Britain's emergency budget
All the scenarios are painful, but some make more sense than others
FROM the outset Britain’s new coalition government has said that its main task is to tackle the yawning fiscal deficit, which hit a peacetime record of 11.1% of GDP in 2009-10. It will set out its plans in an “emergency” budget to be presented on June 22nd. The decisions made by George Osborne, the Conservative chancellor of the exchequer, working with Danny Alexander, the Liberal Democrat at the Treasury in charge of controlling spending, will be momentous, determining, perhaps, the government’s own longevity as well as Britain’s economic prospects.
In practice the budget will have to take into account the compact between the Tories and Lib Dems, as well as each party’s election pledges. But in principle this is an opportunity to start afresh, sweeping aside their own commitments and plans inherited from Labour, and learning from the experience of other countries that have had to impose big clampdowns. The question is how to close the fiscal gap while protecting a still delicate economy, securing public support through a distribution of pain that is seen to be fair.
The first step is to establish just how deep a hole has to be filled. On June 14th the new Office for Budget Responsibility (OBR), now in charge of fiscal forecasting, put the deficit in the financial year to March 2011 at £155 billion ($229 billion), or 10.5% of GDP, before any changes by the current government.
What matters most is the shortfall likely to persist after the economy has fully recovered, unless spending is cut and taxes are raised. On the new forecasts, the permanent weakening in the public finances from the financial crisis and recession is 5% of GDP, according to the Institute for Fiscal Studies (IFS), a think-tank. But that is based on a central projection from the OBR and Mr Osborne may want to build in a safety margin of up to 1% of GDP. Moreover, interest payments will rise by close to 1% of GDP between this year and 2014-15 because of the deluge of borrowing. Taking this into account, the cyclically-adjusted primary budget balance (which excludes interest payments) would need to improve by around 7% of GDP.
Mr Osborne must also decide how swift the consolidation should be. He has already announced net spending cuts worth 0.4% of GDP for 2010-11. A further 6.6% off the deficit by trimming expenditure and raising taxes in the four years to 2014-15 would mean an annual improvement in the structural primary balance of over 1.6% of GDP. If he takes it more slowly over five years, he could reduce the deficit by just 1.3% of GDP a year.
As the chart shows, international experience suggests that either would be feasible. In the ten biggest consolidations since the late 1970s (and Britain’s would rank among them), the average pace of deficit-cutting was 1.9% of GDP a year, according to a study by the OECD. A quick workout now would calm bond vigilantes who fret about Britain’s borrowing, and could to some extent be offset by keeping interest rates lower for longer.
But Mr Osborne will need to take into account the fragility of Britain’s economy these days: the OBR is less optimistic than the previous government about its immediate prospects and also thinks that the long-term trend rate of growth is lower. And the troubles of the euro area, Britain’s biggest trading partner, also argue for a pace that is not too punishing. John Hawksworth, an economist at PricewaterhouseCoopers, an accountancy firm, thinks a fiscal consolidation of around 6.5% of GDP is needed and favours the more gradual approach. This would match the pace of Britain’s previous retrenchment, over six years, in the 1990s.
So what are the options for healing the public finances? If Mr Osborne wiped the slate clean, he could at one extreme rely entirely on spending cuts or at the other on tax rises. The OECD study found that cures based mainly on expenditure cuts tended to be more successful in stabilising the public finances. But Stéphanie Guichard, its main author, says that when fiscal consolidations are large they typically require tax rises as well as spending cuts. There are two particular reasons why higher taxes should take some of the strain in Britain.
The first is that in the middle of the previous decade the exchequer became unhealthily dependent on buoyant receipts from frothy finance and property markets. These will not return on the same scale. The second is that fiscal consolidation will succeed only if the public accepts the package as fair. Since spending cuts tend to hurt poorer people more, it is vital to show that richer folk, who usually pay more tax, are also feeling the pinch, according to Jens Henriksson, who worked on Sweden’s fiscal retrenchment in the 1990s.
Unwelcome though it is, a contribution from higher taxes is required. Just how big it should be is a matter of dispute. The Tories have said they want to rely on taxes for a fifth of the consolidation. That may be too ambitious. If something like 2% of GDP were found by higher taxes, leaving spending to be cut by 5% of GDP, it would still be a tougher mix than all but two of the ten biggest OECD deficit-cutters managed.
Mr Osborne has several choices in raising these revenues. First of all, there is the legacy of planned tax increases left by his Labour predecessor, Alistair Darling, which build to 1.2% of GDP by 2014-15. Of this, just under half comes from higher income tax, including a new 50% top rate on annual incomes above £150,000. Higher national-insurance contributions (NICs) will raise another 0.4% of GDP. The rest is to come from increases in alcohol, fuel and tobacco duties. Although the Tories pledged before the election to reverse most of the NIC increase, that still left them in effect planning for 0.8% of GDP from extra taxes as a result of Labour’s measures.
Mr Osborne could choose to annul all his predecessor’s tax changes, including those already implemented this year, and replace them. There are arguments for sweeping them aside. The new top rate of income tax may well alienate more rich people than raise revenues from them, and the associated pension provisions are nightmarishly complicated.
On strictly economic grounds, it would be better to raise money through higher VAT or, for example, a new carbon tax. Consumption taxes are generally thought to have smaller adverse effects on growth than most other types of tax and are certainly less distorting than corporate or personal income tax, as a 2009 OECD study confirmed. If, for example, the main rate of VAT were lifted from 17.5% to 21%, this would raise 1% of GDP—more, if some exceptions from it, such as that for books and newspapers, were removed. A carbon tax could raise a similar amount and, properly designed, could have the further merit of helping Britain to lower its emissions of greenhouse gases (see article).
The snag with both, however, is that they are regressive, meaning that poorer households would fork out proportionately more of their income paying them than richer ones. If the coalition government is to come up with a plan that will not lead to serious protests, it may have to stick to some of Labour’s income-tax imposts on the better-off while raising allowances to help low to middling earners. For the same reason, there may be a case for raising the rate of capital-gains tax on non-business assets, as the government proposes, provided that gains are indexed for inflation. Taken together, such measures will enhance the perceived fairness of the fiscal-consolidation package, and could then be supplemented by a carbon tax or higher VAT to raise an additional 1% of GDP. A further 0.2% could come from other measures, such as a mooted levy on banks.
That leaves spending, and the remaining 5% of GDP needed to balance the books. On May 24th the chancellor announced a first tranche of cuts worth 0.4% of GDP in the current financial year, so he has 4.6% still to find. According to the OBR, total expenditure in this financial year (before the cuts outlined last month) will be £701 billion, or 47.5% of GDP.
The single biggest component is welfare, which makes up 28% of the total. Around 55% is spent on the public services, such as health and education, and administration. A third category is a miscellaneous bunch of commitments, some of which, including debt-interest payments (2.9% of GDP this year), are unavoidable.
Indiscriminate cuts in welfare would run against the imperative of a socially fair package, since most of the spending goes in state pensions to workers in general, and to the poor and needy. But quite a chunk does not. At present, for example, all families with dependent children receive child benefit, and some quite well-off ones also get extra help through the child-tax credit, which is mainly for poorer families. If the two were combined and means-tested, there could be a saving of around £6.5 billion a year, according to the IFS.
Special benefits for pensioners, who will be gaining from separate plans to shore up the basic state pension, could also be reduced. One candidate is winter-fuel payments, which go to all households with someone over 60. This is a poorly directed benefit, as only 12% of recipients pay more than 10% of their income to heat their homes adequately (the “fuel poverty” which the transfer is meant to alleviate); scrapping it would save £2.7 billion. Ditching free bus travel for the over-60s and free television licences for the over-75s would save £1.6 billion.
And there is scope for other savings. For example, cutting the share of child-care costs that can be refunded through a tax credit from 80% to 50% could save £700m. Tightening the disability-living allowance and housing benefit in the private rented sector could raise £3 billion and £700m respectively, according to the Social Market Foundation (SMF), a think-tank. Altogether, these measures would clip 1% of GDP off the welfare bill.
Such a package would mean that the Tories, in particular, had to jettison pledges, notably over pensioner freebies. But unless substantial savings are made in welfare, public services will pay a disproportionate penalty. Even with a welfare clampdown of this magnitude, another 3.6% of GDP will be needed. Cuts will fall mainly on the departments responsible for the public services.
The next important decision Mr Osborne must make is what balance to strike between current and capital spending, on roads and rail and the like. Mr Darling had already pencilled in investment cuts worth 1.5% of GDP. This seems excessive, repeating the mistake often made in the past of slashing capital spending when times are hard; this has left the country with a poor transport system, for example. For Britain to emerge from its fiscal crisis not only must the deficit shrink but the economy must grow, and this means adequate infrastructure. The government might want to cut net investment by no more than 1% of GDP. That, in turn, would mean reducing current departmental spending by around 2.6% of GDP.
An obvious target is the government’s own pay bill, which makes up a quarter of total spending. Public-sector workers are paid much more than private-sector staff. In 2009 average hourly wages were 15% higher for men and 25% higher for women. But the public workforce is better educated and qualified. Once these differences are stripped out, men in the public sector earn 2% and women 7% more, for an average premium of 5%, according to research by Antoine Bozio and Paul Johnson of the IFS.
This suggests scope for a real cut in public pay of around 5%, which could be delivered through a two-year pay freeze. The gross saving would be £8.9 billion, though some of the effect would be lost in lower taxes. Even so it would deliver a net saving of £5.5 billion, or 0.4% of GDP.
The pensions gap between the public and private sector is greater still. More generous and much more widespread pension provision boosts public pay by a further 12% compared with the private sector, according to the IFS researchers. An increase in public-sector employee contributions of, say, two percentage points would raise £3 billion, or 0.2% of GDP, according to the SMF. Broader reform of the system could take place in slower time.
A squeeze in public-sector employment will also produce substantial savings. The government head count grew by 13% in the decade to 2009. Some of the extra staff were required but a 7.5% cull might be necessary now, bringing down the payroll by 400,000 or so. The potential saving would depend on how many of the job losses were among the lower paid and on whether it caused higher unemployment, pushing up benefit bills, but it might be around 0.8% of GDP. The job losses could be lower if more swingeing cuts in pay and perks were made.
The CBI, an employers’ group, thinks there is also scope for additional savings. Susan Anderson, who heads its public-services unit, argues that public managers will now be forced to make changes, such as sharing or outsourcing services like payroll and service-desk support. Procurement could also be tightened. Bigger economies will come in the medium-term by comprehensively reconfiguring the way that public services are provided. Such savings could build up to 1.2% of GDP.
The need to cut public services should spur more fundamental reforms. The funding bonanza they have had over the past decade has been accompanied by falling productivity. It is time to concentrate on reforming the provision of health care and education, essentially resuming the supply-side liberalisation pioneered by Tony Blair, while also moving towards more co-payment and user fees.
Unfortunately, what would be manageable if cuts were made across all public services has been made much harder by the government’s promise to ring-fence some of them, notably the enormous health budget. The problem with safeguarding favoured services is that less favoured ones face steeper real cuts. And there are pressures to widen the inner circle.
This became clear with the Treasury’s first tranche of cuts in May, mainly in departmental budgets. Because health, overseas aid, big chunks of education and defence were shielded, the cuts elsewhere were much deeper than logic dictated. Several ministries, including transport and environment, lost 5% or more of their planned budgets for 2010-11 at a stroke.
Yet among the bad news lurks a little good. The crisis has forced people to focus on the state and what it should provide—free, for a fee or not at all—and in the nick of time. An ageing population will require more spent on pensions, health and social care in the 2020s. Mr Hawksworth, of PWC, thinks a further fiscal tightening equal to two or three percentage points of GDP will be needed to counter those costs. No bad thing to get the public finances in hand before then.
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