Reformers not spenders

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This report illustrates what lower growth means for the Government’s fiscal targets. Based on this the report then identifies what the Government’s fiscal policy should do and how this relates to issues like the squeezed middle and high pay.

The overall fiscal picture

The Coalition has a target of getting spending down to 39 per cent of GDP by 2016-17. This is a revised target. Since Budget 2010 the target for Total Managed Expenditure for 2015-16 has been moved from 39.8 to 40.5 per cent of GDP. As the outlook for growth has weakened the Coalition has eased its fiscal mandate. Yet there is a limit to which the Coalition can continue to shift the goalposts in this way.

Nevertheless, to achieve its most recent target the Government has a plan to reduce Total Managed Expenditure (set in cash terms). However, this plan was based on a favourable outlook for growth. If growth is lower than the Government expects it will not achieve its target for reducing the size of the state. Reform has estimated that, as a rule of thumb, for every half a percentage point fall in the rate of growth there is a need for the Coalition to find an additional £20 billion in savings to hit the target of 39 per cent of GDP by 2016-17.

Austerity is here to stay. Indeed, as Sir Nicholas MacPherson, the Permanent Secretary to the Treasury, noted at a recent Reform conference, the Treasury forecasts public spending to be even tighter in the first two years of the next Parliament than in this one. The deficit reduction challenge has grown in intensity rather than eased. People who argue that a weakening in growth means that the Coalition should ease up on its spending plans or introduce tax cuts do not grasp the fiscal position. Liam Byrne was right – there really is no money left.

Implications for spending and taxes

It could be argued that easing spending reductions or introducing tax cuts would have dynamic effects that would help achieve the fiscal targets but the empirical evidence for this is very weak.

For any easing in spending plans to have a large impact on growth the change would have to be major. Yet a major shift in fiscal policy would damage the Coalition’s fiscal credibility and risk increasing interest rates.

To show the importance of this Reform calculated that with current low bond rates the UK will be able to service its debt even with low growth. However, if yields on 10-year bond rates were to rise above 5 per cent (similar to the levels currently in Spain) the Government would have to run a surplus in each year of the current Spending Review period or else face a debt spiral.

Achieving additional spending restrain will be challenging. The most principled and effective way of achieving further spending restraint would be to look again at the protected budgets. In particular:

  • Health and education (schools) are the key ring-fenced budgets. In nominal terms, departmental resource spending in health will increase by 8.2 per cent and education 4.9 per cent over the next three years. This compares to the average increase in total nominal departmental resource spending over the next 3 years of 2.0 per cent.
  • If the budgets in health and education increased in line with this total departmental spending only the Coalition would save £12.2 billion a year by 2014-15. If the budgets in health and education remained unchanged in nominal terms by 2014-15 the Coalition would save £16.2 billion a year by 2014-15.
  • Spending on welfare is forecast to increase by £10.1 billion by 2014-15. If, however, this budget was to grow by 3.0 per cent (the average increase in total nominal Annually Managed Expenditure) then the Coalition would save £5.6 billion a year by 2014-15. Greater savings in welfare could come from middle class welfare benefits which are currently protected, such as the Winter Fuel Allowance, free TV licences, free bus passes and concessionary coach fares, which are poor value for money and account for spending of the order of £3.6 billion. Reform has estimated that total spending on middle class welfare is equivalent to around £31 billion.

On tax, while the medium-term goal must be to move towards a low rate and broad based system, many of the current advocates of tax relief fail to consider how tax cuts must be subject to a value for money assessment. In particular:

  • There is no empirical support for temporary tax cuts on labour as firms tend to look through temporary reductions (as the hiring decision is largely permanent) so only hire people they would have hired anyway and any increase in employment tends to displace new employment elsewhere.
  • Temporary reductions in consumption taxes have little influence on the final prices of goods and services to consumers (while increasing compliance costs for retailers).

There is also little serious support for the argument that tax cuts are always fully self-funding, although they may be a “cheap lunch” (partially paying for themselves) if they are designed correctly.

On tax design the Coalition is getting it seriously wrong – it is increasing personal allowances which are a very poorly targeted way of directing support to lower to middle income families. The large majority of the spending on allowances goes to people with incomes above the level of the allowance. They will also fail to grow the tax base and will have no net positive benefit on the labour market (as for most people they will lower average not marginal tax rates).

By introducing high and variable tax rates the Coalition has also increased the incentives for tax avoidance. Incentives have been increased by policies such as the 50p tax rate, the clawback of personal allowances and of pension tax relief, reductions to company tax and increased personal allowances.

It is important to note that the ability to avoid tax will largely depend on personal circumstances. Yet recent policy changes have clearly reduced the integrity of the income tax system. This is especially the case for families that own small businesses. The increase in personal allowances has increased the benefits from tax planning for these families. As shown in the table, the benefit from splitting income between family members to a family on £26,000 has increased by £607 to £2,533 since 2009-10. Increasing the personal allowance further to £10,000 would mean that a married couple could reduce their tax liability by a further £750 through engaging in this tax planning. The benefit from this tax planning increases as marginal rates increase, so the benefits from tax avoidance are greater for higher than lower income families.