By Tony Dolphin
11 March 2010
The UK’s deficit needs to be addressed and neither main party has a credible plan. Ahead of this month’s Budget, Tony Dolphin says it would be dangerous to implement more cuts now but there is an urgent need for long-term action
Cutting the fiscal deficit will be the biggest challenge facing the next government. Whether it is a Conservative administration, which is committed to introducing an emergency budget in June, a re-elected Labour government or a hung Parliament, financial markets, the Bank of England and the public will soon want to know how the deficit will be dealt with.
The global financial collapse and subsequent recession, the deepest since the 1930s, have left the UK with a huge fiscal problem. Government borrowing in 2009/10 is likely to have been around £180bn. At over 12% of gross domestic product, this is the largest borrowing requirement seen in the UK since the Second World War.
It is important to distinguish between borrowing – the deficit – and debt. Net public debt at the end of March 2010 will be about 56% of GDP. Although the debt-ratio has increased sharply from its level before the financial collapse – 36% of GDP in March 2007 – it is close to the average for advanced economies. Ultimately, it is the level of debt and interest payments on it that are a drag on medium-term economic performance, and the critical level appears to be when debt is over 90% of GDP, so the UK is still some way short of a debt crisis.
Of course, if the government keeps borrowing at the current pace, a debt problem will develop, which is why there is broad agreement that the deficit must be reduced over the medium term.
This will happen as a result of economic recovery, which will boost tax revenues and lead to lower spending on welfare payments, discretionary tax increases and cuts in public spending. The discretionary fiscal tightening will probably need to total around £100bn to eliminate the structural current budget deficit – ie, that part of the deficit that will not go away as a result of the economic recovery.
There is, however, less agreement about how much the deficit can safely be reduced in 2010. The government has already taken a number of decisions to cut it over the next year. It increased the standard rate of VAT from 15% back to 17.5% in January. This will add about £10bn to government revenues. From April 2010, there will be an additional rate of income tax of 50%, applied to all incomes over £150,000, and the income tax personal allowance will be restricted for those with incomes over £100,000. Capital expenditure will also fall, according to the 2009 Pre-Budget Report, from £69bn to £60bn, reflecting the government’s decision to bring some spending forward to 2009 to support the economy.
Conservative leader David Cameron and shadow chancellor George Osborne are still calling for a bigger cut in the deficit in 2010, although their message has become rather blurred in recent weeks. At the start of the year, they appeared ready to act much more aggressively than the government in cutting public spending in 2010. More recently, they have suggested any additional cuts would not be ‘swingeing’ or ‘extensive’.
This is almost certainly a good thing. After the Great Depression, the US opted for deficit reduction too quickly in 1937 and tipped the economy back into recession. Sixty years later, Japan repeated the US mistake when it cut public spending and increased taxes in 1997. Acting too aggressively to reduce the UK’s deficit in 2010 is far riskier than delaying further action until 2011.
To understand why, we need to remember that the government allowed the deficit to widen so much in the first place because private sector spending contracted sharply, initially as a result of the credit crunch and then due to a collapse in consumer and business confidence. Households and companies reduced their borrowing, saved more and invested less, so the government did the opposite. By doing so, it limited the scale and length of the recession.
It follows that the chancellor should cut the deficit only when households and companies are willing, and able, to save less and borrow and spend more, or when not cutting it is likely to lead to an increase in long-term interest rates that would hold back private sector spending.
This is unlikely to be the case in the near future. While consumer and business spending are not contracting as fast as they were in the depths of the recession, there is little to suggest they will grow at anything more than a moderate pace in coming months. And demand from overseas, which could give a boost to growth in the UK through stronger exports, is also being held back by economic weakness, particularly in the eurozone.
Despite talk of UK government debt losing its triple-A rating, there is no immediate cause for concern about higher long-term interest rates. Ten-year government bonds yield little more than 4%.
Arguments that investors will abandon sterling also do not hold up. Where would they invest instead? The US fiscal deficit is just as large as the UK’s and the eurozone has Greece’s fiscal problem to deal with, with Portugal, Spain and Italy all waiting in the wings as the next potential crisis. Even worries about a hung Parliament in the UK can be dismissed. The inability of the Barack Obama administration to implement controversial measures is illustrated by the slow progress on health care reform over the last year; while decisions in the eurozone require the agreement of over a dozen governments of differing political stripes.
So no more should be done in 2010, but we still need a credible medium-term fiscal consolidation plan. Neither of the main political parties has produced one.
Labour plans to halve the deficit within four years, and has set out the mix of economic growth, spending cuts and tax increases it believes will achieve this target. There have been calls, led by the Conservatives, for deeper cuts over this period, but these fail to acknowledge that the government’s plans are already ambitious. The envisaged cut in the deficit over the next four years is as large as any implemented in the UK over a similar period in the past 50 years. Arguably, to propose larger cuts would stretch credibility to breaking point.
Where the government’s plans fail to convince is in the detail – or lack of it – on public spending. The prime minister’s reluctance through much of 2009 to admit that spending would have to be cut means his plans now lack credibility.
The Tories fail the test too. Credibility requires consistency but the Conservatives have created confusion by shifting their position on public spending in 2010. They have not stated how much discretionary fiscal tightening they think is needed, or over how many years it should be implemented. They have failed to set out, even in broad terms, whether a faster pace of deficit reduction would involve more tax increases, bigger spending cuts or both.
And they continue to object to some of the government’s plans – for example, saying they would like to drop the planned increase in National Insurance contributions from April 2011 – without explaining what they would put in their place.
This reluctance on the part of both major parties to come up with a credible plan is no doubt explained by the proximity of the general election. Any tax increase or spending cut will hit someone financially – even the much-touted ‘efficiency savings’ will lead to people losing their jobs – and so could cost votes. In a properly functioning democracy, the political parties would set out their plans on this crucial issue and allow the electorate to choose between them on polling day, but it would be naïve to imagine this will happen in the UK in coming weeks.
The new government will, though, have to set out a credible and detailed proposal for cutting the deficit soon after the election. This should not include extra measures for 2010. It should include an estimate of the size of the structural budget deficit and a commitment to eliminate it over a set period of time; a statement of the mix of tax increases and spending cuts that will be used to implement this plan; and specific tax measures and detailed spending plans covering at least the next four years. It might also include a new institutional framework designed to ensure the government sticks to its plans.
Only when we know where the pain will be felt will we be able to say that the government has produced a credible plan for dealing with the deficit.
Tony Dolphin is senior economist at the Institute for Public Policy Research
11 March 2010
The UK’s deficit needs to be addressed and neither main party has a credible plan. Ahead of this month’s Budget, Tony Dolphin says it would be dangerous to implement more cuts now but there is an urgent need for long-term action
Cutting the fiscal deficit will be the biggest challenge facing the next government. Whether it is a Conservative administration, which is committed to introducing an emergency budget in June, a re-elected Labour government or a hung Parliament, financial markets, the Bank of England and the public will soon want to know how the deficit will be dealt with.
The global financial collapse and subsequent recession, the deepest since the 1930s, have left the UK with a huge fiscal problem. Government borrowing in 2009/10 is likely to have been around £180bn. At over 12% of gross domestic product, this is the largest borrowing requirement seen in the UK since the Second World War.
It is important to distinguish between borrowing – the deficit – and debt. Net public debt at the end of March 2010 will be about 56% of GDP. Although the debt-ratio has increased sharply from its level before the financial collapse – 36% of GDP in March 2007 – it is close to the average for advanced economies. Ultimately, it is the level of debt and interest payments on it that are a drag on medium-term economic performance, and the critical level appears to be when debt is over 90% of GDP, so the UK is still some way short of a debt crisis.
Of course, if the government keeps borrowing at the current pace, a debt problem will develop, which is why there is broad agreement that the deficit must be reduced over the medium term.
This will happen as a result of economic recovery, which will boost tax revenues and lead to lower spending on welfare payments, discretionary tax increases and cuts in public spending. The discretionary fiscal tightening will probably need to total around £100bn to eliminate the structural current budget deficit – ie, that part of the deficit that will not go away as a result of the economic recovery.
There is, however, less agreement about how much the deficit can safely be reduced in 2010. The government has already taken a number of decisions to cut it over the next year. It increased the standard rate of VAT from 15% back to 17.5% in January. This will add about £10bn to government revenues. From April 2010, there will be an additional rate of income tax of 50%, applied to all incomes over £150,000, and the income tax personal allowance will be restricted for those with incomes over £100,000. Capital expenditure will also fall, according to the 2009 Pre-Budget Report, from £69bn to £60bn, reflecting the government’s decision to bring some spending forward to 2009 to support the economy.
Conservative leader David Cameron and shadow chancellor George Osborne are still calling for a bigger cut in the deficit in 2010, although their message has become rather blurred in recent weeks. At the start of the year, they appeared ready to act much more aggressively than the government in cutting public spending in 2010. More recently, they have suggested any additional cuts would not be ‘swingeing’ or ‘extensive’.
This is almost certainly a good thing. After the Great Depression, the US opted for deficit reduction too quickly in 1937 and tipped the economy back into recession. Sixty years later, Japan repeated the US mistake when it cut public spending and increased taxes in 1997. Acting too aggressively to reduce the UK’s deficit in 2010 is far riskier than delaying further action until 2011.
To understand why, we need to remember that the government allowed the deficit to widen so much in the first place because private sector spending contracted sharply, initially as a result of the credit crunch and then due to a collapse in consumer and business confidence. Households and companies reduced their borrowing, saved more and invested less, so the government did the opposite. By doing so, it limited the scale and length of the recession.
It follows that the chancellor should cut the deficit only when households and companies are willing, and able, to save less and borrow and spend more, or when not cutting it is likely to lead to an increase in long-term interest rates that would hold back private sector spending.
This is unlikely to be the case in the near future. While consumer and business spending are not contracting as fast as they were in the depths of the recession, there is little to suggest they will grow at anything more than a moderate pace in coming months. And demand from overseas, which could give a boost to growth in the UK through stronger exports, is also being held back by economic weakness, particularly in the eurozone.
Despite talk of UK government debt losing its triple-A rating, there is no immediate cause for concern about higher long-term interest rates. Ten-year government bonds yield little more than 4%.
Arguments that investors will abandon sterling also do not hold up. Where would they invest instead? The US fiscal deficit is just as large as the UK’s and the eurozone has Greece’s fiscal problem to deal with, with Portugal, Spain and Italy all waiting in the wings as the next potential crisis. Even worries about a hung Parliament in the UK can be dismissed. The inability of the Barack Obama administration to implement controversial measures is illustrated by the slow progress on health care reform over the last year; while decisions in the eurozone require the agreement of over a dozen governments of differing political stripes.
So no more should be done in 2010, but we still need a credible medium-term fiscal consolidation plan. Neither of the main political parties has produced one.
Labour plans to halve the deficit within four years, and has set out the mix of economic growth, spending cuts and tax increases it believes will achieve this target. There have been calls, led by the Conservatives, for deeper cuts over this period, but these fail to acknowledge that the government’s plans are already ambitious. The envisaged cut in the deficit over the next four years is as large as any implemented in the UK over a similar period in the past 50 years. Arguably, to propose larger cuts would stretch credibility to breaking point.
Where the government’s plans fail to convince is in the detail – or lack of it – on public spending. The prime minister’s reluctance through much of 2009 to admit that spending would have to be cut means his plans now lack credibility.
The Tories fail the test too. Credibility requires consistency but the Conservatives have created confusion by shifting their position on public spending in 2010. They have not stated how much discretionary fiscal tightening they think is needed, or over how many years it should be implemented. They have failed to set out, even in broad terms, whether a faster pace of deficit reduction would involve more tax increases, bigger spending cuts or both.
And they continue to object to some of the government’s plans – for example, saying they would like to drop the planned increase in National Insurance contributions from April 2011 – without explaining what they would put in their place.
This reluctance on the part of both major parties to come up with a credible plan is no doubt explained by the proximity of the general election. Any tax increase or spending cut will hit someone financially – even the much-touted ‘efficiency savings’ will lead to people losing their jobs – and so could cost votes. In a properly functioning democracy, the political parties would set out their plans on this crucial issue and allow the electorate to choose between them on polling day, but it would be naïve to imagine this will happen in the UK in coming weeks.
The new government will, though, have to set out a credible and detailed proposal for cutting the deficit soon after the election. This should not include extra measures for 2010. It should include an estimate of the size of the structural budget deficit and a commitment to eliminate it over a set period of time; a statement of the mix of tax increases and spending cuts that will be used to implement this plan; and specific tax measures and detailed spending plans covering at least the next four years. It might also include a new institutional framework designed to ensure the government sticks to its plans.
Only when we know where the pain will be felt will we be able to say that the government has produced a credible plan for dealing with the deficit.
Tony Dolphin is senior economist at the Institute for Public Policy Research
