories in times of recession, the empirical evidence for which effect is dominant is not particularly compelling. For some economists discussing the statistical difficulties of measuring stimulus here's a podcast on the subject discussing "Ramey's .. work [which] exploits the exogenous nature of wartime spending. She finds a [fiscal] multiplier between .8 and 1.2. (A multiplier of 1 means that GDP goes up by the amount of spending--there is neither stimulus nor crowding out.)". The specific discussion of the statistics starts around 10 minutes.

For one model attempting to understand the forces at play in the recent recession, see the CBO estimates of the effect of the stimulus package in the United States. CBO estimates Overall, the CBO report suggests force 1 was dominant, finding that gdp increased and unemployment decreased due to the stimulus package, however, looking at the high variance in estimates for fiscal multipliers shows the significant uncertainty surrounding these kinds of model based estimates.

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    I think this answer fundamentally misrepresents the state of economic thinking and does not accurately reflect the sources it mentions. Crowding out and stimulus are not “competing theories” that cannot be tested, both can and do happen… but not in the same conditions. For example, the two economists mentioned frequently insist that stimulating demand would not always work. The Wikipedia article also includes a lot of material about this, which you apparently haven't read or understood. – Relaxed Jul 29 '15 at 17:54
  • @Relaxed feel free to elaborate on any specific critique of why deficit spending doesn't crowd out private investment, explaining why you found the natural experiments or statistical instruments used in the studies to be compelling. – lazarusL Jul 29 '15 at 18:01
  • @lazarusL It might very well be as there is nothing reasonable about building a smoke-screen by asking for “natural experiments” and “statistical instruments” if you are not even able to properly summarize your own sources. Since your theories about crowding out are obviously not based on the scientific literature or on Wikipedia, where does all this come from? – Relaxed Jul 29 '15 at 18:28
  • @Relaxed then post a competing answer but comments are not appropriate place to disagree with the answer unless you are requesting clarification or an improvement. – SoylentGray Jul 29 '15 at 18:40
  • @Chad I made a very clear request, namely that the answer either cite a source or be made to agree with its current source (the Wikipedia article on crowding out). The OP is the one desperately trying to start a debate to avoid dealing with the problem. – Relaxed Jul 29 '15 at 18:51

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