Patrick Nolan

What should the Chancellor do in the Spending Review?

What should the Chancellor do in the Spending Review?
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With this autumn’s Spending Review set to be one of the most important moments in the life of the Coalition Government, Reform has linked up The Spectator's Coffee House blog to ask what could – and should – be in the final document. This post and all previous posts have been collected in a report that you can download here .

 

1). Hold the line on eliminating the deficit in one term

The coalition Government must hold the line on the commitment to eliminate the structural deficit in one parliament. Delaying the task will simply make it harder. Unless programmes and entitlements are reformed now, then the growing costs in areas like health and pensions will swamp any savings identified. Deviating from plans will also damage the coalition’s fiscal credibility – meaning that the costs of government borrowing will rise. As a result the government will continue to spend more on debt interest than on things like schools and the costs of borrowing for households and businesses will rise. These higher borrowing costs will hold back the private sector recovery and mean fewer new private sector jobs will be created.

 

Key figures & quotes:

 

i) It has been estimated that, without the actions taken in the Emergency Budget, annual debt interest payments would have increased to £67 billion – more than the Government spends on schools. The Bank of International Settlements estimates that, given current long-term liabilities, interest payments on government debt could rise to 27 percent of GDP by 2040. This traps the Government in a debt spiral, where the Government is required to borrow more to pay the interest on the outstanding public debt.

ii) Rt Hon Paul Martin, Canadian Prime Minister 2003-06 and Minister of Finance 1993-2002, noted in a foreword to Reform’s alternative Budget: “Because the cuts [in Canada in the early 1990s] were sharp and deep they worked – the vicious circle turned virtuous and the positive payback was not long in coming.”

 

2). Emphasise spending cuts not tax increases

Reform has argued that the burden of adjustment should fall on spending cuts versus tax rises with a ratio of 80:20 (80 percent spending cuts), as a similar ratio was employed in the successful Canadian reforms in the early 1990s. The Chancellor of the Exchequer, Rt Hon George Osborne MP, has a ratio of 77:23 and the Shadow Chancellor, Rt Hon Alan Johnson MP, has a ratio of 60:40. The argument for a lower emphasis on spending cuts is based on the idea that cuts in government spending would take money out of workers’ pockets and hold back economic recovery. However, it is important to recognise that tax increases dampen private consumption. Indeed, tax increases can be more harmful than spending cuts (on a pound-for-pound basis) as these increases reduce the spending that individuals and households undertake while spending cuts reduce spending by government. In cases where individuals have a better understanding of, and information on, their own wants and needs than central government planners, lower taxes would usually lead to greater spending on goods and services that have real economic benefit.

 

Key figures & quotes:

 

i) In only eight of the forty-nine years from 1964-65 to 2013-14 will the government have received more than it has spent. While this problem is not new, since 2001-02 the gap has grown to large levels, reflecting the significant growth in spending since 1998-99.

ii) Hon Sir Roger Douglas MP, New Zealand Finance Minister 1984-88, has noted that voters around the world “seem to have bought the false notion that we can all be made wealthy through government. Elections have become an opportunity for politicians to promise they will take more money off you, only to give it back to you in another way – a gold card for superannuitants (pensions), a tax credit for working families, or an interest write off for students. If we each pretend that we can be made wealthy through taxing others, then we’re destined for poverty. We are increasingly relying on others – be they foreign lenders or domestic taxpayers – to sustain our way of life.”

 

3). Emphasise reforms not cuts

Fiscal consolidation will involve some hard decisions and pose a challenge for the economy. But the risks from not acting are higher. There is scope for reducing spending, as much recent expenditure has been of poor quality. Public services need to be fundamentally reformed from being unmanaged, bureaucratic, monopolistic and secretive to being managed, accountable, competitive (where possible) and transparent. This will require the front line of services to change radically and for commentators to stop confusing the performance of services with their inputs, such as the size of the workforce. Such reforms will be positive for the public sector workforce as reforming the front line will increase productivity and allow sustainable higher wages in the long term.

 

Key figures & quotes:

 

i) Between 1997 and 2007 public service productivity fell by 3.4 percent, equivalent to an annual average fall of 0.3 percent. In the same period, productivity in the private sector grew by an average of 2.3 percent a year, while productivity for the whole economy grew by an annual average of 1.9 percent.  It is estimated that this declining productivity in the public sector could be costing taxpayers £58 billion a year.

ii) Hon Ruth Richardson, New Zealand Finance Minister 1990-1993, noted in a foreword to Reform’s alternative Budget: “The necessity to conduct a public finances rescue mission is a familiar and typically crisis driven task. Imposing a lid on increases in public spending, eliminating waste, and salami slicing existing budgets tend to be the politicians’ stock answer, but none of these approaches go to the heart of the problem. The problem is systemic – the public sector is too big and inefficient, high public spending levels cannot be sustained by high tax levels if the country wishes to be competitive, current public transfers and entitlements represent social and demographic time-bombs.”

 

4). Scrap ring-fencing of budgets

International experience shows that the right way to cut spending is for this to occur over as broad a base as possible. Budgets such as health, international aid and education should not be ring-fenced. No area of spending should be off limits. Areas that account for the greatest shares of government spending, and in which spending performs poorly, should bear the largest cuts. In contrast, however, the coalition has ring-fenced budgets like health. This is despite health accounting for the largest area of departmental spending, having poor rates of productivity and absorbing 40 percent of the increase in public sector spending between 1997 and 2007. This ring-fencing means that reductions in other departmental budgets will be required to be deeper. This will also undermine the case for reforming the health service to be affordable for the 21st century.

 

Key figures & quotes:

 

i) The IFS has estimated that the Coalition’s plans imply that non-ring-fenced departments will face cuts of 25 per cent in real terms. This is based on an assumption that spending on health rises in line with inflation. If the NHS was to get a 1 percent annual real increase then cuts to non-ring-fenced budgets would rise from 25 percent to 27 percent.

ii) Colm McCarthy, Chair of Irish Special Group on Public Service Numbers and Expenditure, noted at a Reform conference on public services and the deficit: “The government asked us to go off and find economies everywhere, which has the advantage that you are proofed against accusations that you are picking on people then because we could honestly say that we were picking on everybody. But, a few years down the road, if the education budget gets hammered and the health budget doesn’t, that’s difficult to sustain.”

 

5). Save early money from welfare

The Coalition needs to have a clear and credible plan for how they will achieve their targets for fiscal consolidation. The lack of a clear plan will lead to uncertainty and this will hold back private sector investment and growth in turn. In developing this plan it is necessary to account for the fact that it takes time to cut departmental budgets given the need to, for example, appropriately negotiate changes with staff. The welfare budget can, in contrast, provide relatively quick and large savings. The welfare budget should also provide an important source of savings as the payoff for growth from public spending is highest for spending on infrastructure, followed by spending on education, then health and then welfare. In making cuts to welfare spending, the focus should go on cutting poor value spending – such as middle class welfare like the Child Benefit and pension gimmicks like the Winter Fuel Allowance. As Reform has recently noted, changes to middle class welfare can be made in a simple way. There is no need to make the welfare system more complex.

 

Key figures & quote:

 

i) Reform’s report The Money-go-round illustrated that middle and high earners received an extra £15 billion in welfare benefits in 2008-09 compared to 1998-99, and an extra £27 billion in benefits in kind. But this apparent gain was just an illusion since they paid an extra £35 billion in direct taxes such as income tax and £6 billion in indirect taxes such as VAT.

ii) Martin Narey, Chief Executive of the children’s charity Barnardo’s, argued on 4 October 2010: “The case for abolishing child benefit while using the tax credit system to ensure poor families do not lose out is economically and morally overwhelming.”

 

 Patrick Nolan is Chief Economist at Reform