Still waiting for numbers on the cuts

Eurfyl ap Gwilym unpicks the economic and political implications of this week’s budget

At a strategic level the UK Budget for 2010 which was presented to Parliament by Alistair Darling this week held few surprises. Given the very poor state of the public finances there was little room for manoeuvre. Information already available in the public domain had already shown that the public sector deficit of £178 billion predicted in the December 2009 Pre-Budget Report would be somewhat lower and in the event the Treasury’s latest forecast is for a deficit this year of £167 billion. This is lower but still a disturbingly high and an unsustainable position. Contributors to this reduction were the one-off tax on bank bonuses and other charges and levies on the banking sector totalling £10 billion These are unlikely to be repeated in future years.

The Chancellor reaffirmed his goal of halving the public sector deficit within the next four years. There are three principal ways to reduce the public sector deficit:

• Raise taxes
• Cut expenditure
• Growing the economy

Striking the optimal balance between these three factors requires fine judgement and some luck. Raising taxes too sharply or cutting public expenditure too quickly could precipitate a double-dip recession. Economic growth will only come if the private sector has the confidence to invest in profitable activities.

In fairness to the Government it has been quite explicit with regard to the raising of taxes, with most measures being set out last December in the Pre-Budget Report, and these will take effect from April 2010. The measures include freezing income tax thresholds, introducing a tax rate of 50 per cent on incomes over £150,000, and reducing or abolishing the personal tax allowance for those earning £100,000 and £150,000, respectively. In this budget there were increases in duties on tobacco and alcohol and some deferring of rises in fuel duty.

There is no such clarity when it comes to reducing public expenditure. Yet this is intended to contribute two thirds of the money required to close the spending gap. The Chancellor reaffirmed his goal of increasing total public expenditure by 0.8 per cent per year over the next Spending Review period from 2011-12 to 2013-14. However, this implies a sharp reduction in departmental spending because the growth will be more than swallowed up by increased interest payments on the burgeoning national debt together with welfare payments to the unemployed.

It was on the basis of the Pre-Budget Report that I estimated many months ago that the Wales Departmental Expenditure Limit over the next Spending Review period would amount to a cumulative loss of funding in real terms of £2.8 billion over three years. The Wales Audit Office last week came up with its estimate of £ 3 billion. In the light of the Budget these estimates remain sound and our best guide as to what to expect.

In the case of UK capital investment the position appears to be even more severe than that forecast in the budget a year ago. Public sector net investment is planned to fall from 3.6 per cent of GDP in 2009-10 to 1.3 per cent by 2013-14, that is a reduction of 64 per cent. This means that spending on new roads, school buildings and hospitals will be severely reduced.

Once again the question of where exactly most of the spending cuts will be made was ducked. All the political parties are more than ready to talk about those spending programmes that they plan to protect, although even here the definitions usually beg many questions. What precisely is a front-line service? There were also many references in the budget to increased efficiency, as if this did not imply cuts in staffing levels or reductions in public sector pay. The Wales Audit Office report drew attention to the fact that many claimed efficiency savings are questionable.

The Chancellor is seeking to impose a ceiling of 1 per cent on public sector pay settlements which would imply a material drop in real pay given that retail price index currently stands at 3.7 per cent. Nevertheless, where cuts will be made remains ‘the elephant in the room’ which all the political parties wish to ignore until after the UK General Election.

The third way of reducing the deficit is through economic growth. In 2009 the UK economy shrank by 5 per cent and it is forecast to grow by between 1 to 1.5 per cent in 2010; 3 to 3.5 per cent in 2011; and 3.25 to 3.75 per cent in 2012. Many commentators are sceptical regarding these growth forecasts. On the other hand, there are a number of factors that favour an optimistic outlook. First, the economy will hopefully be ‘bouncing back’ from a recession. Secondly, there are indications that during this recession many private sector firms have held on to their skilled workforces rather than shedding them. Thirdly, these growth forecasts will be measured against a depressed base level. Optimists will also point out that sterling has fallen against the dollar, which should help exports, and interest rates are likely to remain very low for some years.

In terms of encouraging economic growth the Government is in danger of introducing contradictory measures. The increases in employers’ National Insurance Contributions are a tax on jobs and companies will be faced with reducing their workforce or having to absorb higher costs. At the same time there were a number of modest measures in the budget aimed at stimulating economic growth, including leaning on the state controlled banks to lend more money to industry and establishing a Green Investment Bank.

One of the Government’s successes has been the scheme whereby solvent firms which have a liquidity problem are able to defer payment of PAYE tax. This scheme has been extended for another year. Another measure which echoes the initiative taken by the Welsh Government is to ensure that the public sector pays its bills promptly. The Chancellor has set a target for Central Government to pay 80 per cent of its bills within 5 days. In England business rates will be cut for one year.

One welcome statement by the Chancellor concerned something he would not be doing. He would not be following the Conservatives’ suggestion of reducing the headline rate of corporation tax and paying for it by abolishing capital allowances. This will be welcome in areas such as Wales that are still heavily dependent on manufacturing industry – 17 per cent of our total GVA.

The timing of the UK General Election is not helping in terms of holding an intelligent debate regarding economic policy. None of the political parties wants to specify too clearly where they will make cuts. Thus the electorate is being denied an opportunity to hear what the various parties have to say and then deciding who to support. In normal circumstances one would expect that Labour would be suffering more than it seems to be. This is because it was Labour’s fiscal policies, over the period 2000 to 2007, that resulted in public expenditure growing by 58 per cent while income from taxes and duties grew by just 49 per cent. In turn, this meant that when the banking crisis struck the UK was particularly vulnerable.

Why are the Conservatives not profiting more from this? It can be argued that, in seeking to apply the laws of household economics to the UK economy, the Conservatives do not realise the crucial difference. But maybe the public does. In private households cutting expenditure when faced with a falling income is a logical response, because reducing spending does not lead to a reduction in income. However, running the finances of a state is a little more complex since public expenditure cuts lead to a reduction in tax income.

The key is striking the correct balance and getting the timing right. This is a matter of judgment. The Conservatives and the Liberal Democrats have been calling for spending cuts since the budget in April 2009. Labour and Plaid Cymru have argued that cuts should only take place as and when there are clear signs of a sustained economic revival.

Outside the realm of politics much attention is paid to the reaction of the bond markets to the budget. The UK Government will have to borrow huge sums through the bond markets. This year the borrowing has effectively been paid for by the quantitative easing programme totalling £200 billion. In effect the Government and its agents have printed money and used it to buy up £200 billion of Gilts. Next year the Government will have to convince others to lend them the money. Currently interest rates on UK Government debt are only about 1 per cent higher than that for Germany. The key test will come after the General Election when quantitative easing can no longer be used to support UK borrowing.

In the case of Wales we already have a shrewd idea of the cuts that will be made in the Welsh Government’s budget from 2011 onwards. These cuts are, of course, imposed by Westminster although it will left to the Welsh Government to decide where to make the cuts. At least in the case of the elections to the National Assembly in May 2011 voters will be able to judge the spending plans of the various parties because the cuts will already be underway.

• Eurfyl ap Gwilym serves on the boards of a number of public companies, is an IWA trustee and an economic adviser to Plaid Cymru.

Eurfyl ap Gwilym

Also within Politics and Policy