In the balance: public finances in the next parliament

Having assured us in recent weeks that we are better together, we can expect the three main parties to provide somewhat more discordant visions of the future over the coming conference season. And, with the Coalition expected to have delivered just over half of its intended fiscal consolidation programme by the end of the current parliament, it is likely that disagreements over public finances will come to the fore. But just where does each party stand on the issue?

At the moment the plans are still very sketchy. But with the election moving into sight, it is time to begin the work of drawing out what their different fiscal stances might mean.

In plotting a course through to 2018-19, the Coalition has focused on the cyclically-adjusted current budget. That is, the difference between government receipts and non-investment spending, adjusted to account for the state of the economy. According to the OBR, the trajectory set out by the Coalition implies that this measure will reach surplus in 2017-18, rising to roughly £28 billion by 2018-19 (in 2013-14 prices), with cyclical adjustment making little difference at that point in the recovery. This current surplus would translate into roughly a £1 billion overall surplus – after including investment spending – the first since the start of the century.

After accounting for the £8.5 billion of departmental cuts ear-marked for 2015-16 – itself a challenging target – achieving this path of consolidation is dependent on delivering a further £37 billion of fiscal tightening in the following three years.

While their hands will be relatively tied in the first year of the next parliament, the parties are likely to disagree on how the post 2015-16 bill might be spread across tax increases, cuts in welfare and reductions in public service spending. But neither is there agreement about the fiscal destination: is £37 billion of tightening the right amount? To date, the various parties have provided only incomplete answers to that question. But the pressure for more clarity will grow.

• George Osborne has stated that a Conservative government would convert the projected overall surplus implied by Coalition plans into an explicit target in the next parliament. Alongside this he has pledged to maintain investment spending as a share of GDP, effectively committing to a switch within departments of around £2 billion from resource spending to capital spending.
• Ed Balls has set a different course, offering to get the current budget (that is, excluding investment spending) into surplus “as soon as possible” in the next parliament – leaving it unclear exactly what this means. With the capital budget coming in at £25-£30 billion a year, Labour would have the freedom to borrow significantly more than the Conservatives each year without breaching their target. The main limit on this freedom is offered by Balls’s additional commitment to reduce national debt (which does incorporate capital spending) as a share of national income in the next Parliament.
• For their part, the Lib Dems plan to maintain the Coalition focus on balancing the cyclically-adjusted current budget in 2017-18 (a potentially slightly looser stance than is implied by the current Coalition trajectory which produces a surplus in that year). Once that is achieved, they intend to shift to a balanced budget target that includes some, but not all, elements of capital spending – excluding those parts of investment that “enhance economic growth or financial stability”. Again there is a commitment to falling national debt as a share of GDP.

Assessing precisely what is implied by these differing plans depends on a number of unknown policy details (as well as inevitable economic uncertainty). It is not possible based on current information to say anything definitive about the differences between these plans.  But by way of adding to the debate, we can establish a number of indicative scenarios based on what we think are plausible interpretations of these different approaches. As more information is provided these scenarios will obviously change. Taking this speculative approach, the main options and trade-offs are set out in the chart below.

The Coalition ‘frontier’ shows the full range of combinations that could deliver the required £37 billion of tightening between 2015-16 and 2018-19. At one extreme, all of the consolidation could be drawn from new cuts in annually managed expenditure (AME), mainly welfare, or from tax increases.

At the other extreme, a cumulative reduction in departmental spending (DEL) of 10.3 per cent would be required over the three years, taking the overall level of cuts in DEL since 2010-11 to 20 per cent. If we assume that the spending protections in place for the NHS, schools and international aid in the period to 2015-16 are maintained during the next parliament (and it is hard to imagine any government removing them) such DEL cuts would produce reductions to some departments that to many will sound highly implausible.  By 2018-19, budgets would need to be cut relative to 2010-11 by two-fifths in Defence and BIS, by half in the Home Office and by two-thirds in the FCO. Correcting for population growth would make the impact on public services appear starker still. It seems very unlikely that any of the parties will rely exclusively on DEL cuts to achieve their version of balance.

We might assume that a future Conservative government would stick to the same broad path as implied by Coalition projections, delivering an overall surplus in 2018-19. But, by pointing to an ambition to raise an additional £12 billion from – as yet unspecified – welfare cuts and by arguing that no further tax increases are required, George Osborne could reasonably be considered to have opted for a particular point on the frontier. That point implies a further 7 per cent cut in departmental budgets, taking them from £358 billion in 2015-16 to £332 billion in 2018-19. Such a level of cuts would be broadly in line with the pace of reduction already planned for 2015-16 – and we should bear in mind that each new round of cuts is likely to be harder to make than the last.

The Liberal Democrat language of ‘balance’ rather than ‘surplus’ and their plan to exclude some elements of investment spending from their target beyond 2017-18 implies that they could achieve their preferred measure in 2018-19 without cutting quite as hard as the Conservatives. They would therefore establish a new frontier somewhere to the right of the Coalition one – though more details are needed of precisely which elements of capital would be excluded in order to determine how much extra the Lib Dems would have at their disposal each year. In the scenario we present, we assume that half of the capital budget sits outside of the party’s deficit target.

Also, in contrast to the Conservatives, Nick Clegg has stated that the Lib Dems would seek to move along any given frontier “not just through further spending cuts” but through tax increases too. However, any gains from higher taxes would need to be offset against the party’s continued pledge to raise the income tax allowance, with their target of £12,500 expected to cost in excess of £5 billion over the course of the next parliament.

Labour has given no clear indication of the trade-offs it would make between DEL and AME cuts or tax rises. Instead, its focus on the current budget (rather than the overall budget) implies that it favours shifting the Coalition frontier to the right – though quite how far is unclear because it depends on the precise timing it sets out for reaching surplus. Given that the Coalition trajectory implies a current surplus of £28 billion by 2018-19, Labour might simply choose to target (say) a £1 billion surplus in the same year. Alternatively, it could choose a slower timetable for reaching current surplus.

A relatively ‘sharp’ deficit reduction scenario, in which it achieved a £1 billion surplus in 2017-18 (and thereafter increased spending in line with the GDP deflator), would mean that it faced a trade-off somewhere between a 7.9 per cent reduction in DEL and a £28 billion combination of AME cuts and tax rises. This would be a slightly looser stance than the Conservatives, but not dramatically so.

A more ‘gradual’ approach might be adopted instead, leaving it until 2019-20 – right at the end of the next parliament – to produce a modest surplus (moving in steady increments in the intervening period).  This would provide a Labour government with significantly more leeway. But, by keeping the level of debt higher for longer, it would also mean that additional funds would need to be allocated to debt interest payments.  Under this hypothetical ‘gradual’ scenario, DEL would need to fall by around 1 per cent in real-terms in the period to 2018-19, equivalent to policy interventions of around £3.6 billion.

These different scenarios – all highly speculative – clearly have differing implications for the size and shape of the state in 2018-19. They also involve different trade-offs. One the one hand, more gradual trajectories clearly have the advantage of reducing the immediate burden on public services and on households. But that choice comes at a price. Other things being equal, faster approaches will bring the stock of debt down more quickly therefore reducing the share of government funds allocated to debt interest payments as well as leaving the economy better placed to absorb future shocks and pressures.

All three main parties are likely to disagree over which path to follow. The magnitude of the job at hand means that all approaches will be highly challenging. Nonetheless, all parties will need to tread the precarious tightrope between establishing a clear and timely trajectory towards deficit and debt reduction on the one hand, while committing to a suite of spending cuts and tax-rises that look achievable on the other. As yet we don’t have enough information to give a clear account of how each party will strike this balance. An informed debate requires this information well in advance of the election campaign. When it emerges, we’ll return to this issue.