IFS - Boxed in by his own rule, Mr Osborne has to pull off a precarious balancing act

8 Feb 2016 03:30 PM

The IFS Green Budget 2016, produced in association with ICAEW and funded by the Nuffield Foundation with analysis from Oxford Economics, was published yesterday.

November’s Spending Review was not the last chapter in the Chancellor’s fiscal consolidation. Having set himself a very inflexible target to get to budget balance by 2019–20, Mr Osborne could be forced into additional spending cuts or tax rises if economic and fiscal forecasts again turn out unfavourably. He also has some big promised tax cuts to finance, faces considerable uncertainty over key tax revenues, and may yet find the spending squeeze hard to maintain, even though it is less severe than previously expected.

The fiscal mandate requires the government to run a surplus every year from 2019–20 “in normal times”:

• This is radically different from the UK’s previous fiscal rules, and like most big economies the UK has only rarely run a surplus – just 8 times in the last 60 years.
• Even with steady growth and a surplus of 0.5% of national income by 2019–20, it would take until the mid-2030s to get debt back to pre-crisis levels as a share of national income (40%). Borrowing to cover investment could leave debt still at 60% of national income in the mid-2030s. The faster debt falls, the more room for manoeuvre future governments might have in the face of another recession.
• The rule has the merit of simplicity and transparency but is very inflexible and this could come at a cost. It could require big tax rises or spending cuts with very little notice in order to ensure it is met. Even if the Chancellor gets to the March 2019 Budget with his plans intact, past errors in official forecasts suggest that there would be more than a one-in-four chance that he would need to implement in-year tax rises or spending cuts to deliver a budget surplus in 2019–20.
• The fiscal mandate also rules out borrowing to invest even where low interest rates mean such investment would be economically beneficialand would not otherwise occur. And because it is based on a narrow definition of borrowing, there is a danger that Chancellors will game the rule, just as they have gamed rules in the past.

The more immediate concern is with achieving surplus by 2019–20. Official forecasts are for a surplus of 0.5% of national income, or £10 billion, in that year.The biggest question facing Mr Osborne is how he will respond if forecasts change and he needs greater tax rises or spending cuts to make the books balance. He faces a number of challenges on the tax side:

• He is banking on tax revenues rising, largely in response to big tax increases announced since the general election. But tax revenues are volatile and uncertain. Last week’s Bank of England inflation report downgraded forecast average earnings by more than 1% just since November. If average earnings do rise 1% less by 2019–20 than the November forecast, he could expect to lose £5 billion of income tax and National Insurance revenues. The fall in equity prices seen just since the Spending Review could, unless it proves purely temporary, cost the government £2 billion in lower capital tax receipts in 2020.
• Mr Osborne has promised £8billion per year of income tax cuts in the form of a higher personal allowance and an increased higher-rate threshold. These promises are currently unfunded. Other things equal, delivering them will require equivalent tax rises or spending cuts elsewhere.
• His forecasts depend on him raising fuel duties in line with the RPI – something he has failed to do since 2011. Freezing them for a further five years would cost £3 billion.
• His forecasts also depend on keeping the £150,000 threshold, at which the 45% income tax rate kicks in, frozen. The number of additional-rate taxpayers has already increased by 40% since the additional rate was introduced in 2010. Similarly, current policy implies a 50% increase in the numbers losing some or all of their child benefit within five years, as the point at which this happens stays fixed in cash terms.

Public service spending by central government and local authorities is forecast to be cut by 1% in real terms between 2015–16 and 2019–20. This compares with a cut of more than 8% between 2010–11 and 2015–16, but even so it won’t be easy:

• On current plans, total public spending in 2019–20 will reach its lowest share of national income for over 60 years with the exception of 1999–2000 and 2000–01. Spending on public services other than health will be at its lowest level as a fraction of national income since at least 1948–49, at a time when the population continues to grow and age.
• Public sector employers, such as the NHS and schools, will need to find more than £3billion a year from 2016–17 to pay higher National Insurance contributions.
• Spending plans are based on pay in the public sector rising by at most 1% a year for the rest of this parliament. If official forecasts for private sector pay are right, this will take public sector pay to easily its lowest level relative to that in the private sector for at least 25 years. This may prove difficult to sustain.

Oxford Economics, with whom we are again collaborating, forecast that UK growth will be a relatively disappointing 2.2% in 2016, similar to growth in 2015. On the plus side, the forces driving strong consumer spending growth last year are still present, while the environment for business investment remains favourable. However, significant tightening of fiscal policy and problems in the international environment will continue to hold growth back, even though UK exporters’ focus on other advanced economies will offer some insulation from problems in emerging economies. Nevertheless, these problems in emerging economies mean that the risks to growth – both at home and in the global economy – are very much skewed to the downside.

Looking further ahead, Oxford Economics say that the combination of a sizeable output gap and solid prospects for potential output should provide the conditions for firm growth and low inflation over the medium term. However,the planned fiscal consolidation is so large that it will exert a significant drag on growth prospects and mean that the UK’s spare capacity is eroded more slowly than it otherwise could be.

ICAEW provide a detailed analysis of Whole of Government Accounts (WGA), which illustrates the importance of taking a wider view of government finances than the traditional National Accounts. On a WGA measure, the accounting deficit fell by just 20% between 2009–10 and 2013–14 compared with a fall of 35% in the traditional National Accounts measure. The WGA also provide further insight when considering the vulnerability of the public finances to future economic shocks, with total liabilities at 31 March 2014 of £3.2 trillion, or 177% of GDP. This is substantially higher than public sector net debt, the National Accounts measure typically referred to in this context, which stood at £1.4 trillion, or 78% of GDP, at that date.

Paul Johnson, Director of the Institute for Fiscal Studies and an editor of the Green Budget, said: “Mr Osborne’s new fiscal charter is much more constraining than his previous fiscal rules. Uncertainty in the fiscal forecasts means that he may well have to cut spending further or raise taxes to get to surplus in 2019–20. With public spending reaching historically low levels relative to national income, promises on tax cuts to keep and pay for, and pressure on revenues from a number of taxes, there may be more tough decisions to come. How he responds to any further unpleasant fiscal surprises may, more than anything we have seen so far, come to define his period as Chancellor.”

Andrew Goodwin, Lead UK Economist at Oxford Economics and co-author of a chapter in the Green Budget, said: “The renewed fall in the oil price promises to keep inflation lower for longer and should prolong the ‘sugar rush’ enjoyed by UK consumers over the past year. This is a very welcome development given the substantial headwinds to global growth. But once this ‘sugar rush’ has faded, GDP growth is likely to slow as the welfare cuts and cuts to government departmental spending exert a significant drag. This will mean that the pace of growth remains underwhelming and that the economy still has some spare capacity left at the end of the parliament.”

Ross Campbell, ICAEW Director of Public Sector and co-author of two chapters in the Green Budget, said: “The Government was elected on the promise to reduce borrowing. But currently it does not have a comprehensive view of the UK’s financial accounts. Getting the best outcomes for the public finances in challenging times, means being supported by modern financial management as well as having the full economic picture. Without these, the consequences of policies decided cannot be seen in their full context.”

Conclusions from other chapters in the Green Budget include:

ICAEW’s view is that government decision-making needs to change to protect infrastructure investment

Current accounting measures and the desire to reach a surplus on a relatively narrow measure of government borrowing will favour public–private finance partnerships over simply borrowing to invest. Favourable treatment of these arrangements in the National Accounts is no good reason to favour funding infrastructure spending in that way. PFI and PF2 should be brought on balance sheet to avoid decisions being driven by accounting rules.

At the same time, government should consider adjusting its fiscal rules to allow borrowing for infrastructure investment where it can be demonstrated that the investment will provide a financial return to government in the form of revenues – from additional taxes or charges – that more than offset the cost of the investment.

It’s time to think seriously about the structure of excise duties

Having accounted for more than one pound in ten of tax revenues at the end of the 1970s, duties on road fuel, tobacco and alcohol are forecast to account for just 6% by 2020–21, down from 7.2% now.

Alcohol taxes are very badly targeted at the social harms caused by alcohol consumption. They are not focused on heavy drinkers and charge very different rates of tax on the same alcohol content depending on the form in which it is consumed. For example, the excise duty on a litre of 7.5% strength cider is 39p; a litre of beer of the same strength attracts duty of £1.38. The government is said to be considering introducing a minimum price for alcohol. If it wants to tackle harmful drinking, it would be better to sort out these anomalies in duty rates and to reverse the long-term trend to lower duties on spirits, which are disproportionately consumed by heavy drinkers.

There is a case for extending excise duties to other products, excess consumption of which can cause social harm; hence the recent calls for a sugar tax. Implementing such a tax successfully may be much harder than for traditional excise duties because diets are complicated and multifaceted.Just imposing the tax on sugary drinks, for example, could simply lead people to increase other sugar consumption – perhaps by eating more chocolate, which also contains saturated fats – and in any case could not on its own bring sugar consumption down to recommended levels. A more broad-based sugar tax is an alternative but its effect on consumption of other nutrients, and hence overall diet, is uncertain. Careful, evidence-based design and a clear understanding of its role alongside other initiatives are needed before any such policy is rolled out.

The Green Budget also contains chapters on universal credit and tackling tax avoidance by multinational companies, which were pre-released last week and the week before, respectively.

We are delighted to have produced this year’s Green Budget in association with ICAEW and with funding from ICAEW and the Nuffield Foundation. Additional analysis will be provided by Oxford Economics and ICAEW. We are also grateful to the Economic and Social Research Council for funding much of the day-to-day research at IFS that underpins the analysis in this report.

Notes to Editors:

1. The full Green Budget 2016 publication, with analysis from IFS and additional analysis from ICAEW and Oxford Economics, was launched at 10:00 on Monday 8 February 2016 at the Guildhall, City of London.

2. The full report is available at http://www.ifs.org.uk/publications/8129

3. ICAEW is a world-leading professional membership organisation that promotes, develops and supports over 146,000 chartered accountants worldwide. They provide qualifications and professional development, share their knowledge, insight and technical expertise, and protect the quality and integrity of the accountancy and finance profession.

4. As leaders in accountancy, finance and business ICAEW members have the knowledge, skills and commitment to maintain the highest professional standards and integrity. Together they contribute to the success of individuals, organisations, communities and economies around the world. Because of this, people can do business with confidence. ICAEW is a founder member of Chartered Accountants Worldwide and the Global Accounting Alliance.

5. The Nuffield Foundation is an endowed charitable trust that aims to improve social well-being in the widest sense. It funds research and innovation in education and social policy and also works to build capacity in education, science and social science research. The Nuffield Foundation has funded this project, but the views expressed are those of the authors and not necessarily those of the Foundation. More information is available at nuffieldfoundation.org.