Could Labour and the Liberal Democrats agree on deficit reduction and spending cuts?

At first glance

How much of a difference is there between Labour and the Liberal Democrats on fiscal policy (we’ll consider the gap between other parties in future briefings)?

Labour’s policy is to get “the current budget into surplus and national debt falling as soon as possible within the next Parliament” – ‘current’ meaning excluding net investment. At the extreme, that might mean delivering a negligible current budget surplus in 2019-20. The Liberal Democrats’ headline goal is to balance the cyclically-adjusted current budget from 2017-18, and they set out their fiscal path in detail in their ‘yellow budget’.

Ignoring for now the composition of consolidation – whether spending cuts or tax increases – the graph below shows the trajectory of overall consolidation under these two scenarios: i.e. the net takeaway or giveaway relative to 2015-16. We assume the £8 billion of departmental cuts in place for 2015-16 will be unchanged in every scenario.

If the target were only to reach current balance in 2019-20, Labour could actually increase spending or cut taxes slightly each year and still meets its goal. However, this would come at the cost of extra debt: the Liberal Democrats say Labour might borrow £70 billion more than them over the next parliament, which is (roughly) the cumulative difference between the red and yellow lines below across the four years after 2015-16. Clearly these are large differences in the scale and trajectory of consolidation, with a gap of almost £30 billion in 2017-18 in these assumed scenarios.

Note: 2015-16 terms.

At second glance

However, there are reasons to think the gap between what might be acceptable for each party – given their stated commitments – is not as great as it first appears.

On the Liberal Democrat side, the detailed plans set out go beyond what is strictly necessary to reach their likely manifesto pledge. As they have said, the yellow line above “would actually meet [the target in 2017-18] with headroom of £7.7 billion”. As their pre-manifesto only referred to balancing the cyclically-adjusted current budget, they could easily reduce the planned consolidation they require if they choose.

Once this target is reached, they have suggested they would move to a target of balancing the overall budget excluding only certain ‘productive’ investment. Their figures suggest around half of net investment would be excluded, in line with earlier Resolution Foundation assumptions. However, it remains to be seen how this new deficit measure would be defined or how much emphasis they would put on it in any post-election negotiations. Were they to exclude all investment, by maintaining only their goal (and that used by the coalition) of balancing the current budget, their 2019-20 endpoint would be more like that in the Labour ‘steady’ line, ending up in essentially the same place but via a very different trajectory. (Whether cyclical adjustment is used or not makes almost zero difference beyond 2017-18, as the economy is assumed by then to be at full potential.)

On the Labour side, while a slow increase in spending to 2019-20 is consistent with the party’s stated aim, they have given indications they might go faster. First, their goal is to do so “as soon as possible” – ambiguous but certainly not ruling out an earlier date. Secondly, Ed Balls has told shadow cabinet colleagues that “you should be planning on the basis that your departmental budgets will be cut not only in 2015-16, but each year until we have achieved our promise to balance the books.” They have also proposed some departmental cuts, welfare cuts and tax increases. Thirdly, while the scenario above assumes current budget balance in 2019-20, they might target a significant surplus. And finally, they have signed up to the Charter for Budget Responsibility.

Fulfilling the Charter

The Charter for Budget Responsibility currently has the following goals:

• a forward-looking aim to achieve cyclically-adjusted current balance by the end of the third year of the rolling, 5-year forecast period;
• an aim for public sector net debt as a percentage of GDP to be falling in 2016-17.

While the Charter could be either amended or ignored by the next government, it is likely that a post-election Emergency Budget will be judged by the Office for Budget Responsibility (OBR) on these criteria. Meeting them would require plans for steeper consolidation than in the Labour ‘steady’ scenario set out above.

The dotted blue line in the graph below shows the path of consolidation that was previously needed to just meet the Charter’s goals, with cyclically-adjusted current balance in 2017-18 (the third year of the forecast period). The only difference between this and the Liberal Democrat line is the “headroom” the Liberal Democrats have given themselves.

However, an important point – made recently by Chris Giles – is that now the 2015-16 fiscal year has begun, the five year forecast period in the next fiscal statement will have moved forward a year. This means that the crucial third year, as used in the Charter’s target, is now – and in any Emergency Budget – 2018-19, not 2017-18. This shifts the necessary path of consolidation to the green line, with a maximum consolidation of £10 billion in 2016-17 – the year in which the debt target must be met. Note that the Charter does not require £30 billion of consolidation (nor did it ever), despite the repeated use of this figure in the media.

The supplementary debt target within the Charter is discussed less than the main fiscal mandate – although the logic of such an inflexible and specific target is often questioned – but it is this that drives the green line’s sharp dip in 2016-17. If the next government were indeed constrained by trying to have debt as a share of GDP falling in 2016-17, they would have little scope to depart significantly from the deficit reduction plans for that year set out in the Budget, which forecast debt of 80.2 per cent of GDP in 2015-16 and 79.8 per cent in 2016-17. If this target were removed or delayed (and indeed the target is a year later than the coalition originally planned), meeting the 2018-19 deficit goal would require only the dark red line, with a maximum consolidation of £6 billion in that year relative to 2015-16.

So there are a number of possible paths related to the Charter, in between those first implied by Liberal Democrat and Labour statements. Note that the Charter was voted for by both parties (plus the Conservatives, UKIP and DUP), and indeed the Liberal Democrats were reported to have played a role in authoring it. Therefore, although very significant differences remain between all of these five paths, there may well be some overlap in what the parties can accept.

Meeting these goals

All of the above refers to ‘consolidation’, which – while often confused with ‘cuts’ – could mean spending cuts or tax increases. However, for many on the Labour and Lib Dem sides the point of contention may be as much about the scale of spending cuts as it is about the overall pace of consolidation. It’s interesting therefore to consider what difference the tax increases that have already been floated by the parties might make to how the paths described above might be met.

The Liberal Democrats have said that tax revenues could be £6 billion higher than forecast if new measures are taken to tackle tax avoidance. The Conservatives have similarly suggested such a sum is available (£5 billion in their case), and so it is likely all parties would raise this money if possible. If this revenue can indeed be found (or at least incorporated into the OBR’s forecast), the Charter’s deficit target (a balanced cyclically-adjusted current budget by 2018-19 – the dark red line) could be met without any further spending cuts or other tax increases – although freezing departmental spending in real terms until after that time would present its own challenges.

Furthermore, the Liberal Democrats have said they could find another £6 billion from other tax increases for deficit reduction, as well as a further £1 billion for the NHS in 2016-17. Proposed changes include the ‘high value property levy’; other increases on wealth such as through Capital Gains Tax and dividend taxation; increasing the Bank Levy; potentially further changes to pension taxation; and ending Conservative policies such as the marriage tax allowance and ‘Shares for Rights’. Labour have also proposed a number of tax increases – including their own version of a mansion tax, a tobacco firm levy, closing hedge fund ‘loopholes’ and raising the top rate of tax – though some of this would be used to boost NHS funding by £2.5 billion rather than reduce the deficit.

Let’s suppose that the two parties could find £4 billion of tax increases (primarily from the wealthiest, it seems) for the purpose of deficit reduction, on top of any boost to the NHS. (To be clear: we offer no judgement in this note on the economic wisdom of relying on these sorts of taxes compared to other potential measures). In that case, including the anti tax avoidance measures, revenue might be increased by £10 billion a year, enough to meet the fiscal Charter in full (the green line) without any further spending cuts beyond 2015-16. Indeed, there would be some limited room to increase spending or cut taxes in 2017-18 and 2018-19. The graph below outlines the potential year-on-year changes in tax and spending in this hypothetical scenario (including the spending cuts already put in place for 2015-16). Once the budget target is reached in 2018-19, spending would then be able to grow in line with the economy (or taxes cut) – in this case providing some ‘proceeds of growth’ or ‘light at the end of the tunnel’ in 2019-20.

The particular assumptions made in this chart, and discussed above, are – once again – purely illustrative – rather than a prediction of what the parties may do or should do. However, it’s worth noting that this package delivers:

• Current budget balance in 2018-19 and beyond, in line with the fiscal mandate
• Debt as a share of GDP falling in 2016-17 (and indeed in every year), in line with the fiscal Charter’s supplementary goal and both parties’ aspirations, though higher than in the plans set out by the Conservatives
• No new net departmental or welfare cuts beyond those already announced
• Funding which could be used to increase NHS spending by a further £5 billion by 2020-21 (see IFS analysis and noting the possibility of earmarked tax increases), meeting the Simon Stevens proposals and a front-page Liberal Democrat manifesto goal
• A tax cut (if desired) – in this case of around £4 billion: enough to do most of the work of increasing the Personal Tax Allowance to £12,500 by 2020-21 – another key Liberal Democrat goal
• This adds up to a £15 billion increase in spending by 2019-20 while meeting the various fiscal targets and raising the Personal Allowance. By way of comparison, this is a larger increase than that implied by the SNP in recent proposals. Their plan (pre-Budget figures) saw a 0.5 per cent annual increase in departmental spending, meaning an extra £7 billion by 2019-20 relative to 2015-16.

Clearly it is possible the parties might strongly wish to go further than that (i.e. be fiscally tighter) and deliver cyclically-adjusted current balance in 2017-18 (as in the Liberal Democrat goal), or to have a surplus or buffer in other years. Labour’s suggestion that they might cut departmental spending each year until they reach their deficit goal, and the specific changes they have put forward, as well as the Liberal Democrats’ plan to shave a further £11 billion off departmental spending and £3.5 billion from welfare spending, might suggest real spending cuts could be made. But the above does not seem implausible.

We might also ask whether Labour or others could even stomach three years of deep spending restraint (if not actual cuts). Is £6 billion more from tax avoidance and £4 billion from other sources really achievable? Would the Liberal Democrats be willing to stick to the Charter as it stands today, rather than reaching balance in 2017-18 and creating new, tighter rules beyond that? And what might happen if the forecasts change and particularly if productivity growth continues to disappoint?

The answers to all of these questions are, of course, unclear. But the facts above do suggest that – once their respective wiggle room and the potential for revenue raising are considered – the fiscal gap between the Liberal Democrats and Labour may be smaller than many think. In the next briefing we’ll look at the Conservatives and the Liberal Democrats.