Britain will never succeed with a bloated and overmighty public sector

Successive governments have avoided the tough cuts that need to be made to state spending

During the past few weeks, I have heard repeatedly from businesses and investors that they are sitting on their hands until they know what Labour will announce in its first Budget on Oct 30.
Unusually low volumes in UK equity markets and a sudden drop in business confidence point to widespread anxiety and a degree of paralysis. But why?
The economy seems to be on the up after two years of stagnation. Banks are well-capitalised, businesses have good balance sheets and consumer demand is strong. A healthy private sector should not be holding its breath for weeks on end until a government decides its tax and spending plans. This does not add up.
Most commentators seem to blame Labour’s overblown pessimism for the sudden bout of gloom. But even that seems a stretch, given that Labour has already signalled much of the Budget ahead of time.
The Government has promised no increases in income taxes, employee National Insurance, value-added tax (VAT), or corporation tax. Even with the announced rise in public sector wages, likely VAT on private school fees, and possible increases in capital gains tax, this is normal centre-Left policy by modern standards.
Perhaps that misses the point. By modern standards, yes, this is all par for the course.
But as the standard for what is considered a normal degree of government interference in the economy is so high, private markets now reflexively take their lead from government policymakers.
While this problem has worsened over time, it is not new. Its roots took hold long ago.
When the Soviet flag was lowered for the last time over the Kremlin on 25 Dec 1991, it seemed to bring an end to the failed experiment in central planning.
Instead of achieving a more equitable economy as their proponents had predicted, command-and-control economies produced slow economic growth, stagnant living standards, high prices, and eye-watering discrepancies in incomes and wealth.
In sharp contrast, market-oriented economies in the West and in parts of East Asia reliably produced healthy economic growth and rising living standards for the masses.
No sooner had the consensus of opinion ruled in favour of free enterprise – and even as countries like China and Russia started to embrace markets – the UK, as part of a broader Western trend, set course to expand its state sector.
In 1991, public spending accounted for 37pc of GDP while taxes accounted for just 33.5pc. In the decade before the fall of communism, when the UK had been aggressively pruning the state under Conservative prime minister Margaret Thatcher’s staunchly free-market government, per capita GDP growth had averaged 2.7pc per year with a strong uptrend in productivity.
Today, government spending accounts for around 44pc of GDP while taxes are around 41pc of GDP. During the past decade, per capita growth has averaged 1pc per year while productivity has remained virtually stagnant. This is not a coincidence.
We have almost no hope of returning to historically normal rates of economic and productivity growth unless we tackle the bloated public sector that is crowding out private activity.
To get to that point, however, those in favour of markets need to start making a genuinely compelling case for them. Instead, they repeatedly commit at least one of the following errors.
First, too many claim to be “pro-business” as a badge of honour. It is hard to pinpoint when this trend started. As it is often heard in Washington, it may be an American import.
Even Rachel Reeves, the Chancellor, has a habit of saying it.
But it is wrong-headed. “Pro-business” implies higher margins, distortive subsidies, and high barriers to entry. When businesses believe that they can get a helping hand from the Government, they stop innovating and start lobbying.
To be genuinely pro-market means to be pro-consumer. Policymakers should aim to set rules and taxes in a way that makes markets as contestable as possible. In properly regulated markets, the desire by businesses to survive by competing on price and quality increases consumer welfare.
Second, free markets are not a perfect solution to the economic problem. They have flaws which must be managed. Some state intervention is necessary to soften boom-bust cycles, contain negative externalities that are often not properly reflected in prices, and mitigate socially and economically damaging inequality.
The best arrangement for the UK remains a well-balanced mixed economy. We should aim for lightly regulated competitive markets, a powerful but not overgrown public sector as well as independent courts, regulators, and a central bank with a narrow price-stability target. This roughly describes the situation in the UK at the start of the 1990s when it was the most vibrant economy in Europe.
Third, tax cuts are not a silver bullet. The now infamous October 2022 mini-Budget under then prime minister Liz Truss failed because financial markets correctly spotted that demand-boosting tax cuts during the worst inflation and energy supply crisis in a generation would make matters worse, not better.
Thatcher succeeded where Truss failed because she first addressed public overspending, which, along with deregulation, helped to improve economic efficiency. Too high taxes are the result of too high public spending. And this lands on the really difficult issue.
In the first instance, governments know they will pay a heavy price in the voting booths if they cut public spending. And second, it is hard to convince a frustrated public that cutting already-stretched services is a sensible economic choice.
People want better public services and faster economic growth. But the problem is that by promoting public services over healthy economic growth for some three decades, we have ended up with neither to any acceptable standard. This is a ‘cart before the horses’ policy dilemma.
The good news is that the state has become so overgrown that any steps to shrink it down to size would likely stimulate private activity. But for this to happen, people need to be persuaded once again about the merits of markets. Free-market proponents need to up their game.