Surplus to requirements

28 Feb 14
Emran Mian

‘Surplus hawks’ in the Treasury and on the Opposition benches risk neglecting productivity growth in the public sector. But years of spending restraint could be self-defeating in the long run

Danny Alexander started it, suggesting at the Liberal Democrats’ conference last September that his ambition, if returned to the Treasury after the 2015 election, would be to run a surplus by the end of the next parliament. The chief secretary’s boss, Chancellor George Osborne, firmed up the commitment in the Autumn Statement. Now Ed Balls, the shadow chancellor, has also become a ‘surplus hawk’.

There may be differences in what each means by ‘running a surplus’. Are they counting current expenditure alone or do they mean to run a surplus with capital investment included in the spending figure? Will the figure be adjusted for where we are in the economic cycle? And which is the target year for achieving it? There is billions of pounds’ worth of difference in the extent of public spending controls, depending on the details.

This month’s Budget will provide more clarity on the implications of the chancellor’s commitment, and on this basis we will be able to work out how the other parties compare. What is already clear is that they are all signed up to what commentator Hopi Sen has called the ‘Long Ugly’; that is, spending restraint that lasts until the end of the decade.

The Institute for Fiscal Studies estimates that, on the government’s plans, more than half of departmental spending cuts are still to come.

The targeting of the surplus is therefore the single largest policy choice shaping this year’s Budget and the fiscal debates beyond. But is it the right thing to do? There has been remarkably little discussion of the pros and cons.

The pros, you might say, are obvious. If we’ve run up debt as a country during the bad times, then it’s necessary to ‘fix the roof while the sun is shining’. Continuing the analogy, there are more storm clouds on the way. For example, the Office for Budget Responsibility forecasts that the ageing population will create fresh pressures on the debt-to-GDP ratio through higher pensions spending and a lower tax take from a smaller working population.

The government has also benefited from the quantitative easing provided by the Bank of England; that policy has lowered debt interest costs below what they otherwise would have been. When the easing is reversed, the costs of the government’s debt will increase – all the more reason for starting to pay it down.

The most significant argument against running a surplus is that raising productivity has higher priority than paying down the debt. While the economy is growing again, productivity is flat and a long way below where it was before the crisis. This is worrying for three reasons. The first is that, unless productivity rises, wages growth will be limited; all other things being equal, it is difficult for employers to pay more per hour if output per hour is not increasing.

Secondly, future growth prospects, and therefore future tax revenues, diminish unless productivity starts increasing. The OBR estimates that the debt-to-GDP ratio will be rising again by the middle of the next decade, despite spending restraint in the next parliament, even if productivity growth rises to 1.7%. Only increasing productivity growth to something like 2.7% will keep the debt-to-GDP ratio falling. To put those figures in perspective, the latest data suggest that productivity growth is as low as 0.5%. Or, in other words, if we are fixing the roof during the next parliament, then with productivity growth as weak as it is, it’s nothing more than a temporary patch.

The final reason for being worried about productivity is that it determines the consequences of spending restraint in the public services. Getting more for less, or even the same for less, is only possible if productivity in the public sector is improving. And yet, at least in some areas of the public sector, productivity lags behind even the weak growth seen in the private sector. As Stephen Dorrell, chair of the Commons health select committee, has put it, the challenge for the NHS in particular – even assuming no cuts to spending, but merely spending restraint – is to increase productivity growth from about half the wider average to double that average. That’s a very ambitious target and, if it isn’t achieved, then spending restraint will mean reductions in service or managing demand.

While productivity is a big issue, I don’t want to suggest that more government spending is the only way to tackle it. In the private sector, spending on new technology, new processes and on entirely new businesses should mean that workers in the UK start producing more per hour. However, business investment remains low, and it fell during 2013 even while the economy began to recover. Plus, a lot of people creating new businesses are doing so due to need; the switch to self-employment is often driven by redundancy or a fall in income, rather than the drive to bring a more competitive product or service to the market.

Policymakers should be alert to the possibility that business activity will fail to drive up productivity and be ready to respond. In practice, this may mean using the tax system to incentivise investment in more radical ways than have been tried to date; speeding up the cycle of innovation by increasing public investment in new technologies and processes; or charging up the skills of people in the workforce. All of this costs money, money that will be scarcer due to the consensus in favour of targeting a surplus in the public finances.

In the public sector, increasing productivity will require a different orm of ambition: a new wave of public service reform. So far we’ve heard little of substance from any of the political parties about their agenda for this over the next parliament.
Labour is kicking off a zero-based spending review as part of its manifesto process, rather than starting with a set of hypotheses, as previous Labour administrations have done – like choice, competition and the extensive use of targets – for what it wants to achieve by reforming public services. Meanwhile, the two coalition parties are preoccupied with simply ensuring that there are no delivery failures in the run-up to the election.
The surplus is in fashion; boosting productivity and public service reform, unfortunately, are not.

Emran Mian is director of the Social Market Foundation

 

This opinion piece was first published in the March edition of Public Finance magazine

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