Last week, the highly-respected Institute for Fiscal Studies produced its annual “Green Budget”: its attempt to inject some realism into the national debate on the economy ahead of the chancellor’s actual budget in March.
The document makes for uncomfortable reading in parts, particularly as we head towards another general election in which the complicity of silence on deficit reduction is likely to be as deafening as it was in 2010.
Starting with the deficit, the IFS’s conclusions are stark. Had the government not taken steps to increase taxes and cut spending in the years since 2008, they estimate that the deficit would have reached 10% of national income by 2018-19. Because of the estimated 16.7% permanent reduction in economic capacity caused by the crash of 2008, 98% of that deficit would be “structural” – i.e. would not be expected to reduce naturally once growth picked up:
For an economy such as the UK, this level of borrowing would have been unsustainable on an ongoing basis. Public sector net debt would have increased markedly year-on-year, likely surpassing 100% of national income before the end of the current decade, and 200% within the next two decades.
On the question of whether a reduction in tax receipts or relative increases in spending contributed most to the post-crisis deficit, the IFS are clear: while tax receipts did decline (particularly from the industries most associated with the boom – particularly financial services), it was increases in spending relative to the size of the economy which contributed most:
The biggest effect of the crisis and recession, however, was on spending as a share of national income, which increased markedly up to 2009–10. This was because the huge downward shock to the size of the economy in the crisis meant that the previously-set cash spending plans suddenly represented a much larger share of national income than had been anticipated.
While the IFS are too polite (and non-partisan) to say so, that of course was an inevitable consequence of the actions of a Labour government which believed it had abolished boom-and-bust and that tax receipts from a debt-fuelled boom would continue indefinitely.
Of course, thanks to the coalition the public finances did not continue on their “natural” path to permanent unsustainable deficits, and the IFS notes the success of deficit reduction so far, with 46% of planned tightening set to be achieved by the end of the current financial year.
On the composition of that fiscal tightening — the balance between tax cuts and spending — the IFS says this:
The composition of the planned tightening is currently heavily weighted towards spending cuts. Only 14% of the overall tightening (1.4% of national income) is planned to come from tax increases, while 71% of the overall tightening (7.2% of national income) is to come from lower than planned non-interest spending – 8% from investment spending, 14% from benefit spending and 50% from other current non-interest spending (0.8%, 1.4% and 5.0% of national income respectively).
It is also interesting to note that a whole 15% of deficit reduction will result from the coalition paying less in debt interest because of measures already taken to reduce the deficit.
While forecasts show the public finances going from deficit to surplus sometime in the next parliament, the IFS note to continuing negative effect the accumulated debt will continue to have on public finances:
Even if the forecasts do prove correct, that would still leave public sector net debt standing at nearly £1.6 trillion, or 76% of national income in 2018–19. This will constrain government policy for many more years to come, since such a high level of debt (at least relative to recent decades) involves substantial annual debt interest payments and leaves the government highly exposed to increases in interest rates.
Low pay: a challenge to all parties
The Green Budget dedicates a whole chapter to the issue of low pay, and the possible policy solutions that are on the table.
First, they summarise the coalition’s actions on the income tax personal allowance:
In April 2014, the current government will meet its commitment to raise the income tax personal allowance for under-65s to £10,000. The personal allowance will then be £2,545 higher than under the plans the government inherited, at an estimated cost of £10.7 billion per year – a substantial tax cut at any time, and even more so in an era of severe fiscal restraint. This will have taken 2.0 million people out of income tax, meaning that the 4.6 million lowest-income workers (17% of all workers) will pay no income tax.
The paper then discusses at some length the Lib Dem proposal to raise the threshold further, to around £12,500 (the equivalent of a full-time minimum-wage salary). While they note that:
On average, the workers who would gain most in percentage terms from this further increase are those in the lower-middle of the individual earnings distribution.
They also point out that because such tax cuts are by their nature not targeted:
Overall, the numbers…imply that 69% (£8.4 billion) of the £12.2 billion per year giveaway would go to working families in the top half of the income distribution, and a further 16% (£1.9 billion) would go to non-working families (mostly pensioners). Just 15% (£1.9 billion) would go to working families in the lowest-income half of the population.
They also note that there is a significant problem in those at the lower end of the income scale losing much of the benefit of such cuts because of the withdrawal of social security entitlements that accompany them. The IFS make many similar points to Centre Forum, in their recent publication on this topic.
But while the IFS can be summarised as having reservations on further increases in the personal allowance, there is no such ambivalence in their view on Labour’s proposal to reintroduce the 10p income tax rate:
In short, the reintroduction of a 10% marginal rate band would add unnecessary complexity to the income tax system. There is no plausible economic objective which could not be better and more simply achieved through further increases to the personal allowance.
Like CentreForum, the IFS are much more keen on increases in the national insurance contribution threshold, as a more cost-efficient way to help the lowest paid:
…aligning the employee NICs threshold and the personal allowance represents a better way to help the low paid than further increases in the personal allowance alone. First, there is a group of low-paid individuals who already pay no income tax, but whose tax burden can be reduced through cuts to NICs. Second, because cuts to NICs reduce taxes only on earned income, the gains for workers are larger at a given exchequer cost than the gains from increasing the personal allowance.
On the living wage, the IFS have two reservations:
…the policy also has two key problems. First, it does not seem particularly well targeted at addressing the ultimate causes of low pay – low productivity and/or exploitation by employers with substantial labour market power. Second, it may distort the behaviour of employers in ways that reduce employment and economic output, and reduce rather than increase exchequer revenue.
LVT: an idea whose time has come?
Another chapter is devoted to the issue of business rates and ideas for their possible replacement. At the very least, the IFS would like the government to look seriously at whether a land value tax should be considered:
We cannot say conclusively that the administrative hurdles to replacing business rates with an LVT could be overcome at reasonable cost. But this is such a powerful idea, and one that has been so comprehensively ignored by governments, that the case for a thorough official effort to design a workable system seems to us to be overwhelming. In particular, significant adjustment costs would be merited if the inefficient and iniquitous system of business rates could be swept away entirely and replaced by an LVT.
Economic growth: a sustainable recovery
The IFS note that economic growth over the past year has been driven in part by increases in consumer spending. However, it cautions us not to worry too much about this for two reasons: first, because the increases have come not from increases in borrowing but from reductions in saving levels, and secondly because the recovery is likely to become more broad-based this year:
…our forecast points to slightly weaker growth in the near term as consumer spending growth cools, with quarterly growth rates stepping down from 0.7–0.8% to nearer 0.6%. But as the recovery broadens out, with the contributions of business investment and exports improving, then the recovery will achieve the ‘escape velocity’ that Mark Carney is desperately seeking. Our forecast shows GDP growing by 2.6% in 2014, which would be the strongest growth for seven years, and 2.4% in 2015.
Looking at the thorny issue of the effect of fiscal consolidation on growth, the IFS throw their hat into the ring with this estimate:
…we estimate that fiscal retrenchment has reduced the level of GDP by 3.7% compared with what would have happened had there been no fiscal tightening.
Households have been repairing their balance sheets over the past six years, but recently the pace of deleveraging has eased and the level of household debt remains high by historical standards (see Figure 4.18). Our forecast assumes that households continue to deleverage in a relatively orderly fashion, with the low interest rate environment giving them room to plot a path towards more sustainable debt levels.
Overall, then, what conclusions can we reach?
I’d say we can conclude that deficit reduction was necessary, but that it inevitably had an impact on growth rates.
But clearly the job is not done. There will be many difficult choices to be made on public spending before we reach a point at which the public finances can be called sustainable.
And we can cautiously say that the economy is recovering, and that that recovery is set to become more broad-based and investment-focused, with household finances and balance sheets continuing to improve.
You can read all of the chapters of the Green Budget here.
* Nick Thornsby is Thursday Editor of Liberal Democrat Voice and blogs here.