Headroom for taxes ‘a mirage’

READING the tax review over the summer, I was surprised to discover that the States had been so successful at restraining expenditure in recent years it had created ‘headroom’ in the ‘fiscal framework’ to increase expenditure by 3% of GDP.

As revenue spending last time I looked wasn’t too far short of half a billion, up from the £300m. when I came to Guernsey, this narrative that expenditure was successfully squashed in the decade following zero-10 doesn’t really sense check.

Being the author of the original fiscal framework more than a decade ago, I really couldn’t understand how that had come about, so I thought I’d look and try and find out how.

Many hours sifting through reports later, I discovered this headroom is a mirage appearing at some point during the last two States terms.

Before I take you down that rabbit hole, let’s just look at some simple numbers to understand what actually happened to expenditure in the post zero-10 decade. I’ll keep analysis to a handful of macro variables. Enough to paint a decently accurate picture. I subscribe to Warren Buffett’s view that it’s better to be approximately right than exactly wrong.

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Table 1’s numbers are taken from the two relevant sets of accounts. Table 2 from the Facts and Figures supplemental data downloadable from gov.gg. These are nominal figures, ie. current price numbers, as they appeared in that year.

We haven’t factored in inflation yet, but at first glance spending seems to have gone up quite a bit. More so than economic activity but in nominal terms it still seems to have risen reasonably so.

I’ll cut to the chase – the real variables of interest are the real growth figures. Factoring in inflation (that is the change in the price level), which was 24% over this period, we can quickly work out increases in real terms, as seen in figure 1.

It’s easy to see public spending increased significantly in real terms in the decade after introducing zero-10. Social security is the fastest growing element of expenditure, increasing by more than a fifth in 10 years. Much, but crucially not all, of this is down to changing demographics.

It’s also easy to see that spending growth outpaced economic growth. Topline, by not so much. GDP grew by 13% but significantly this was mainly driven by profit growth. Labour income (salaries, wages etc) grew by a paltry 4% in the decade post zero-10.

Zero-10 shifted the burden of taxation to individuals, increasing it by 10%. Spending growth outstripping growth in the tax base has increased it by another 10%. As indirect and direct taxes on personal incomes account for 80% of revenues, it’s a major concern that total spending growth has been four times wage growth.

We have an issue with sustainability of taxation here and now, before we start to think about increasing it further.

Critical analysis is important. It helps to understand the true pattern of spending and economic performance which is needed to make correctly informed choices about future spending and taxation. Choices that impact on the long-term sustainability of public finances.

While the Guernsey Policy and Economic Group have this year published a couple of critiques of the accounts, decent critical analysis of fiscal and economic issues is usually thin on the ground in Guernsey. There used to be a reasonably effective independent annual fiscal review published – an arrangement I introduced myself as States economist over a decade ago – which was quietly killed during the last States term. If we’d continued with these arrangements, there might have been a questioning before now of how on earth, given increased spending and tax burden, did a ‘spending headroom’ of 3% of GDP in the fiscal framework emerge?

It’s perplexing but, more importantly, if wrong it creates a false prospectus, ie. a sense of comfort, for tax rises. After all, if we have ‘headroom’ of 3%, increasing taxes seems the logical move, doesn’t it? To call a spade a spade, if it’s wrong it’s misleading.

Policy & Resources provided the following justification last term:

‘The 24% of GDP limit on aggregate revenues applied in the Framework … was set with acknowledgement of the projected increase in demand for public services as the population ages. It provided headroom to accommodate the anticipated need to increase aggregate revenues beyond their current level to meet this demand.’

An unusually honest admission by the old P&R – to paraphraise, 24% is just an arbitrary number set conveniently to give a bit of wiggle room for planned spending increases.

Except that it’s a bit more complicated (and concerning) than that. The method of calculation of this 24% number did once have some grounding in a principle even if it’s been lost in the passage of time.

The first fiscal framework in 2009 was just established to ensure any future borrowing (which was being considered at the time) was sustainable. The simple rule to ensure this was that expenditure, plus the costs of borrowing, needed to be less than revenues. It covered general revenue only because social security income couldn’t be used to secure borrowing.

Doing the maths, revenues had averaged around 21% of GDP for the last few decades. (Spending had regularly been a little less, so healthy reserves had been built up.) As GDP had been calculated using the same method since 1969, the figures could be trusted and 21% was set as the limit for general revenues.

Including social security in the framework happened during the States term before last (back in the days of Treasury & Resources) in the Tax Review of 2014. A limit of 28% was set again, based on (that’s right) historic levels of income. At the time this report noted that total income was only 26.5% and the ‘difference’ could potentially create ‘headroom’ to help fund future spending increases. And thus the existence of spending headroom takes hold in the States’ psyche.

By the time of P&R’s review last year, this spending limit was now set at 24% (the ratio having to be recalculated when a new method of calculating GDP was introduced in 2017 – you know, when our reported GDP jumped suddenly because the method changed). P&R also stated that as public spending was then around 21%, this headroom was a conveniently sized ‘headroom’ of 3% for additional taxation to fund the increased spending presented in the report. The only question it set was, how do we do that?

But elsewhere in the same report P&R stated that ‘aggregate income has been at approximately the same level … for most of the last 20 years’. There’s even a picture provided in the report to prove it (figure 5.2). How can income be simultaneously less than its historic levels and also be unchanged for 20 years? Clearly this contradiction was missed. It doesn’t sense check. Was the convenient concept of fiscal headroom just too distracting?

So how did the 3% figure materialise? I’ll stop teasing. The answer is that GDP had been over-reported in the years leading up to the change in GDP methodology. To the tune of £200m. or so I believe. The effect was that the increase in reported GDP, moving from old to new method, was bigger than was reported. That is, in reality, the reported figure jumped by 30%, not the 19.5% increase published at the time. This all got cleaned up but I don’t believe the mistake was publicly acknowledged, and I suspect when the new ratios of the fiscal framework were calculated, whoever did the maths was unaware. The fiscal framework ratio of spending in line with the new GDP is more like 21.5%, not 24%. This reconciles with figure 5.2 in the report.

The lesson is that a reasonable degree of expertise is required to analyse our numbers correctly. Once that’s done, it’s clear that the old P&R was wrong to suggest the notion that increasing expenditure to 24% was in line with the economic principles of the fiscal framework.

I didn’t need to do the maths to explain that. My tax return tells the same story.

u Don’t miss Dr Sloan on the Guernsey Press politics podcast, out today.