Spending review heralds more economic pain for Wales

Tomorrow the Chancellor of the Exchequer will unveil the outcome of his spending review for 2015-16. The last spending review covering the years to 2014-15 was in 2010 and followed close on the heels of the last UK General Election. At that time, in an article for the IWA’s the welsh agenda, I noted that “the strategy underlying the spending review is to undertake financial consolidation over four years in the hope that such swift and decisive action will lead to a revival in economic growth powered by a revitalised private sector and a diminished public sector”.

That strategy has failed. Key indicators such as deficit reduction and economic growth being way behind target. The deficit in 2011-12 and 2012-13 was £120 billion in each year and is forecast to be at this level for 2013-14. This compares with the 2010 forecast deficit of £60 billion for this year. The independent Office of Budget Responsibility is now forecasting that it will take until 2017-18 to eliminate the structural deficit. The IMF forecasts UK growth of 0.7 per cent this year and 1.5 per cent next year.

No doubt the Chancellor will plead in mitigation that no one in 2010 foresaw both the crisis in the Eurozone and the worldwide slowdown in growth. These factors have undoubtedly made recovery in the UK much more difficult. Nevertheless, those of us who criticised the strategy at the time claiming that the cuts in public expenditure were too deep and too rapid and would undermine the prospects for renewed economic growth will feel vindicated. Austerity has failed to reduce the deficit. Growth is all but stalled. And the UK has lost its AAA credit rating.

Against this background what is the outlook for the spending review to be unveiled tomorrow? In particular, what can we expect to see in terms both of the funding of the National Assembly and other public spending in Wales? Because the Labour Party has committed itself to following the current UK Government’s austerity plans at least for 2015-16, this question has additional relevance.

Whatever the outcome of the next UK General Election there is unlikely to be any material change in fiscal policy in the short term. Moreover, the UK faces the possibility of many more years of very low economic growth and a continuing decline in living standards. One virtue of the spending review is that the current UK Government will set out in detail where it plans to make additional cuts and this will challenge the Labour Party both in London and Cardiff to set out an alternative strategy. Given Labour’s commitment to adhering to the current UK government’s austerity plans in 2015-16 they will have limited room for manoeuvre.

The funding of the National Assembly is determined by the annual block grant, changes to which are determined by application of the Barnett formula. Thus to estimate what will happen in Wales we must first look at what will be planned for England. What happens in Wales is a consequence of spending decisions made for England. Whereas the secretaries of state for English departments such as education and health will be able to argue their cases with the Treasury, the Secretary of State for Wales and the First Minister will play no such part. They will merely be recipients of a note from Whitehall advising them of what the Welsh block grant will be in 2015-16.

Public expenditure is split into two broad categories: departmental expenditure limit [DEL] spending and annual managed expenditure [AME]. DEL spending is usually set three years in advance and spending departments are expected to keep within such limits. Major components of DEL include defence, health and education. In the case of AME, spending is demand driven and not so easily controlled. Such expenditure includes old age pensions, disability payments and unemployment benefits.

One of the challenges facing the UK Government is that AME continues to grow and is proving very difficult to contain. Between 2010-11 and 2017-18 it is estimated that AME will grow by 28 per cent in real terms. This is due in part to policy decisions such as protection of increases in the state pension. In addition the failure to generate sufficient growth means that expenditure on unemployment related benefits is much higher than forecast back in 2010.

Given the continuing growth in AME it is necessary to cut DEL if total managed expenditure is to be stabilised at ~£740 billion a year: a key component of the UK Government’s fiscal strategy. To achieve this target the Institute for Fiscal Studies [IFS] forecasts that DEL spending will have to be cut by 2.8 per cent in real terms in 2015-16. These cuts will not fall evenly across all spending departments because the UK Government has decided to protect certain spending programmes such as international development, health (in England) and most of education (in England). To ensure an outcome of 2.8 per cent on average, the ‘unprotected’ departments could see planned cuts averaging 8 per cent.

What does this imply for the Welsh block grant which is the principal source of funding for the Welsh Government? An estimate of the cut to the block grant can be made using base data included in the Treasury’s Statement of Funding Policy last published in October 2010. Approximately 74 per cent of changes to devolved spending in Wales is determined by changes to spending on health and education in England. To the extent that these programmes are protected in England they help to ameliorate cuts to the block grant.

However, as already noted because health and education in England are protected, much deeper cuts to other programmes will have to be made. In the case of Wales the most material are cuts to Communities and Local Government programmes. They are significant for two reasons:

• Since they are fully devolved, they have Barnett comparability factors of 100 per cent.
• They total approximately 14 per cent of those spending programmes which, in the case of Wales, are devolved.

The Institute of Fiscal Studies estimates that these Communities and Local Government department programmes will be cut by between 10 and 12 per cent. Taking the expected cuts in the DELs of each spending department and applying the Barnett formula leads to an estimate of a real terms cut in the Welsh block grant of ~2.6 per cent in 2015-16 [see Table 1]. This is slightly lower than the IFS’s estimate of an average reduction of ~2.8 per cent in total DEL for the UK.

These two estimates are not of course comparable. Total UK DEL includes those programmes which are not devolved to the National Assembly but are spent directly in Wales by Whitehall departments. Examples include elements of policing, the prison service and other non-devolved, identifiable public expenditure as well as non-identifiable expenditure. These too will be subject to real term cuts.

Table 1: Estimated Wales Departmental Expenditure Limit (£billion)

2012-13	2013-14	2014-15	2015-16
13.3	13.2	13.0	12.7
1.4	1.3	1.3	1.3
14.7	14.5	14.3	13.9

Budget 2013. HC 1033. HM Treasury March 2013 using OBR GDP deflators to derive real term changes in 2012-13 prices. Totals are subject to rounding errors.

Thus in real terms the Wales DEL will be cut by ~£370 million in 2015-16 compared with 2014-15. In cash terms the reduction will be ~£150m. No doubt the UK government will emphasise the smaller cash reduction while others will focus on the real terms cut.

The Institute of Fiscal Studies estimates that across the UK current spending will be cut by 2.7 per cent and capital spending by 3.3 per cent. The Welsh Government could, if it wished, switch some spending from current to capital expenditure. Capital spending has already taken a battering. The current UK coalition government followed closely the plans of the previous Labour Government which projected a real terms cut of 40 per cent in capital spending over four years in its last budget in 2010. The split between revenue and capital spending in Wales estimated in Table 1 is assumed to follow the pattern for the UK as a whole. 

The need to cut DEL spending means that there will be considerable pressure to contain pay increases in the public sector as well as reducing the numbers employed. The Office of Budget Responsibility estimates that up to one million jobs could be lost across the UK between 2011 and 2018. The Institute of Fiscal Studies’ worst case scenario is up to 1.2 million. Such reductions will have a disproportionate impact on Wales which has a higher proportion of the workforce employed in the public sector. It could result in the loss of up to an additional 50,000 jobs over and above those already lost. In practice there will be a trade-off between job losses and real term cuts in pay.

The other major component of public expenditure is AME which the UK Government is now seeking to cap for the first time. The bulk of AME is on state pensions and other welfare benefits. Spending on such programmes accounts for over £10 billion of public expenditure in Wales. Because the government has no direct control on the number of people eligible for the receipt of such benefits the principal ways in which it will be able to cap such spending is by cutting or, at a minimum, reducing increases in the rates of benefit and/or by tightening the eligibility criteria for such benefits. Such measures are expected to impact disproportionately on poorer people. The current UK Government has protected pensioners but the incoming administration in 2015 will face some hard choices if AME is to be capped.

Are there any grounds for optimism? There are some signs of an increase in business confidence but such sentiment remains fragile. Difficulties in the Eurozone appear to have abated for the time being but may well flare up again as in the past. The position of the banks in the UK and in the rest of the EU remains precarious with inadequate capital buffers and losses arising from non-performing assets not yet recognised in full. Until this is done banks will remain limited in their ability to lend to business.

At the same time the UK Government has been reluctant to provide a short term stimulus to the economy by making a material investment in infrastructure. Leaks from the government over the weekend hint that this may be about to change. If this proves to be true such a change of strategy, although late, is to be welcomed. Now would be a good time for such investment given that real rates of interest on government borrowing are near zero. At present the Welsh Government does not have borrowing powers and will have therefore have to rely on UK Government initiatives or seek creative ways such as Plaid Cymru’s proposed Build4Wales scheme to inject some life into our economy.