The big squeeze, by Gemma Tetlow and Carl Emmerson

4 Dec 08
The real casualty of the PBR is public spending and no area is safe, say Gemma Tetlow and Carl Emmerson

05 December 2008

The Pre-Budget Report made great play of long-term tax rises to fill the fiscal hole. But these combine to just £4bn of the £22bn needed. The real casualty is public spending and no area is safe, say Gemma Tetlow and Carl Emmerson

Last week's Pre-Budget Report, as expected, painted a bleak picture of the outlook for the UK economy and the public finances over the next few years. A permanent loss of productive capacity in the wake of the financial crisis and weak economic growth over the next couple of years are expected to knock a £70bn hole in the government's finances in 2012/13, some of which has been filled by announcements in the PBR.

Chancellor Alistair Darling announced that he would fill £22bn worth of this hole through fiscal tightening. Although much of the emphasis in his speech was on tax changes, the majority of this forecast tightening is actually expected to come from cuts in public spending.

The PBR announced a short-term net giveaway to try to mitigate the depth of the recession. However, most of the deterioration in the forecasts for the public finances compared with the last Budget is as a result of the deteriorating economic outlook, rather than these discretionary giveaways. Had Darling enacted no new policies, last week's PBR would have shown that £70bn of additional borrowing would be required in 2012/13. The majority of this is due to permanently weaker future economic performance rather than simply because the economy is in a temporary recession – in other words, Darling could not simply rely on economic activity bouncing back in order to close this hole; he had to announce some changes.

Much of the focus in Darling's speech was on longer-term tax rises. Income Tax will rise for those earning more than £100,000 and National Insurance Contributions will be higher for those on more than average earnings. However, the combined effect of all the tax announcements was to increase the tax take only by £4bn. The remainder of the £22bn tightening will come from lower than previously expected public spending.

If Darling had made no new announcements in his PBR last week, the combined effect of his previous plans (plus additional spending that would automatically have come about during the recession as the burden of, for example, increased social security payments) would have been to leave total spending rising to 44.5% of national income in 2010/11 before declining to 43.4% of national income in 2012/13.

However, Darling announced a number of additional changes last week – some capital spending is to be brought forward from 2010/11 into the two previous years, an additional £5bn per year of efficiency savings are now claimed to be possible from April 2010 onwards and public spending will grow less quickly than previously forecast from April 2011 onwards. The net effect is that total public spending is now forecast to be 42.4% of national income in 2012/13. In other words, total spending will be 2.5% lower in 2012/13 than if Darling had made no active changes last week.

In relative terms, the biggest casualty of this overall scaling back of future spending is set to be investment spending, which Labour previously targeted for funding increases. Last week's forecasts show a cash freeze from April 2011. This means that planned investment spending for 2012/13 has been cut by 16.5%. The cut in planned current (ie, non-investment) spending is smaller at 1.7%.

What do these new spending plans mean for the next Spending Review settlements? If we assume that the next Spending Review will set departmental spending plans for the years 2011/12, 2012/13 and 2013/14, last week's figures imply that spending will grow on average by just 1.1% a year in real terms over this period. This is half the rate that spending was set to grow at over the current Comprehensive Spending Review period.

What this implies for departmental spending depends on how fast non-departmental spending needs to grow over this period and, most importantly, how quickly social security spending and debt interest payments will grow. Let us assume that in total these spending commitments grow by 2% a year in real terms over this period – in other words, they grow faster than inflation but less quickly than projected real growth in the economy. It is possible that growth in social security spending will be low over this period as the economy is expected to be recovering from the recession and the burden of unemployment benefits might well be falling.

On the other hand, the burden of debt servicing might be growing as the government is expecting to continue adding to underlying public sector debt over this period. If, however, these elements of spending do grow by 2% a year in real terms, the remainder of departmental spending would be left with just 0.5% a year in real terms – in other words, real growth rates 1.5 percentage points lower than under the previous Spending Review.

This implies plans that are so tight that, if delivered, no spending department could expect to escape the belt-tightening. At the time of the last Spending Review, the areas that did relatively well were health, education, overseas development, transport and the budget for the Olympics. Some of the administration budgets did receive real cuts in spending under the 2007 Comprehensive Spending Review – in particular, the Department for Work and Pensions, the Department for Business, Enterprise and Regulatory Reform (which then included energy and climate change responsibilities) and the Foreign and Commonwealth Office.

If the pain of the spending squeeze were shared equally next time, many more would probably suffer the same fate. If we assume that all departments experience a 1.5 percentage point lower growth rate of spending over the next Spending Review period compared with the current one, then spending on defence, the Home Office and government grants to local government would all be cut in real terms. Even health and education spending would start to fall as a share of national income, although they would still grow in real terms.

Some real spending cuts might be achievable without damaging public service delivery. However, with so many efficiency savings already having been found in recent years and with more pencilled in for 2010/11, it is likely to become increasingly difficult to deliver any more. The government also has ambitious targets for child poverty and aspirations to bring UK public services up to a world-class level. It might be hard to achieve these objectives within such a tight budget. Either the government will have to hope that more money can be found or these aspirations will have to be scaled back.

Darling's PBR speech last week focused mainly on tax giveaways and tax takeaways. However, the greater change to previous plans is on the spending side. Those on very high incomes are one group who will lose out from the Pre-Budget Report tax plans. But, if the spending plans are delivered, a bigger group of losers will be those who would have benefited from the public spending that is now to be cut back.

Carl Emmerson is deputy director and Gemma Tetlow is senior research economist at the Institute for Fiscal Studies


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