How tightly has the Chancellor tied his own hands on fiscal policy?

Having secured a majority on 7 May, the Conservatives must now set about the difficult job of delivering on their various pre-election pledges. In relation to fiscal consolidation in particular, they can no longer point to the demands of a junior coalition partner as cause for rowing back on any of the harder to execute promises. In this note we reassess the commitments made by the Conservatives to date, and consider just how much wriggle room the Chancellor may still have as he sets about planning his summer Budget.

How far and how fast? The consolidation trajectory
The Conservatives’ central pre-election fiscal pledge was to deliver an overall budget surplus within the new parliament (and indeed to introduce a rule that this must be maintained “in normal economic times” thereafter). This stance set them apart from both Labour (who were focused on current budget balance – thereby excluding spending on investment) and the Liberal Democrats (who said they would exclude some – unspecified – parts of investment spending). The tougher Conservative approach went to the heart of their claim to be the party of fiscal prudence. As such, while there may be scope for differing interpretations of some of the details, there seems little latitude on this goal: by 2019-20, the overall deficit should have been closed and debt should be falling not just as a proportion of the economy but also in nominal terms.

The purple line in the chart below sets out an assumed default way of achieving such an outcome – following the trajectory specified in the March (coalition) Budget. In fact, George Osborne has asked departments to deliver some new savings in 2015-16 (not reflected in the graph), which would marginally reduce the size of the task to follow in all scenarios – but it would of course mean delivering still deeper cuts in the current year.

Given that we don’t yet know how sizeable these additional savings will be, we retain the 2015-16 existing baseline in what follows. The path set out at the Budget suggests that relative to the current fiscal year the size of the consolidation required (which could be tax increases or spending cuts, and is represented by the depth of the line) reaches almost £40 billion by 2018-19 – delivering an overall surplus in that year. In the final year of the parliament, real spending could then be increased (or taxes cut) by around £13 billion while still maintaining the overall surplus.

But this default position can be softened in two ways.

First, the Chancellor may choose to reduce the size of the surpluses pencilled in for the end of the parliament. Although such figures this far out are entirely speculative, the £5 billion surplus in 2018-19 and £7 billion surplus in 2019-20 could be reduced to, say, £1 billion while still meeting the government’s goals. This approach is shown by the gold line. We have assumed that the path for 2016-17 is as set out in the March Budget – partly to ensure that the Chancellor’s aspiration to have debt over GDP falling is met, and partly to front-load the consolidation. And for 2017-18, we have assumed that the Chancellor would want to have delivered a small current budget surplus, in line with previous fiscal statements (though strictly his commitments do not tie him to this).[1]

The second, and potentially more significant, choice the Chancellor could make is to aim to deliver overall surplus by 2019-20 rather than by 2018-19. While it’s true that the party’s manifesto referenced the Budget plans, it stopped short of committing to a specific target date. Moving to 2019-20 would greatly reduce the extent of the fiscal squeeze required in the medium term, and lessen the potential spending ‘rollercoaster’, at the cost of a slightly higher stock of debt (and therefore debt interest costs too). This more gradual flightpath, also including lower surpluses, is shown in blue, and is an indication of the maximum leeway the Chancellor may plausibly have to work with.

In this case, the maximum net consolidation needed would be £25 billion by 2017-18. Thereafter, no further consolidation would be needed to deliver a £1 billion overall surplus by 2019-20 – with economic growth doing the work of closing the deficit. This may be surprising to some, but such is the power of delay (a similar logic applied to Labour’s pre-election targets). By 2018-19, spending could be around £16 billion higher (or taxes lower) than if the March Budget path were followed.

However, even in this scenario, spending (in the absence of tax rises) would have to remain almost flat in real terms in both 2018-19 and 2019-20. This would hardly feel like the return of good times. Increases in line with economic growth would have to wait until 2020-21 – which should now be included in the Budget’s five year forecasts and spending assumptions – presenting a less politically attractive proposition than the March Budget approach in which “light at the end of the tunnel” could be delivered in 2019-20.

Revenue raisers or cost cutters? The composition of consolidation
There are difficult trade-offs associated with all of these approaches, but they do at least suggest that the Chancellor has some room for manoeuvre. Just as important as the question of how fast they reduce the deficit, though, is how they plan to do it.

Prior to the election, the Conservatives stated that they would achieve around £30 billion of consolidation by 2017-18, comprising £5 billion from clamping down of tax avoidance, £12 billion of cuts to the welfare budget and £13 billion of departmental budget reductions. The blue line in our chart suggests that the total consolidation required by 2017-18 could be a little lower than previously stated, providing the Chancellor with the chance to impose slightly lower spending cuts.

However, the picture is complicated once we consider the cost implications of some of the party’s other pre-election pledges. Most notably, they have committed to boosting NHS spending by £8 billion and delivering income tax cuts amounting to at least £6 billion by the end of the parliament, without yet identifying where the funding would come from.

It is very difficult to imagine the Chancellor reneging on his NHS pledge. And, on income tax, the intention is to legislate for the personal allowance to rise at least as fast as the minimum wage. The £16 billion of consolidation that could be ‘saved’ by taking a slower path on the deficit could just as easily be needed for other purposes.

Given these (and other) major fiscal pressures, even if the Chancellor moves the government onto a slightly looser path of deficit reduction as shown in our chart, his pre-election figures on tax rises and spending cuts might remain the best estimates of what is required in the next few years.
In theory, he could choose a different balance of tax increases and spending cuts, but again the Chancellor is boxed in. The government intends to introduce a new law forbidding itself from raising the headline taxes of VAT, income tax and National Insurance, reducing the scope for revenue increases. And it has already committed funds from one of the more obvious sources of savings – restricting pension tax relief – on cutting inheritance tax and extending the free childcare offer to three and four year olds. Nevertheless, the Chancellor could still raise other taxes to reduce the scale of the squeeze elsewhere.

By way of illustration, it’s worth considering just how difficult the currently proposed spending cuts might be to deliver. The infographic below gives a sense of the scale of £13 billion of departmental cuts. It looks only at day-to-day departmental spending – given both general and specific commitments the Chancellor has made on capital spending[2] – and health, schools and international aid budgets have been protected.[3] The combined non-capital budget of the remaining ‘unprotected’ departments is roughly £150 billion in 2015-16, meaning £13 billion would represent a cut of around 9 per cent. New, or partial, protection for any of the other departments – such as the largest, defence – would of course increase the scale of the cuts for others. Note that the devolved budgets cannot be directly cut, given the Conservatives’ “clear and unequivocal” support for retaining the Barnett formula.

The importance of growth
Of course, all of these figures assume the economy (and with it the tax base) grows as projected.
The government has suggested that it hopes to beat the OBR’s employment outlook, generating welfare savings and higher tax revenue. However, what plans lie behind this hope remains to be seen, particularly given that the OBR’s forecasts include higher net migration than the government has indicated it wants to see.

The great hope for this parliament must be that productivity growth outperforms projections (the OBR sees a rise to 1.7 per cent in 2016-17, and then to 2 per cent). Unfortunately, the Bank of England has just revised down its own expectations for productivity growth in 2015 and 2016 (the latter down from 1.5 per cent to 1.25 per cent).[4] If the OBR follows suit at the summer Budget, then the size of the deficit reduction task facing the Chancellor would (all else equal) be even greater than the one set out above.

However, if productivity growth can overshoot the OBR projections, the spending cuts could be made far more manageable. As we discussed before the election, if productivity growth somehow performs as it did in the early 1970s and 1980s – which would close much, but not all, of the post-crisis gap – the government could reach its ambitious deficit goal while delivering discretionary spending increases. Such is the importance of growth. This is the context for the “productivity plan” George Osborne intends to publish in the run-up to the Budget.

But without better than expected growth, or a major departure from their deficit goals, it does seem that the new ‘One Nation’ and one party government will need to operate within a very tight, though not entirely pre-determined, fiscal space.

[1] In fact, the Chancellor could in theory opt for an even smaller current budget surplus in 2017-18 than we have assumed. In this case, the maximum consolidation would be significantly lower and the trajectory beyond 2016-17 even flatter.
[2] The Chancellor has said that “in the next Parliament we will always grow capital investment at least in line with GDP”, and the Conservatives have made numerous commitments on transport and science capital spending, and promised to increase the defence equipment budget in real terms.
[3] Specifically, the government will maintain per-pupil school funding in cash terms only but, according to the IFS, overall this is roughly a real terms freeze, given rising pupil numbers.
[4] The OBR projections here are for productivity per worker, while the Bank figures are per hour worked.