Saturday, June 02, 2007

David B Smith on Regional Fiscal Inequalities

My previous post on the politics of regional fiscal imbalances didn't do enough to explain the harms that those imbalances cause. Vino challenged me to explain what was wrong with the North, which is poorer, getting more state money. Fortunately, David B Smith's paper "Does Britain have Regional Justice, or Injustice, in its Government Spending and Taxation" (PDF) for the Economic Research Council's Spring 2007 Britain and Overseas does an excellent job of explaining both the degree of fiscal transfers between regions and the, very real, harms they create. The paper is well worth reading for yourself but I'll give a quick summary.

Even after correcting for living costs the other regions are substantially poorer than the Greater South East. After adjusting for prices London is still 42% richer than the North East.

Using regional spending figures from the Public Expenditure Spending Analyses Smith works out the degree of socialisation of each region, the share of its economy that is made up of state spending. With this analysis it emerges that the South East, if independent, would have the second lowest level of government spending in the OECD, after South Korea, at 31.3%. By contrast, in the North the level is 58%. That is uncomfortably close to the 75% of the Soviet economy that the state was thought to actually control thanks to the black market.

Smith points out the questions this raises about how we need to understand the Northern economy:

"Many academic economists spend a lot of time analysing the consequences of ‘market failure’ in the private sector. However, no more than the remnants of a market economy now survive in many parts of the British Isles. Irrespective of whether one regards this as a good or bad thing, it is difficult to avoid the conclusion that ‘government failure’ could now be a more important source of the problems facing certain UK regions than any failure in the private market sector."

Smith presents three key harms that emerge from an economy dominated by the state, even if that state is paid for by someone else:

First, it encourages people to seek an income through political activism or state dependency instead of through earning a living in the marketplace. This is similar to the Bauer analysis of the harms of foreign aid to developing countries. Effort is redirected away from the productive economy.

Smith also describes this in terms reminiscent of Baumol's argument that a free-market economy is successful because it directs entrepreneurs towards productive activity. Smith describes the rise in Northern political entrepreneurship in place of market entrepreneurship since the North's industrial heyday:

There is also the interesting phenomenon that high government spending regions, such as Scotland, Wales and the North-East, seem to produce large numbers of political entrepreneurs, who live off and lobby for a large state, but few of the traditional wealth creating kind these days – compare and contrast the careers of James Watt and Gordon Brown, or George Stephenson and Alan Milburn, for example."

Smith also links this to the finding, in psychology, that welfare dependency can encourage the pursuit of instant gratification. This can explain the huge levels of drug and alcohol abuse of those on benefits. There are serious social harms to depedency on the scale seen in the North.

Second, regional income inequalities mean that other state policies such as the minimum wage do far more damage to employment in the North than the South as they translate into far higher levels of income. Benefits set on a single level throughout the UK are also a far better alternative to work in the North. This kind of affect has been seen in the poor regions of other countries with severe income inequalities such as East Germany or the Italian Mezzorgiorno.

Finally, public sector employment is an attractive alternative to work in the private sector. With the massive piles of cash provided by the Southern subsidy to play with the state can attract the best people away from cash-strapped Northern employers. This is a very direct crowding out effect.

The costs to the South of paying 8% of its GDP to the rest of the country are obvious. That money, if given back to its people, could make the South a remarkably wealthy place. The South East of England, with levels of taxation at the low end of Eastern European levels, would be a fearsomely competitive economy. To pay this opportunity cost and do serious harm to the North is pretty tragic. David B Smith's paper, by breaking down the effects of the state in different parts of the country, makes an invaluable contribution to understanding the harm that the British state does to our country as a whole.


Gracchi said...

Intriguing. I wonder as well about the ways that one might learn from places in the north like Leeds that have been reinvigorated by the growth of private affluence- largely from the financial services not government aid. Perhaps though in one way the government could do more or less which would equal more- I was chatting to a Mancunian about Manchester's revival which he put down in part to the destruction of a large part of the city centre by an IRA bomb which forced its reconstruction. So you had teh development of more appropriate places for people to live and work- instead of sixties tower blocks- it strikes me that the state should be much more interested in creating urban environments through the use of planning laws which encourage enterprise. I don't know enough about this and am eager to see Vino's rejoinder- but its an interesting issue.

Anonymous said...

Interesting article. The problem with your analysis is that you don't go far enough. Let's have taxation and spending on the borough level so the millionaires in Chelsea can pay near-zero taxation and those in places like Lewisham don't have their economies 'distorted' by such 'Stalinist' measures as social security, housing benefit and decent public services.

Vino S said...

Interesting post. I have to say, I disagree with it on a number of levels. Firstly, I would say that part of the role of the state is to boost the income of those with low market income. It seems more of those individuals live in the north than in the south. Therefore, it seems logical that there should be a net fiscal transfer form south to north. If you disagree with the principle that part of the role of the state is to assist those with low incomes, then that's fine, that's a perfectly consistent libertarian view. But it is not really a regional issue. Much public expenditure is transfers of social security (and working tax credit) benefits to people with low income. Whether they live in the south or the north is secondary to whether you believe they should be doing that.

Secondly, regarding public sector jobs in the north, surely, as someone who favours economy in public spending, you should be happier that lots of government offices are in the North [where rents for office space are lower] than in the expensive South.

Thirdly, regarding the negative impact of state spending on economic growth, this is a complex issue. Some state spending is clearly beneficial, such as building an infrastructure. Additionally, the provison of social security benefits to the jobless helps maintain a certain degree of purchasing power in poor areas which would be even less if the people didn't even get DSS money.

Fourthly, you draw an odd comparison with South Korea. It may have low state expenditure as a % of GDP [compared to Britain] but it is hardly laissez-faire. In fact, the South Korean regimes of the 1950s, 1960s, 1970s and 1980s were very protectionist. They had import controls while benefitting from exporting to other countries. The state also intervened a lot in the economy to encourage economies of scale by company mergers and to encourage people to go into certain business sectors [e.g. cars, hi-tech]. And, furthermore, for a variety of reasons [including, perhaps, a recent upsurge of trade union militancy], South Korea seems to have one of the most equal _pre-tax_ income distributions in the developed world.

James Higham said...

Matthew, it's not fiscal inequalities but ... don't forget to get those nominations in for the Blogpower Awards - vote early and vote often!

Matthew Sinclair said...


I'm not sure you've quite addressed the arguments in that piece. I didn't go into South Korea's growth performance at all. Also, this isn't about offices for national agencies, those are still mostly in London.

The point isn't to make absolutist statements about government spending being bad (an argument for another day). Equally, it isn't about helping those on low incomes or not. You don't need to spend 58% of regional GDP to do that. It's to point out that a state that constitutes 58% of GDP up North will completely suffocate its economy, that it will create the problem it purports to try to solve. You don't seem to have addressed my point on that at all. You just seem to assume that the North cannot form a functioning private sector.

What is wrong with David B Smith's arguments, and mine, about how such a huge, overbearing government will suffocate the private sector? Why should we assume that the North's options are dependency or starvation?

Vino S said...

Matt, but the 58% figure you come up for is made up of a number of different things.

Given the state provides education, healthcare, housing (for c.30-40% of the population in many areas in the North), social services, transport etc then these together probably add up to a fair chunk of GDP anywhere. In addition, the state is engaging in income transfer to low-income workers and to pensioners [who may also make up a high proportion of the population in certain wards].It is both _public services_ and _transfers_ that make up that 58%. Now, given all of the activities the state is involved in _and_ the political decision taken by the government to engage in boosting the income of low-income people, I do not think that 58% is "too high".

Not being an economist, I don't know what the extent of crowding out effects etc are. What I can say is that the figures that show that most of GDP in the north is accounted for by the state conflates lots of different things - all the way from local transport services, through housing, through to local branches national quangos, through to direct income transfers.

And, I don't think that you have addressed my point. If you think that 58pc of GDP being spent in some way or another by the state in the north is too high, what would you cut?

Dave Cole said...

Do you object to cash flows from St James ward (where I live) to Warwick ward (where I think you live)?

Matthew Sinclair said...

Dave, I doubt they occur. The coach station isn't pretty but it's a money spinner. Also, with "Jenny Lo's Tea House" just opened Warwick Ward is on the march.

Vino, how can you reconcile the notion that 58% isn't a lot when it is so much more than the rest of the OECD spends?

As for what I'd cut: all sorts.

I think that David B Smith's analysis lays out pretty clearly that the crowding out effects could be massive. They could well explain why the North still hasn't recovered from the decline of the staple industries almost a century ago.

Vino S said...

Matt, i think any fixing of a level as 'too high' is fairly arbitary. And, I am sure that there are _regions_ of other OECD countries which have high levels of public expenditure as well. For example, if Sweden has a whole as public spending in the region of 55% of GDP, then areas within Sweden must have a higher rate.

Instead of saying, ideologically, that a certain level of public spending is too high, I would look at the entire range of services that the public sector provides. If some of those services do not need to be produced or if the expenditure on them is more than enough, then the expenditure is too high. Otherwise it is not.

I also wonder about double-counting. For example, if someone works for a quango and lives in a council flat - will both his salary and his rent count towards the figures for 'state share of GDP'?

Vino S said...

Re crowding out, I would argue that - although it might take place - it is not more notable than the effect that high wages in one sector of the economy (say banking) can have on recruitment to other industries.

For example, given that maths and economics graduates can earn far more working in the city than in teaching or research, the City is 'crowding out' the supply of maths graduates for teaching. I think this is as much an issue as the state (by offering better terms and conditions) recruiting workers who would otherwise go to the low-paid part of the private sector [remember top jobs tend to pay less in the state than in the private sector].

Matthew Sinclair said...

Money is a scarce resource. One can always find new state services you would like to spend money on. Particularly given that the returns to extra state spending diminish so quickly as unions and other groups take advantage of a monopoly. The public sector has an insatiable demand for funds.

It has to be balanced against the massive damage its expansion does to the private sector. If present levels of spending doom the Northern private sector to endless failure then it seriously needs cutting. Particularly with the associated cost to the South.

Vino S said...

Yes, resources are finite, Matt, we agree on that. But surely the point at issue - and it come down to our basic left/right split - is whether it is better or not for expenditure on public services to account for a large proportion of those resources. I do not see anything intrinsically wrong with it. And I also see viewing matters as regional transfers rather than (a) provison of services and (b) dealing with (relative) poverty as a rather misleading way of phrasing things. After all, transfer payments benefit the poor in the south as well - its just there are fewer of them.

Interestingly, Matt, do you see the rise of a Lega-Nord-type party in Southern England. Personally, I don't since the south seems to lack regional identity [or, to be more accurate, there are several regional identies in the South - London, the West Country and the home counties].

Matthew Sinclair said...

Well, the paper's argument is that there are particular harms to the private sector in regional inequities in fiscal policy...

I'm not sure I can see a Southern league happening any time soon but I'm not sure why. Perhaps give it time. At the moment anger at the hard fiscal deal the South of England gets is being directed into English nationalism (as a big subsidy without the justification of more poor people goes to Scotland). However, that is relatively novel and could morph into a South-Everyone Else grievance.

Further devolution will continue to strengthen regional identities as it breaks down British nationalism. I doubt that process has run its course yet and the South could begin to feel more out of place in the UK. Would pose an interesting question for the Midlands.

Vino S said...

Well, I would argue that English nationalism is somewhat overstated as a political phenomenon. I am not sure the average voter is that bothered one way or another by the devolution settlement.

What you say about the Midlands is interesting. Not having lived there, I don't know whether they see themselves as being closer to the North or the South.

And, to go back to my earlier point, I am not sure the 'south of England [gets] a hard fiscal deal' as you state in your last comment. People there do pay more taxes but it is because they are wealthier. I think the key issues are issues of class rather than issues of regional and national identity.