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Funding the state.

Funding the state.

This section notes the pressures on the industrial world states to spend more, to do so with greater efficiency and expertise, but to do so whilst avoiding the need to raise more tax. The resulting squeeze on resources has many implications for how resource allocation is handled in the public sector. The squeeze will almost certainly get worse as demographic features make themselves felt.

This section divides these issues into four sections. First, it looks at the scope of state income and expenditure over time, and considers the implications of imbalance. Second, we look at tax take. Third, we consider where the state withdraws, and public-private partnership in capital enterprises. Finally, we look at the future drivers of state spending. The impact of demographics on this last elsewhere.

The pressure on state resource will continue. Many of the steps which the state can take to back out of commitments have now been fully exploited. Many public assets have been now been sold to the private sector. Capital projects have been deferred and many states find increasing problems with their infrastructure. We discuss some of the features concerned with benefit and tax recycling.

The struggle for resource will continue to develop. It will become more professional in its use of the media and public sentiment. The explicit politicisation of claimancy around the issues of age is almost unavoidable in many states. There is an acute need to develop a countervailing debate, based on a systems view of what the political unit needs to arrive at a balanced future. This is, however, discussed elsewhere.

State income and expenditure.

The most striking single feature about state income and expenditure is its growth relative to the economies which support it. As the left panel in Figure 1 shows, the C19th state spent in the order of 10-15% of the sum of added value. Today, charities, political parties, lobby groups and other NGOs spend roughly the same proportion. The formal state consumes between a third and a half of all value added. It does this for two primary reasons:

As explored elsewhere, the task of the state has become much more complex and expert. There are more things to be done, and a greater expectation that these things will be done by public sector organisations rather than by the citizenry, buying services on their own behalf.

The scope of welfare has grown immensely. The OECD estimate that in the order of a third of all value added is diverted to social transfers, mediated by the state. There are, as we shall see, huge pressures to extend this.

Figure 1: The scale of state expenditure, and of state deficits.

The drive to spend more has not been matched by equivalent taxation, creating the gap shown in yellow on the right of Figure 1. This deficit has been met by borrowing, adding around 1.5% to the world cost of capital. The importance of a solid system of state finance was not recognised in the early stages of deficit funding and net money was issued, leading to the chronic stagflation of the Seventies. Corrective measures have had a dramatic affect on world levels of inflation. More recently, rapid non-inflationary growth in the USA and better-than-expected growth in the UK have pushed both of these economies into fiscal surplus. Commentators tend to believe that this situation will be short lived, not least as pressures to spend the money (rather than accelerate debt repayment) are inevitable. European efforts to achieve fiscal near-neutrality have been driven by the political Euro project. The accounting behind some of these measures is dubious and market reaction to the Euro reflects a general concern that pressures to spend will again increase. As we shall see in a section which follows, spending pressures are almost inevitable.

Tax raising.

Taxation is, of course, resented. The growth in overall tax take as a proportion of all value added has slowed, as Figure 1 shows. This is chiefly due to political pressures to 'cut taxes', or rather to slow their growth and redistribute their impact. Such pressures will not abate, and have proven a sure vote-catcher in recent elections. Additional forces are the de-localisation of economies and trading, discussed elsewhere, and the effective benchmarking of corporate tax as a result of the growing mobility of capital and intellectual assets. Corporate tax is usually a small fraction of overall tax take (8.2% on average in the OECD), and states will tend to focus increasingly on those sources of revenue which it is easy to tap. Income taxes contribute an average of 26.8%, topped up to 49.1% when social security taxes are added to this. Value added taxes contribute around a third of all tax revenue on average in the OECD nations. These are particularly favoured to grow as they enlist the services of all in the value chain to collect them, and are thus relatively resistant to de-location. It is for the trader to capture the tax elements due to them, after all. We will discuss environmental taxes in a moment.

Conventional sources of income taxes may be fully-tapped in many nations. Figure 2 shows the extent of income and employment taxes in a range of countries. An individual who works in Portugal can expect to 'give' around 30 weeks in the year to the state.

Figure 2: Taxes and social security levies in a range of industrial countries.

Tax is, of course, primarily aimed to finance the state. It is, however, also for two other purposes. One of these is to influence activity, which we discuss in a moment, using environmental taxes as an example of this. Second, however, it is used to transfer income from one group to another. This leads to a conceptual muddle which is seldom separated in public debate, for taxes are themselves supposed to discriminate between the wealthy and the poor; and the results of collecting taxes are also used to discriminate in the same way. Many taxes which are advanced because they are easy to collect - such as VAT - or for environmental reasons are disliked because they are not 'progressive', which is to say, they do not impact in a way which progresses with the income of the individual taxed. This muddle prevents simple tax system being installed, and hedges all attempts to reform tax raising with a myriad of caveats designed to protect the poor or those who live in poor areas, country dwellers and the inner city; and so forth.

Figure 3: The top 5% of earners in the USA contribute around half of all federal income tax receipts.

The scale of progressive taxation is illustrated by Figure 3, which shows that ten years of increased income inequality in the US has been met with a significantly lower proportional income tax burden on the low-paid majority. The extent to which this can be driven much further, particularly in the light of the political articulacy of the high income groups, must be problematic. The situation elsewhere is even more extreme.

Net transfers occur through extremely complex channels, such that net tax payers may well receive many cash benefits as well as access to the public benefits conferred by the state upon all. We discuss this issue later.

A new area for tax will, undoubtedly, be driven by environmental motives. Crudely, if the state increases the cost of something, then citizens and companies should use less of it, either by substitution or deterrence. In particular, effective new technologies are developed and investment decisions are altered. This concept is further developed elsewhere. However, Figure 4 shows how Europe has tended to tax jobs and to lessen the burden on the use of polluting or scarce resources.

Figure 4: Tax on work and tax on the use of scarce or polluting resources.

Environmental taxes will increase for at least four reasons.

State expenditure is very complex. The industrial state employs about 20% of the total workforce (from 30.6% in Norway, 5.9% in Japan.) Composite figures for how the state spends its money are, however, difficult to develop. Figure 5 shows the results for a segmentation US federal expenditure.

Figure 5: The breakdown of US federal expenditure by category in 1999. Social spending is shaded blue.

In common with most other industrial nations, the expenditure on social issues is very large. These are shaded blue on the figure. Issues such as defence, transport, justice, science and international relations take a relatively minor component. Similar results are mirrored in state-level estimates for the US, and for national figures for other OECD nations. The growth in state expenditure during the past century has been driven by social considerations. This will continue to be the dominant force.

The mitigation of expenditure: public-private partnership.

The state has made a rod for its own back in one particular regard. As we have noted, fiscal balances are important in creating an environment of low inflation. If the state prints money, the results will probably be inflationary. However, if the state borrows money from abroad to finance projects, this increases money supply in the short term and this, too, can be inflationary. Further, major state projects can increase money velocity, with like results. As a result of this, most states have learned to control the ability of their agencies to borrow. Extreme examples from Latin America - and more recently, from Asia - saw statal organisations borrowing with no reference to central government, pouring money in to the economy and running up huge external debt. Local authorities in the US, UK and continental Europe issued bonds and in other ways borrowed huge sums when real interests rates were negative in the early 1970s, and were crippled by the results of this in the 1980s. Their actions contributed to inflation and central government had to bail them out - with more inflationary consequences - a decade later.

Having learned this lesson, governments have become extremely careful about allowing public sector organisations to raise their own funds. In most cases, revenue surpluses are paid into a central fund, and then redistributed in conjunction with tax monies. Each activity has then to compete with all others, often in a politicised environment in which public education does battle with transport, justice and the environment.

States have been shedding as many activities as they reasonably can. In 1980 Britain, for example, the state owned or was the dominant shareholder in the order of half of industry. It owned the mines, ports and forests, almost all of energy production, telecommunications and most broadcasting, car making and defence manufacture, much of the aerospace complex and air transport. Health provision and education were essentially statal activities, and farming and fishing were both intensely regulated and wholly dependent on state subsidies.

There has been radical change in most of these areas, although some remain state-dominated. In general, however, the aim of policy has been consistently to create a competitive arena where once a state monopoly existed. Policy has sought to create expert regulatory frameworks that can manage that which needs public oversight in a constructive, expert manner.

Many of these new structures have removed the financing burden from government. The managerial burden has often changed, rather than lessened, but the custodians of this have a more focused task. The quality and cost of the service provided has, almost invariably, improved out of all recognition. Nevertheless, the issue of how to fund public infrastructure remains a crucial and a painful one.

There are a range of infrastructural issues - as with cities, explored elsewhere, transport, education, health, security - that require very considerable investment if private affluence is not to be met with 'public squalor'. Most of these projects offer a social rate of return which is very attractive, and can be constituted such that a commercial partner can extract a satisfactory return. Partnerships of this sort remove managerial and financing burdens from state shoulders, but may add regulatory complexity and will certainly require new skills from those in the public sector who oversee operations, contracts and specifications. At issue is the mechanism by which activities which have a government imprimatur, even if not strictly of the government, can raise capital with compromising the management of inflation.

These considerations stand between major investment in public utilities and a continual stranglehold on expenditure. There are two issues. First, the means by which the private sector investor is to extract a return, Second, the apportionment of risk between the private investor and the state.

These thoughts can be taken further. 'Free' state services can be priced where a structure of this sort begins to emerge. Patients can be given the means where to choose where they place their patronage. Vouchers and health- or transport-specific 'currencies' can be used where there is a fear that cash subsidies will be abused. Whilst this offers ideological comfort for some, the practical overheads to doing this seem greater than any benefits that seem likely to flow from it. This is particularly true where choice is an expert mater and geography has a major role to play. Regulators, rather than customers, may well be the way to ensure that roads are of a high quality or that schools deliver what is needed of them.

This is a complex area which carries huge political risks. Our fear of entering it has, on occasions, prevented progress being made. As a result, we have few entrepreneurial schemes for the provision of, for example, effective urban transit systems on the drawing board. Some nations have been more daring than others, and some have been more effective in managing the consequences of their initiatives than their peers. The issues of welfare, efficiency, managerial clarity and financing have, however, been deeply muddled together in public debate, to such an extent that many of the issues are now hard to discuss. There is a major task of clarification ahead.

Forces that will increase pressures on states to spend more.

States have a schedule of increasingly complex tasks to fulfil, as explored elsewhere. In addition, they have to ensure that competitiveness is maintained. This evokes a complex web of requirements, from education to infrastructure, ethos to incentives. All of this costs time as well as money and creates a major managerial task. We have already examined various ways of handling some of the more obvious examples of this, and we have considered the issues of expert regulation elsewhere.

Figure 6: The funding gap.

The practical limits to tax take have been discussed, and are symbolise by the thick red line. A wider, discretionary pink zone rises as the country itself become richer. It is driven up by unavoidable costs that increase as the state becomes more complex. Where the discretionary pink area overlaps the red line, states may cut, become more efficient, borrow or print money. The later option is no longer open to any major state which wishes to retain the co-operation of its peers.

There are three main forces that drive us towards greater proportional state expenditure.

In the resulting battle for resource, the rational expenditure aimed to better competitiveness is unlikely to be the net winner. Indeed, the lobby constituency is not likely to recognise - or want to recognise - economic-rationalist arguments. It may be excessively unkind to claim that the discount rate of the old may be tempered by impending mortality. It is, however, rational to 'want it now' when tomorrow one may well be dead.

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