Not just a crash diet: Improving public finances through structural reform

Transcription

1 Not just a crash diet: Improving public finances through structural reform Cathy Corrie Dr Patrick Nolan James Zuccollo March 2013

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3 Not just a crash diet: Improving public finances through structural reform Cathy Corrie is a Researcher at Reform Dr Patrick Nolan is Reform s Chief Economist James Zuccollo is a Senior Economist at Reform Reform Reform is an independent, non-party think tank whose mission is to set out a better way to deliver public services and economic prosperity. Reform is a registered charity, the Reform Research Trust, charity no This publication is the property of the Reform Research Trust. We believe that by reforming the public sector, increasing investment and extending choice, high quality services can be made available for everyone. Our vision is of a Britain with 21st Century healthcare, high standards in schools, a modern and efficient transport system, safe streets, and a free, dynamic and competitive economy. 1

4 Contents Executive summary 3 Chapter 1: Can the Budget look after itself? 5 Chapter 2: Fiscal management needs improvement 14 Chapter 3: How current plans measure up 20 References 30 Annex 1: Expenditure and receipts data 31 Annex 2: Changes in ring-fenced budgets 35 2

5 Not just a crash diet / Executive summary Executive summary A phrase attributed to J. M. Keynes is to look after unemployment, and the Budget will look after itself. The argument is that when the economy faces a downturn then spending, especially on welfare, will increase and taxes will fall. It is further argued that when the economy improves welfare spending will fall and revenues will rise, so any deficits incurred during the downturn will be automatically offset. Yet these arguments only apply to those areas of spending that adjust with the economic cycle (automatic stabilisers). Other features of the government accounts (structural spending and tax changes) do not vary in this way. Assessing the effect of a recession on the Budget and the degree to which any increase in growth will reduce future deficits (and in turn debt) thus requires estimating how much of these changes are cyclical and how much are structural. If the changes are purely cyclical then the Budget may well be able to look after itself. Yet if some of the changes are structural then the deficit will persist even when growth returns. Consequently governments cannot simply sit back and rely on growth to rescue the public finances. Structural reform will be required. This distinction should give the Chancellor grounds for concern. If the poor state of the government s accounts is due to changes in areas like pensions and health then his problems will not be solved by stronger growth. He cannot sit back and hope the finances will take care of themselves. As Reform shows in this paper, even if the Chancellor could wave a magic wand to put the economy at 100 per cent health: > Government spending would have only been 23 billion lower in This is little more than 3.4 per cent of total spending of 674 billion that year. > Tax revenues would have only been 1 per cent higher. > The deficit would have only fallen by about 40 per cent. Structural and cyclical contributions to the deficit Source: Office for Budget Responsibility (2012), Working Paper No. 3: Cyclically Adjusting the Public Finances; Reform calculations Structural debt Fiscal stimulus Cyclical debt 100 billion Fiscal year beginning These figures should not come as a surprise. Take the welfare budget. It is often assumed that this spending largely reflects economic conditions. Yet around 55 per cent of this spending goes on pensioner benefits which do not vary in this way. Department 3

6 Not just a crash diet / Executive summary for Work and Pensions (DWP) data show that even in the current recession the number of people receiving the State Pension is around twice the number of people receiving the main benefits for unemployed and disabled people. The importance of structural spending in the welfare budget has actually been strengthened by policy changes such as: > Lowering the rate at which working aged benefits are indexed, which will reduce the growth in spending on benefits like the Job Seekers Allowance that vary with the economic cycle. > Increasing the generosity of the indexation of the State Pension, which will accelerate growth in spending on this programme that does not generally vary with the economic cycle. There may be a rationale for these changes on a micro-economic level, but at a macroeconomic level the implications are clear. Their combination means that more spending is structural and so the ability of future growth to rescue the public finances is reduced. Recent history highlights another reason to doubt that the Budget can take care of itself. The UK Government was running deficits even before the Global Financial Crisis hit. In the years from to general government gross debt increased from 37.0 per cent to 43.6 per cent of GDP. This was while the economy was growing strongly and debt should have been falling. This is a reflection of a longer running problem with public fiscal management in the UK, with the government s fiscal balance only venturing above the sustainable level for 8 of the 38 years to The advent of the financial crisis amplified pre-existing problems. The Coalition s approach has failed to properly address this habit of overspending. They have protected major budgets while salami slicing others. This is like putting the public finances on a crash diet, which actually reduces the chances of long term weight loss. The result is an overall perception of underfunding while the major drivers of spending are left untouched. The NHS, pensioner benefits, schools and international aid have all been ring-fenced from cuts. Yet this spending drives some of the biggest budgets, with the health, welfare and education budgets alone accounting for 51.6 per cent of all government spending in To illustrate their importance, if these three budgets were fixed in cash terms between and , then the planned increase in total spending over these years would fall from 38.6 billion to 17.3 billion. The increase in health spending alone is equivalent to almost a quarter of all the planned increase in spending. No wonder the Coalition has struggled to hit its fiscal targets and that austerity will have to continue well into the next Parliament. Ring-fencing has meant other budgets have had to be cut deeper and major tax cuts continue to be unaffordable. Ring-fenced areas have also failed to benefit from the pressure to change and innovate, in the way that other services such as policing are already showing. By failing to address the major drivers of spending, the Coalition s approach has also threatened longer term prospects for growth. It is hard to be confident that the UK s problems with overspending will be addressed without a new approach. The problems facing the economy are structural and they require structural solutions. Crash diets do not work. 4

7 1 Not just a crash diet / Can the Budget look after itself? 1 Can the Budget look after itself? Automatic stabilisers and the business cycle 6 The effect of growth on spending and revenue 7 The effect of growth on the deficit and debt 10 The relationship in the other direction 12 5

8 1 Not just a crash diet / Can the Budget look after itself? A phrase attributed to J. M. Keynes is to look after unemployment, and the budget will look after itself. The argument is that when the economy faces a downturn then spending, especially on welfare, will increase and taxes will fall. It is further argued that when the economy improves welfare spending will fall and revenues will rise, so any deficits incurred during the downturn will be automatically offset. Yet these arguments only apply to those areas of spending that adjust with the economic cycle (automatic stabilisers). Other features of the government accounts (structural spending and tax changes) do not vary in this way. Indeed, as Robert Skidelsky noted in 1996: The champions of the welfare state have a seductive alternative strategy. If European governments were to pursue expansionary monetary policies, unemployment would come down, growth would be faster, and budget deficits would dissolve in higher revenues and lower spending. [.] This would be fine if budget deficits were purely cyclical, as they were in Keynes day. But they are now structural products of steady upward pressure on spending, combined with tax resistance. 1 Assessing the effect of a recession on the Budget and the degree to which any increase in growth will reduce future deficits (and in turn debt) thus requires estimating how much of these changes are cyclical and how much are structural. If the changes are purely cyclical then the Budget may well be able to look after itself. Yet if some of the changes are structural then the deficit will persist even when growth returns. Consequently governments cannot simply sit back and rely on growth to rescue the public finances. Structural reform will be required. Automatic stabilisers and the business cycle The automatic stabilisers are the cyclical component of the Government deficit: in recessions they may lead to more borrowing when growth falls and in boom times they may lead to surpluses. They include benefits and other support for people whose incomes fall in recessions. They may also include taxes that vary with the economic cycle. Empirical estimates put the degree of output smoothing in Eurozone countries at 20 to 30 per cent of the shock to the economy. 2 Automatic stabilisers may dampen the loss of income in recessions and reduce public spending during periods of growth. Not only may they reduce the monetary cost of a recession, but they may also diminish social costs. However, while they are essential mechanism for ensuring that households do not suffer from large shocks to their incomes in any given year, they do not change the fundamental fact that households must create the wealth that they consume. They lead to borrowing which merely allows future wealth to be consumed or invested today. There are risks associated with automatic stabilisers. They can inhibit structural change in an economy in the face of a permanent shock. 3 A permanent shock to national income may require a permanent change in government expenditure levels and patterns. There is also a risk in the other direction. What is supposed to be a temporary and automatic response may become embedded in structural policy and become permanent. It is also important to not overstate the importance of the automatic stabilisers to the government accounts. Not all of the changes to these accounts can be attributed to the operation of them and, in turn, the business cycle. Many changes reflect explicit policy decisions to make structural (persistent) spending and tax policy changes. This chapter assesses the degree to which the changes to the public finance outlook over the last few years can be attributed to cyclical or structural factors. 6 1 Skidelsky, R. (1996), Welfare without the State, Prospect, Vol 4, January, pp. 38 to In t Veld, Larch and Vandeweyer (2013), Automatic Fiscal Stabilisers: What They Are and What They Do, Open Economies Review, Volume 24, Issue 1, pp Buti and Franco (2005), Fiscal Policy in Economic and Monetary Union: Theory, Evidence, and Institutions.

9 1 Not just a crash diet / Can the Budget look after itself? These calculations are crucially dependent upon estimates of the output gap. This measure shows the amount of spare capacity in the economy through comparing actual GDP and potential GDP. The output gap is, however, difficult to measure and there is considerable dispute over the size of it. The estimates in this report are based on the Office for Budget Responsibility s (OBR s) estimates from their December 2012 Economic and Fiscal Outlook. If the output gap is larger than the OBR estimates then a greater share of the deficit will be cyclical. Yet as Figure 1 shows, the OBR s estimate for the output gap is fairly central among major forecasting bodies. Figure 1: Estimates of the output gap in 2012 Source: Office for Budget Responsibility (2012), Economic and fiscal outlook, December 2012, Chart Per cent Average -2.9 per cent Oxford Economics NIESR IMF Lombard Street Commerzbank EC Goldman Sachs OBR CBI Nomura OECD BCC Barclays Schroders IM Scotiabank Fathom Consulting *NIESR estimate is between 4.0 and 4.5 The effect of growth on spending and revenue Spending Following the approach used by the OBR, Reform estimated the share of Total Managed Expenditure (TME) that is structural and the share that is cyclical. 4 As noted above, cyclical spending varies with the business cycle and is based on estimates of the output gap. This analysis showed that the cyclical component of total spending is very small. Therefore, while the cyclical component of spending increased following the Global Financial Crisis this was only equivalent to around 26 billion in 2009, out of TME of close to 670 billion. Thus if the economy was at potential in this year (as opposed to the rate it actually was) the reduction in government spending would only be 3.9 per cent of total spending, holding all else equal. The result does not just hold for 2009 and, indeed, cyclical spending has remained elevated and actually increased in importance between 2011 and To illustrate, if the economy was at potential in , total spending would only have been about 2.7 per cent lower (as only around 19 billion of the 690 billion TME was cyclical). Consequently the automatic stabilisers have shrunk in importance. This means that growth is playing a smaller role in influencing the amount that the Government spends, and so rescuing the public finances will increasingly require structural reform. 4 Total Managed Expenditure (TME) can be separated into Departmental Expenditure Limits (DEL) and Annually Managed Expenditure (AME). Departmental Expenditure Limits (DEL) refers to the budgets for Departments, Non Departmental Public Bodies and local authorities. This includes all firm spending plans, running and procurement costs, subsidies and grants paid to the private sector, capital depreciation and receipts, and reserves. Annually Managed Expenditure (AME) refers to spending that cannot be subject to close control, such as social security and public sector pension spending, tax credits, council spending funded by council tax and other local sources and central government debt interest. 7

10 1 Not just a crash diet / Can the Budget look after itself? Figure 2: The cyclical and structural elements of TME Source: Office for Budget Responsibility (2012), Working Paper No. 3: Cyclically Adjusting the Public Finances; Reform calculations billion Total Structural billion Cyclical Fiscal year beginning As the OBR has also shown, most of the effect of the automatic stabilisers comes through spending on unemployment benefits. This is to be expected. The stabilisation effect due to spending on unemployment is estimated to be over four times the size of the effect of reduced corporation and capital taxes. The effect of reductions in income taxes and VAT takings are also found to be negligible. Most of the change in Total Managed Expenditure (TME) as a percentage of GDP is due to the change in GDP, rather than a change in TME. Nonetheless, this analysis does suggest that recent changes such as the reduced generosity of the indexing of working aged benefits will have a negative impact on the effectiveness of the UK s automatic stabilisers. Much of the spending that is often claimed to vary with economic conditions (such as welfare spending) is actually also mostly structural. On the welfare budget, for example, the largest share of the spending (around 55 per cent) is structural spending on pensioner benefits. The share that is spent on benefits that are more influenced by the cycle, such as out of work benefits like the Job Seekers Allowance (JSA), is relatively small. This can be illustrated with data on benefit categories caseload and is also reinforced with data on the duration of benefit receipt which shows that the majority of JSA recipients are on the benefit for just a short time, with the 56.4 per cent of recipients remaining on the benefit for 26 weeks or less. 8

11 1 Not just a crash diet / Can the Budget look after itself? Table 1: Share of welfare spending on pensioners (per cent) Source: Department for Work and Pensions (2012), Benefit Caseload National Statistics DWP and HMRC Benefits DWP Benefits Only The importance of policy decisions in increasing structural spending can be illustrated with recent welfare policies: > Lowering the rate at which working aged benefits are indexed reduces the growth in spending on benefits like the Job Seekers Allowance, which vary with the economic cycle. > Increasing the generosity of the indexation of the State Pension accelerates growth in spending on this programme, which does not generally vary with the economic cycle. There may be a rationale for these changes on a micro-economic level, but at a macroeconomic level the implications are clear. Their combination means that more spending is structural and so the ability of future growth to rescue the public finances is reduced. Revenue Government revenues can be similarly decomposed into their structural and cyclical parts using the coefficients estimated by the OBR. Receipts vary as a percentage of GDP far less than expenditure. As Figure 3 illustrates, revenues dropped by only about 8 billion as a consequence of the cyclical effect of the recession, while total revenues were about 550 billion in that year. Note that while revenue fell by more than this the cyclical component is relatively small as it only relates to the share that can be expected to recover automatically when growth returns (in the absence of structural reform). 9

12 1 Not just a crash diet / Can the Budget look after itself? Figure 3: The cyclical and structural elements of public revenue Source: Office for Budget Responsibility (2012), Working Paper No. 3: Cyclically Adjusting the Public Finances; Reform calculations billion Structural Total 400 billion Cyclical Fiscal year beginning The effect of growth on the deficit and debt The section above discussed the cyclical and structural influences on government spending and revenue. This discussion can be extended to show how these spending and revenue effects combine to influence the deficit and government debt. Figure 4 shows the cyclical and structural components of the deficit as a proportion of GDP. Figure 4: Structural and cyclical contributions to the deficit Source: Office for Budget Responsibility (2012), Working Paper No. 3: Cyclically Adjusting the Public Finances; Reform calculations Structural debt Fiscal stimulus Cyclical debt 100 billion Fiscal year beginning 10

13 1 Not just a crash diet / Can the Budget look after itself? Figure 4 highlights that while the deficit has begun to fall, the Government was still adding around 122 billion to the national debt in Importantly it also highlights that a large part of this deficit is structural and so will not automatically reduce as the economy recovers. Reform is required to address this structural deficit. The structural reductions in spending planned by the Coalition Government are required to shift the Budget back to balance. Consequently the operation of the automatic stabilisers has created some structural borrowing, which will become permanent in the absence of reform. There is also the question of what caused the increase in structural spending in To help answer Figure 4 separates out the borrowing required to fund the Government s 2008 fiscal stimulus package and shows that this was not sufficient to account for the rise in spending. Rather, much of the increase in spending was caused primarily by the operation of the automatic stabilisers, and much of this spending became structural as the economy contracted. This final point can be illustrated by data that shows how the UK economy is not only below potential (by 3 per cent) but is also below the previous trend (by 16 per cent). The implication is that some of the drop in incomes following the Global Financial Crisis is now permanent. Consequently the operation of the automatic stabilisers has created some structural borrowing, which will become permanent in the absence of reform. In other words, the shock to the economy from the Global Financial Crisis led to a permanent hangover. Figure 5: Nominal GDP versus trend growth Source: Office for National Statistics billion NGDP trend NGDP Fiscal year beginning The shock to the economy from the Global Financial Crisis led to a permanent hangover. Figure 5 also shows that these problems are not just a result of the Global Financial Crisis. Indeed, the UK was running structural deficits even before the crisis began. Structural deficits had been run since In contrast to the hangover from the Global Financial Crisis, these earlier deficits took place during a period of strong and steady growth, which is often referred to as the Great Moderation. These structural deficits were wholly caused by increases in discretionary spending and tax policies. These estimates of the structural deficits can be used to estimate what share of the current government debt is structural. As Figure 6 shows (which uses cumulative deficits as a proxy for debt), the large majority of the current stock of debt is structural and so will not reduce with economic growth. 5 Indeed, less than 45 billion of the total 1 trillion of public debt is purely cyclical. The remainder constitutes debt that will not be offset by the automatic stabilisers once growth returns. 5 In the short term there are small differences between the cumulative deficit and public debt as the deficit is calculated on an accrual basis while the debt is calculated on a cash basis. These two measures, however, track closely and the cumulative error over the sample period in this report is under 4 per cent. 11

14 1 Not just a crash diet / Can the Budget look after itself? Figure 6: Cyclical and structural debt (cumulative deficit) Source: Office for Budget Responsibility (2012), Working Paper No. 3: Cyclically Adjusting the Public Finances; Reform calculations Cyclical debt Structural debt billion In the current recession it would be foolhardy for the UK to run the risk of jeopardising an economic recovery by failing to address structural debt problems. Proportion of GDP Fiscal year beginning The relationship in the other direction This chapter has so far emphasised the effect that changes in growth can have on the public finances. But this relationship does not just go one way. Changes in the public finances can also affect growth. Major debates on this relationship are discussed below Debt thresholds The Government s fiscal sustainability rules require it to eliminate the structural deficit within five years. The OBR s latest forecasts indicate that the target will be met but net debt will rise to nearly 80 per cent of GDP in the meantime and gross debt is still expected to peak at 97.4 per cent of GDP in That is troubling because recent estimates suggest that gross public debt levels over 85 to 90 per cent of GDP could reduce the annual growth rate by up to 1 percentage point. Moreover, as the analysis above showed, debt will not be significantly reduced without changes to current spending patterns. In the current recession it would be foolhardy for the UK to run the risk of jeopardising an economic recovery by failing to address structural debt problems. Persistent and high debt can cause concern because of high debt levels: > Encourage pro-cyclicality of fiscal policy, which can exaggerate the economic cycle and prolong recessions. > Can decrease growth. Debt levels exceeding 90 per cent of GDP could decrease growth rates by up to 1 per cent. > Restrict governments ability to respond to crises with fiscal policy. For these reasons, it is prudent for governments to keep debt levels anchored below about 90 per cent of GDP. This, in turn, requires the deficit to be maintained at a 12

15 1 Not just a crash diet / Can the Budget look after itself? The benefits [of increasing spending] depend on the type and not just level of spending. There could thus be benefit from changing the composition of the Coalition s plans for fiscal consolidation to place greater emphasis on reducing spending in relatively less productive areas such as welfare and health. sustainable level that at least ensures a structural surplus in the medium term. These problems with structural debt will be exacerbated by demographic change. Multipliers There is concern that reducing government spending could weaken private demand and investment. However, there is mixed evidence on the macroeconomic benefits of easing fiscal policies. In the short term the benefits are often illustrated by multiplier analysis. These multipliers include both direct and (temporary) indirect effects of a change in fiscal policy. The direct effect consists of the immediate (or first round) effect on economic activity. The size of this effect depends on the responses of households and businesses to fiscal policies. Indirect effects relate to upstream effects on economic activity. These effects may offset or amplify direct effects. 6 While multiplier analysis often forms the basis for claims that in the short term more government spending generates economic benefits greater than the money spent, it is extremely hard to measure whether spending adds value in this way or not. A particular problem is that multiplier analysis often assumes that the resources employed are free and have no alternative uses. The methodology is silent on the opportunity costs involved in other words, whether the activity being funded is the best use of scarce government resources. Analysis also often fails to consider an appropriate counterfactual and how the benefits depend on the type and not just level of spending. As Reform noted in June 2010, fiscal consolidation involves a trade-off between short term economic costs and long term gains, and that reconciling this trade-off will not be pain free. Yet, as Reform went on to argue, there is a right way and a wrong way to cut public spending. The wrong way involves salami-slicing budgets and introducing measures such as a public sector pay freeze. The right way involves structural reform to allow services to offer value for money. 7 International evidence also indicates that the return from spending on economic development (such as infrastructure) tends to be higher than spending on social protection (such as welfare and health). 8 Multiplier analysis provides a much weaker case than commonly assumed for consumption spending funded by debt. There could thus be benefit from changing the composition of the Coalition s plans for fiscal consolidation to place greater emphasis on reducing spending in relatively less productive areas such as welfare and health. 6 As the Congressional Budget Office has noted indirect effects include immediate reductions in demand for goods and services from private firms [that] would prompt those firms to cut back on hiring and reduce capital investment because of scaled-back investment plans. Those reductions, in turn, would lead to additional reductions in demand and output. At the same time, the lower path of expected future budget deficits would reduce interest rates, which would spur spending and output. The enactment of a significant deficit reduction policy would probably also reduce uncertainty about future policy actions and enhance business and consumer confidence (Congressional Budget Office (2011), The macroeconomic and budgetary effects of an illustrative policy for reducing the federal budget deficit, p. 7). 7 Bassett, D. et al (2010), Budget 2010: Taking the tough choices, Reform. 8 Gemmell, Kneller and Sanz (2008), The Composition of Government Expenditure and Economic Growth: Some Evidence from OECD Countries, European Economy. 13

16 2 Not just a crash diet / Fiscal management needs improvement 2 Fiscal management needs improvement Persistent deficits 15 Not just the Global Financial Crisis 15 Fiscal rules more honoured in the breech 17 Demographic changes mean the outlook isn t much better 18 14

17 2 Not just a crash diet / Fiscal management needs improvement The government s fiscal balance only ventured above the sustainable level for 8 of the 38 years to This chapter illustrates the immediate challenge of eliminating the structural deficit and putting public debt onto a sustainable footing. It highlights how the problems in the UK public finances pre-date the 2008 Global Financial Crisis. It also illustrates the long term challenge facing the public finances due to the changing demographic outlook and demand for public services. Persistent deficits There are many measures of fiscal sustainability and, as Reform argued in 2010, the criteria used by credit rating agencies should only be seen as a minimum standard. 9 One key measure is the sustainability of the level of debt: it is essential to avoid a debt spiral where interest is paid for from new debt. This means that over the business cycle the Government must ensure that its average, annual surplus is large enough to cover the interest payments on debt. Governments may run deficits to support the economy in periods of weakness but they must, on average, have a surplus that at least covers the cost of servicing debt. If the primary surplus falls below the required level then the Government has to borrow more to service its existing debt: debt begets more debt. The level of taxation would have to rise, or the services provided fall, just for the Government s revenues to keep pace with interest payments. In December 2012 Reform compared the actual and forecast primary surpluses to the surplus that would be required to maintain a stable debt level (the sustainable surplus). 10 As debt rose the primary surplus also needed to rise to cover the increased costs of servicing the debt. However, as Reform showed, the government s fiscal balance only ventured above the sustainable level for 8 of the 38 years to Further, while the cumulative gap was not so great through the 1990s, it clearly departed from average balance since As a consequence, gross debt levels rose steadily over that period. Overall, the figures showed that the UK has not had a sustainable level of debt for some years, most notably through the boom period of the mid-2000s, when it would ideally have accumulated large surpluses. The advent of the financial crisis amplified these problems. Not just the Global Financial Crisis Governments in the UK have consistently run deficits over the past decade. These deficits have contributed to a debt burden that was rising even during the period of steady economic growth before the Global Financial Crisis. Indeed, in the period from to general government gross debt increased from 37.0 per cent to 43.6 per cent of GDP and net debt from 29.8 per cent to 36.4 per cent of GDP. 9 Bassett, D. et al (2010), Budget 2010: Taking the tough choices, Reform. 10 Zuccollo, J. (2012), Long term fiscal sustainability, Reform Ideas, No 1, Reform. 15

18 2 Not just a crash diet / Fiscal management needs improvement It is incorrect to say that the deterioration in the public finances was solely due to the Global Financial Crisis. The most important cause was poor government policy since in the UK since the turn of the century. Table 2: Government debt and the deficit Sources: HM Treasury (2012), Public Sector Finances Databank; Office for Budget Responsibility (2012), Economic and Fiscal Outlook, December Public sector net borrowing Percentage of GDP Public sector net debt General government gross debt Public sector net borrowing Value ( billions) Public sector net debt General government gross debt , , , , , , , , , , , , , , , ,830.4 Following the financial crisis there was a sharp increase in the deficit to 6.9 per cent in and then to 11.2 per cent of GDP in Since then public sector net borrowing has been on a downward track and the Office for Budget Responsibility (OBR) expects it to reach 1.6 per cent by on the back of economic recovery and the Government s consolidation plans. They currently forecast public sector gross debt to peak at 97.4 per cent of GDP and net debt to peak at 79.9 per cent of GDP in Outturns since the December forecasts are likely to result in these figures being revised upwards by the OBR in the March 2013 Budget release. As Reform has previously argued, it is thus incorrect to say that the deterioration in the public finances was solely due to the Global Financial Crisis. 12 The most important cause was poor government policy in the UK since the turn of the century. The first decade of this century saw an unsustainable increase in public spending, short-sighted and ad hoc tax policy, and high levels of government and household debt. Changes in the deficit and debt not only reflect changes in spending, but also changes in government revenue. Indeed, as HM Treasury noted in the 2010 Spending Review: In the 20 years to and the beginning of the financial crisis, public spending averaged around 40 per cent of GDP. It then increased to a historically high level of 48 per cent by Receipts by contrast did not exceed 40 per cent over the whole period, and fell to 37 per cent in These data do not include debts held off balance sheet such as liabilities under the Private Finance Initiative and public sector pensions. The also do not include liabilities accrued by the Bank of England under its Asset Purchase Facility. 12 Bassett, D. et al (2010), Budget 2010: Taking the tough choices, Reform. 13 HM Treasury (2010). Spending Review 2010.

19 2 Not just a crash diet / Fiscal management needs improvement These changes to spending and revenue reflect both the automatic stabilisers and structural changes. The effect of the automatic stabilisers should be reversed as unemployment falls and the economy returns to growth. Structural changes can only be addressed through reform. Figure 7 summarises the movement of public expenditure and receipts over both the past decade and the next five years using the OBR s forecasts. The left hand column shows the usual figures, while the right hand column shows the structural element of them: the part that does not change with the business cycle. The structural series are slightly smoother than the total series, as is to be expected since the cyclical fluctuations have been eliminated. However, much of the rise in expenditure at the outset of the financial crisis remains in the structural series, as does the drop in revenues. That suggests the worsening of the finances as a consequence of the crisis is unlikely to fully rectify itself when growth returns. Observe [the difference] between raw values in the upper row and percentages of GDP in the lower row. These two explain many of the seemingly conflicting statements about the state of the public finances. Figure 7: Impact of Global Financial Crisis on expenditure and receipts Source: Office for Budget Responsibility; Office for National Statistics; Reform calculations billion Total Structural TME Receipts 48 Proportion of GDP Fiscal year beginning The next contrast to observe is between raw values in the upper row and percentages of GDP in the lower row. These two explain many of the seemingly conflicting statements about the state of the public finances. At the beginning of the crisis receipts fell dramatically, while expenditures increased only a little, as the upper row shows. That is why some people say that the deficit is due largely to lower receipts. The lower row, by contrast, shows very little movement in receipts because they fell in line with GDP. However, expenditures, by failing to move much in value terms, rose dramatically as a percentage of falling GDP. That is why people also claim that the deficit is due to the Government s expenditure plans. 17

20 2 Not just a crash diet / Fiscal management needs improvement Fiscal rules more honoured in the breech One area where there is relatively broad agreement is the importance of credible precommitment. Fiscal rules could an important role in helping the Government commit to a sustainable medium-term plan to deal with the debt problems it faces. Yet their previous use in the UK has not been a success. From 1998 to 2008 the UK had two rules: a Golden Rule to ensure budget balance, and a sustainable investment rule to constrain total debt. These rules did not prevent the increase in government debt in the UK between 2003 and 2008, even before the Global Financial Crisis. 14 A better approach is required. International experiences with fiscal rules show a range of approaches can work, so long as they are appropriate to the situation. No one size fits all. However, key features that determine the success of fiscal rules include: comprehensive coverage of the Government s accounts to avoid gaming, the flexibility to deal with unexpected contingencies, and supporting institutions that hold the Government to account. A new fiscal rule must commit the Government to ongoing, sustainable surpluses. The current fiscal rules require revision. In particular, the rule requiring debt to be falling as a percentage of GDP suffers from the same crucial flaw as the previous government s Golden Rule: there is no clear rationale for it. International evidence shows that when fiscal rules lack a coherent rationale they become significantly weaker and far easier for governments to abandon. For the past decade in the UK, governments have been living by the idiom that rules are made to be broken. A new fiscal rule must commit the Government to on-going, sustainable surpluses. Unlike previous fiscal rules (such as the Golden Rule) these surpluses should be measured comprehensively, rather than excluding capital spending. Failure to do this will simply encourage gaming. International examples also show the importance of strong and independent oversight of fiscal rules. The Office for Budget Responsibility should thus play an enhanced role in monitoring compliance. The rule should be theirs to enforce, not the Chancellor s to break. Demographic changes mean the outlook isn t much better The need for reform is not only a result of short term changes to the public finances but also reflects the challenges posed by an ageing population and increasing costs of public services. The future costs of health and pensions entitlements particularly need to be reduced left unreformed they could severely weaken the fiscal position over the coming decades. To illustrate, Reform combined data for total spending and total taxes in Budget 2011 with Office for National Statistics projections to illustrate the long run trends for expenditure, revenue and the fiscal balance (deficit excluding debt repayments). 15 The figure showed that, even with conservative estimates, the overall outlook for the UK public finances is poor. Spending as a share of GDP was projected to increase to 43.6 per cent by This was consistent with HM Treasury s 2009 estimates that spending would increase to 43.3 per cent of GDP by Indeed, for 2038, the Reform model estimated spending as a share of GDP at 43.0 per cent Zuccollo, J. (2012), Long term fiscal sustainability, Reform Ideas, No 1, Reform. 15 Cawston, T. et al (2011), Old and broke: The long term outlook for the UK s public finances, Reform.

21 2 Not just a crash diet / Fiscal management needs improvement Figure 8: The big picture on spending and taxation Source: Cawston, T. et al (2011), Old and broke: The long term outlook for the UK s public finances, Reform % % 42% 40% 38% 36% Fiscal Balance (2011 Reforms) (Left Hand Axis) Spending share of GDP (2011 Reforms) (Right Hand Axis) Revenue share of GDP (2011 Reforms) (Right Hand Axis) 34% 32% 30% The challenge of rescuing the UK s public finances has only begun. Figure 8 also illustrates how longer term increases in costs will swamp the gains from the Coalition s plan to eliminate the structural deficit. The challenge of rescuing the UK s public finances has only begun. Even before the change to the indexation of the state pension, demographic and other pressures would lead to spending as a proportion of GDP continuing upwards, meaning that real tax burdens would have to rise. Even with an estimated increase in tax burdens from 35.5 per cent to 39.4 per cent of GDP in the 3 decades from 2011 to 2041, the government accounts were still projected to remain in deficit. Under such a scenario public finances in the UK would not be sustainable as governments would not run the surpluses required to stabilise debt. This is even before account is made for dynamic effects of changes in policy settings, such as increases in tax burdens. 19

22 3 Not just a crash diet / How current plans measure up 3 How current plans measure up Plan A 21 Where does the money go? 22 Where have savings been made ( to )? 23 What is the outlook ( to )? 26 Scope for unfunded revenue changes 28 20

23 3 Not just a crash diet / How current plans measure up Current government plans are based on a fiscal mandate to eliminate the structural deficit and have the UK government s debt shift onto a downward track. To pursue this fiscal mandate the Coalition government completed a Spending Review in This Spending Review looked out to and protected (ring-fenced) a number of budgets including the National Health Service, schools, international development and pensioner benefits. The Coalition is now planning a further Spending Round for the year and has committed to further protecting the ring-fenced budgets. This chapter assesses the degree to which ring-fencing is a factor in explaining the Coalition s ability to meet its fiscal mandate. This chapter also assesses trade-offs in continuing to protect these budgets as fiscal consolidation continues into Plan A In Budget 2010, the Coalition set out a fiscal mandate to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period and for public sector net debt as a percentage of GDP to be falling at a fixed date of To achieve this mandate Budget 2010 proposed a total consolidation of 113 billion per year by and 128 billion per year by , of which 99 billion per year comes from spending reductions and 29 billion per year from net tax increases. This consolidation would be made up of Coalition policy decisions and policies inherited from the previous administration. Coalition s proposals were for an additional consolidation of 40 billion per year by , which would be composed of 8 billion a year from net tax increases and 32 billion a year from spending reductions. Table 3: Breakdown between Coalition and Inherited Plans in Budget 2010 (, billion) Source: HM Treasury (2010), Budget 2010, p. 15 Policy Inherited by Coalition Government Total taxation Total spending Total Budget 2010 Policy Decisions Total tax policy decisions Total spending measures announced at Budget Changes to capital spending Changes to current spending Specific welfare measures Total Total Discretionary Consolidation Total taxation Total spending Total

24 3 Not just a crash diet / How current plans measure up A comparison of the plans contained in the 2010 Spending Review and the OBR data for December 2012 show that the Coalition s spending plans have remained broadly on track in cash terms. Yet, while there was little deviation from overall path in cash terms, lower than expected economic growth has meant that the Coalition has missed its fiscal mandates. There has also, however, been a significant change in the composition of the Coalition s planned consolidation. Higher than expected spending on Annually Managed Expenditure (AME) (particularly resource AME) has been largely offset by deeper cuts in Departmental Expenditure Limits (DEL budgets). Further, within the total DEL budget, the cuts to spending have fallen more heavily on resource DEL than was planned in Table 4: Existing fiscal plans to (, billion), including Depreciation Source: HM Treasury (2012), Public Expenditure Statistical Analyses; Office for Budget Responsibility (2012), Economic and fiscal outlook, December 2012, Table 4.18 Higher than expected spending on Annually Managed Expenditure (AME) (particularly resources AME) has been largely offset by deeper cuts in Departmental Expenditure Limits (DEL budgets) RDEL (Inc. DEP) Capital DEL Total DEL (Inc. DEP) Resource AME Capital AME Total AME TME Total TME (% GDP) National Account Taxes (% of GDP) Current Receipts (% of GDP) Cyclically Adjusted Current Budget Public Sector Net Debt Where does the money go? The distinction between DEL and AME made earlier in this report is important as AME includes the automatic stabilisers. By contrast, DEL is composed largely of Government services and programs such as healthcare, education, and criminal justice. Changes to DEL are not cyclical and represent persistent, structural changes in spending. DEL comprised 52 per cent of total managed expenditure (TME) in Figure 9 shows the size of major departmental budgets and the parts that are in DEL and AME. This figure shows the importance of welfare spending, which is largely AME. The importance of health and education are also shown in these data. Health has by far the largest DEL. The health, education and welfare budgets alone account for 51.6 per cent of the spending in this year. These three major budgets have all been (at least partly) partly protected from fiscal consolidation (ring-fenced).

25 3 Not just a crash diet / How current plans measure up Figure 9: Spending by department in Source: HM Treasury (2012), Public Expenditure Statistical Analyses Work and Pensions NHS (Health) Education Defence Scotland Chancellor's Departments CLG Local Government Business, Innovation and Skills Northern Ireland Wales Home Office Justice Transport International Development Culture, Media and Sport Energy and Climate Change Cabinet Office Foreign and Commonwealth Office Environment, Food and Rural Affairs AME DEL CLG Communities Further, while the Coalition may point to administrative savings to support their progress in fiscal consolidation these claims should be taken with a grain of salt. As Table 12 in Annex 1 illustrates administrative budgets make up very small shares of total DEL. While making government and administration work better is undoubtedly important, making cost savings on the scale required means going beyond seeking incremental improvements in value for money. The challenge is not to become more efficient at doing what has always been done, or to simply reduce administrative spending. The challenge is to focus resources on doing the correct things (to reform not just to cut). Making cost savings on the scale required means going beyond seeking incremental improvements in value for money. Where have savings been made ( to )? As the Institute for Fiscal Studies has shown, resource DEL (including depreciation) is expected to fall by 9.3 per cent in real terms between and This consolidation is then expected to continue so that by these resource departmental budgets are expected to be 16.9 per cent below their levels in real terms. 16 As well as looking at resource DEL, the data below show how total departmental settlements (including Annually Managed Expenditure) have changed in cash terms since To be consistent with the presentation of the data in the 2010 Spending Review these data are for resource budgets excluding depreciation. 17 Note that is used as the baseline for comparison as TME for is significantly affected by one-off accounting changes. 16 Emmerson, Johnson and Miller (eds.) (2013), IFS Green Budget: February 2013, Institute for Fiscal Studies. 17 While it is useful to note the different treatment of depreciation this does not have a material impact on conclusions. To illustrate, while resource DEL including depreciation is expected to fall by 9.3 per cent in real terms between and , the figure excluding depreciation is 8.9 per cent. 23