Crisis and consolidation in the public finances – reflections on our seminar with the OBR

An exciting morning at RF-HQ. In one room, the first of our Universal Credit expert panel meetings, starting the process of reviewing the current design of UC and thinking about changes that would make the policy more likely to support people to get into and progress in work. In another, the OBR arrived to launch its latest working paper – Crisis and consolidation in the public finances– a 100+ page account of the huge changes affecting government spending, receipts and borrowing in the period since 2007, and the likely shape of things to come. Between them, the two events brought a who’s who of UK economists and public policy experts through our doors.

The OBR’s paper and presentation amount to a fiscal whodunnit, adding to its already impressive catalogue of explanations and assessments of these remarkable times. It is to its credit that it continues to help shape the debate in this area with publications that are accessible, informative and data-rich. The timing of this particular paper is helpful too because it comes out just as we’re putting the finishing touches to our own update on the pre-election landscape. So what are the key takeaways?

1) Pre-crisis control of public finances was consistently undermined by erroneous forecasting.

The report concludes that pre-crisis Governments (both Conservative and Labour) were characterised by fiscal outcomes that regularly underperformed against their forecasts.

Focusing on the period after 1997 for example, it shows that after achieving a budget surplus in its first term – the product of strong growth and adherence to inherited plans for spending cuts – Labour subsequently ran annual deficits of between 2½ and 3½ per cent of GDP. Across three spending review periods, revenues came in lower than predicted. Predicted by the government that is – external forecasters were, on average, around £10 billion more pessimistic about future net borrowing.

2) The scale of the post-crisis deterioration in public finances reflects the highly unusual nature of the downturn.

As a result of disappointing receipts, increased spending on public services pushed the debt-to-GDP ratio steadily higher, leaving it just below the government’s target ceiling of 40 per cent when the crisis hit. Yet, the presence of a deficit immediately before the crisis does not explain what followed. Instead, the experience of the last few years owes much to the strange behavior of the economy.

A combination of factors – including weak nominal GDP, stubbornly high consumer price inflation, the productivity puzzle, falling real wages, the hit taken by the finance sector and very low interest rates and weak asset markets – interacted with well-established features of tax and spending policy that are recognised as good things during more normal economic times.

So, whereas multi-year spending plans are designed to prevent political short-termism, in the context of falling nominal GDP they have the effect of rapidly increasing expenditure as a share of output. Likewise, indexed-linked benefits and tax thresholds are designed to increase tax receipts and reduce welfare spending as a share of GDP over time. But in an environment in which nominal wages aren’t keeping pace with consumer prices, fiscal drag goes into reverse and benefit spending rises in relative terms.

The result – as the chart shows – is a spike in spending relative to projections at Budget 2008 and an even sharper fall in receipts.

If there’s a lesson for the future here, it’s that politicians might want to think about the extent to which they prepare for the unexpected – establishing contingencies and flexibilities around otherwise sensible rules.

3) The burden of fiscal consolidation is falling most heavily on day-to-day spending on public services.

The job of restoring public finances to balance is made much harder by the cost pressures associated with rising welfare and debt interest payments. As this chart from the report shows, sending more of GDP on these factors, means that cuts relative to GDP required in other areas is that much greater.

In this regard, receipts have done very little – any gains from tax increases (such as VAT) have been offset by tax cuts (such as the increase in the personal tax allowance) and by lower receipts from areas such as the financial sector and the North Sea. Capital spending is set to fall sharply – by around one-third as a share of GDP – but because it only ever accounted for 2.7 per cent of total output, it doesn’t account for much of the overall adjustment. Instead, the heavy lifting is being done by day-to-day spending on public services (RDEL for those who know about these things).

4) Once the process is complete, the shape of the state will look very different.

According to the OBR’s calculations, the effect of this reduction in RDEL is such that real per capita spending on public services will be cut by 23 per cent between 2007-08 and 2018-19, even as real per capita GDP increases by 3½ per cent. As a result, spending on public services is set to fall to its lowest share of GDP since 1948.

Yet overall government spending will stand at 38 per cent of GDP – roughly where it was in 2001-02 (when the budget was last in balance). What will have changed is less the size of the state, but more the shape. Reductions in public service and capital spending – themselves unevenly distributed across government departments – will have been offset by increases in welfare, debt interest and other forms of annually managed expenditure.

5) All of this might yet change, due to inevitable economic uncertainty and to potential changes in direction after next year’s election.

While the economy is perhaps on a more stable footing than was the case just one or two years ago, the forecasts of the OBR and others remain highly uncertain. Current forecasts are based on an assumption that the economy continues to normalize, with productivity and pay recovering for example. Clearly there is scope for upside and downside deviations, with implications for the public finance outlook.

But there is also a political element. The current projections are based on existing Coalition policy. The outcome of the next election will change the picture, and not just if Labour win. The Coalition partners have expressed different views about the appropriate way forward after 2015-16 (the period covered by the latest Spending Review).

The fiscal plans of the main parties remain somewhat vague this far out from the election, but their differences are potentially significant. For example, the Conservatives have vowed to deliver an overall budget surplus, while Labour has focused on the current budget – a distinction in the region of £30 billion a year. That might give Labour more to play with, but it also changes the trajectory of debt reduction.

Assessing the varying pre-election posturing is of course beyond the OBR remit. But not ours, so watch this space.