Budget 2010 briefing

Key points

The task facing the Chancellor in his Budget is a straight forward one:

To eliminate the UK structural deficit of around £100 billion through spending cuts and tax rises.

To secure economic growth and employment so that the cyclical part of the deficit is eliminated as well.

To reform the UK public sector so that it achieves greater productivity even after the deficit is eliminated, allowing taxes to be reduced.

The best means to do that are:

To cut spending on benefits and reduce labour costs in the civil service, health and education. Other EU countries are already making these changes.

To eliminate the exemptions in VAT (with protection for the poorest households), cut National Insurance Contributions and abolish the 50p rate.

To make the NHS and education accountable to their users.

How to cut spending – at home and abroad

In all countries, public spending is very largely composed of benefit payments and public services. Of public services, the great majority of the costs is labour.

The Chancellor needs to announce policies to reduce benefit payments by restricting eligibility and encouraging employment and wage growth. He needs to announce policies to reduce public sector labour costs through wage cuts, reductions in headcount and reforms to public sector pensions.

The other heavily indebted countries in the EU – Portugal, Ireland, Greece and Spain – show what the UK has to do. These countries have already announced their deficit reduction plans:

Portugal is means-testing more benefits and cutting the costs of the public sector workforce by 1 per cent of GDP.

Ireland is cutting the costs of the public sector workforce through reductions in both pay (an average 7 per cent cut for all public servants) and headcount and reforming public sector pensions.

Greece is cutting the costs of the public sector workforce through reductions in both pay (a 10 per cent cut in total public sector pay), reductions in full time civil service headcount through natural wastage and cuts in short term contracts.

Spain is cutting the costs of the public sector workforce by 2 per cent of GDP through a pay freeze and reductions in headcount through natural wastage and cuts in short term contracts.

Despite not being a heavily indebted country, Germany is making similar savings. It is reducing all public sector budgets and increasing the retirement age.

Where to cut

Public spending in the UK is largely made up of health, benefits (pensions and other benefits) and education – which between them account for nearly 60 per cent of total government expenditure. Each of these areas should expect cuts in line with their shares of public spending.

Table 1: Share of government expenditure on key services
HM Treasury (2009), Public Expenditure Statistical Analyses

Cost, £ billion (2008-09) % of all government spending
Non-pensioner benefits 127 20
NHS 110 18
Pensions 77 12
School education 47 8

Some cuts, such as the abolition of benefits for middle and higher income people, can start immediately. Others, such as the removal of inefficiencies in public services through reforms to their structure, will take years of effort to achieve.

The public sector employs 6.1 million people compared to 5.2 million in 1999. Previous Reform research has found that the costs of the workforce should fall by around 15 per cent, equivalent to approximately one million front line jobs.

How to raise taxes

The Chancellor must raise taxes given the hole in the public finances. His challenge is to do so in such a way that the damage to economic growth is minimised.

The current proposals to increase National Insurance Contributions and introduce a 50p rate will damage employment and growth. They will delay the reduction in the non-cyclical deficit.

The right way to raise extra revenue would be to eliminate the exemptions in VAT while protecting the poorest households.

When to cut?

The typical goal of economic policy is to increase consumption and output. But in some cases the risk to the integrity of the economy is more important. That is the current position of the UK.

The UK is in the danger zone – at risk of damage from a withdrawal of investor support – as long as its debt-to-GDP ratio is rising. The Treasury currently predicts the debt-to-GDP ratio to rise until 2015. It is likely to be years after that given the Treasury’s over-optimistic growth forecasts.

The UK has run unbalanced public finances for years. In the last 35 years, the UK has been in surplus for only seven. For these reasons the reductions in UK public spending need to start now and to last for many years.