Not just a crash diet: improving public finances through structural reform

A phrase attributed to J. M. Keynes is to “look after unemployment, and the Budget will look after itself.” The argument is that when the economy faces a downturn then spending, especially on welfare, will increase and taxes will fall. It is further argued that when the economy improves welfare spending will fall and revenues will rise, so any deficits incurred during the downturn will be automatically offset.

Yet these arguments only apply to those areas of spending that adjust with the economic cycle (automatic stabilisers). Other features of the government accounts (structural spending and tax changes) do not vary in this way.

Assessing the effect of a recession on the Budget and the degree to which any increase in growth will reduce future deficits (and in turn debt) thus requires estimating how much of these changes are cyclical and how much are structural. If the changes are purely cyclical then the Budget may well be able to look after itself. Yet if some of the changes are structural then the deficit will persist even when growth returns. Consequently governments cannot simply sit back and rely on growth to rescue the public finances. Structural reform will be required.

This distinction should give the Chancellor grounds for concern. If the poor state of the government’s accounts is due to changes in areas like pensions and health then his problems will not be solved by stronger growth. He cannot sit back and hope the finances will take care of themselves.

As Reform shows in this paper, even if the Chancellor could wave a magic wand to put the economy at 100 per cent health:

  • Government spending would have only been £23 billion lower in 2012-13. This is little more than 3.4 per cent of total spending of £674 billion that year.
  • Tax revenues would have only been 1 per cent higher.
  • The deficit would have only fallen by about 40 per cent.

These figures should not come as a surprise. Take the welfare budget. It is often assumed that this spending largely reflects economic conditions. Yet around 55 per cent of this spending goes on pensioner benefits which do not vary in this way. Department for Work and Pensions (DWP) data show that even in the current recession the number of people receiving the State Pension is around twice the number of people receiving the main benefits for unemployed and disabled people. The importance of structural spending in the welfare budget has actually been strengthened by policy changes such as:

  • Lowering the rate at which working aged benefits are indexed, which will reduce the growth in spending on benefits like the Job Seekers’ Allowance that vary with the economic cycle.
  • Increasing the generosity of the indexation of the State Pension, which will accelerate growth in spending on this programme that does not generally vary with the economic cycle.

There may be a rationale for these changes on a micro-economic level, but at a macro-economic level the implications are clear. Their combination means that more spending is structural and so the ability of future growth to rescue the public finances is reduced.

Recent history highlights another reason to doubt that the Budget can take care of itself. The UK Government was running deficits even before the Global Financial Crisis hit. In the years from 2001-02 to 2007-08 general government gross debt increased from 37.0 per cent to 43.6 per cent of GDP. This was while the economy was growing strongly and debt should have been falling. This is a reflection of a longer running problem with public fiscal management in the UK, with the government’s fiscal balance only venturing above the sustainable level for 8 of the 38 years to 2012. The advent of the financial crisis amplified pre-existing problems.

The Coalition’s approach has failed to properly address this habit of overspending. They have protected major budgets while salami slicing others. This is like putting the public finances on a crash diet, which actually reduces the chances of long term weight loss. The result is an overall perception of underfunding while the major drivers of spending are left untouched.

The NHS, pensioner benefits, schools and international aid have all been ring-fenced from cuts. Yet this spending drives some of the biggest budgets, with the health, welfare and education budgets alone accounting for 51.6 per cent of all government spending in 2011-12. To illustrate their importance, if these three budgets were fixed in cash terms between 2011-12 and 2014-15, then the planned increase in total spending over these years would fall from £38.6 billion to £17.3 billion. The increase in health spending alone is equivalent to almost a quarter of all the planned increase in spending. No wonder the Coalition has struggled to hit its fiscal targets and that austerity will have to continue well into the next Parliament.

Ring-fencing has meant other budgets have had to be cut deeper and major tax cuts continue to be unaffordable. Ring-fenced areas have also failed to benefit from the pressure to change and innovate, in the way that other services such as policing are already showing. By failing to address the major drivers of spending, the Coalition’s approach has also threatened longer term prospects for growth. It is hard to be confident that the UK’s problems with overspending will be addressed without a new approach. The problems facing the economy are structural and they require structural solutions. Crash diets do not work.


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