Will the UK's 2011 budget lift animal spirits?

The budget today outlines the UK government’s plans for a private sector led recovery. It was promised that rather than focussing on the stick of the cuts (as last year), it would use carrots to increase incentives for investment. The incentives are aimed at creating the right conditions for growth as stated in the government’s Growth Review paper in November 2010 “What the Government can do is provide the conditions for success to promote a new economic dynamism – harnessing our economic strengths, removing the barriers which prevent markets from supporting enterprise, and putting the private sector first when making decisions on tax, regulation and spending.”

Today, these carrots came mainly in the form of tax relief (and reduced regulation in areas like planning): a large 2% reduction in corporate income tax; simplification of the tax regime; reduction of the fuel tax; and the creation of 21 new Enterprise Zones which of course are mainly focussed on tax incentives (i.e. they are not science parks). It also provided good news in terms of the fuel tax. So are we to believe that it is changes in taxes that will achieve growth, which has just fallen to only 1.7% from the originally estimated 2.1%?

The emphasis on tax brings us back to the 1980s’ supply-side ‘trickle down’ economics. Reduce corporate income tax, which will increase investment and employment, benefitting us all.   But such tax cuts in the 1980s, in the UK and the USA, did not increase investment, they only changed the composition of where the total tax bill came from, and had a regressive effect on income distribution.

That is wrong with focussing on taxes to increase investment? While the concept of ‘animal spirits’ came back after the financial crisis to explain the ‘herd-behaviour’ that characterised financial markets, its main lesson did not. Keynes’ main insight was that business investment, the most volatile element of spending in GDP, is not a function of taxes or interest rates but of ‘animal spirits’, the gut instinct of business regarding the future growth prospects of a particular sector (e.g. the future of biotech), a particular stock, or of an entire economy (e.g. emerging markets). These growth expectations are affected by important structural and institutional properties of a country such as its education system which widens the pool of potential innovators, its science base which provides the fruit which determines new technological opportunities which incumbents and new entrants can profit from, regional and national agencies which encourage networking between businesses, and between businesses and academia, the open-ness of a country’s lead sectors to new entrants and competition, its venture capital system and institutional arrangements (e.g. an efficient patent system). And more.

Reagan’s and Thatcher’s tax cuts did not increase business investment because they were not accompanied by serious industrial policy targeting such investments in a systematic way. In the same years, Japanese growth soared due to its successful industrial policy, which its s Ministry of International Trade and Industry (MITI) used to tackle many of the above aspects. In the same way that US industrial policy around computers and later the internet revolutionised growth in the US through major government funding which resulted in the invention of the internet by DARPA, massive funding of computer science departments, and an efficient decentralised funding system for small new start-ups in related sectors.

How does the budget deliver on such fronts? The carrots came in various forms, but unfortunately as separate blips rather than as part of a coherent industrial policy that could revolutionise infrastructure, education, networking, and other fundamental aspects which increase animal spirits. The budget includes of course some excellent initiatives such as funding for 24 new University Technical Colleges, 25,000 new apprenticeships, and 21 new Enterprise Zones.  But given that this is all happening at the same time that Regional Development Agencies have disappeared; the UK Film Council has been abolished (a successful and efficient funder of one of the UK’s top sectors); many universities are seeing their teaching budgets cut by 80%; research budgets cut up to 40% (except in STEM subjects); EMA cuts hurting the ability of youths stay in school; and the primary education system becoming ever more elitist with successful schools becoming academies, and new Free Schools taking money away from existing state schools, both leaving behind the great majority of children in normal state schools—the signs for ‘growth’ are not encouraging.

There are also few serious initiatives around the future of green technology: the Green Investment Bank (even with its extra £2 billion injection) remains a small blip in the ocean unaccompanied by an industrial policy that targets different aspects of this sector (for fear of ‘picking winners’), and its impact on the entire economy. Very different from Obama’s National Nanotechnology Initiative which promises to put the US at the forefront of this new revolution.

Only once the carrots become more substantial and targeted towards long-run investments and growth opportunities will they stop serving only token purposes to hide the impact of the cuts, which for now are very real in their impact on the current low 1.7% growth rate.