Public spending maths – or why the state has peaked

As usual, the IFS briefing on the budget was more informative than anything the government put out. Among the graphs were some that clearly show the peaking of public service provision and help to explain why it is almost certainly on a downward trajectory.

First up, public spending over the last decade and a half, with projections for the next five years.

Spending is split into Departmental Expenditure Limits (DEL) and Annually Managed Expenditure (AME). DEL is the amount spent by government departments, so it is, effectively, the funding for public services. AME is the amount spent on welfare, debt repayments and other less predictable expenses.

Annually Managed Expenditure is one of those wonderful government euphemisms. ‘Annually managed’ means that it is difficult to plan and therefore has to be re-forecast each year. Welfare payments, pensions, housing benefits and debt interest can be influenced by a number of factors so it’s difficult to predict. Another way of looking at the term ‘annually managed’ is that the government has no idea how it is going to turn out from one year to the next.

As the graph shows, overall public spending has fallen slightly in real terms and is expected to stay static or even rise again over the next few years. This is not driven by public service spending though but by the rise in AME. As Ed Conway says, we are about to reach a “landmark moment” for the UK economy:

For the first time, the amount the Government spends on uncontrolled, non-discretionary stuff like welfare will become greater than the amount it spends on Governmental departments.

Surprisingly, I couldn’t find a breakdown of AME over a similar period to this graph anywhere. (If anybody has one I’d be interested to see it.) These figures from HMRC and the Department for Work and Pensions give us a clue about why it has risen though.

The cost of welfare in its various forms has been rising over the past few years. This isn’t just due to the increase in unemployment after the recession. More people in low wage employment and self-employment are claiming  in-work benefits, which has added to the welfare bill. Underpinning it all, is the inevitable rise in pension payments that comes with an ageing society.

So, even without cuts in the public spending total, the amount available for public services must reduce as AME increases.

Assuming there is no policy change, public services will have 18.4 percent less to work with in 2017-18 than they did when the Coalition took power.

Now you might say that this only takes us back to 2002 spending levels and things were OK then. However we have 3.7 million more people than we had in 2002 and a lot more of them are over 65.

Which brings us to the second problem. An ageing population doesn’t just exert upward pressure on welfare, it also increases the demands on public services, notably the NHS and local government. NHS costs have increased at around 1.5 percent above inflation in recent years. More old people will mean more needing help and treatment from the NHS. Although the health service has been protected from spending cuts, it will almost certainly struggle to keep pace with these increasing demands over the next few years.

And, of course, if you ring-fence some departments, others have to take a bigger hit. The IFS reckons unprotected departments, everything apart from health, education and overseas aid, will need to make cuts averaging 5.2 percent per year between 2010 and 2017. Few organisations could manage that without severely reducing their operations.

This is not going to get any better. As our population ages, that purple AME line will keep going up. Whichever party is elected after 2015 will therefore have three options:

1. Further cuts to public services;
2. Stop the growth in AME through cuts to welfare and pension entitlements;
3. Increase taxes.

This IFS graph sums up the problem neatly. The more money we want for public services (horizontal axis), the more we have to cut welfare or raise taxes (vertical axis).

Is there room to cut yet more from public services? Even the cuts already in train are starting to cause serious concern among public service providers. Head of the Local Government Association Sir Merrick Cockell, hardly a left-wing rabble-rouser, warned that even Tory councillors are in revolt over the level of cuts they are having to make. LSE’s Tony Travers said that the unprotected public services are shielding health, education and welfare from more serious cuts:

The unprotected services have become a safety-valve to allow AME and protected DEL to continue to grow within Total Managed Expenditure which is planned to fall in real terms.  Over time, public resources will be further diverted from transport, housing, economic development, culture, the police and fire so as to continue to increase social security spending and debt servicing.

Curbing the growth in AME, which George Osborne has said he intends to do, would reduce the pressure on public services. However, given that much of the welfare bill is pensions,  it’s difficult to see how he is going to make any significant cuts. The trouble with welfare is that, even if you reduce individual entitlements, if the number of people claiming rises, the bill still goes up.

Which leaves tax increases – about 2p on income tax, says the IFS, just to avoid any more spending cuts than those already planned.

It will probably be a mixture of all three. Some welfare cuts, some more public service cuts and an increase in taxes. What is almost certain, though, is that neither the tax cuts demanded by the right nor the return to pre-crisis public service spending demanded by the left are going to happen this decade. Or the next one for that matter.

Of course, we could get away without needing to do any of this if we had a sudden surge in economic growth and the tax take went up accordingly. Sadly, looking at the low growth forecasts for the next few years, that looks improbable too.

It is very unlikely that we will see a return to the level of public service spending we had in the late 2000s. This is not because the state is being shrunk but because there are other demands upon it. Over the past half-century, we have expected the state to do more and more. Thanks to debt, demographics, low growth and a financial crisis, the peak of state provision has passed. The state in the 2020s will look very different from the one we have been used to.