The high road or the low road? What a balanced current budget by 2017-18 does and does not mean

Taken at face value a new Charter for Budget Responsibility, with a goal of eliminating the structural current deficit by 2017-18, has potentially significant implications for the parties’ fiscal plans. This applies most to Labour – given their separate pledge to do this by 2019-20 – and to a significant extent for the Liberal Democrats. There has been some focus on the implications for the first years of the next parliament, though even here there is confusion as to just how much consolidation reaching balance in 2017-18 would require. But little attention has been given so far to the implications for the public finances over the course of the whole parliament (nor of the Charter’s debt target). Given Labour’s pre-existing pledge to reach current balance by 2019-20, the conclusion is that public spending may be at a similar level in the year 2019-20 (regardless of the new 2017-18 goal) but that this would be reached via a very different path of consolidation. If balance is first hit in 2017-18 this implies a pattern of sharp reductions in spending followed by a recovery which is likely to lead to different policy choices. If balance is delayed to 2019-20 this implies a different pattern of steady, relatively gentle, consolidation across the Parliament, but higher debt. Balance in 2017-18 would also mean significantly lower overall spending over the course of the whole parliament (compared to only achieving balance in 2019-20).

Last month, the Chancellor published an updated ‘Charter for Budget Responsibility’, which would commit the government to two objectives:

• Returning the cyclically adjusted current budget to balance over a three year rolling horizon: this implies an initial target date of 2017-18 for an incoming government in May, shifting to 2018-19 at Autumn Statement 2015; and
• For debt to be falling as a percentage of GDP in 2016-17.[1]

Without any rolling over of the target year, the Charter’s deficit goal implies new spending cuts and/or tax increases of £23 billion by 2017-18 in today’s prices (£24 billion in 2017-18 terms), on top of those coming in to effect in 2015-16. This differs from the £30 billion figure cited by the Treasury (see end note). And the new debt target requires that around £14 billion of tightening is achieved in 2016-17, to ensure net debt as a proportion of GDP is (marginally) smaller than in 2015-16.[2]

A vote on the update is due in the Commons tomorrow (Tuesday 13 January) and the indications are that all three main parties will vote to approve it. Yet, despite this apparent consensus, the parties have set out significantly different deficit pledges ahead of the election. Notably, all also differ from the aims set out in the Charter.

• For the Conservatives, the Charter’s deficit goal appears to be no more than a staging post en route to balancing the overall budget (i.e. including capital spending) – with some indication that they hope to achieve this by 2018-19.
• The Liberal Democrats have declared achieving balance on the cyclically adjusted current budget in 2017-18 to be a central goal (so the Code is closest to their previously stated position), but they too intend to go further afterwards by targeting a balance that includes some, but not all elements of the capital budget (though just how much is still unclear).
• In contrast, Labour’s focus on balancing the current budget “as soon as possible” and by 2019-20 “at the latest” suggests that they do not have any intention to go further than the goal set out in the Charter (though their apparent focus on the non-cyclically adjusted current budget marks a small distinction[3]).

On the face of it, Labour’s continued acknowledgement that its pledge might involve reaching balance as late as 2019-20 doesn’t sit straightforwardly with the Charter’s implied initial target year of 2017-18. However, it is important that this year is not fixed, and will move out one year at each Autumn Statement.[4] So it could in theory be argued that the rolling nature of the commitment may be consistent with Ed Balls’ position that the timescale for budget balance will be contingent on the performance of the economy – but with 2019-20 as a backstop. Others will argue that an implied commitment to current balance in 2017/18 is a real shift in policy even if this is on a rolling basis.

Either way there is an important prior issue about how much this week’s vote will really bind any future government who could – with a similar vote – rewrite the Charter as it sees fit. It is also worth noting that the language in the Charter has changed from ‘targets’ to ‘aims’. And rolling deficit targets have not been met in the current Parliament.

For this note, however, we take the goals of the vote at face value. Those wishing to meet the spirit of the new Charter will need to set out plans that deliver balance by 2017-18, even if those plans are subsequently changed to reflect circumstances. There is also the debt target, which is fixed in time, and is therefore a clearer commitment by all the parties (though it should also be remembered that the Coalition’s existing debt target has been pushed back by a year and has taken a clear second place relative to the main deficit target).

Same destination, different route

Notwithstanding these uncertainties, what appears clear is that Labour’s aim is to end the parliament in current balance (i.e. this assumes they don’t start building a surplus if they meet this objective at an earlier date – no indication has been given that this is what they intend). So – irrespective of whether they meet the target in 2017-18 or not, the size of the deficit in 2019-20 will be the same. Which begs the question: if the end destination is unchanged, does the chosen route – i.e. when they first achieve balance – really matter?[5]

To which the answer is ‘yes, it makes a big difference’. Taking a linear path towards balancing the current budget in 2019-20 implies a very different trajectory from one in which the cyclically adjusted current budget must also be balance in 2017-18. The former can be considered to be one of ‘steady gentle consolidation’, while the latter might, slightly tendentiously, be characterised as ‘bust and (mini) boom’. Both are set out in the chart below.

Figure 1: ’Steady consolidation’ vs ‘bust and mini-boom’

Notes: Total departmental spending excluding depreciation, in 2014-15 terms. Resolution Foundation analysis of OBR/HMT. Accounts for extra debt interest relative to the OBR projection using forecast borrowing costs. CACB = cyclically adjusted current budget.

In each instance, we consider the outlook for departmental spending if all of the required consolidation came from departmental cuts – as is the standard working assumption – rather than from welfare spending or tax increases. In practice it is very likely that any government would make alternative choices.

Under the ‘bust and mini-boom’ scenario, total departmental spending falls from £355 billion in 2015-16 to £332 billion in 2017-18. But because revenues grow in line with GDP, spending can thereafter rise in real-terms while still delivering Labour’s intended current budget balance at the end of the parliament. So, real-terms spending cuts of 3 or 4 per cent a year in the first half of the parliament are replaced by spending increases of 2-3 per cent a year in the second half.

The ‘steady consolidation’ path, in contrast, delivers Labour’s proposed current budget balance only in 2019-20, reducing departmental spending steadily in preceding years to achieve that. It does not meet the debt target in 2016-17 – but does meet Labour’s separate goal of falling debt within the next parliament. Relative to 2015-16, real departmental spending is cut by £7 billion (2 per cent) by 2019-20, rather than £23 billion (6 per cent) by 2017-18 in the ‘bust and mini-boom’ path.

If we look at the whole parliament, reaching balance for the first time in 2019-20 under the ‘steady consolidation’ path  implies a cumulative total of around £40 billion higher departmental spending over the period than would occur under the ‘bust and boom’ approach, even though spending in 2019-20 is broadly equal in both cases.

While this distinction has most relevance for Labour’s plans, it also has implications for the Liberal Democrats. The more capital spending they choose to exclude from their post-2017-18 deficit target, the closer their final destination will be to Labour’s. Potentially then, they too will commit to some form of ‘bust and mini-boom’, and indeed they have proposed to increase spending in line with GDP once their targets are reached. However, the inclusion of at least some capital spending would give them a tighter policy than Labour.

Departmental spending figures forecast by the OBR under existing Coalition plans (which appear likely to most closely match current Conservative plans) are also shown in the chart, by way of context. These deliver growing current budget surpluses (and overall budget surplus from 2018-19) – going well beyond what is needed to fulfil the Charter.

Differences

In the short term, there are big practical differences between the two paths. To help understand the significance it’s useful to consider what the two paths might feel like from the point of view of a Whitehall department. Here we look at Business, Innovation and Skills (BIS – one of the largest currently non-protected departments, whose main expenditures are science and research, higher education and further education).

The BIS budget would be subject to broadly similar trajectories as those set out in Figure 1– note that we are assuming all consolidation comes from departmental spending rather than from welfare or tax rises. Again, in practice this is very unlikely. But under this standard assumption, in the ‘bust and boom’ scenario (and with some simplifying assumptions), BIS might experience two years of large cuts to its £16-17 billion budget, totalling a 12 per cent reduction (on top of the six preceding years of cuts), followed thereafter by real increases of 2-3 per cent per year. In the ‘steady consolidation’ path, by contrast, the budget would need to be cut by 1 per cent or less for four years in a row, giving a cumulative cut of 4 per cent before spending begins to rise again. Over the whole parliament, the 2017-18 commitment would mean it would have £5 billion less to spend.

Yet it is not just the scale of consolidation that differs between the two paths. The nature of any cuts and the economic impact of tightening may also be different.

1. First, a sharp cut in spending followed by a reversal may come with inefficiencies: there may be waste associated with going through redundancies and programme closures, only to rehire and reopen a few years later, or with having volatile pay settlements. The chief executive of NHS England recently said that a “boom-bust” approach rather than steady funding was “inefficient for taxpayers and bad for patients”. The same might equally be said of a ‘bust-mini-boom’ approach to other, unprotected departments.
2. There is an alternative view, however, that that there would be benefits to having larger, concentrated cuts as they would force debates about priorities and radical changes, in contrast to an incremental ‘salami-slicing’ approach which favours doing ‘the same, but less of it’. While this may equally be considered a bad thing by some, the ‘bust-mini-boom’ approach may provide a way to move funding to where it is considered most effective, both across and within departments.
3. Tighter policy might affect the distribution of spending between departments in another way. In a ‘bust and mini-boom’ approach, it may well be unlikely that the distribution of spending increases in the ‘mini-boom’ – once the budget is in balance – would match the distribution of earlier cuts. It could be asymmetric. For example, the schools budget might well share in the real spending increase that followed balance, without (if its protection is maintained) having shared in the cuts: so for non-protected departments ‘bust and mini-boom’ might be worse than if consolidation were gentler but more protracted.
4. The other main difference between the two example paths is that one leads to higher debt – over £45 billion more over the period (though both would lead to falling debt over GDP). The ultimate question is whether the extra pain of temporary sharper consolidation is worth it for lower debt and lower debt interest. On the right of Figure 1, we show that departmental spending in the ‘steady consolidation’ scenario is actually lower in 2019-20 (though only slightly) due to the cost of paying interest on the extra debt accumulated by going slower, which (other things being equal) permanently reduces the resources available for public services.
5. Finally, there are possibly broader economic considerations: at times – particularly when monetary policy is at the zero lower bound – fiscal restraint can negatively impact on the economy. Spending cuts in 2019-20 and spending cuts in 2016-17 may not therefore have the same macroeconomic impact: it will depend on the circumstances. And in so far as fiscal choices may permanently affect the economy, different paths may not lead to the same destination. Similarly, it is also important to consider the large uncertainty here: a strict approach might prove unnecessary thanks to higher growth or a looser plan might prove insufficient to achieve a given target.

Alongside these considerations, there are also of course questions of political economy. Some might argue that a sharp down-then-up approach might be preferred politically – getting the pain out of the way earlier in the parliament and allowing for a subsequent period of spending increases later on – even if policy over the whole period would be tighter. Equally, however, the severity of consolidation in the first half of the next parliament could define the public’s views of the next government regardless of the pick up in the second half of the term. And in a world where there is currently speculation that the next administration may struggle to last a full five year term it is arguable that there would be less incentive to front-load the political pain. Finally, it is also possible that the depth of consolidation will impact on the balance parties choose between spending cuts and tax increases, with implications for distributional effects and the long-term size of the state.[6]

It is not for us to guess how these different factors might play out. But it is clear that given that Labour has suggested that they would have (at least) a balanced current budget in 2019-20 and beyond, whether or not they reach that point of balance in an earlier year does matter significantly.

Note

The government has said that “In order to meet the fiscal mandate and supplementary debt target set out in the updated charter the government estimates that on current forecasts around £30 billion of discretionary consolidation is likely to be required over the following 2 years 2016-17 and 2017-18.” Our methodology, which gives a figure of £23 billion, differs from theirs in three main respects:

1) Our figure is that needed for a balanced cyclically adjusted current budget. Theirs gives a £14 billion surplus that is not strictly necessary with respect to the Charter. Using their measure but accounting for this therefore gives a required consolidation of £16 billion (not £30 billion). Our figure accounts for the effect of extra debt interest that would need to be funded if these surpluses were not generated.
2) Ours includes consolidation that is needed to counteract changes in non-departmental spending other than debt interest – spending cuts or tax increases that are needed to offset, for example, increased state pension spending as forecast by the OBR. Theirs is only a change in total spending (less debt interest).
3) Their figure is in 2017-18 terms while ours is in 2014-15 terms.

[1] The Charter also includes the cap on welfare spending.

[2] This number is very sensitive to the economic forecast and represents a fall in debt from 81.1 per cent of GDP in 2015-16 to 81.0 per cent in 2016-17.

[3] We might assume that Labour’s pre-election pledge ignores cyclical adjustment because they have never used that language – though they have not explicitly stated their intention one way or another. In this briefing we use only the cyclically adjusted current budget (as in the Charter) for consistency and to avoid confusion  The OBR forecast is that the output gap will close over coming years. Balancing the current budget without cyclical adjustment would require £3.4 billion more consolidation by 2017-18 than when using cyclical adjustment, and (only) £600 million more by 2019-20.

[4] In theory, the first fiscal event after the May 2015 election will be Autumn Statement 2015, in which the target year will be 2018-19. However, it has been suggested that a Labour government, for example, would hold an Emergency Budget before then.

[5] The chosen level is a separate question from timing – for example, there is a big difference between current budget balance and overall budget balance, or between a balanced budget and a large surplus.

[6] For example, if the current government’s target of an 80:20 split between real spending cuts and tax increases were to apply, the ‘steady consolidation’ path would actually lead to lower spending and lower taxation in 2019-20, because more of the work would have been done by reducing spending not in real terms but as a proportion of the economy (which does not count towards the 80:20 target).