Budget reflections

It is usually wise before commenting on the budget to reflect for a few days. Often what appear to be the principal issues on the day recede in importance on reflection and other matters, often buried inadvertently or deliberately in the Budget Red Book, come to the fore. In the case of the budget for 2009 the principal forces at play were clear even before the Chancellor rose to speak: the economic recession was going to dent the public finances in two ways – tax revenue would fall and public expenditure on programmes such as social security and debt interest would rise.

These issues had been highlighted in November’s Pre Budget Report, although the forecasts were viewed by most independent commentators as being optimistic. In the event the state of the public finances, as revealed by the Chancellor on 22 April, were dreadful. The collapse in tax revenues (£39.4bn lower than in the Pre Budget Report) and the growth in public expenditure (an increase of £17.7bn in Total Managed Expenditure since last November) meant that even on the Treasury’s forecasts the public sector deficit this year would be £175bn and over the next five years the cumulative deficit would total £703bn, equivalent to £11,500 for every man, woman and child in the UK. The one crumb of comfort is that even after such an increase in debt the total public debt as a proportion of GDP at 79 per cent by 2013-14 could still be manageable and will be comparable to some other advanced countries, as Professor James Foreman-Peck noted yesterday.

Much attention since the budget has been focussed on three factors: the forecasts for economic growth which are viewed by many as still being unduly optimistic; the decision to levy a higher rate of income tax on those earning over £150,000 a year; and the planned efficiency savings in the public sector. Given the uncertainties surrounding the global economy whether or not growth resumes at the end of this year and hits 3.5 per cent in 2011 is probably academic at this stage. Forecasting, always a hazardous exercise, is even more so given the uncertainties. The decision to raise the rate of income tax to 50 per cent on those earning more than £150,000 may be symbolically significant but the increase in revenue by 2011-12 will be a modest £1.8bn according to the Treasury forecasts. A much more material consideration is the impact of the planned efficiency savings but many of these are timed for 2012-13 and later which conveniently fall outside the forecasting cycle in the budget which is up to 2011-12.

The UK’s Public Finances

An important point to make is that while the current contraction in economies around the world is exacerbating the position it has been clear for some years that the UK’s public finances were in a mess. Between 1999 and 2009 cash GDP grew by 52.4 per cent, income from taxes and duties grew by 42.1 per cent whilst nominal public expenditure grew by 92.3 per cent. As many have pointed out over recent years, after abandoning ‘prudence with a purpose’ at the start of the decade, public expenditure growth has been at an unsustainable level. We have had the boom, now we have an almighty bust. The only certainty is that there will be a need for radical action to start to address the public finances: action much more radical than that outlined in the budget. It can be argued that whilst most advanced economies around the world are suffering from the recession the UK is in a particularly poor state because of the poor management of its public finances over the last decade.

Unfortunately, because there will be a UK General Election within the next year, the UK Government is reluctant to specify the far-reaching actions they will have to take in the event that they are in power after that election. For similar reasons the Conservatives are also unready to be too specific. Given the scale of the problem there will have to be a combination of tax increases and spending cuts. What we do know is that over the course of the next Parliament 30 per cent of the fiscal tightening will come from lower capital investment in the public sector, 50 per cent will come from other cuts in public expenditure and 20 per cent only from tax increases (IFS April 2009). The mantra of growing public expenditure more slowly than GDP used in the past and still being clung to by both principal UK parties will not work. Both parties will also be all too aware of what has happened in Ireland, the country with its public finances in a comparable mess to the UK. There the government has raised taxes and cut public expenditure. While this may be the right thing to do financially it has been rewarded with a slump in popular support (in Ireland Fianna Fáil polled 23 per cent – the party’s lowest ever recorded result).

Tax and Spend

If serious steps are to be taken to close the public sector deficit over the coming years then it is inconceivable that taxes will not have to be raised further and some spending programmes will not have to be cut. While a case can be made for delaying these moves until decline in the economy has levelled out, planning for these cuts should be underway now.

Public Expenditure

The Government has stated that current spending will grow by 0.7 per cent in real terms between 2011-12 and 2013-14 compared with a planned 1.1 per cent in November’s Pre Budget Report. As has been demonstrated by the Institute of Fiscal Studies it is probable that all this growth will be swallowed up by increased expenditure on debt interest and social security with none being available for health and education and other programmes. The Government has avoided the term ‘cuts’ and has called for efficiency savings. It is probable that there will have to be both cuts and efficiency savings. At the same time public sector net investment ‘will move’ (in plain English: be reduced) to 1.25 per cent of GDP. Three public spending programmes account for 59 per cent of public expenditure: education; social security; and health. If serious reductions in public expenditure are required some of these programmes will have to be cut.

Taxation

The three main sources of tax revenue this year are income tax; national insurance; and VAT. These three taxes account for over 60 percent of the total revenue. If tax increases are to make a material contribution to closing the gap in public finances then some of these three taxes will have to be increased. It will not be sufficient simply to tax more heavily those earning over £150,000 a year. The Treasury’s estimated yield from this tax rate increase (£1.81bn by 2011-12 which is little more than the £1.75bn from fuel duty increases) is already subject to debate with the ‘Laffer effect’ being raised as usual (the Laffer hypothesis is that cutting marginal tax rates can lead to an increase in the total tax take while increasing the marginal tax rate can lead to a fall in total tax take). Given that capital gains tax is now 18 per cent irrespective of the time over which the gain is made, remuneration consultants, ever quick off the mark, are already promoting schemes where remuneration for the better off can be structured as capital gains rather than income, thus incurring tax at 18 per cent rather than 50 per cent. It is probable that the Government will either have to increase broad based taxes such as the standard rate of income tax or VAT.

Of course there may be an attempt yet again to avoid raising the rate of income tax (which was only cut to 20 per cent in 2007 when the public finances were already in difficulties: that cut cost £10bn a year) and to play around with thresholds. This is already being done for those on higher pay. Another way of increasing the tax take would be to broaden the range of goods and services on which the standard rate of VAT is levied and use part of the proceeds to target help for those on low incomes and using the remaind
er to help plug the gap in public finances. VAT is a regressive tax with those on higher incomes benefiting most from exemptions, such as food and children’s clothes. In practice it is unlikely that any political party will be prepared to risk such a move irrespective of its financial merits but it could well be that when the standard rate of VAT is restored after the temporary cut it will be raised to 20 per cent. Such an increase would yield £8bn a year.

Impact on Wales

What will be the impact here in Wales? After some confusion on budget day WAG announced that the planned budget meant a cut of £416 million next year. It is unclear as to the baseline being used in this case. Of course, it was already clear from the Pre Budget Report last November that Wales would suffer its share from the planned cuts in forecast spending of £10bn in 2010-11 and 2011-12. Some of this reduction will come though the block grant and the remainder from Whitehall programmes which are not devolved.

The Institute of Fiscal Studies is predicting that the block grants to Scotland and Wales will show no growth during the next Spending Review period. The reductions already identified and the subsequent reductions foreshadowed in the Budget will hit particularly hard in Wales because growth in identifiable public expenditure here has not kept pace with that in England and Scotland over the last decade. Real growth in England between 1999-00 and 2006-07 was 33.0 per cent, in Scotland 32.9 per cent but in Wales it was only 30.0 per cent. A difference of 3 percentage points may appear small but this represented a shortfall of £700 million in 2006-07 alone. Given that the Assembly Government acquiesced in the current funding shortfall during the good times it is unlikely to be effective in getting a sympathetic hearing from the UK Government if it seeks to plead a special case this time.

Until now it is the private sector that has borne the brunt of the recession and some commentators in Wales have taken comfort that its impact may be that much less in Wales because of our higher reliance on the public sector (23 per cent of those in employment in Wales are in the public sector compared with 20 per cent in the UK as a whole). As efficiency gains and public expenditure cuts take effect over the coming years Wales will, unfortunately, suffer due its over-reliance on public spending.

It is to be hoped that the UK Government will at least start to spell out in greater detail its planned reductions in spending over the coming years so as to enable the Assembly Government to estimate the future level of the block grant and to start planning for the harsher financial environment.