Opinion: Fiscal consolidation and the Liberal Democrats

Newly minted coins by James Cridland james.cridland.net
Over the past few days, questions have emerged about the Liberal Democrats’ proposals for fiscal consolidation. Liberal Reform felt it would therefore be helpful to clarify what the challenges are, to explain how some of the figures are derived and to help people understand what the scale of the problem is.

Which deficit are we cutting and how much does it cost?

All three political parties have committed to eliminating the budget deficit over the next parliament. There are two things that divide the parties, however:

  • The speed of the consolidation – in what year will the budget be balanced
  • The definition of the “budget deficit.”

The Liberal Democrats have committed to eliminate the budget deficit by 2018-19. The Labour Party have postponed consolidation to 2020 and the Conservatives are being vague about when in the next parliament the budget will balance. The Lib Dems position reflects current government plans.

More importantly, the three parties are focusing on a different deficit:

  • The Conservatives wish to eliminate the overall deficit – the difference between government income and government outgoings (known as “Public Sector Net Borrowing” or PSNB)
  • Labour wish to eliminate the cyclically-adjusted current budget, also known as the “structural deficit” – that part of PSBN that is not due to the current state of the economy but would exist even if output were back to trend.
  • The Lib Dems wish to eliminate that part of the cyclically-adjusted current budget that does not include investment spending – that is to say, eliminating the structural exempting “borrowing for investment”.

These difference matter. The 2015-16 deficit on these different calculations is as follows:

  • Conservative: £75.9bn
  • Labour: £68bn
  • Lib Dem: £49.4bn

These figures are the OBR’s prediction for next year’s budget deficit, which the next parliament will need to close. Note that they may be revised in the budget on 18th March 2015

On the face of it, this leaves the Lib Dems needing to find £49.4 billion of spending cuts and tax rises.

However, according the Lib Dem website:

Next year, the government will make £20bn of efficiency savings, including:

  • £1.9bn on advertising, consultants and temporary agency staff
  • £1.7bn by making large projects on time and within budget
  • £600m by selling empty government buildings

These “efficiency savings” would reduce the remainder of the consolidation needed to close the deficit to £29.4 billion. However, it is notable that the website only specifies how £4.2 billion is to be achieved. Members and voters would have more confidence in those £20 billion of savings if further details were available.

Conversely, The Institute for Fiscal Studies note that:

…in a June 2014 speech, Nick Clegg suggested that only investment that ‘enhances economic growth or financial stability’ would be excluded from headline borrowing when calculating the Liberal Democrats’ measure of the current budget. This could imply a tighter fiscal stance than under the standard definition of the cyclically adjusted current budget.

Spending cuts versus tax rises

At least as important as the scale of the fiscal consolidation is how we go about it – what taxes we raise, what spending we cut, and it what proportion. It is this last that has prompted much of the debate in recent weeks.

It is widely recognised by economists that how fiscal consolidations are structured is a key factor in achieving successful and lasting reductions in the debt-to-GDP ratio. Economists also agree that fiscal adjustment packages that are made up primarily of spending cuts are more likely to lead to lasting debt reduction than those composed of tax increases, and that they are less likely to trigger another recession. There is also research that suggests that fiscal adjustments based mostly on the spending side are less likely to be reversed.

More specifically, there is a strong consensus around the view that developed economies recover most quickly where fiscal consolidation is based on 80% spending cuts and 20% tax rises. This is why, in 2010, the Chancellor committed the Coalition to roughly that approach. It was, he explained, “supported by the international evidence, compiled by the Organisation for Economic Cooperation and Development, the International Monetary Fund and others…” Since the early 1990s, this has been amply demonstrated in Sweden, New Zealand and Canada, none of which was obviously a hotspot of zealous economic neo-liberalism.

How do the Lib Dems plan to eliminate the deficit?

Recently the Lib Dems announced that they would aim for a 60:40 ratio between spending cuts and tax rises. This in turn led some people to propose an alternative, 50:50 balance. The following table compares the balance of spending cuts and tax rises under three scenarios:

  • International best practice
  • The Liberal Democrat proposal
  • Alternative proposal.

We further factor in the assumption that the Lib Dems have already found £20 billion of savings.

Fiscal consolidation
However, the Liberal Democrats have also made a number of additional spending promises that need to be added to the list. Any additional spending must be met either with an alternate cut or a further tax increase. These additional spending commitments include:

  • Increase the personal allowance to £12,500 by 2020–21
  • £250 bonus for anyone receiving the carer’s allowance/premium for a continuous 12 months
  • Offer free childcare for all 2-year-olds, paid for by abolishing the married couple’s tax allowance
  • Two-thirds discount on bus travel for 16- to 21-year-olds
  • Extra £1 billion of spending on the NHS.

Summary

If the Lib Dems wish to fund 40% of fiscal consolidation from 2015 from tax increases, this will require around £20 billion of new taxes. If the alternative proposal succeeds in persuading the party to increase this to 50%, the new taxes required will be £25 billion. To this needs to be added the cost of the above promises.

Just one of these promises – increasing the personal allowance from £10,500 to £12,500 – will cost £10 billion. Ignoring all other potential spending promises, this adds a further £10 billion that needs to be funded by cuts or tax rises elsewhere. That leaves the Lib Dems looking for £30 billion of tax rises, while the alternative proposal would require £35 billion of tax rises.

These are phenomenally large sums of money. Considering the balance of government income (see chart), the vast majority of this will fall on ordinary people.

Photo by James Cridland james.cridland.net

* Tom Papworth is a member of Waltham Forest Liberal Democrats

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33 Comments

  • Alisdair McGregor 12th Mar '15 - 11:39am

    Pushing the Tax Threshold to the level of NMW might reduce income tax take by the level you specify, but that money will then be spent by the earners, so the tax take from VAT & Corporate profits on that expenditure will rise.

    It’s meaningless to look at the “cost” of the Tax Threshold rise without also acknowledging the economic benefit of increased personal liquidity it implies.

  • Paul Reynolds 12th Mar '15 - 11:49am

    A useful and very well set out analysis. I would like to see alternative approaches of equal quality set out by those LibDems who argue for more cuts and those that argue for more tax increases, or just those that disagree with Tom’s overall analysis. I think it is fair to say that, agree with him or not, Tom has raised even further the quality of fiscal debate in the Lib Dems; already way ahead of the quality of debate in the other 6 main parties. Thanks Tom for your hard work.

  • Alistair – not really.

    Even if all the money not taxed was spent on VAT-able goods in the UK you’d have another £1.7B from VAT and making the generous assumption that companies will make 20% marginal profit that would be £330M (@20% rate of corporation tax) meaning that you’d be getting a maximum of ~£2B back. Bearing in mind that only ~50% of household spending is on VATable goods (See the ONS) that leaves you with £1B and if you take debt repayments and savings out of that it’ll be less and you also have the reality that some spending and a lot of company taxation is non-UK. So rather than meaningless, Tom is probably going to be right to within 3%, but definitely within 10%.

  • Eddie Sammon 12th Mar '15 - 12:00pm

    First of all to delight Liberal Reform I think there is an agenda for lots of tax cuts on things like VAT, Stamp Duty and Employer’s National Insurance. Cutting these would increase the Corporation Tax and Income Tax takes. Similar to what Alisdair McGregor says: you have to consider the economic benefits as well as the costs.

    Secondly: I have no strong opinions on the ratio of cuts to tax rises, but I fear that a 50% ratio between spending cuts and tax increases will lead to lots of unfair double taxation. You can’t just whack dividend and capital gains tax to income tax levels because of corporation tax. Removing the fair tax deductibility for interest paid would also be a tax on small businesses.

    Thirdly: monetary policy can reshape the economy as much as fiscal policy, yet Lib Dems appear to say little on it. A proper economic plan needs to be putting pressure on central bankers and we need to stop the ECB from printing lots of money – a recipe for volatility.

    Regards

  • > £600m by selling empty government buildings

    You can’t reduce the deficit by selling things, unless those things are costing money. I find it hard to believe that the government spends £600m a year servicing empty buildings.

    If on the other hand it means, (which is more likely) we have empty buildings that if sold will bring in £600m, then that’s fine and conceivably a sensible thing to do, but that does not affect the deficit, because the deficit is an annual amount, we can only sell properties once

  • Gwynfor Tyley 12th Mar '15 - 12:04pm

    The cost of the increase in the personal allowance can also be adjusted by reforming the higher rate thresholds so that those on higher incomes do not benefit from the increase – though I disagree with the withdrawal of the allowance above £110,000. Surely it would be better and simpler to have rates at 20%/30%/40%/50% and not have the withdrawal of the personal allowance.

    Does the £10bn cost of increasing the personal allowance also reflect savings on benefit reductions? £10bn across 31m working people suggests a cost of £320 per person against a reduction assuming one received the full benefit of £400 per person. Given the number of workers earning below £12,500 or above £110,000, that strikes me as a worse case scenario.

    One figure not included in your report though is what the % split between spending cuts and tax increases has been since 2010 – shouldn’t we be looking at the total period of recovery rather than just looking forward?

    But ultimately, the question is what sort of state do we want – if you baulk at raising taxes then you are subscribing to the Tory vision of a small state. Define the services you wish the state to provide then determine how to fund them in a progressive way looking at taxes on both income and wealth.

  • Adam Corlett 12th Mar '15 - 12:06pm

    The fact that the current budget deficit (even if that were what LDs were targeting) is expected to be £49.4bn in 2015-16 does not mean that that is the consolidation needed to balance that budget by 2017-18 or beyond. If you hold spending unchanged in real terms, the deficit will shrink every year as the economy and tax revenues grow and grow (over and above any cyclical fluctuation). The spending cuts and tax increases LDs would need for their 2017-18 target is probably more like £22 billion (before taking account of tax cut and spending increase promises – though these could potentially be delivered later, using the proceeds of growth).

    That said, I don’t think the £20 billion of efficiency savings figure is relevant – I assume that relates to cuts the government has already implemented: not for the period beyond 2015-16.

    I don’t think those particular figures are quite right, but the scale of cuts and/or tax increases is certainly challenging on this timescale, and I think we do need to discuss the practical implications more (i.e. which departments would we want to cut most?) within the party.

  • I can’t believe Clegg is talking about income tax cuts. Raising the personal allowance would only be acceptable to my mind if you raise taxes higher up the scale. We have had 5 years of the state being pared back. We still have a deficit of nearly £100bn. Any party that does not believe in massively reducing the size and scale of the state should be talking about raising income tax. We have an ageing population, a housing shortage and a chronic weakness in investment. I don’t see how these problems can be solved in the UK at the moment without state support. Clearly the Conservatives don’t believe in this and haven’t since 1975. I’m worried the Lib Dems no longer do either.

  • Toby Fenwick 12th Mar '15 - 12:32pm

    Tom – many thanks for a very useful – and challenging – article. Alastair is technically correct, but the reasons outlined above, your figures will be at least 95% right in my view. Adam’s point is well taken, but in the thought experiment where we left everything as it was and watched the deficit shrink, I’d be very surprised if it shrank as much as he suggests.

    On raising the PA to something like the NWM (a variable feast in that it depends on how many hours per week you decide is “full time”), the costs are very high for a policy that doesn’t actually help the poorest. If this goes ahead (as it looks like it will in the face of the evidence that sorting out NI would be more useful to low wage earners) then it will have to be funded somehow – and making it fiscally neutral by raising the required cash from the 40% and 45% bands implies either (i) a significant increase in those marginal rates, (ii) a reduction in the the thresholds or (iii) both. We should be clear what we’re proposing here.

  • Bill Le Breton 12th Mar '15 - 12:55pm

    This is really useful Tom. Congratulations. Always thought that all three party fiscal proposals were unrealistic and still do.

    In effect we have three versions of another Plan A, and as in this Parliament we shAll see that plan abandoned halfway through the next Parliament.

    Surely if we ended up 2020 with a deficit running 2% of GDP we would be doing well and have enough fuel in the tank to keep growing at present levels (see next para)

    What we also therefore really need to know is what is happening on the monetary policy side. It seems as if we have NGDP growth fairly steady at around 4.75%. We need to watch this figure very carefully and all measures of money + the exchange rate. Anything tighter than this would be dangerous, a repeat of 1937 in the US or similar ‘stops’ in Japan.

    Surely we have to err on the robust side. If Carney goes on time we need to recruit Lars Svenson

  • Simon McGrath 12th Mar '15 - 12:56pm

    Very helpful but isnt it £8bn a year extra for the NHS?

  • Toby Fenwick 12th Mar '15 - 1:02pm

    Bill – if Carney goes, we’d do a lot worse than to have Jens Weidmann.

    Tom – I was referring to the second possibility. It is of course possible to make the whole thing revenue neutral and if I were trying to do it, I’d look at how to increase taxes on families earning above the median national family income. This would be a direct transfer from the better off to the not-the-poorest, of course.

  • Charlie Kingsbury 12th Mar '15 - 1:21pm

    This was a really useful article, Tom, thanks for sharing this with us!

  • Bill Le Breton 12th Mar '15 - 1:23pm
  • Bill Le Breton 12th Mar '15 - 2:17pm

    Tom somewhere in the back of my mind was £26 billion by then,

    Let’s meet in 2020 to see If any of the Next lot of Plan As survived.

    As carney has just said, “While the MPC can be expected to look through one-off shocks, it may be appropriate to take into account persistent external deflationary forces arising from the combination of continued foreign low inflation and the protracted effects of sterling’s strength on the prices facing UK consumers if those forces were to intensify.”

    Unrealistic fiscal policies which serve only to depress investment confidence make the task far harder and puts even more strain on monetary policy. My guess is that by 2017/18 we shall be scratching our heads wondering how we can create more money with QE4!

    Wish we had the political courage to say in this election that the new plan a’s are hogwash and set out fiscal policy so as to arrive at a deficit of 26 or 30 billion by 2020. (2020 is only 2003 in Japanese time, if you understand me.) And I am not a Keynesian.

  • Denis Mollison 12th Mar '15 - 2:25pm

    On raising the personal allowance to 12.5 K. My calculation (last year) was that raising the personal allowance from 10 to 12.5 K could be paid for by raising the standard rate of income tax to 24%. This would mean less tax for those on under 25 K, more for those earning more.

  • Toby Fenwick 12th Mar '15 - 2:54pm

    Dennis – that sounds about right, but are we prepared to campaign for a 20% rise in the basic rate? I suspect not.

  • jedibeeftrix 12th Mar '15 - 3:38pm

    Makes me long for the merger of IT and NI with the following bands:
    0 – NMW= 33%
    NMW – 3.3x NMW = 41.5%
    3.3x NMW – 10x NMW = 50%

    No its, no buts. no exemptions, and no abusable tapers.

  • Malcolm Todd 12th Mar '15 - 3:56pm

    Tom Papworth – “I could find £30 billion of savings in a manner that would hardly affect most people at all, and where those who did feel the pinch would be well able to afford it.”
    I’d be genuinely interested to hear what you have in mind.
    I’m not sure why you say £30bn though — if you’re referring to Bill’s “deficit of 26 or 30 billion by 2020” then you still have to account for getting the deficit down to that figure in the first place, don’t you? Apologies if I’ve misunderstood.

  • Malcolm Todd 12th Mar '15 - 4:50pm

    Jedi – 50% tax rate? Have you had a blow to the head recently? :-O

  • Malcolm Todd 12th Mar '15 - 4:57pm

    I’ll wait with interest to see your sketch, Tom! I’m afraid that neither going to Liverpool or attending another Lib Dem conference is my idea of a fun way to spend the weekend…

  • Thank you Tom for explaining the different deficits that are being targeted and why in particular Labour and the Tories seem to be shouting at brick walls rather than debating with each other. However, whilst this discussion is undoubtedly important I am concerned that it takes up so much of our effort that the major changes in the structure of society are ignored. Some pundits are saying that the top 1% of the country own as much wealth as the bottom 55% . I am sure you will know the correct figures. This represents a huge shift towards a pre industrial revolution society. Apart from the obvious injustice this means that the middle classes are being squeezed. You may think who cares in the face of the obvious poverty of those who cannot heat their homes and who have to use food banks to survive.
    The problem is that capitalism requires the traditional middle class conspicuous consumption for the economy to grow. It also requires hope and determination to be upwardly mobile and ultimately share in the prosperity of the class above you. In turn as society becomes wealthier it can afford to help those who are unable for whatever reason to help themselves. Relative poverty being extended to over half the population can only result in the failure of capitalism as we know it.
    It is quite obvious at the present time that we are unable to provide a decent safety net to those who are struggling and at the same time reduce the deficit, whichever one you are trying to reduce. Surely it is time to make sure that benefits are targeted at those who need them rather than offering free child care to all two year olds and other broad based benefits . Means testing happened nearly a hundred years ago so surely we don’t have to be hung up on that old chestnut?
    I would like to see the party take a long hard look at these issues if the General Election gives us a result that enables us to do so, so that we can emerge with proper Lib Dem policies to address these long term problems , ready to fight another day.

  • jedibeeftrix 12th Mar '15 - 5:58pm

    @ Malcolm – 😀 apologies, perils of writing from a mobile phone. Meant to say:

    Makes me long for the merger of IT and NI with the following bands:
    0 – NMW= 0%
    NMW – 3.3x NMW = 33% (from £12,500)
    3.3x NMW – 10x NMW = 41.5% (from £41,250)
    10x NMW – infinity (and beyond) = 50% (from £125,000)

    No its, no buts. no exemptions, and no abusable tapers.

  • Philip Thomas 12th Mar '15 - 6:51pm

    I think you’ve forgotten the pledged increase in pensions (Triple Lock)- an additional expenditure commitment.

    I am no economist but I find it difficult to believe that it can *always* be true that cutting spending is better for the economy than raising taxes. Reduction ad absurdum suggests that this policy culminate in zero public spending, which I don’t think would be beneficial to the economy, even taking into account the wonderful benefits of zero taxes. There must be a point at which reductions in public spending have a worse effect than tax rises.

    In fact I thought some economists say increasing public spending is better than cutting taxes as a stimulus: spending automatically feeds into the economy whereas people can pocket the tax cut and save it or invest it outside the UK. The same logic says giving money to poor people (who generally spend everything, from necessity) is better than giving it to richer people (who save a proportion of their income).

  • Gwynfor Tyley 12th Mar '15 - 9:01pm

    There has been no debate about extending taxes to wealth beyond an extension of council tax. This is despite the clear beneficiaries of the past at least 15 years having been those who own property – with the single most valuable asset that the majority own, their house, being free of capital taxes and only bearing the lowest level of an annual tax on some historical valuation.

    Is it time to look at a total overhaul of council tax, updating valuations of all properties and uplifting the tax payable progressively. A substantial uplift in council tax however cannot go through unless accompanied by the abolition of stamp duty on principal residences – then anyone without the income or desire to meet a higher council tax will not be prevented from downsizing. The additional benefit of this would be to free up some of the 25 million empty bedrooms in this country, reducing the number of new houses needed.

    Clearly, such a policy would not go down well with Daily Mail readers, but then again, I am not sure any Lib Dem proposal ever will. Given our unfortunate position in the polls, it could be that now is the time to put forward more radical suggestions for taxation reform – whilst it is unlikely we will be in a position to implement them ourselves, we can get the debate into the open.

  • David Howarth 13th Mar '15 - 1:32pm

    Tom
    I’m afraid your remarks on the 80/20 split are very out of date. Neither the IMF nor the OECD currently advises anything like that – indeed as far as I remember neithernow gives a specific figure but instead recommends that each country looks to its own capacity for efficiency-enhancing tax increases (eg further taxing externalities and increasing property taxes) and its own capacity for efficiency-enhancing expenditure reductions (eg industrial subsidies). This is because since papers such as Baldacci et al ‘Reassessing the fiscal mix for successful debt reduction’ Economic Policy (2012:367) economists have noticed that especially for big fiscal consolidations following banking crises, the strategy of concentrating on the expenditure side risks taking out spending that itself would have enhanced economic growth.

  • Bill Le Breton 14th Mar '15 - 8:23am

    Understanding the link between fiscal policy, debt and money has recently been brilliantly explored by the social anthropologist, David Graeber, on Radio 4. The last episode is of note with its examination of the monetary effects of a ‘surplus’. http://www.bbc.co.uk/programmes/b054zdp6

    Also the LSE’s Centre for Economic Performance has recently sent out this on Austerity: Growth Costs and Post Election Plans http://cep.lse.ac.uk/pubs/download/ea020.pdf

    Looking forward to Tom’s report back from Liverpool.

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