Tax rises ahead

The IFS published its Green Budget yesterday. Chapters 1 and 2 on the public finances are excellent and go into quite a lot of detail about the prospects for the second half of this decade. Taking into account the Autumn Statement, the Chancellor’s aim to achieve an absolute surplus by 2019 and the slightly improved economic growth forecasts, they give a revised assessment of the UK’s fiscal position. And it’s still bad.

Over the course of the decade, public spending falls only slightly in real terms but the continuing rise in social security and debt interest payments eats into the amount available for spending on public services.

Unless the government increases borrowing, the only way to stop further cuts to public service spending would be by cutting welfare or increasing taxes. The possible trade-offs are illustrated on this chart.

Slowing down the proposed rate of post-election cuts to the same rate as we have experienced during this parliament would need an extra £12 billion to be found from welfare cuts or tax increases. To avoid any further spending cuts beyond the current spending review would require a further £33 billion.

It’s very unlikely that savings from further welfare cuts will yield anywhere near £12 billion. The IFS explains the size of the problem:

[I]f the £12 billion were to come from further cuts to social security spending, this would require an average cut of around 6% across all state pensions, benefits and tax credits.

But the government has promised not to touch pensions, so…

If the state pension were to be protected, an average cut of around 11% would be required, increasing to around 13% if all pensioner benefits were protected.

A 13% cut in all other social security benefits? Good luck with that one, George.

Which brings us back to tax increases:

[R]aising £12 billion in extra tax revenues would require policy action of the order of around a 21⁄2 percentage point increase on the main rate of VAT or a 3 percentage point increase on the basic rate of income tax. Raising £33 billion would require even greater action (for example, 7 percentage points on the main rate of VAT or 81⁄2 percentage points on the basic rate of income tax).

Any easing up of cuts to public services would require significant tax increases. To keep the cuts at the same rate we’ve seen during this parliament will need another 3p on income tax. To stop any further cuts at all, we’d need at least 8p on the basic rate.

Without these extra taxes, or an unlikely re-allocation of budget from welfare savings, the cuts to public service spending will be deep. More than a fifth of the overall budget will have been cut by 2018 but, by the time the protected services, health, schools and overseas aid, have taken their cut, the cumulative cuts to other areas will be more than a third; an annual cut of 5.5 percent.

Should the NHS lose its protection? Some have argued that it should but then we come up against the demographic and other pressures pushing up healthcare spending. For the NHS, a real-terms freeze amounts to a cut because its costs outstrip inflation and the level of demand rises as the population increases and ages.

Health spending is one area of particular concern. Estimates from the Department of Health imply that in 2011 that approximately seven times as much was spent on an average 80-year-old as on an average 30-year-old.24 If health spending were to be increased in line with population growth and changing demographics (but the level of spending for each person of a given age were held constant in real terms), then this would imply an average real increase in health spending of 1.2% a year between 2010–11 and 2018–19.

In other words, the NHS needs a real-terms increase of 1.2 percent per year just to keep up with rising demand. The changing population will put other pressures on public services too:

The real spending cuts highlighted in Table 2.4 therefore understate the difficulty involved in sticking to the government’s spending plans. Demographic pressures will increase demand for public services such as health and long-term care in particular, but also for education and for all other areas of public spending where the increasing population feeds through into an increase in demand and consequently an increasing cost of provision.

And, of course, we mustn’t forget all those silly promises the government has lobbed in without saying how they will be funded.

One such pressure is the cost of additional policies that the government has announced over the last couple of years without making any additional money available to departments to fund them. Some of these are existing policies that only start to cost money (or cost more money) from 2016–17 onwards – for example, the ending of contracting out into defined benefit pension schemes, which will increase employer NICs in the public sector (by £3.3 billion per year), the Dilnot reforms to social care funding (costing around £1.0 billion per year) and the new tax-free childcare scheme (costing an additional £0.4 billion per year from 2016–17 – see Chapter 8). Others are policies announced in the 2013 Autumn Statement for which additional money was made available up to 2015–16 (since departments’ budgets have been set up to that point) but not in subsequent years – for example, the extension of free school meals (costing around £0.8 billion per year) and abolishing the cap on higher education student numbers (costing around £0.7 billion per year by 2018–19). All these additional cost pressures will need to be borne from within DEL budgets, and therefore they make the pressure on other spending areas greater than the headline DEL cuts would suggest. Together, the policies listed above amount to over £6 billion – around 2% of the total DEL budget – and this money will have to be made available through an equivalent reduction in other areas of departmental spending.

Hey, what’s another £6 billion? A penny or so on income tax, maybe?

The chapter concludes:

Even if the OBR’s economic forecasts turn out to be correct, the key question that remains is whether the planned fiscal consolidation can be implemented. While virtually all of the tax increase and benefit spending cuts planned are in place, considerable cuts to public service spending are still required in future. These cuts have not yet been delivered, and in terms of the cuts planned for after 2015–16, they have not even been allocated between departments. While this is understandable since these financial years start after the next general election, it does increase the uncertainty over the effect of these cuts on public service provision and quality, and therefore the acceptability of these cuts to voters.

[I]t is far from certain that the current or a future government will have the political will to see state provision of services reduced to this extent.

Which is a polite way of saying that, when services start to collapse, voters will complain and politicians will lose their cost-cutting bottle.

In the covering press release, IFS director Paul Johnson said:

Returning growth, and forecasts suggesting we should be running a Budget surplus by 2018-19, should not lull us into a false sense that all is now well with the public finances. The outstanding debt will still be very large and the scale of additional spending cuts required to hit that budget surplus remains hugely challenging, especially on top of cuts already delivered. A combination of significant additional spending pledges already made and a growing and ageing population will only add to the challenge.

Eliminating the deficit by 2019, without increasing taxes, means cutting spending on public services so far that only the bare essentials will be left. It’s unlikely that any government, of whatever colour, will get away with pushing things that far.

Still, it means I can update my spending dilemma diagram. Whoever wins in 2015 will have to deal with the fiscal challenge one way of the other. At the moment, politicians from all parties are still in La La Land.

The 2015 dilemma