Still doomed, slightly less ill

The Office for Budget Responsibility has published its annual update to the Fiscal Sustainability Report. I wrote a piece earlier this year on the 2011 report, and in particular the way it was used by Newsnight's resident Tory stooge, Allegra Stratton, to assure us that the welfare state was doomed. I made three key points:

1) The OBR's brief means it cannot make assumptions about anything that is not a direct extrapolation of current policy. Thus it can note that some revenue streams will decline (fuel and tobacco duty), but it cannot make provision for new or substitute taxes in the future (e.g. a land value tax or a tax on jet-packs). This means its projections on future tax revenues are understated.

2) The OBR assumes increased longevity would result in increased morbidity - i.e. every extra year of life would be spent in illness. But the reason we are living longer is because we are becoming healthier, so this does not follow.

3) The belief that health sector wages will grow faster than productivity is based on the premise that the health sector is relatively labour-intensive and will remain so. However, the past is not always a guide to the future. It is just as reasonable to anticipate future productivity gains coming through greater preventative care (labour effectiveness) and more investment in technology (labour efficiency).

This year's report attempts to address points 2 and 3 in an appendix. I don't imagine Robert Chote reads this blog, so I must assume lots of other people (presumably including some who know what they're talking about) made the same points, hence why he and his team have taken the trouble.

The OBR now accepts (B.26) that an increase in longevity may not lead to an expansion in morbidity but may instead lead to "an increase in healthy life expectancy". No shit, Sherlock. The grudging improvement in costs is about 1% of GDP. However, they exact their revenge by suggesting that their assumptions about health productivity last year may have been at the optimistic end of the spectrum, and that consequently their projections should now assume lower growth and thus higher costs that more than offset the life expectancy gain (B.35).

The central premise behind their pessimism over health productivity is the labour-intensive nature of the industry and its consequent susceptibility to Baumol's Cost Disease - i.e. capital investment to improve productivity through automation runs at a below-average rate, so wage inflation tends to rise faster than productivity. The OBR's difficulty in pointing to an agreed historical record of health productivity highlights part of the problem. There's no specific product, nor is there a market price for public health that stands proxy for that product. Measures of health activities and opinions on quality are fuzzy at best and open to manipulation at worst.

For me, the biggest flaw is that their model simply extends the past, which means the continuation of what remains at heart a Victorian model of health care (the dominance of hospitals and high-status consultants), which was itself a replica of a medieval religious model (charity hospitals, severity and priests). The foundation of the NHS famously required that Nye Bevan allow this model to continue in order to secure the doctors' cooperation. What was added was a modern bureaucracy. I was amused last night watching a documentary on the human gut that a consultant, doing high-tech keyhole surgery, was still being referred to (even by the narrator) as "Mister", which in the NHS is superior to mere "Doctor". But I digress. The point is that the future may look radically different.

In respect of the first point, declining tax revenues, this year's report still has its hands tied with regard to new or substitute taxes. However, they have started to speculate about the future beyond simple extrapolation of recent trends. Unfortunately, this is limited to the prospect of two further revenue declines.

The first area of concern is the impact of globalisation on corporation tax: "global corporation tax rates have been on a declining trend as governments around the world compete to attract mobile profits and capital. If a similar pattern were to persist whilst the UK headline rate remained unchanged, the incentive to draw profits away from the UK would reduce corporation tax receipts over time". (section 4.58, pg 114). Luckily, the Tories are cutting corporation tax from 28 to 22 per cent over the life of the parliament. However, further reductions to maintain a differential with other leading countries would be counter-productive as the loss of domestic tax revenue would be greater than the gains from profit-shifting (i.e. foreign profits immigrating and domestic profits not emigrating) (section 4.37, pg 106). Looks like George Osborne has got it spot on.

In plain English, the OBR thinks the UK corporate tax rate shouldn't go below 22%. As they expect other leading countries to stay around 28%, this means in effect that we're committed to a policy designed to attract profits (and foreign direct investment) to shift to the UK. Happy days for the City and its tax haven offshoots. The clear trend, which the financial crisis has done nothing to arrest, is for more and more profits (and thus capital) to be promoted to a de facto supra-national realm. This questions the capability of nation states to manage global capital.

The second area of concern is that "another possible effect of globalisation has been to reduce the price of tradeable goods relative to other goods and services. Most tradeable goods are subject to the standard rate of VAT, so if international trade were to exert downward pressure on such prices, and households spent relatively less money on such goods as a consequence, VAT receipts would fall modestly as a share of GDP". (section 4.58, pg 114). In other words, commodity deflation.

This is likely to be a red herring. If we have more money left over after buying ever-cheaper iPads, we'll probably spend it on one of those new-fangled jet-packs, so the percentage of disposable income that attracts VAT need not change. As the recent reports on the minimum acceptable standard of income show, the material wealth of the developed world continues to race ahead. Commodity deflation (more precisely commoditisation) simply shifts goods from the category of luxury, to nice-to-have, to necessity. As this occurs, new luxuries are developed to back-fill demand at the premium end of the market. The mobile phone has made that journey in little over a couple of decades.

If material wealth is increasing, why is public spending unsustainable? The real issue is one of distribution. The concern of declining VAT receipts masks a fear of continuing stagnation in median wages. If broad inflation remains ahead of wage inflation, this will largely be because of increases in the cost of food, petrol, utilities and housing. As not all of these attract VAT, increases in the cost of these necessities will leave less in the household budget for VATable items.

The reductions in corporation tax, and similar rich-friendly measures, together with median wage stagnation, will result in widening income inequality. It is this which puts pressure on public expenditure and leads to the ideologically-motivated claims that the welfare state is unsustainable. These are policy decisions, not inescapable facts of nature.