The Pin Factory Blog

In his most recent open letter to the Chancellor, the Governor of the Bank of England, Mervyn King, wrote that inflation was expected to remain above its 2% target until the end of 2011. Inflation was running at 3.1% in July. The current bout of above target inflation was attributed to a series of temporary shocks: the VAT hike, energy price rises and increased import prices following a depreciation of the pound. The Governor paints a rosy picture, saying that the effects of these shocks will gradually fade away and that spare capacity in the labour market will ensure inflation returns to target. This outcome is predicted even though the Bank’s current interest rate policy, in more ordinary times, would have caused substantial inflation. The problem with the prediction is, as ever, to do with inflation expectations.

If people and businesses expect higher inflation, they demand higher wages or charge higher fees; this in turn causes inflation, which again increases inflation expectations and so on. The Bank’s interest rate is at its lowest level in three centuries. Quantitative easing has seen the Bank effectively print 200 billion pounds. Presently, most of this 200 billion is part of the monetary base and not yet ‘real money’ and so is exerting only limited upward pressure on inflation. The low interest rate and quantitative easing are signals that the Bank is not serious about tackling inflation, caring more about bolstering GDP figures.

These twin policies may be the thin end of the inflationary wedge. First, by behaving as though it doesn’t care about keeping inflation in check the Bank could well be increasing inflation expectations and so risks becoming a cause of higher inflation in its own right. Second, as the economy returns to growth, there is every possibility that the huge amount of newly printed base money will be converted into real money. This would decrease the purchasing power of each pound and cause upward inflationary pressure, particularly if combined with a low Bank interest rate. What compounds these two pitfalls is that the Bank is unlikely to act against rising inflation soon enough. The Bank’s interest rate policy has its maximum effect on inflation two years after it is enacted. If the Bank has to wait to see rising inflation before it does anything it will already be too late.

On Sunday, David Willetts, the universities minister, claimed that a graduate tax is “by far the best option to go for in tough times” when looking to ensure university teaching and research funding is maintained.

Presently, non-medical undergraduate students from middle-income backgrounds pay between 15 and 30% of the costs of their degrees. Taxpayers and university endowments pay the rest and subsidise interest on student loans. This means that undergraduates pay far less than the full cost of their university education. When people can buy something for much less than it actually costs, they tend to buy too much of it. Since 1980 the proportion of people going to university has more than doubled. Many students have gone to university but gained degrees which will not increase their future income; at the same time they have spent three years out of the job market losing a small fortune in forgone wages. A ‘double-cost’ for the students and taxpayers.

Replacing student fees and loans with a graduate tax goes too far in the opposite direction. If the tax is implemented as simply as possible, an individual will pay an additional flat rate (say 3 to 5%) on top of their income tax if they go to university. A tax like this would distort the higher education market by encouraging people not to go to university and so avoid the tax altogether. This could impact especially badly on school leavers from poorer backgrounds.

When university-leavers go into graduate jobs the tax would encourage them to work less hard so they pay less in tax. UCU estimates that a graduate tax of 5% would leave the average secondary school teacher about £46,000 worse-off over 25 years. People could end up paying much more than the value of their university education in graduate taxes over their lifetime, discouraging them from going to university. This would mean too few people go to university, decreasing their future earnings and holding back economic growth.

Additionally, people may go to university, enter high-paying jobs and then emigrate to avoid paying the tax. The Student Loans Company has had a tough time getting loan-repayments from emigres so enforcing a graduate tax internationally will be difficult at best. The result would be a state which pays for most of the university education of high-earning emigres, but which cannot recoup the money and whose policies (by causing the emigration of high-earners) decrease future economic growth.

A more complex graduate tax could be implemented, one where different percentages of income are paid according to university attended, degree taken and income earned. This might lead to a better- targeted tax but it would have much higher administrative costs and would cause even more distortion in the higher-education and job markets.

In fact, the idea of a graduate tax needs to be scrapped and instead Willetts should enact James Stanfield's proposals set out in The Broken University.