To fill the fiscal hole, the next government will have to slash some budgets by as much as 25%, cut benefits or raise taxes
The December 2009 Pre-Budget Report estimates that the recession and financial crisis have punched a permanent £73bn hole in the public finances. As part of the eight-year repair job currently planned by Labour, cuts to public spending will fill £32bn of this hole by 2014/15. In large part this will be achieved by freezing total public spending in real terms for four years from April 2011.
As tight as a four-year freeze on total public spending sounds, it almost certainly understates the looming squeeze facing departments. Spending on debt interest payments, social security and other non-departmental spending is likely to be growing in real terms over this period.
Unless there are new cuts to welfare spending, our best estimate of the outlook for departments is bleak: real cuts of an average 2.9% a year over the four years 2011/12 to 2014/15. In other words, by the end of this period, total departmental spending would be almost 11% lower than in 2010/11.
At least in 2011/12 and 2012/13, the Labour government’s plan is that this pain will not be equally shared. They have pledged to protect spending on priority areas, including overseas aid, parts of the NHS and education, in these two years.
However, this ‘protection’ is only relative – the commitment to freeze 95% of NHS spending in real terms will still imply the tightest two-year squeeze on the health service for 60 years. The cost of protecting some areas is that other departments’ spending will have to be cut more.
We estimate that by 2012/13 the budgets of the unprotected areas are likely be cut, on average, by 13% relative to what they are set to enjoy in 2010/11. These unprotected areas include defence, higher education, transport and housing.
The government has not indicated whether its ‘protection’ of parts of the NHS and education would carry on beyond 2012/13. If it were continued for a further two years, the budgets of unprotected departments could by cut by an average of almost 25%.
If there is a change of government after the next election then the outlook for public services might be slightly different. The Conservative Party has proposed to reduce borrowing more quickly than Labour. Unless this additional fiscal tightening is achieved entirely by increasing taxes, the Conservative plans imply a greater squeeze on total public spending. In the absence of any cuts in welfare spending, this could imply cuts to departmental spending of 14% by 2014/15.
The Conservatives have so far pledged to protect only overseas aid and the NHS from real spending cuts. This could leave other departments – including education – vulnerable to deep budget cuts. Indeed, the average cut would be around 23% from their 2010/11 levels.
The reason that such large cuts to budgets are necessary is that the public finances are in need of significant repair, which will have to be done in a convincing and sustainable way. In fact, our judgement is that the government should do more fiscal tightening more quickly than it has planned. Doing so in a sustainable way would aid credibility and might calm the nerves of investors and credit rating agencies. It would also add room to manoeuvre if things turn out worse than the PBR forecast. However, we do not think the government should implement any further significant fiscal tightening in 2010/11.
This or the next government might also need to look at options for raising taxes or cutting social security spending. Some tax increases would not only raise money but also remove some distortions. For instance, charging the standard rate of VAT on goods that are currently on a zero or reduced rate could raise £15bn, even after paying for a compensation package to reduce the impact on low-income households. Other tax rises and welfare cuts would limit the detrimental impact on public services.
Rowena Crawford and Gemma Tetlow are respectively a research economist and senior research economist at the Institute for Fiscal Studies
