Taking a load off

6 Nov 13
The government’s half-hearted approach to fiscal consolidation is like going on a crash diet, but still not getting the desired result. It’s time to wise up to the fact that eliminating the deficit is a long, painful game

By Patrick Nolan | 6 November 2013

The government’s half-hearted approach to fiscal consolidation is like going on a crash diet, but still not getting the desired result. It’s time to wise up to the fact that eliminating the deficit is a long, painful game

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George Osborne has correctly set out to eliminate the structural deficit and put public debt on a downward track, but he has gone about this with one hand tied behind his back. He set out to rescue the public finances while protecting the biggest budgets – the NHS, pensioner benefits and schools. The result is like putting the public finances on a crash diet that reduces the chances of long-term weight loss. 

The perception is that services are being underfunded while the real drivers of spending are left untouched. The coalition thought they could avoid hard decisions on the big budgets as they failed to grasp the scale of the changes required. It was expected that most work could be done through reducing waste or administrative changes by freezing wages. Yet the scale of the savings required meant that they would have to go further.

Indeed, the National Audit Office has raised concern that there has been insufficient emphasis on the delivery of long-term changes. Departments tend to lack a clear strategic vision of what they are to do, what they are not to do and the most cost-effective way of doing it.

Yet recent changes indicate that a new reality may be starting to take hold, with Osborne outlining plans at this year’s party conference to continue with the austerity programme and to run a cash surplus by 2020. This would, he argued, ‘bear down on our debts and prepare us for the next rainy day’.

Like a typical British summer, it’s a pretty safe bet this rainy day will come. With an ageing population, the proportion of people who work and pay the taxes that fund services and transfers is falling. This not only reflects a bulge in the population reaching retirement age, but increasing longevity. A person retiring in 2010 has a one-in-six chance of spending 30 years in retirement; by 2035, it will be a quarter of people with this scenario. 

This is leading to important political changes, too – a quarter of all voters were over 65 in the past general election, and this is expected to grow every election to reach one in three by 2050. The result is that major areas of government spending require reform. Yet although health and welfare (including tax credits) account for around 48% of total spending – over half of the increase in spending since 2011 – it is areas like pensions and health where the coalition has failed to get a grip over the finances. This has not only jeopardised their ability to hit their targets, but has meant that the economic costs from austerity have been higher than otherwise.

The return from capital spending on things like infrastructure tends to be higher than spending on areas like welfare and health. Yet, as the House of Commons Public Accounts Committee has noted, the pattern of consolidation has been the opposite.

Rather than reducing long-term costs, policy has gone in the other direction on pensions. Although the coalition brought forward a planned increase in the retirement age and is planning a single-tier pension, the savings will be offset by the change in the way the state pension increases over time. This will increase by either the highest of earnings, the consumer price index or 2.5% (the triple lock). Unless this policy is reversed, it will add around 0.9% of GDP to the cost of pensions by 2062.

But there are signs that the desire to get to grips with spending on pensions is growing. The Labour Party has proposed means-testing the Winter Fuel Payment (Nick Clegg’s long-standing position), and the 2013 Spending Review included a proposal to withdraw this payment from expatriate pensioners living in hotter European countries. A cap on the overall level of spending on welfare transfers has also been proposed. Yet the coalition plans to exclude the state pension from this cap, which means its coverage will be so narrow as to be meaningless. In 2013/14, pensioners will receive 54% of all spending on welfare and tax credits, and the state pension alone will account for 75% of pensioner benefits.

On the NHS, the coalition again failed to get to grips with spending. This partly reflects the concerns of the elderly voting bloc, with the NHS accounting for 95% of all of spending on services for the average retired household. Yet the policy of protecting the NHS budget has meant that the squeeze on areas of related spending, such as adult social care, has been deeper than otherwise. This has worked against the integration of services and the need to shift care from the acute setting into the community and the home.

The government appears to have recognised problems with the health ring-fence, as the 2013 Spending Review extended a policy where NHS funds can be used by local authorities to integrate care. But without further progress on civil service reform and joint working, it is hard to see how the joint fund for health integration will change outcomes as hoped. Instead, it risks being a source of tension rather than transforming the way government works.

The coalition has also failed to grasp the importance of reforming how the NHS is funded. Improving resource use is important, but the narrow basis for NHS funding is out of step with mainstream international practice, and is vulnerable to the pressure from an ageing population. On average, Organisation for Economic Co-operation and Development countries spend 2.7% of GDP on private healthcare, while in the UK, this is just 1.6%; clearly, this signals the need for review. The coalition could consider scaling back the exemptions to prescription charges and introducing fees for GP visits.

Meanwhile, fiscal consolidation should not just take place on the spending side. Changes on the revenue side are important, too, but there has been little recognition that the need for greater tax revenue (as a share of GDP) is not just a short-term phenomenon. Public sector current receipts are expected to average 38.2% of GDP for the next 20 years, while total managed expenditure is expected to average 39.9%. There is no fiscal headroom for lowering tax burdens without also going significantly further on entitlement reform.

It could be argued that this is a static view and that tax relief can fund itself, at least partly. Yet the priorities in current tax policy do not satisfy the test of expanding the tax base and generating additional revenue. 

Take the coalition’s approach to business taxation. On the one hand, it has reduced the main rate of company taxation to create a more competitive tax regime. On the other, it has introduced ad hoc taxes on important economic sectors such as banking and attacked corporations’ legitimate efforts to reduce their tax bills. 

The government needs a different approach that will restore the link between taxation and spending. The public should no longer be led to believe that ever-increasing spending will be available for them at little or no extra cost. There must be greater recognition that while individuals may have paid taxes and National Insurance Contributions all their working lives, these contributions will be less than they can expect from the welfare state under the current arrangements. This was only possible (although perhaps unwise) when the retired population was relatively small, but as the demographic outlook changes, fiscal sustainability will become increasingly challenging.

This shows how crucial improving the management of the public finances is. There have been some positive steps, particularly the introduction of the independent Office for Budget Responsibility and Osborne’s latest target of running a cash surplus by 2020. Yet both New Labour and the coalition have failed to introduce fiscal rules that would have held them to a sustainable plan for reducing the UK’s public debts. This continued failure risks undermining the credibility of fiscal policy. 

Chancellors need to play the long game. Sticking to a sustainable medium-term plan for dealing with debts is urgent in order to protect important public services and ensure families achieve the living standard they need.


Patrick Nolan is chief economist at Reform


This feature was first published in the November edition of Public Finance magazine

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