How far apart are the Conservatives and Liberal Democrats on fiscal policy: could the coalition renew its vows?

Recently we looked at the degree of potential overlap between Labour and Liberal Democrat fiscal plans, and found that the parties are not as far apart as might first be assumed. In this second note, we consider the relative positions of the Conservatives and Liberal Democrats.

The Conservative goal appears relatively straightforward: they want to deliver an overall budget surplus in 2018-19 and beyond. The Liberal Democrats’ position is slightly more complicated: they seek to deliver a surplus on the cyclically-adjusted current budget (excluding capital investment) in 2017-18, before moving to a target that excludes only certain (undefined) ‘productive’ investment.[1]

The level of cuts in spending and/or increases in taxes required by each, relative to 2015-16 (therefore not including the £8 billion of departmental cuts being implemented this year), is shown below.[2] Total consolidation reaches around £24 billion by 2017-18 for the Liberal Democrats (the solid gold line) and £38 billion for the Conservatives (solid blue line) by 2018-19.[3]

Notes: All figures in 2015-16 terms using GDP deflator. Conservative line equivalent to Budget 2015 plan. Liberal Democrat line based on ‘yellow budget’. Dotted green line gives £1 billion overall surplus in 2018-19 and 2019-20.

The light gold dotted line shows the minimum needed to eliminate the cyclically-adjusted current budget deficit in 2017-18 and beyond, and to have debt as a fraction of GDP falling in 2016-17. This would meet the initial Liberal Democrat goals and deliver on the fiscal Charter introduced by the coalition.[4] In our previous briefing we suggested that this is the kind of path the Liberal Democrats would try to persuade a Labour-led government to move towards. However, the actual path they have set out goes beyond this minimum, delivering sizeable current budget surpluses from 2017-18 onwards. As such, the gap between their position and the Conservatives’ is smaller than it might otherwise be.

The Conservatives have also pencilled in surpluses that go beyond what is strictly required to meet their stated aims, meaning they have some room for manoeuvre. The green dotted line shows the consolidation needed to reach an overall surplus of (only) £1 billion in 2018-19 and 2019-20 (i.e. meeting but not surpassing the Conservatives’ goal). Taking this approach would further narrow the gap between the two parties.

A trajectory for the first half of the parliament

In assessing the potential for Conservative and Liberal Democrat agreement, it is worth splitting the next parliament into two halves. With the error that surrounds long-term economic projections, and depending on how precarious the political outlook is for the next government, it is possible that negotiations might put more weight on agreeing a fiscal path for the shorter-term.

All parties largely agree on the fiscal plan for 2015-16 – unsurprising perhaps given that we’ll be over a month into it by the time of the election. And the Liberal Democrat and Conservative plans for the deficit in 2016-17 are also identical (remember that we’re only talking about the deficit at this point, not how that’s achieved). This delivers the Charter’s debt target with some (small) headroom.

However, by 2017-18 the Conservative consolidation comes to £33 billion. The Liberal Democrats’ trajectory implies £24 billion.[5] This is of course a significant difference in terms of spending cuts or tax increases. But given that the Conservatives could remain on course to reach their ultimate goal of overall surplus in 2018-19 with total consolidation of £25 billion by 2017-18 (the dotted green line), the gap may be much smaller in practice. And compared to the rest of the consolidation programme and vagaries around forecasts and consolidation plans, it’s hard to imagine this gap in 2017-18 being a major obstacle to agreement.

So it seems from their statements that both parties could agree reasonably easily on the path of the deficit (if not the measures to bring this about) for roughly the first half of the next parliament.

2018-19, 2019-20 and beyond

In both parties’ plans, fiscal consolidation slows after 2017-18. In the case of the Conservatives, whose manifesto refers to “the second phase of our deficit reduction plan starting in 2018-19”, a further £5 billion of consolidation is enough, together with naturally growing tax revenues, to deliver an overall surplus of £5 billion in 2018-19. A similar surplus (£7 billion) is then maintained in 2019-20 even though spending is increased in line with GDP.

The Liberal Democrats, in their plan, meet their main goal (of balancing the cyclically-adjusted current budget) in 2017-18. Beyond that they propose ‘light at the end of the tunnel’, by raising spending (and/or cutting taxes) in 2018-19 and 2019-20. The scope for loosening is limited by their policy of excluding only ‘productive’ investment from their deficit target. Their figures imply they would in effect be seeking to balance the overall budget excluding around half of net investment, though we await the crucial details of what counts as “capital spending that enhances economic growth or financial stability”: the less capital spending that is excluded, the closer they get to overall surplus (and therefore to the Conservative trajectory).

As it stands, the two plans differ by around £20 billion in both 2018-19 and 2019-20 – a very significant amount. To reduce the gap, the Conservatives could well reduce the surpluses they have pencilled in. (The gap would be further reduced if they pushed their surplus goal back to 2019-20. But, since the Budget at least, they too have talked about the importance of reaching better times for spending by the end of the parliament, so this seems unlikely). The dotted green line assumes a £1 billion surplus in both years, and might well be considered the minimum amount of consolidation that the Conservatives’ key pledges would permit.

Moving to this position would of course require a significant tightening of the Liberal Democrat position. But it’s worth remembering that the two parties have a recent history of coming to agreement, and both are keen to ‘finish the job’ (despite their different interpretations of what that means) and have returned to public spending growth ahead of the (assumed) 2020 election. So our dotted green line might be taken as an entirely speculative but roughly plausible compromise for the two parties on the overall path of consolidation.

Composition of consolidation – a potential stumbling block?

Having pointed out how the Liberal Democrats and Conservatives might come to an agreement on the path of the deficit up to 2017-18 and potentially beyond, we come to the question of whether they could agree on how to cut the deficit.

The Liberal Democrat proposals to 2017-18 consist of:

• an unallocated £12 billion of spending cuts for unprotected departments;[6]
• £7 billion from increased efforts against tax avoidance;
• almost £3 billion of net welfare cuts; and
• around £5.5 billion of tax increases for deficit reduction (and additional tax increases on top of this to fund tax cuts and an NHS spending boost).

This compares to the stated Conservative plans of:

• £13 billion of departmental cuts by 2017-18 (though the real sum required for their goals may be £16 billion by 2017-18 and £21 billion by 2018-19);[7]
• £5 billion from tax avoidance; and
• £12 billion of welfare cuts.

Even though details have not been forthcoming on how some of these goals would be achieved, let’s make the assumption – which some say is debatable – that all of these goals are deliverable. Given that, it does not seem too difficult for the parties to agree on a consolidation package to 2017-18 that would exceed the Liberal Democrat’s plan and keep the Conservatives on track to meet their 2018-19 goal. The £25 billion needed to follow the green dotted line in 2017-18 could, for instance, be delivered with relatively small compromises on departmental spending (for the Liberal Democrats) and tax and tax avoidance (for the Conservatives). For instance:

• £13 billion of departmental cuts by 2017-18;
• £7 billion from tax avoidance;
• £4 billion of welfare cuts; and
• £1 billion of tax increases.

However, to deliver an overall surplus in 2018-19, further and more difficult compromises would be needed.[8] That’s because £34 billion of consolidation is required by 2018-19 – £9 billion more than the package above.

For ease of exposition, and reflecting the Liberal Democrat ambition not to make real public sector pay cuts, we assume departmental cuts are limited to the £13 billion above, and that no more than £7 billion is available from tax avoidance (a figure which some think stretches credulity). The remaining gap would need to be filled by deeper welfare cuts and tax-rises. Any number of mixes can of course be constructed, but let’s take a specific formulation in which the Conservatives accept the full £5.5 billion of deficit-reducing tax increases proposed by the Liberal Democrats and the junior partner accepts £8.5 billion of welfare cuts by way of example.

The former (tax rises) would be difficult given previous Conservative comments, and more challenging still given that some of the suggested tax increases are repeals of Conservative tax cuts.[9] The latter (welfare cuts) would be tough for the Liberal Democrats to swallow: they have said that they “would not accept” Conservative welfare cuts of £12 billion and David Laws has said that “£3 billion is the maximum amount of welfare cuts we can safely find”. Presumably, though, both parties are expecting to have to compromise.

Light at the end of the tunnel?

The question of how to deliver enough consolidation to reach some form of budget balance is not the only potential obstacle to agreement. Both parties also have expensive priorities for tax cuts and new spending and these must somehow be reconciled with any deficit agreement.

Given that both have agreed to boost NHS spending by a total of at least £8 billion by 2020, and both wish to raise the income tax personal allowance to £12,500 (costing over £4 billion), these policies are sure to feature in any coalition agreement. But their cost is not accounted for in the consolidation figures we’ve been referring to.

Recall that both parties have said that spending will rise in line with economic growth once their budget targets have been met (though in the case of the Conservatives, as well as in our hypothetical compromise, this is a year later than in the Liberal Democrat plan). In theory, growth in the economy could create the headroom in 2019-20 to fund the NHS boost as well as smaller manifesto promises and general departmental funding increases. However, if the 2020 NHS goal requires early investment near the start of the parliament rather than deferring it all until the end (as many have said is the case) then this would require yet further tax increases or spending cuts elsewhere on top of those we’ve alluded to.

The (as yet unclear) Conservative plan for funding their income tax cuts (raising the personal allowance to at least £12,500 and also raising the higher rate threshold) might have been to use the surplus they had pencilled in for 2019-20. But in the looser compromise position we’ve set out above that option no longer exists: the overall surplus amounts to just £1 billion. In the extreme, the tax cuts could in theory be implemented as late as April 2020 (i.e. in financial year 2020-21), but if they are to be made earlier than this it would require yet more tax increases, even deeper cuts, or eating into the (NHS-focused) promised public spending increase in 2019-20.

A less high profile Liberal Democrat commitment is that they would like to see increased investment in “capital spending that enhances economic growth” – such as on housing, energy and transport. Under their fiscal rule, such an increase would not count towards the deficit. But without any exclusions of capital spending – as with the Conservative plans for an overall balance that we assume the Liberal Democrats accept in our compromise deal – such increases would need to be offset elsewhere.

A game of two halves

Our Labour and Liberal Democrat comparison argued that given the flexibility of Labour’s plans and the small wiggle-room in the Liberal Democrats’ (as well as their expectations as a smaller party), a deal might be possible that would give ‘wins’ to both sides, not least given the potential for relying on revenue increases.

Here we show that a deal between the Conservatives and Liberal Democrats is also likely to be possible. But in this case it looks more like a game of two halves. In the first, to 2017-18, there is substantial overlap between the parties. Beyond that, very significant compromises might be required from both parties to deliver an overall surplus. And doing this while delivering income tax cuts and other manifesto spending promises only adds to the scale of the challenge.

And, to reiterate our usual caveat, we shouldn’t forget that the fiscal path will be affected at least as much by economics as by politics. Today’s projections are unavoidably speculative (and we must guard against the danger of false precision). In practice, the size of the fiscal job in the next parliament will depend on the pace of economic growth and, most particularly, on what happens to productivity. And whatever deal is delivered after the election, there is the potential for ‘dynamic effects’ (which we make no attempt to account for) to alter the underlying economic backdrop. But despite these many uncertainties, getting a handle on what the different parties might agree (and disagree on) matters: after all, it is today’s projections which will set the context for negotiations after 7 May. We’ll pull all this together in a concluding piece that looks across the parties.

Notes

[1] The Conservative path is derived from Budget 2015 (which their manifesto suggests they would follow) and the Liberal Democrats’ from their ‘yellow budget’ and manifesto cost sheet.

[2] For simplicity, we assume the policies of both parties – including fiscal policy – have no effect on the economy compared to OBR forecasts.

[3] UKIP’s policies are not explored in this briefing but they say they are “the one party that can stick to the Treasury’s deficit elimination plan” and would “make sure the Treasury sticks to this latest [Budget 2015] plan, with no backsliding”.

[4] The Charter for Budget Responsibility requires the government to aim for “cyclically-adjusted current balance by the end of the third year of the rolling, 5-year forecast period” (i.e. 2018-19 in the next fiscal statement) and “for public sector net debt as a percentage of GDP to be falling in 2016-17”.

[5] Note that the Liberal Democrats’ own figure is £27 billion. The difference from our figure reflects both differing methodologies and the fact that we are using real rather than nominal figures.

[6] ibid

[7] The Conservatives refer to £13 billion of departmental cuts by 2017-18 but this figure does not deliver their target deficit and is based on an alternate methodology that doesn’t account for rising state pension costs, for example. The IFS’s ‘Post-election Austerity’ briefing suggests the Conservatives would need to cut unprotected departments by £30 billion up to 2018-19, but this takes account also of promised tax cuts and spending increases for some other departments, which we ignore at this stage.

[8] If 2019-20 were the target date instead then no more consolidation in the strictest sense would be needed beyond the above.

[9] The Liberal Democrats wish to abolish the Marriage Allowance and the Employee Shareholder Status tax break.