POLICY BRIEFING. ! Institute for Fiscal Studies 2015 Green Budget

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1 Institute for Fiscal Studies 2015 Green Budget 1 March 2015 Mark Upton, LGIU Associate Summary This briefing is a summary of the key relevant themes in the Institute of Fiscal Studies 2015 Green Budget which discusses some of the issues confronting the Chancellor ahead of his 2015 Budget Statement on Wednesday 18 March. Growth at 2.6% places the UK at the top of the G7 league table, though it did lose momentum towards the end of Growth is expected to be 3% in 2015 and 2.8% in 2016 driven by domestic markets. There are short term risks associated with an uncertain election outcome and the US and euro zone economies. Since the 2008 recession the domestic labour market has been characterised by robust employment and weak earnings growth for particular groups underpinned by weak productivity. Employment is back to its pre-2008 levels. Government debt is forecast to fall from 81.1% of national income in to reach 1% surplus in Nonetheless debt is likely to remain high by international standards for some time. All three of the main political parties have set out slightly different approaches for borrowing, but all want to see debt falling as a share of national income by at least the end of the next parliament. The 2014 Autumn Statement implies a real cut of 14.1% to departmental spending over the next parliament. However for all these parties the cuts may not be as deep as this. There is an apparent political consensus that spending on health, overseas aid (and education) should be protected, leaving considerable uncertainty for other departmental spending. What seems certain is that some will face large cuts regardless of the outcome of the general election.

2 Even if the NHS achieves it productivity target (2.4% per year) it will require a 0.8% a year real terms increase to meet demand and cost pressures. To deliver the 2014 Autumn Statement public borrowing plans without increasing taxation would require a 21 billion reduction in social security spending. Continuing the current policy of freezing most working age benefits for five years would only save 6.9 billion. The last five general elections have all been followed by net tax rises of more than 5 billion per year. This briefing will be of particular interest to elected members and officers in all authorities concerned with finance and strategic planning. Briefing in Full This briefing is a summary of the key relevant themes in the Institute of Fiscal Studies 2015 Green Budget which discusses some of the issues confronting the Chancellor ahead of his 2015 Budget Statement on Wednesday 18 March. The 2015 Green Budget comprises ten chapters spread across 293 pages. Coverage in this briefing is necessarily selective, and focuses on the prognosis for the UK economy, the public finances, and earnings growth. Not included are chapters on the global economy and on the government s financial accounts. Public Finances under the coalition In 2010 the coalition government planned to cut structural borrowing in a package which amounted to 7% of national income with the overall aim to eliminate the structural deficit (i.e. not related to the ups and downs of the economic cycle) by This fiscal tightening comprises 20% of tax rises and 80% of spending cuts to social security and public services. Over the next two years, the outlook for economic growth and tax revenues had deteriorated in large part due to fall in domestic economic output and tax revenues. This led to the coalition not to increase fiscal tightening planned for this parliament.

3 Rather it decided to extend the period of consolidation into the next (to ). This means that over the five years of this parliament (i.e. until ) borrowing is estimated to be around 100 billion higher (running at 5.7% of national income in rather than 1.9%) than was forecast in 2010 Autumn Statement. Since the 2012 Autumn Statement the outlook for public finances has little changed; structural borrowing is running at 8.4% of national income. Nonetheless, the coalition government have scheduled further spending cuts for the second half of the next parliament. Increasing the overall size of the post-crisis fiscal consolidation to 10.7% of national income to not only eliminate the deficit but to deliver an overall surplus of 1% (of national income) by This will involve 2% from net tax increases and 98% from spending cuts. This diagram, below, taken from the report shows the pace of austerity over time: Earnings since the recession Since the 2008 recession the UK labour market has been characterised by robust employment and weak earnings growth underpinned by weak productivity. Employment among 16-to-64 year olds is back to its 2008Q1 rate (of 73%) which is close to the highest rate recorded since Employment of men and women has equally held up during this period, though slightly increasing for women, reflecting longer-term trends. Employment has also risen among older adults, highly-educated individuals and relatively skilled occupations. There has also been rises in the proportions of workers who are self-employed from 13% in 2007 to 15% in 2014 Q1-3, and in part-time employment from 25% to 27% over the same period.

4 Productivity is still no higher than before the recession and has not grown since the end of Pay seems to have fallen by even more than productivity. In a competitive labour market, employee remuneration should reflect their productivity. A lack of earnings growth might therefore reflect a lack of productivity growth. But the IFS says that the key puzzle is over why productivity has fallen so much, rather than over the relationship between productivity and pay. Average earnings remain well below their pre-crisis level. This has made this recession, and the recovery from it, very different from previous ones. But while fewer people have faced losing all of their income (through unemployment) falls in (and the continued stagnation of) real earnings has meant that the pain has probably been considerably more widespread. Substantial variations in the fall of real earnings has been larger for men, young adults and in the private sector; falling less at lower points in the earnings distribution. Falls in earnings would have been larger if the characteristics of an employee had not changed since the recession, with increasing education levels pushing average earnings up. The continued weakness of earnings is due to continued weakness for given types of employee, for example (see above). There is little sign of this reversing or slowing down. The UK economic outlook The UK s economy has expanded with GDP growth of 2.6% placing it at the top of the G7 league table; though it lost momentum towards the end of last year. Lower fuel prices boosting consumer spending power is expected to propel growth to 3% in 2015 and 2.8% in Business investment is expected to make a disproportionate contribution with firms displaying confidence to spend their accumulated cash reserves. This is likely to be confined to the domestic market. Export trade is expected to only make a modest contribution over the next five years. The output gap (i.e. difference between actual GDP or actual output and potential GDP) narrowed slightly in 2014 ending the year at 4% of potential output. The prospects for output growth are favourable, with the labour supply boosted by: inward migration; a staged increase in the state pension age; and robust growth in business investment. Providing the conditions for relatively strong growth and low inflation over the medium term, with GDP growth expected to average 2.6% a year from 2015 to These forecasts from the IFS are stronger than those offered by the Office of Budget Responsibility (OBR) and other commentators.

5 However the risks around the IFS forecasts are skewed to the downside, with the forthcoming general election the most immediate source of uncertainty given the wide range of possible outcomes. A decisive result could mean changes to fiscal policy, while an inconclusive result and a minority government could undermine business confidence. However it is international events which have the greatest potential to impact on the UK outlook. Stronger recoveries in the US and the euro zone would boost UK export growth. The biggest threat would be a downturn in those international economies which could push the UK back into recession in late Public finances: a dicey decade ahead? Government debt is forecast to fall from 81.1% of national income in to reach a 1% surplus (of national income) in Maintaining a budget surplus over the longer term would have the advantage of reducing public sector net debt (expenditure less the total receipts) as a share of national income relatively quickly. Nonetheless debt is likely to remain high by international standards for some time. The IFS warns that maintaining low levels of borrowing may prove difficult, given an ageing population putting pressure on spending and given uncertainties around falling tax revenues. Future governments may find it difficult to index fuel duties as currently intended (freezing them for five years would cost 4.1 billion). There may also be pressure for more generous indexation of certain tax thresholds for instance the number of families set to lose child benefit will double in the next ten years. The public finances have also become increasingly reliant on and sensitive to the incomes and behaviour of the highest-income individuals. In , the highest income 1% of taxpayers (or just 0.57% of the adult population) paid over a quarter of all income tax revenues. And it is particularly difficult for the government to control debt interest spending and spending on social security benefits. According to independent forecasters the fiscal tightening needed to bring about a balanced budget range from 1.2% to 5.5% of national income (or 23 billion to 108 billion in real terms). These widely differing forecasts reflect the uncertainties facing public finances, including the growth in tax revenues. The government is currently planning to implement a tightening of 4.9% of national income ( 92 billion) cutting public spending to its lowest level, as a share of national income (to 35.2%) since at least Each of the three main political parties have set out slightly different objectives for borrowing, but all have said that they want to see debt falling as a share of national income by at least the end of the next Parliament. Options for further departmental spending cuts

6 The Coalition s current plans imply departmental spending cuts in real terms of 9.5% between and ; however with the protection afforded to health, overseas aid and current school funding (not capital) other departments have faced cuts averaging 20.6% over this period. The department facing the largest budget cuts is the Department for Communities and Local Government. Its communities budget is forecast to be cut by 52.5% in real terms, while its local government budget is forecast to be cut by 45.5%. The IFS say that this overstates the cut to local authority spending power over this period, since local authorities have other sources of revenue including council tax, retained business rates and user charges which have typically fallen less over this period than central government grants. The OBR forecast that local authority spending would fall in real terms by between 15% and 20% from to Actual spending over this period has differed from these plans. Resource spending has been cut more than planned in cash terms, but inflation turned out lower than forecast, so spending has been cut less than originally expected in real terms (7.8% compared with 8.3%). Real capital spending cuts have also turned out much lower than originally planned (13.6% rather than 25.9%) again, due to lower-than-forecast inflation, but also because of decisions since 2010 to top up these spending plans. The coalition government has not planned departmental expenditure after However the 2014 Autumn Statement implies real cuts of 14.1% to departmental spending between, and , returning departmental spending in real terms to around its level. The OBR forecast that these cuts would entail a cut in general government employment of 900,000 in the next parliament, on top of a cut of 500,000 since reducing the size of the government workforce, and its share of total employment, to its lowest level since at least However cuts post may not be as deep as the 2014 Autumn Statement implies. This is because all three main political parties have announced fiscal rules that would allow them to increase spending relative to those plans. They could also decide to implement a different combination of further tax increases and benefit cuts in order to lighten the load of deficit reduction on public spending. Given their fiscal rules and stated policy intentions, the Conservatives plans could imply cuts to departmental spending as little as 6.7% between and , the Liberal Democrats as little as 2.1% and Labour as little as 1.4%; compared to the 14.1% implied in the 2014 Autumn Statement. On this basis, the IFS calculate that if parties also decide to protect NHS, overseas aid and non-investment spending on schools, then this would require unprotected departmental spending to be cut by a further 13.1% by the Conservatives, 3.3% for Labour and 4.5% for Liberal Democrats (rather than the 27.0% under the Autumn Statement plans). This is illustrated in Table 7.9, taken from the report, below.

7 [Note: The IFS Green Budget was published just before the Conservatives announced that they would protect in cash terms the schools resource budget, and Labour committed to protecting the whole education budget (from early years to 18 years) in real terms, as is Liberal Democrats policy] In terms of employment levels in government the projected cuts for all three parties could also be lower at 550,000 for the Conservatives and around 300,000 for Labour and the Liberal Democrats; compared to 900,000 (see above). A 2015 Spending Review will allocate departmental budgets beyond April The IFS note the apparent political consensus among the three main parties that spending on health and overseas aid will remain protected from cuts. Leaving considerable uncertainty for other departments; though what seems certain is that some will face large cuts on top of those already delivered regardless of the outcome of the general election. Challenges for health spending The Department for Health s budget is currently planned to increase in real terms by an average of 1.2% per year between and compared with a real cut of 3.3% per year to other departmental spending over the same period. However, this is just enough to keep pace with the demands arising from a growing and ageing population. In addition demand will also increase over time as a result of the rising prevalence of some chronic conditions, improvements in access to care,

8 and improvements in technology, combined with government policy increasing the range of healthcare treatments available. NHS England and the Nuffield Trust estimates that the combined impact of demographic and these other pressures could increase demand by around 3% per year. The IFS note that up to now the health service has been assisted in coping with these additional pressures by government policy restraining public sector pay; with low private sector earnings growth helping to contain any adverse effects of this pay restraint on the recruitment, retention and motivation of NHS staff. However, as private sector wages recover, continuing pay restraint without adverse effects is likely to be harder to achieve. NHS England estimates that both those demand pressures and rising costs could create real financial pressures of around 3.5% per year and that it needs real budget increases or improvements in productivity amounting to around 30 billion ( prices) annually by to meet these pressures without a decline in service quality. The 2014 Autumn Statement forecasts, for example, imply departmental spending cuts averaging 3.7% per year between and The IFS calculate that if the NHS achieves the productivity improvements of 2.4% per year it is aiming for (reducing the financial pressures from around 30 billion to 8 billion), the DH budget would still need to increase by 0.8% a year in real terms to meet demand and cost pressures. This would imply the cuts to other departments need to average 6.1% per year rather than 3.7% per year implied by the 2014 Autumn Statement forecasts. Options for reducing spending on social security Total social security spending is forecast to be 220 billion in , around 30% of total government expenditure. According to the IFS this makes it likely that any government taking office after the general election will consider making further cuts to social security. 55% of this expenditure is expected to be spent on pensioners. A growing proportion as a result of: increased numbers of pensioners; greater state pension entitlements; and the fact that pensioners have so far been largely protected from cuts to social security. Indeed spending on pensions is expected to be 6.2% higher in real terms in than it was in , while non-pensioner spending is expected to be 6.5% lower. In other words, over this parliament rising pensioner spending has cancelled out the reduction in expenditure on those of working age. So far (i.e. until ) 17 billion of the total deficit reduction has comprised of cuts to social security benefits and tax credits. But despite these reductions total spending (on social security) is expected to be roughly the same in as it was in in real terms.

9 The Conservatives have said that they would seek to make further cuts of 12 billion to annual social security spending were they to form the next government. If carried through, this will bring social security spending in relation to national income to its average level between and (10.6%). According to IFS calculations some 21 billion per year reductions in social security would be required to the deliver the coalition s plans for public borrowing without raising taxes. To give an idea of scale of this: freezing all benefits and tax credits other than state pensions for five years would cut spending by 13 billion while continuing the Conservatives proposed freeze of most working-age benefits for five years would only reduce spending by 6.9 billion. IFS provide a range of illustrative options: making all tenants pay at least 10% of their rent ( 2.5 billion); abolishing child benefit and increasing universal credit to compensate low-income families ( 4.8 billion); reducing the generosity of means-tested support for children to its level ( 5.1 billion); and restricting benefits for families with children to the first two children (which would save around 4 billion a year in the long run). They note that many of the policies suggested by the Conservative and Labour parties, such as withdrawing winter fuel payments from higher- and additional-rate taxpayers, cutting housing benefit for young people, reducing the benefit cap, and increasing child benefit by 1% for a further year would reduce spending by relatively little. Table 9.7, below, taken from the report summarises the estimated savings from the options we consider.

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11 Options for increasing tax The IFS point out that the last five general elections have all been followed by net tax rises of more than 5 billion per year in today s terms. Although just 2% of the remaining fiscal consolidation is currently planned to come from tax rises, and none of the main political parties is proposing significant tax rises, the IFS believe that it would not be surprising to see an incoming government increase taxes in order to limit the scale of public spending cuts required to meet its fiscal targets. The IFS illustrate that of the big three taxes: a 1 percentage point rise in all rates of income tax would raise 5.5 billion;

12 a 1 percentage point rise in all employee and self-employed National Insurance contribution (NIC) rates would raise 4.9 billion; and a 1 percentage point rise in the main rate of VAT would raise 5.2 billion. All according to IFS - would weaken work incentives and hit the rich harder than the poor. The main differences between them are that the VAT rise would be less progressive than the others (as it would affect poor, non-income-tax-paying households) and that the retired and savers would not be affected by a rise in NICs (which only tax the earnings of those below state pension age). Increasing rates of corporation tax, council tax, business rates or fuel duties could also raise significant sums, though the recent trend has been to reduce the rates of these taxes. Politicians from all main parties have indicated that they think the burden of fiscal consolidation should be focused on the better-off though tax payments are already highly concentrated: for example, a quarter of income tax comes from just 0.5% of the adult population and around half comes from 3% of adults. Aside from increasing income tax or NICs rates for high-income individuals, options include increasing inheritance tax or capital gains tax. In both cases reducing thresholds might have greater revenue-raising potential than increasing rates. The IFS takes the view that introducing a separate mansion tax would be unnecessarily complicated when council tax could be brought up to date and refocused on higher-value properties. While removing various tax reliefs would leave the tax system simpler and more efficient than increasing tax rates. They see that increasing stamp duty land tax is particularly damaging and recent governments tendency to turn to it for more revenue should be resisted. And while there are sensible ways to raise more revenue from the taxation of pension saving, the widespread proposal to restrict income tax relief on pension contributions to the basic rate is misguided. Comment The Chancellor s Budget Statement on 18 March is a key milestone on the road to May s General Election. Coming just before the ballot box it will be characterised - as previous pre-election Budgets - by the embellishment of what has come before with one eye on the electorate. Contentious issues may be ignored or kicked into the long grass. In any case they can be addressed in the emergency budget after the election.

13 The election is very likely to be followed regardless of the result - by an emergency Budget in mid-to-late June. This will involve an immediate re-prioritisation of departmental budgets for followed over the summer months by a formal Spending Review setting departmental budgets certainly for and and quite possibly for the rest of the parliament. The outcome of that review can be expected to be announced in late October. External Links IFS Green Budget 2015 Report Related LGIU Briefings Autumn Statement 2014: Analysis Local Government Finance Settlement 2015/16: Analysis For more information about this, or any other LGiU member briefing, please contact Janet Sillett, Briefings Manager, on janet.sillett@lgiu.org.uk