This is going to hurt

17 Apr 09

Next week’s Budget will take place against the backdrop of a £40bn hole in the public finances.

Next week’s Budget will take place against the backdrop of a £40bn hole in the public finances. This leaves the chancellor two tough choices, argue Carl Emmerson and Gemma Tetlow – tax rises or severe spending cuts

In last November’s Pre-Budget Report, Chancellor Alistair Darling forecast that public sector borrowing would reach levels not seen since the Second World War and total public sector debt would be as high as in the early 1970s. Just five months on, those forecasts appear not to have been bleak enough.

The recession is now widely projected to be deeper and longer lasting than the PBR suggested, pushing up borrowing in each of the next few years. In addition, tax revenues are likely to be permanently weaker than the chancellor implied. As a result, if this government – or its successor – is to get the public finances back on the Treasury’s desired course by 2015/16, it is likely to have to implement a further £40bn a year of spending cuts or tax rises before the end of the next Parliament. After a decade of strong growth in public spending, the public sector now looks set for some serious belt-tightening.

The PBR consisted of a short-term giveaway in 2008/09 and 2009/10 to help stimulate the economy, followed by a repair job from 2011/12 onwards to bring the public finances back into balance by 2015/16 – the probable end of the next Parliament. According to the PBR figures, underlying public sector net debt was expected to increase to 57.4% of national income by 2013/14, due to the combination of the fiscal stimulus package and – to a much greater extent – a permanent weakening of the economy’s productive potential. Thereafter, the fiscal repair job announced in the PBR looked set to be sufficient to bring debt back down to pre-crisis levels by the early 2030s. This included plans to cut the public spending growth rate to just 1.1% a year in real terms over the five years from April 2011.

But the PBR forecasts for economic growth and future growth in tax revenues are now widely seen as optimistic. The latest Bank of England forecasts for economic growth, published in the February Inflation report, show a deeper and longer recession than expected. This would push up borrowing over the next few years, as tax revenues come in less strongly and additional demands are placed on the social security budget. In the longer term, the PBR’s predictions for tax revenues after the recession also seem optimistic.

This suggests there is a permanent hole in the government’s books, amounting to around 2.3% of national income. This consists, first, of 0.4% of national income to service the extra debt built up during a recession that is longer and deeper than anticipated. Second is the gap between the Treasury’s PBR forecast for long-run tax revenues and the Institute for Fiscal Studies’ projections, which amounts to a further 1.9% of national income from 2015/16. So, in the absence of additional measures to cut spending or raise taxes, borrowing will be 2.3% of national income higher each year thereafter than the PBR suggested. This is sufficient to suggest that public sector debt would continue to grow as a share of national income for the foreseeable future.

But this figure excludes the long-run cost of any permanent losses from the interventions in the financial sector, such as the huge taxpayer stakes taken in Northern Rock, Bradford & Bingley, Royal Bank of Scotland and the Lloyds Banking Group. The International Monetary Fund recently estimated that the UK government would incur an eventual direct loss of 9.1% of national income from all its financial sector interventions.

If the IMF is right, servicing this extra debt at the existing average interest rate on government debt would initially cost approximately a further 0.4% of national income a year. Such an outcome would worsen the outlook for debt, and enlarge the hole to be filled – although the outlook for the economy and the public finances might have been even worse had the government not intervened.

So, what would the chancellor have to do to get the public finances back on track by 2015/16, as he hoped in the PBR? The estimated hole in the public finances – 2.7% of national income – equates to £39bn a year in today’s terms. This will have to be found from some combination of cuts to public spending plans and further tax-raising measures. Darling already announced what amounted to a £38bn tightening by 2015/16 in the PBR, with the majority of this coming from reductions in future spending. So our estimates suggest that a tightening of about the same magnitude again is required.

Since 1997, the Labour government has increased public spending by an average of 3.2% a year in real terms (in other words, after economy-wide inflation). But the real increase has been even faster on average since Spending Reviews were introduced in April 1999 – real spending over this period has risen by 4% a year on average.

Over the current Spending Review period (April 2008 to March 2011), public spending is set to grow on average by 2.8% a year in real terms. The original settlement (as published in the 2007 Comprehensive Spending Review) suggested a tighter squeeze on spending. However, lower than expected inflation and upwards revisions to the cash spending plans mean that the end result will not be as tight as originally intended.

Beyond April 2011, the PBR pencilled in even tighter spending plans – with real total public spending set to grow at just 1.1% a year on average in 2011/12, 2012/13 and 2013/14. If achieved, this would be tighter than the Conservatives’ average spending settlements from 1979 to 1997. Given that social security spending and debt interest spending are set to grow faster than this average rate, departmental spending looked likely to be left with a real freeze from April 2011 onwards under the PBR plans. In other words, there would be no increase in spending by departments over and above that required to keep up with economy-wide inflation. This would be a tight settlement for departments generally. If the government chose to focus resources on traditionally favoured areas such as schools and hospitals, other areas would have to suffer real cuts in spending.

But what Darling has announced so far (both in terms of this spending squeeze and the tax increase announced in the PBR) does not, on our forecasts, go far enough if he wants the current budget – that is, total government borrowing excluding that used to finance investment – back to zero by 2015/16. The hole in the public finances that we identify above – £39bn a year in today’s terms – equates to an average of £1,250 per family in the UK. If the chancellor agrees with our projections and wants to avoid having to plug the whole of this hole with a further tax increase of this magnitude, he will have to announce a further squeeze on spending.

If the chancellor – or his successor at the Treasury – prefers not to announce any further tax rises, he or she would have to freeze total public spending in real terms for the five years from April 2011 to March 2016. Given that some elements of spending – such as debt interest payments and social security spending – are likely to grow in real terms over this period, the remainder (which in the near term is more under the government’s control) would have to be cut. If such a spending squeeze were implemented, no large spending department would be immune from the pain. Even favoured areas such as health and education would undoubtedly see much lower spending growth than they have received in recent years.

This might suggest that, rather than all of the tightening being through spending cuts, some further tax increases will be required. But what if the chancellor – or his successor – did try to achieve such a tightening through spending cuts alone?

It would be far from easy to produce real spending growth of 1.1% a year over the five years from April 2011 – as envisaged by the PBR – let alone a five-year freeze in spending. For comparison, spending growth over the 11 years of Margaret Thatcher’s premiership was 1% a year, and this was partly brought about by sharp reductions in public sector investment that could not be repeated. The government – or its successor – will undoubtedly (and rightly) look for further efficiency savings to minimise the impact of spending restraint on the quality and quantity of public services.

But implementing such tight spending plans would likely require more than this. Achieving a five-year spending freeze to cut spending plans by the equivalent £39bn a year would require some very tough choices. For example, the annual public sector pay bill is currently £170bn and a similar amount is spent on social security benefits and tax credits. This suggests that reductions in the wages of public sector workers or in the levels of benefits could contribute only a limited amount of the £39bn.

Indeed, achieving the entire squeeze through spending would likely reduce non-debt interest public spending to a lower level as a share of national income than at any point under the Conservatives from 1979 to 1997. Regardless of who wins the next election, doing this might involve cutting those areas that, in a recent speech, Conservative leader David Cameron identified as ‘extensions of the state that shouldn’t have happened at all’.

Aspirations for what the state can provide are likely to have to be scaled back. By how much will depend on exactly what trade-off between further tax rises and further cuts to spending plans is chosen by whoever is chancellor after the next general election. Announcing and implementing fresh tax-raising measures to bring in an extra £1,250 per family would be far from attractive, but then so too would be a five-year freeze in public spending.

If Darling acknowledges a structural hole in the public finances, there will be no easy choices on how to deal with it in next week’s Budget. And things will be no easier for whoever is in Number 11 after the next election, when the full pain of any fiscal adjustment would start to be felt.

  • Carl Emmerson and Gemma Tetlow

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

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