Sunday, December 07, 2014
Eliminating the deficit: hard work but not impossible
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Has the world changed? We knew before Wednesday’s autumn statement that George Osborne would be forced to concede that the budget deficit remains uncomfortably close to £100bn, so there would rightly be no room for a meaningful pre-election giveaway.

We knew that the growth numbers would be better but that it would be hard to generate too much of a political lift out of essentially rearranging the deckchairs.

So how was it? The budget deficit is uncomfortably large but Osborne wrong-footed Labour, and most commentators, by announcing that this year’s borrowing total, £91.3bn, will be below last year’s £97.5bn. That is still an overshoot of nearly £5bn compared with the official forecast in the March budget but it is still on the way down.

The Office for Budget Responsibility (OBR), which slightly encouraged the idea that borrowing this year would be up rather than down in its monthly commentaries, might turn out to be wrong. But a good rule of thumb is that this chancellor will find always a way of announcing that his deficit reduction plan has not gone into reverse.

Similarly, by deft footwork involving debt interest and a few other factors, Osborne managed to avoid the prolonged deficit overshoot confidently predicted by many economists. Again the OBR may be wrong but the big picture is that a slightly higher deficit this year and next is balanced by lower deficits later. That does not mean, of course, that the public finances are in any sense healthy.

As for growth, the OBR was over optimistic early on in its existence but has become too pessimistic since. Its forecast of 3% growth for this year, 2.4% next, was indeed revised up but looks downbeat compared with the Bank of England’s 3.4% and 2.9% predictions. The official forecast is also cautious on long-term growth, just over 2% a year.

In terms of content, Osborne did manage a small political gain. Stamp duty was sold as a tax cut for most homebuyers but in reality it was a sensible and long overdue reform of a clumsy “slab” tax, which had no place in any tax system. A few other Labour foxes were wounded, if not killed outright, and it is probably the case that the chancellor just about reinforced his reputation as a responsible custodian of the public finances, which is no mean feat when you are running a £91bn deficit.

Today, however, I want to look to the future, and in particular the big question that has arisen since the autumn statement. Have we reached the point where the chancellor is obliged to offer what many economists are calling “fantasy” ideas about eliminating the budget deficit, based on unspecified and undeliverable future cuts in public spending? Osborne accused the BBC of “hyperbolic” reporting of future cuts, which to be fair to him it sometimes is. But if he thought that was bad, he had not seen my e-mail inbox, full to the brim of commentary which, if not hyperbolic, was certainly highly sceptical.

I sense a little tension between the OBR and the Treasury. The OBR was not told in time of Osborne’s plan to spend more on the NHS, while its observation that to achieve a budget surplus public spending will have to be cut to its lowest for 80 years (the sub-text of which is “not a chance”) has not gone down too well with the chancellor, provoking some of that hyperbolic coverage. The Treasury thinks the OBR may be overstating the extent to which deficit reduction has to come through spending cuts.

Is it all fantasy? The first thing we should do, I think, is get away from that 80-year figure. Even if it were useful to use it, it would mean that, since the economy is six times the size it was in the 1930s, the government is aiming for a real level of public spending which is also six times what it was then.

That figure, total managed expenditure, is 40.5% of gross domestic product this year, having come down steadily from 45.3% in 2009-10. According to the OBR it needs to come down to 36% of GDP by 2018-19 to eliminate the budget deficit and give a small – 0.2% of GDP – surplus. It needs to come down to 35.2%, which we have not seen since before the war, to produce Osborne’s ambitious goal of a 1% of GDP budget surplus.

The reason why the 80-year comparison is a bad one is that for most of the period in question, capital spending by government, on roads, hospitals and schools (the building of) and other infrastructure was a lot higher than it is now, gross investment reaching 10% or more of GDP at times in the 1960s and 1970s. Currently it is just over 3.5%. In a pre-privatization era, the nationalised industries swelled public sector investment.

So a better measure of the squeeze on day-to-day spending is public sector current expenditure, which is mainly the spending on public services. This also needs to come down, to 32.7% of GDP to eliminate the deficit and 31.9% to achieve a 1% surplus. You also have to go back into history for times when this measure of spending was this low. It was 32.4% in 1973-4 and 31.1% in 1972-3. The economy, by the way, is roughly 2.5 times the size it was then.

Is it pie in the sky to think such numbers can be achieved? Does it mean, as Paul Johnson of the Institute for Fiscal Studies says, “spending cuts on a colossal scale” and the smallest state for generations?

I bow to nobody in my respect for the IFS but I think that is overstating it. Public spending on this measure has come down from its peak of 40% of GDP in 2009-10 to an estimated 36.9% this year and a projected 36% in 2015-16. Reducing it further, by just over three percentage points of GDP to eliminate the deficit, will be very hard but it is not impossible.

It would be a lot easier, of course, if the government did it properly, and freed its own hands. The more spending that is ringfenced – the National Health Service, schools, overseas aid – the more the burden of cuts is shifted to local authorities, and other non-ringfenced departments, as well as welfare.

We are, unfortunately, in a an environment in which every party is desperately scrambling to ensure it is in power, without thinking what it will do when it gets there. Labour, to be fair, talks of a zero-based spending review but it is hard to see that breaking too many eggs.

A proper review of spending is, however, needed. The coalition is still running on the basis of the rushed spending review it carried out in the summer of 2010. What was needed then, and what is needed now, is a fundamental review of the size and scope of the state, including a full public debate, with no sacred cows, including health, education and pensioner benefits.

If that were to happen, and if tough but realistic decisions were taken, total government spending of 35% of GDP and current spending of 32% of GDP is perfectly possible. If not, the public finances will be on a wing and a prayer.

Why not, to finish, just raise taxes to ease the burden on spending cuts, as favoured by Labour and the Liberal Democrats? There may be a small role for higher taxes in cutting the deficit but it would be wrong to think there is much. One lesson of the past 25 years is that it is hard to get tax receipts much above 36% of GDP. If you want to eliminate the deficit you have to get spending down to that level. The question is whether there is the appetite to do so.