05 November 2009
By Carl Emmerson and Gemma Tetlow
A year and a half into the recession, how close are the public finances to Treasury forecasts and what does the future hold? In the run-up to the Pre-Budget Report, the IFS’s Carl Emmerson and Gemma Tetlow second-guess the options ahead
The optimism of the 2008 Budget seems such a long time ago. It stated that ‘growth is expected to pick up from the first half of 2009’, with borrowing, excluding that used to finance investment spending, ‘to return to surplus from 2010/11’. So in these bleaker times, what is the government likely to put in the imminent Pre-Budget Report?
The financial crisis and associated recession have dramatically increased UK government borrowing for two main reasons. First, the economy is producing less than it is thought to be capable of, because the workforce and other factors of production are underemployed. This temporarily increases government borrowing as tax revenues are depressed and spending is higher than usual, for example on welfare benefits. As the economy recovers, this extra borrowing will disappear.
Secondly, and more important for the policy choices it confronts, the Treasury estimates that the crisis has permanently reduced the real productive capacity of the UK economy by 5%, with the current low rate of inflation leading to a further permanent fall in the size of the cash economy. These factors mean that tax revenues will be permanently reduced, and spending plans that were set in cash terms will represent a larger share of our national income than was previously thought. In the absence of policy changes these would cause borrowing to be higher every single year in the future.
Figure 1 overleaf shows how the public finances would have deteriorated between Budget 2008 and Budget 2009 if the government had not announced any policy changes over the past year. In the medium term, annual government borrowing would have been expected to stabilise at an unsustainable 7.6% of national income once the economy recovered.
The most eye-catching effect of the economic crisis on the public finances is the public money spent supporting financial sector firms such as the Lloyds Banking Group, Royal Bank of Scotland and Northern Rock. This will dramatically increase the headline measure of public sector net debt in the short term, but by less in the long term. In the Budget, the Treasury estimated that the long-term impact would be to increase public sector net debt by between £20bn and £50bn. More recently, on November 3, it stated that it now expects to be able to revise this down in the Pre-Budget Report.
Much uncertainty remains: not least over what the value of taxpayers’ shares in Lloyds Banking Group and the Royal Bank of Scotland will be when these are sold. The value will in part depend on the regulatory environment in place when the shares are sold. When considering the extent to which regulation should be tightened, the government should resist any temptation to prioritise reducing the direct losses from these shareholdings over broader economic welfare.
A cost, for example, of £50bn would not be peanuts, but it would not have much effect on the picture set out in figure 1. This is because a one-off addition to debt will affect annual spending (and hence borrowing) only to the extent that we must pay interest on this new debt. So, were we to pay interest at 5% a year, the interest payments on £50bn would amount to £2.5bn a year, or just less than 0.2% of national income (and declining over time as national income grows). This amount would hardly show up in figure 1. Moreover, the rationale for the interventions is, at least in part, that the economic situation would have been much worse without it.
Government borrowing is forecast to be high because UK economic output has been hit hard by the recession and is not forecast to return to its previously expected levels. It is this – and not one-off bail-outs of the financial sector – that necessitate significant changes in policy to bring about a year-on-year reduction in borrowing, either through permanent cuts to spending or permanent increases in tax.
Maintaining annual borrowing at almost 8% of national income in the medium term would have implied ever-increasing levels of debt and eventually our creditors would take fright. So in the November 2008 Pre-Budget Report and the March 2009 Budget, Chancellor Alistair Darling set out a two-pronged fiscal response: a short-term fiscal boost for the economy (in 2008/09 and 2009/10) and a longer-term fiscal tightening (beginning in 2010/11 and running until 2017/18). The latter is designed to return government borrowing to a sustainable level in order to halt and then reverse the large increase in public sector indebtedness. The Treasury estimated in Budget 2009 that to achieve this borrowing and debt reduction would require a fiscal tightening to increase tax revenues and/or cut government spending by 6.4% of national income (equivalent to £90bn in today’s terms) every year from 2017/18.
So far, we have some detail on how the government plans to do half of this. It estimates that new tax raising measures, implemented between 2010/11 and 2013/14, will raise 0.7% of national income a year. It has also set out figures implying cuts to current spending and investment spending plans worth 1.5% and 1.0% of national income per year, respectively, by 2013/14.
In other words, 20% of this part of the fiscal tightening will come from tax increases and 80% from spending cuts. We do not know yet how the government plans to deliver the second half of the fiscal tightening, which they have pencilled in for the years 2014/15 to 2017/18, aside from an intention to protect investment spending from any further cuts.
Treasury figures recently leaked to the Conservative party show that spending cuts of this magnitude would require average reductions of 2.9% a year in central government spending on public services (after taking account of economy-wide inflation) from April 2011 to March 2014. This is the period expected to be covered by the next Spending Review.
These government plans imply the tightest three-year squeeze on public service spending since the late 1970s. As figure 2 shows, cuts of this size would reduce Departmental Expenditure Limits as a share of national income in 2013/14 back to the level in 2001/02. In addition, if half of the as yet unallocated fiscal tightening between 2014/15 and 2017/18 were to come from cuts to DEL, central government spending on public services as a share of national income would fall back to the level inherited by Labour from the Conservatives.
We have very little idea how the government plans to share this pain across departments. The main announcement so far has been for tight control on the pay of 40,000 senior and 700,000 middle-ranking public servants and a large cut to public sector net investment, which is likely to lead to cuts in relatively capital-intensive areas of spending, such as transport and housing. The Pre-Budget Report is expected to fill in some of the details.
However, for any further detail to be meaningful, the Treasury needs to confirm the overall spending envelope for public services for the three years starting in April 2011. In other words, it will need to update the figures leaked to the Conservatives in September, publish them and confirm an intention to stick to them.
Shadow chancellor George Osborne’s speech to the Conservative Party conference contained slightly more detail on how he would cut spending. In particular, he announced plans to cut £3bn from Whitehall administration and quangos and to save £3.2bn by imposing a pay freeze on all but members of the armed forces and the lowest paid 1 million public sector workers.
A series of other smaller policy proposals would add a further £800m of savings, making the package announced in his conference speech ultimately worth, he estimates, £7bn a year. This is in the context of the total £90bn fiscal tightening the Treasury thinks is required over the next seven years. This is not an insignificant sum, but there is clearly more to be done – on either tax increases or spending cuts – unless the current or a future government takes a much more optimistic view of the outlook for the public finances.
Budget 2009 set out one view of the future, in terms of the outlook for the economy and the size and timescale of the fiscal tightening. The Treasury might modify its view in the forthcoming
Pre-Budget Report but, given the continuing uncertainty of the outlook, it might be wary of revising its underlying assessment of the policy challenge.
Figures published by the Office for National Statistics for growth in the third quarter of 2009 were worse than many had expected, with economic output estimated to have declined by a further 0.4%. Budget 2009 forecast that economic growth in 2009 would be –3.5%.
Unless the ONS figures for the first three quarters are favourably revised, meeting the Treasury’s Budget forecast would require growth in the fourth quarter of around 5%, which has been seen only once – in 1973 – since comparable records began in 1955.
However, this worse-than-expected outturn for economic growth does not mean that the public finances are necessarily in an even worse state. In spite of the weaker-than-anticipated figures for economic growth, unemployment has not risen as much as Budget 2009 assumed while the stock market has roared ahead of the Budget assumption. The latest figures for borrowing so far this year suggest that the Treasury is roughly on course to hit its forecast for 2009/10 as a whole.
This could even be an indication that the permanent addition to borrowing might not be quite as large as the Treasury previously thought. However, the size of the gap that needs to be filled by a combination of tax rises or spending cuts would still be very large.
As we move towards the general election, the public and investors in government debt will be looking to the government and the other main political parties to provide more detail of their plans to reduce government borrowing back to a sustainable level.
This will require some tough choices to be made over who to make financially worse off through tax rises or benefit cuts, and which public services should not be protected from cuts.
The forthcoming Pre-Budget Report is the obvious opportunity for the government to start to fill in some of the gaps.
Carl Emmerson and Gemma Tetlow are respectively deputy director and senior research economist at the Institute for Fiscal Studies
