Productivity as much as politics will determine the scale of cuts and tax rises in the next parliament

The scale of fiscal consolidation in the next parliament will depend largely on future productivity growth. Assuming the parties maintained their fiscal targets regardless of the underlying economic circumstances, a future Conservative government would be in the position of tightening less under a strong productivity scenario than is implied by existing Labour plans. Equally, a weak productivity scenario would mean Labour undertaking more fiscal tightening than current Conservative plans call for. The difference in the scale of the fiscal challenge implied by alternative productivity outcomes dwarfs the – still sizeable – differences between the parties.

This uncertainty does not mean that the parties are right to be vague about their fiscal plans. Between now and the election, all parties need to close the ‘candour deficit’ and set out how they intend to meet their fiscal targets, and what these policies will look like in practice.

Much of the speculation surrounding the Budget on Wednesday has been about whether changes in the economic outlook have given the Chancellor the fiscal space to trim his pencilled-in spending cuts, or to lay out further tax cuts. This is of course a better position to be in than before the 2014 Autumn Statement, where the speculation was of low tax receipts causing a “black hole” in the public finances (though in the end this was somewhat counteracted by other factors). Both underline the sensitivity of the fiscal outlook to economic forecasts that will inevitably prove to be wrong, one way or another. And with an election looming, there are implications for the fiscal plans of all parties. Uncertainty over how much the taxman is bringing in, movements in borrowing costs and inflation form part of this sensitivity. Ultimately though, the achievability and consequence of any given deficit target will depend on the outlook for growth, and in particular productivity.

In its last forecast, the Office for Budget Responsibility (OBR) looked at two scenarios to test the sensitivity of its fiscal outlook to the degree of growth in the economy. Combining these with the parties’ stated deficit goals – and some necessary assumptions about the details of these plans – we can show the wide range of possible spending cuts and/or tax associated with these scenarios in the next parliament.

In a ‘weak productivity scenario’ growth in productivity per worker remains at around ½ per cent a year for the next five years, which is broadly in line with its recent trend. In the ‘strong’ scenario, productivity grows at close to 4 per cent a year, as it did in the early 1970s and 1980s.

It seems a safe bet (barring calamity or an extraordinary economic renaissance) that reality will fall somewhere in between the two: neither extreme should be considered likely, but nor are they completely implausible. Even in the optimistic scenario, five years of very strong productivity would nonetheless leave the UK below its pre-downturn path.

Notes: Outturn from ONS (series A4YM); projections using OBR rates

The OBR’s much-discussed public finance projections are based on the central scenario above. This alone gives large potential differences in assumed consolidation between each of the parties (given their different fiscal rules), as we have shown elsewhere.

• The Conservatives so far appear committed to the large (£21 billion) surplus laid out for 2019-20 in the Autumn Statement (or at least using this for tax cuts), and UKIP have said they would “stick to the Treasury deficit elimination plan”. This would require almost £50 billion of new spending cuts or tax increases, on top of those planned for 2015-16, though their target of budget balance could be reached without such a large surplus.
• In 2019-20, Liberal Democrat policy suggests they would run a balanced budget excluding some but not all investment spending. Excluding, say, half of capital spending – and not running a surplus – reduces the overall consolidation to around £15 billion.
• Labour’s goal of balancing the current budget (i.e. excluding all investment) could – using their slowest possible timetable – mean as little as £7 billion in new consolidation, at the cost of higher debt.

Notes: RF analysis of OBR. 2014-15 prices. Conservative and UKIP figures give a £21bn surplus in 2019-20, based on the Autumn Statement. Liberal Democrat goal taken to be a balancing of the budget excluding half of capital investment. Labour target taken here to be a balancing of the current budget in 2019-20. We have accounted for any extra consolidation needed to cover additional debt interest, having assumed that Labour follow a steady path to a balanced budget and that the Lib Dems balance the cyclically adjusted current budget in 2017-18.
Strong and weak alternatives imputed from Table 5.7 of OBR EFO December 2014. These indicative figures do not take account of other effects of changed productivity, e.g. in the need for working-age welfare, the triple-lock for pensions, the cost of government borrowing, or the implications of public sector productivity; nor any feedback from dramatically reducing or increasing public spending or taxes. Capital spending is assumed to be the same in all scenarios.

Yet as the graph above shows, the difference between the weak and the central productivity scenarios, or between strong and central, (let alone between weak and strong), is greater than the largest difference between parties. The £48 billion of consolidation – departmental cuts, welfare cuts or tax increases – implied by the central coalition figures would more than double to just over £100 billion if productivity followed the weak scenario and the surplus goal were unchanged. On the other hand, strong productivity growth would allow spending to be increased – or taxes cut – by £18 billion relative to 2015-16, while still delivering the large overall surplus. Similar differences apply with all of the parties’ targets. At the extreme (and not necessarily a plausible one), the Labour target plus strong productivity growth might allow spending to be increased by £59 billion, or 8 per cent, relative to 2015-16.

Notably, and assuming the parties retained their current fiscal targets, Labour could have to cut more than the current coalition plan – if productivity growth does not return; while the Conservatives could spend far more than Labour currently intend to – if productivity bounces back more strongly than expected.

It might be tempting therefore to say that politicians would be right to be vague about their plans and the implications of their targets for the next parliament – as they have been to a large extent. But there are good reasons to expect more.

Over recent months we have had a drip feed of new information about how far and at what pace the parties intend to go on fiscal consolidation, and – to a lesser extent – what forward-looking or conditional targets they might use to account for changing economic fundamentals. But there remains plenty of uncertainty in their positions.

The much more important gap, from the perspective of establishing clear election choices, is just how each party would deliver its deficit goal: how consolidation – whatever its size – would be divided between tax increases, welfare cuts and public service cuts; and

what they might look like in practice. In particular, the cover of a post-election Spending Review means that the division of cuts between and within unprotected departments has been largely passed over in debate, despite the prospect of significant further cuts.

It remains to be seen if the party manifestoes really will set out costed plans that meet their deficit reduction goals – as well as the spending increases and tax cuts all parties will promise – and to what extent they will rely on new and unspecified crackdowns on tax avoidance, and unallocated departmental or welfare cuts.

And while it is right not to assume that things will turn out better than the OBR projects (though many in Westminster do), the parties should also tell us, in effect, if they have any plans to get us on the strong productivity path. It is on that, rather than on changes in OBR figures, that the Budget should primarily be judged.