The Independent View: IFS Director Paul Johnson – Balancing the books: some unpalatable choices

Paul Johnson is Director of the Institute for Fiscal Studies. He will be speaking on ‘Balancing the books – tax and spending choices in the next Parliament’ alongside Ian Swales MP and Anne Fairpo of the Chartered Institute of Taxation, with BBC Scotland’s Business and Economy Editor Douglas Fraser in the chair, at 6.15pm on Tuesday at the SECC (Dochart 1). All conference attendees welcome.

We weren’t supposed to be here. When George Osborne delivered the Coalition’s first Budget in June 2010 the plans he set out suggested that the job of rebalancing the nation’s finances would be more or less complete by now. However, despite four years of fiscal austerity pretty much unprecedented in recent times, slower than anticipated growth means that the Government are only halfway to their goal of balancing the books.

In fairness we should remind ourselves of the scale of the task the Government took on. The deficit (that is, the amount the Government spends in a year minus the amount it raises) reached £157 billion in 2009/10 as a result of the deepest recession in around 100 years. It is still hovering around £100 billion this year. The Office of Budget Responsibility estimates that around £70 billion of that deficit is structural (as opposed to cyclical) which means £70 billion of tax increases or spending cuts over the course of the next Parliament if the Government are going to balance the books.

The next government faces four choices, none of them attractive. First, huge additional cuts to public service spending, taking us to the lowest levels since 1948. Second, not being quite so nasty to public services but making some big cuts to social security. Third, smaller cuts to spending and doing more to get debt under control later on. Fourth, substantial tax rises – not the easiest of sells, politically.

The chart below shows current government plans.

IFS chart 1

The Government’s overall deficit reduction programme amounts to around 10% of national income or roughly £150 billion. The chart shows that the proposed tightening for the next parliament is nearly all in the form of spending cuts. This contrasts with tax increases, which have been mostly front loaded.

Why is this? The chart below offers a clue.

IFS chart 2

What happened in 2008/09? The economic crisis occurred, national income decreased and spending carried on rising, so spending as a proportion of national income went up to very high levels; taxes decreased moderately.

The Government is planning to close that gap by getting taxes and spending to the same level as each other by 2018, at about 38% of national income. Despite the spending cuts in prospect, this is not in any sense a historically low level of spending. It is about the share of national income the last Labour government was spending halfway through its second term.

In terms of the money involved, even allowing for inflation, overall public spending cuts appear at first glance quite modest. Starting at 2010/11, and following Conservative plans through to 2018/19, total spending is set to go down just £33 billion, or 4.4%, over eight years. That’s roughly the same amount it rose by in Labour’s last two years in power.

So how on earth does this stack up with the massive cuts to departmental spending we’re hearing about?

Well, if we look at government spending a little closer, we see a big increase in debt interest spending. Strip that out and we see spending cuts close to 8% in what’s left. Then we see that social security costs are going up quite a lot, primarily because of an increase in pensioner benefits (there will be two million more pensioners at the end of the decade than at the beginning). Exclude social security and tax credits and we are looking at a 14% cut in public service spending generally. Leave out non-departmental public service spending such as public service pensions (rising fast!) and we find departmental public spending going down by 20%. Factor in that health, schools and international development are being protected and that implies eye-watering 36% spending cuts for local government, transport, the Home Office and every other department.

While overall public spending would not be unusually low, on these Conservative plans, spending on public services would by the end of the next Parliament be at its lowest level since World War 2 as a proportion of national income.

The Tories have said they will cut social security therefore reducing, slightly, the need for public service spending cuts. However, finding £12 billion (6% of the total) from social security budget would be a significant challenge, and would still imply cuts of 31% in unprotected departments.

How different are Labour and Liberal Democrat plans?

While George Osborne has said he wants to balance the books completely by 2018, Ed Balls has said he wants to balance the books by then on current spending. That allows him more wiggle room – about £28 billion of it. If Labour did the minimum necessary to hit their target and then allocated all the extra borrowing to easing the planned cuts to departmental spending (rather than to tax cuts or increases in benefit spending), then the cut required to departmental spending would be reduced from around 10% to around 2.4%.

The Lib Dems have stated that they will seek to balance the cyclically-adjusted current budget from 2017–18 onwards. Given that the latest OBR forecasts suggest that the output gap will close in 2018–19, meaning that cyclically-adjusted measures of borrowing are almost exactly the same as headline measures of borrowing in that year, that would leave the party with a similar commitment to Labour, with £28-29 billion of extra borrowing permitted.

None of the parties has so far identified more than a fraction of the measures they would use to hit their deficit targets. While 2.4% departmental cuts look more manageable than 10% cuts there is of course a trade-off between the benefits of higher spending/lower tax and higher borrowing and debt. This looks like being the core dynamic as we head into the election: are you willing to believe the Conservatives can make the numbers add up on spending cuts, or are you willing to accept additional borrowing and debt?

* Paul Johnson is Director of the Institute for Fiscal Studies.

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13 Comments

  • Whichever way we go there is still a lot of pain ahead as the UK recovers from the global recession. However I expect the political discourse of the general election is going to be more about “giveaways”: tax thresholds, utility bills etc than about allocating the pain. When reality hits disillusioned voters are going to be ever more likely to turn to UKIP and the like.

  • Bill Le Breton 6th Oct '14 - 10:58am

    Mr Johnson thank you for such an excellent review of the position on the fiscal adjustment paths put forward by the three parties.

    I do hope you have a moment to look at any comments and I appreciate the demands on your time may make that difficult. Here’ shopping …

    Have you had a chance to read Prof Simon Wren-Lewis’s piece on further alternative adjustment paths here,
    http://mainlymacro.blogspot.co.uk/2014/06/uk-fiscal-policy-from-2015.html

    And have you had a chance to check the scatter plots here http://econbrowser.com/archives/2013/09/gdp_growth_and which appear to demonstrate that countries that increased the structural budget balance the most between 2008 and 2012 experienced the slowest growth?

    Would you be able to comment on these?

    Do they suggest that there is a strong case for your third option listed in your piece, ‘ Third, smaller cuts to spending and doing more to get debt under control later on.’?

    It is a pity that in the coming general election no one will be campaigning for this, to me, the traditional Liberal approach to both fiscal and monetary policy.

  • Bill Le Breton 6th Oct '14 - 11:00am

    ‘Shopping’? Clearly not! Just a n unnoticed auto-correction.

  • jedibeeftrix 6th Oct '14 - 11:38am

    Thank you, this should be on the conference required reading list.

  • Everyone said that the 2010 general election was the one that no party wanted to win, and it looks like 2015 will be the same because of the painful choices that will need to be made.

    What is missing in this piece is the potential impact of economic growth on these figures. If growth is higher than the IFS assumes here (the growth rate is not made explicit in what Paul Johnson says), then the expenditure line will be slightly lower (mainly because of reduced working age benefits) and the revenue line will be higher because of increased receipts from corporation, income and other taxes, allowing the two to meet either sooner or with less pain in terms of spending cuts. Secretly, all three parties have their fingers crossed that this high growth scenario will be the case.

    What the Lib Dems need to do is to set out how they will redirect as much spending as possible into growth-generating investment in skills, infrastructure and research so that this more positive scenario can be achieved and the pain of fiscal adjustment made more bearable.

  • David Evershed 6th Oct '14 - 12:12pm

    The option for politicians to put off hard decisions and just continue to increase borrowing may not be available of course.

    If investors decide that lending to the UK Ltd is too risky then the government will be unable to pay the salaries of public sector workers without a rescue by the IMF. The IMF will then make the hard decisions for us.

    This is not theoretical. It happened to the Labour government in 1976. In exchange for IMF loans, emergency cuts had to be made by the government.

  • Bill Le Breton 6th Oct '14 - 12:54pm

    David, just remind us at what interest rate the Government can borrow at for ten years today? Absolutely no sign that the Bond Vigilantes are going short on uk gilts. If a more gradual approach to fiscal adjustment were to lead to a faster growth path, then, it is plain sense to follow that policy.

    The choice of trying to go into surplus in the next Parliament is more a political wheeze than an economic virtue.

    The Econobrowser scatter plots linked to above show that accelerated fiscal contraction in 2010 (without sufficient offsetting monetary easing) was just that … Contractionary. It delayed recovery by two and a half years as another Econobrowser chart confirms. This at huge cost to the national debt and to the life chances of uk citizens alive today and to their children and grandchildren.

  • Matthew Huntbach 6th Oct '14 - 12:58pm

    Yup, this is very sensible.

    Anyone with any sense would have answered David Cameron’s speech with arguments on this line to show he was talking nonsense, and the Conservative share of the opinion polls would have slumped. Yet only the Financial Times really said that, and the first reaction of Liberal Democrat nation image making people was “The Tories have nicked our policy”. OK, we’ve had some more sensible reaction since, but we too are in this position of being scared to face reality,and so still coming out with the politicians’ speech of which this is a very good example. Tax cuts talked up, the odd spending rise talked up, but nothing that really deeply tackles the underlying problem. And since it doesn’t tackle the underlying problem, since it is wildly over-optimistic, the result is that politicians just get condemned as being untruthful and not listening when actually they do have to do unpleasant things, they can’t provide wonderful services without tax rises, and they can’t provide tax cuts or even tax standstills without service deterioration.

    A very big part of the problem, which is just not being recognised, is that so many of these cuts have knock-on effects which cause more fire-fighting expenditure later in. Ask almost anyone who works in public service, and they’ll tell you that and be able to give examples. That’s why it just isn’t working.

    The problem is that if national government says “cuts must be made” and passes that lower down for others to work out the details, there’s no co-ordination. Everyone scrabbles around trying to find the cuts they are ordered to make, without being concerned with the knock-on effects it might have on someone else’s budget. National government may feel there’s “waste” which can easily be disposed of, but that was all done years ago. We’ve seen that putting things out to tender certainly doesn’t work well in the long-term to reduce expenditure, it isn’t the magic answer some (mostly from highly elite backgrounds with little experience of how life is for most people) suppose.

    There are huge pressures pushing spending upwards even if we appear to be standing still. Yet almost no-one in politics seems to be prepared to come out openly and acknowledge that. That lack of acknowledgement and what it inevitably leads to in what appear to be “broken promises” is now seriously damaging democracy itself. We MUST tackle it. Speeches like the one I linked to above just don’t do that.

  • Bill Le Breton 6th Oct '14 - 1:04pm

    RC , I have been making exactly the same point about growth elsewhere and getting the rather weak answer , viz ‘we can’t be sure of the effect on growth of different combinations of tax, spend and deficit over the years 2015/2020.

    That is of course absurd. If Danny Alexander asked his Treasury advisers to reveal the results of doing so using their model , we would have an answer. Perhaps that answer would be inconvenient to those advocating a fast pace of deficit elimination. He could for instance use Prof Wren Lewis’s figures for fast, medium and slow adjustment paths and share the answers with the world.

    Of course the IFS could also do this with their model. Please could you, Mr Johnson.

    I am afraid we just want to advocate this reckless fiscal policy in order to beat Labour over the head with it.

  • Bill Le Breton 6th Oct '14 - 1:22pm

    Matthew if you think the Party’s economic policy makers are saying this, then, they are trying to have their cake and eat it.

    Mr Johnson is clear about the effects of our stated fiscal rules and their implication. As he writes above, “The Lib Dems have stated that they will seek to balance the cyclically-adjusted current budget from 2017–18 onwards. Given that the latest OBR forecasts suggest that the output gap will close in 2018–19, meaning that cyclically-adjusted measures of borrowing are almost exactly the same as headline measures of borrowing in that year, that would leave the party with a similar commitment to Labour, with £28-29 billion of extra borrowing permitted.”

    Adam Corlett has made a similar calculation. And I warned last December that the Fiscal Compact that the leadership seemed willing to sign up to with the Tories then was a recipe for disaster. We would not have had that £28-29 billion of permitted extra borrowing.

    So, our slight easing of our fiscal policy is welcome but still leaves a huge hole to be filled with potentially damaging cuts or tax increases. Here again is Johnson from the op ed above, “The Office of Budget Responsibility estimates that around £70 billion of that deficit is structural (as opposed to cyclical) which means £70 billion of tax increases or spending cuts over the course of the next Parliament if the Government are going to balance the books.”

    I still believe this is both an unachievable and deeply policy which will be damaging to the long term interests of the economy and UK citizens (including their grandchildren!).

    The answer is further easing of the policy stance. See Prof Wren-Lewis’ medium to slow adjustment paths in his excellent piece that I linked to in my first comment. With such a policy we would get greater growth, more employment, lower welfare costs and higher tax revenues, ultimately bringing the deficit down more quickly .

  • Andrew Colman 6th Oct '14 - 3:03pm

    The answer is to sort out the tax system.

    There needs to be a bonfire of tax reliefs , especially at the higher rate , especially pensions related.
    Tax havens need to become a think of the past. Only those who permanently live there and conduct ALL there business there should be able to benefit from tax haven rates.
    A Land value tax needs to be seriously considered and rolled out . I suggest a 1% Per annum tax on the value of all properties with an exemption for owner occupied or tenanted proiperties worth less than the national average.
    We should also work with G7 and G20m pertness to introduce an international Tobin tax on financial transactions which will tax the gambling / short term element of the financial markets.

  • Capitalised land rent and taxes on income/capital both incur deadweight costs. The total of which for the UK have been estimated at 48% GDP by economists who have taken the trouble to study this area.

    Quite simply we could kill two two birds with one stone by using land rent as public revenue instead of private income and capital. The result of this would not only to expand our economy by 48%, but over a period of twenty years, reduce our private debt mountain by 60%.

  • Julian Tisi 7th Oct '14 - 12:29pm

    A very sobering and fair analysis except I’d challenge the politics around this. The 2010 “deficit closed by end of the parliament” target was a Conservative target (both Labour and LibDems had aimed for about half that) but more importantly 2010 saw the sovereign debt crisis (led by Greece) which made things a whole lot worse. The government pretty much abandoned Osborne’s target early on when it became unsustainable. But there was a false public debate where Labour accused the Government of cutting “too far, too fast” when in fact (as many in the City pointed out) they’d barely started cutting at all. It suited both Tory and Labour to maintain this lie that some straightjacketed plan A had been followed whereas in fact the plan adopted was more flexible (Nick Clegg tried to square the circle by saying that Plan A was always intended as a flexible target).

    It’s partly because the government did not cut early and hard that we’re still barely half way to our target of eliminating the deficit. And partly because the economic circumstances have been so very very difficult. Any government would have found this out. Blaming the lack of growth early on misses the point because in the circumstances the slowish growth was at least better than the recession others were experiencing. Comparing Britain’s growth since 2010 to anyone else in Europe and it’s clear that we’ve done at least as well as could have expected.

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