House of Commons - Spending Review 2010

Spending Review 2010 - Treasury Contents

2 Economy

Impact of the Spending Review

7. In the June 2010 Budget, the Chancellor announced an extensive fiscal consolidation. That Budget forecasted that the policies of the previous Government inherited by the current Government would have led to a fiscal consolidation of £73 billion by 2014-15, made up of £52 billion of spending reductions, and £21 billion increases in net taxation.[2] The June 2010 Budget was forecast to add a further consolidation of £40 billion by 2014-15, comprising of £32 billion of reduced spending, and £8 billion from additional net taxation.[3] The Spending Review 2010 provided further information on the Government's plans, which had changed slightly over the period, although the scale of the overall fiscal consolidation remained largely unchanged.

8. As the National Institute of Economic and Social Research (NIESR) explained in their written evidence, cuts to departmental spending ended up lower than expected at the time of the June 2010 Budget:

In cash terms the Emergency Budget showed RDEL [Resource Departmental Expenditure Limit[4]] being cut by £15.5 billion in 2014-15 in comparison to the Pre-Budget forecast of the OBR [Office for Budget Responsibility]. The CSR has reversed some of these cuts with the difference from the pre-Budget forecast of the OBR now only £4.5 billion. It is of course not possible to fully detail which departments scaled back their cuts the most, but the reductions are not balanced across departments.[5]

9. The reduction in the cuts to departmental budgets was however, as NIESR explained, offset by further cuts to the welfare (within Annually Managed Expenditure[6]) budgets:

To keep budget spending on course something else has had to give and the Chancellor has focused yet again on the welfare budget. A further £7 billion is to be cut from this budget by 2014-15. This is on top of the £11 billion of welfare cuts in 2014-15 announced [in] June's Budget. In the space of 5 months the planned spending on the welfare budget has been reduced by 1 per cent of GDP.[7]

10. On capital spending, NIESR reported that "Investment plans have been raised by £2.2 billion by 2014-15. This returns the capital expenditure plans to those of the previous government by this year. But capital spending still falls over the next four years, from £51.6 billion in 2010-11 to £40.2 billion in 2014-15; a real terms cut of 29 per cent".[8]

11. The Spending Review set out spending cuts which will result in total public expenditure falling from over 47% in 2009-10 to approximately 41% in 2014-15, as a proportion of GDP. Over the last 45 years the average figure for total public expenditure as a proportion of GDP has been 42.7%. Chart 1 Total Managed Public Expenditure as a proportion of GDP

Source: HM Treasury website, Public Sector Finances Databank, Table B2

12. Lord Turnbull told us "you need to look at public expenditure in relation to the resources available"[9] and that:

expectations about what we as a nation could afford were 10% or 11% higher than they are likely to turn out to be. You can work this out by looking at money GDP. The latest figure of money GDP in the Budget Red Book, for 2014-15, is £1,800 billion. The expectation was that that would be about 10% more than that—that's, let's say, another £200 billion. The state, on average, takes about 40% of GDP, so it would have expected these revenues to be about £80 billion higher than they are likely to be. That is pretty roughly the number that people talk about as the savings that are necessary.[10]

The Government has embarked on consolidation which is significantly faster and deeper than that envisaged by the previous administration, but that should not obscure the fact that, whilst there is general party political agreement that consolidation is necessary, there continue to be differences over its precise method, timing and pace.

13. The Government should be realistic about the scale of the task it faces. In evidence, we pressed witnesses on whether the economic situation was as dire as had repeatedly been claimed.[11] While there was general agreement that the United Kingdom faced a very serious situation, we questioned witnesses about whether assessing the situation through the scale of the deficit, rather than of debt, which is not out of line with international comparisons, was appropriate.[12] We also questioned witnesses about the long run trend of public expenditure.[13] We agree that the Government faces an extremely serious economic situation; however an important task for Government is to maintain economic confidence. That confidence is undermined if the Government is unrealistically optimistic in its outlook; it is also damaged if the Government overstates the economic difficulties it faces.

Fiscal multipliers

14. We examined whether different forms of Government spending and taxation had different impacts on the economy. In its Budget forecast, the OBR provided table 1 of fiscal multipliers. The OBR explained the fiscal multipliers as follows:

A figure of 0.6, for example, means that a measure which has a direct effect of raising revenue by 1 per cent of GDP is estimated to reduce GDP by 0.6 per cent in the short run. The multipliers are based on a range of empirical studies which, together with judgement, can be applied to specific policy changes. The table shows the impact multipliers, which show the immediate effect of the change. We assume that the immediate effect is reduced over time through a number of processes as the economy adjusts.[14]Table 1: Estimates of Fiscal Multipliers

Impact multipliers

Change in VAT rate 0.35

Changes in the personal tax allowance and National Insurance Contributions 0.3

AME welfare measures 0.6

Implied Resource Departmental Expenditure Limits (RDEL) 0.6

Implied Capital Departmental Expenditure Limits (RDEL) 1.0

HM Treasury, June 2010 Budget, OBR Budget Forecast, p 95, paras C.54-60 and Table C8

15. As can be seen in Table 1, reductions in capital spending have the largest immediate impact on economic growth. Ian McCafferty, the Chief Economist of the CBI, noted that "infrastructure spending has a higher than average multiplier, in terms of stimulating growth over the short term".[15] He thought that "getting the infrastructure of this country right in support of business is particularly important".[16] In their written evidence, the CBI continued their call "for public sector net investment to return to 2.25% of GDP as soon as possible".[17]

16. We questioned Adam Lent, TUC, on whether the cut in capital spending placed the UK economy closer to recession, given the multiplier attached to it. He replied:

Obviously, any reduction in Government spending that has a fiscal multiplier of that sort will make it harder for the economy to grow effectively. That inevitably brings us closer to recession. That doesn't necessarily mean that we will go into recession, because there is a lot of uncertainty and unpredictability in the global economy and in how the national economy will perform. [...] Obviously there are spending restraints, but you also have to remember that capital spending, particularly on infrastructure, purchases assets for the Government that can be turned into future sources of revenue, so this is not a straightforward case of money lost into the economy. It is a serious mistake to cut it.[18]

When we questioned the Chief Secretary on why capital expenditure had been cut by 29%, given its high impact on growth, he replied:

In the context of a set of decisions that were about the need to go further and faster with deficit reduction than had been set out, [...], we decided not to reduce capital expenditure further, even though we were going further and faster in other areas, precisely because we thought that that was wrong in the context of economic growth.[19]

He then questioned whether all capital spending was of equal value:

As I said, when we then pored over the individual capital projects in detail, from a sort of bottom-up point of view, if you like, and we looked at the economic value—it's not quite true to say that all capital expenditure has the same economic value, because different projects have different economic value, as the analysis showed—we chose to emphasise and focus our expenditure on those areas that delivered most in terms of the wider economy. We are getting better value, in terms of economic growth, from the capital expenditure that we have chosen to sustain as a result of the quality of decision making in the spending review process.[20]

17. As explained in paragraphs 8 and 9, the Spending Review has increased the amount of projected departmental expenditure by £11 billion in 2014-15, and decreased welfare spending by a further £7 billion (in comparison with the June forecast). Although Table 1 suggests there is no difference between the OBR's fiscal multipliers for welfare and departmental spending changes, NIESR sets different multipliers for welfare and departmental spending. NIESR told us:

The fiscal multipliers derived from our global econometric model NiGEM suggest that a reduction in government spending on goods and services (broadly similar to RDELs) has a larger negative impact on overall GDP growth than a reduction in the size of the welfare budget (see Barrell and Kirby, 2010b). Overall then, this redistribution of spending may well boost GDP growth in 2013 and 2014 by 0.1 to 0.2 percentage points. Given that our latest forecast is for GDP growth to have accelerated to 2½ per cent per annum in 2013 and 2014 this positive contribution to economic growth comes when the economy is already well on the way to recovery.[21]

18. Given that it appears capital spending by Government has the greatest impact on overall growth, we welcome the additional £2.2 billion of capital spending by 2014-15 announced in the Spending Review, compared to the June Budget. We look forward to the forthcoming Autumn forecast, where the new Office for Budget Responsibility's forecasts will be presented. We will use subsequent opportunities to examine further the impact of the Spending Review on economic growth more closely.

Employment

19. Such a large-scale fiscal consolidation has given rise to questions about its effect on employment. The OBR had previously published a forecast of the expected reduction in general government employment, based on the effects of the June Budget. Table 2: OBR employment forecast

2010-11 2011-12 2012-13 2013-14 2014-15 2015-16

Whole economy Employment (LFS measure, millions, end of financial year) 28.89 29.08 29.36 29.69 29.97 30.23

General Govt employment level (millions, end of financial year) 5.53 5.47 5.39 5.23 5.04 4.92

Source: Office for Budget Responsibility, OBR forecast: Employment, 30 June 2010

That OBR forecast, set out in Table 2, suggests that General Government employment will fall by 610,000 from 2010-11 to 2015-16. On the day of our hearing, the Chartered Institute of Personnel and Development (CIPD) published a press release providing analysis of its expectations of job losses in the public sector. It expected that "based on soundings from public sector managers, [...] from the end of 2009-10 to 2015-16 the public sector will shed a total of 725,000 jobs".[22] This includes changes in employment projected to occur from 2009-10 to 2010-11, an additional year outside that covered by the OBR forecast figures in Table 2. We also questioned Dr John Philpott, Chief Economist of CIPD, on what was meant by "soundings".[23] He provided further information and clarification in written evidence explaining his projections.[24] Dr Philpott acknowledged though that these were 'first-round' effects, measuring the initial impact of the spending cuts, but without any consideration of behavioural reactions in later periods.[25]

20. Potential job losses in the public sector are only one factor in determining the overall forecast for unemployment. For that, further information is required on the potential for job losses in the private sector stemming from the spending cuts or tax rises, as well as the ability of the private sector to provide job opportunities. In the short-term, several of our witnesses expressed concern about the ability of the private sector to absorb these public sector job losses. Dr Philpott noted that "The big question is whether the economy will sustain a 3% rate of growth for the next few years. I think that that is a debatable point".[26] Ian McCafferty, CBI, told us that:

We have worries that in the very short term it is clear that 2011 is likely to be a period in which growth is relatively sluggish. I believe that we will see growth, but it is probably not going to be significantly in excess of our economic potential so unemployment is unlikely to come down and job creation is likely to be lower than average in the short term.[27]

However Mr Priyen Patel, Financial Affairs and Local Government Adviser of the Federation of Small Businesses, noted that:

I don't think that in the short term—in the next 18 months or two years or so—we will see top-line unemployment levels rise much more above what they are now. We think that with our flexible labour market, people accept pay freezes, working part-time and reduced hours, and that dampens down top-line unemployment figures. We think that will continue for some time in the short term, but we don't see a massive rise in unemployment above the current levels.[28]

21. Despite his forecast for public sector job losses, and concern over the near term, Dr Philpott was more optimistic about the ability of the private sector in the economy to absorb the job losses in the medium term. He noted that "My expectation is that once we get to 2012-13, given the amount of spare capacity that we have in the economy and growth returning to trend, we should see a healthy and decent recovery. I expect that we will get substantive and strong employment growth."[29] Ian McCafferty, stated that:

If we look at the performance of the economy both over the decade of the 1990s, when we had a similar period of economic austerity in terms of the public sector, and in the period from 2000 to 2008, we saw growth in total economy employment of some 250,000 or 300,000 a quarter over those two long periods. In that regard we would argue that over time the sorts of figures that the OBR has estimated so far are absorbable within the broader economy.[30]

However, Adam Lent, Head of the Economic and Social Affairs Department, TUC, was more cautious:

The OBR's expectation is that 2 million jobs will be created in the economy by 2015, and that will absorb the job losses that occur through the fiscal consolidation. However, if you look back to the recession in the early 1980s, it took seven years to create 2 million jobs in the economy and that was off an average growth rate of 3.6%. After the recession in the 1990s, it took nine and a half years to create 2 million net jobs in the economy, off an average growth rate of 3.2%. The OBR is predicting an average growth rate of 2.5% over the next five years. I'm not saying that its forecasts are wrong, but there are questions to be asked.[31]

The Rt Hon Danny Alexander MP, Chief Secretary to the Treasury, felt that the private sector would absorb the job losses in time:

The forecast we have for employment is for a marked reduction in the public sector head count of 490,000—that is the latest OBR forecast for June; it will publish another one in November—and for a growth in private sector employment over the same period of 1.6 million. The historical evidence suggests, in the way that you say, that that pattern of significant growth in private sector employment is one that has happened during previous consolidations, albeit not as marked as this one. None the less, experience suggests that those people who deny the possibility of the private sector creating jobs and leading the recovery are wrong.[32]

22. Several witnesses pointed out that the flexibility of the private sector had reduced the impact of the recession on employment. Ian McCafferty pointed out that:

It has already been cited this morning that many economists expected that unemployment would already have reached 3 million, rather than the 2.6 million that we have. That is testimony to the fact that the labour market has behaved very differently in this recession; there has been a great deal more flexibility and a great deal more adjustment in terms of hours and working conditions and less unemployment or at least total unemployment. There are more part-time/full-time splits than would have been expected at the outset.[33]

Mr Lent also suggested that there had been some flexibility:

What we certainly saw in the private sector, as you said, were unions willing to negotiate short-time working, pay freezes etc., although the extent of that was often overplayed quite considerably. About a third of trade union settlements in the private sector during the recession were pay freezes. There was no overwhelming 100% pay freeze across the private sector by any means.[34]

23. We asked whether the flexibility shown in the private sector, if extended to the public sector, would reduce job losses. Several observers were not sure that could occur. Mr Lent replied that:

It is really important to keep in mind here that that was possible in the private sector and key private sector organisations where there are high levels of trust between management and trade unions. Trade unions need to be absolutely convinced that there is a pressing financial need for those measures to be put in place, and they also need to be convinced that the measures are being put in place through careful negotiation with due consideration to the impact on trade union members and the wider work force. My concern is that, with the Government essentially announcing everything in one go, without any serious discussion with trade unions and public sector employee representatives, they have potentially lost the opportunity to create that trust and create a process whereby the changes can be negotiated.[35]

Dr Philpott also noted that:

The important distinction to make though between what happened in the private sector during the recession and what's going to happen in many public sector organisations over the next few years is that during the recession many private sector employers wanted to hold on to key staff. They had realised that there would be a demand for them in the medium term, but they were struggling to survive in the short term. They therefore looked to wage restraint as a way to reduce labour costs on a temporary basis, in the expectation that things would get back to normal at some stage. The difference in many public sector organisations in the current context is that they're engaged in substantial restructuring and employment downsizing. The prospect for continued employment is much lower and therefore, selling the quid pro quo is that much more difficult.[36]

Over the course of the Parliament, we will be monitoring the extent of public sector job losses, the capacity of the private sector to absorb reductions in public sector employment, and the relationship between employment and growth. As a first step, we look forward to the publication of the OBR's updated forecasts of employment later this month.

2 HM Treasury, Budget 2010, June 2010, Table 1.1, p 15 Back

3 HM Treasury, Budget 2010, June 2010, Table 1.1, p 15 Back

4 Departmental Expenditure Limits (DEL) effectively set out the expenditure budget for government departments. Resource DEL is the budget for current expenditure and Capital DEL is the budget for capital spending. Back

5 Ev 21 Back

6 Annually Managed Expenditure (AME) is expenditure which is not included in DEL and is not as readily controlled as DEL. It includes social security expenditure, local authority expenditure financed from local taxation and government debt interest. Back

7 Ev 21 Back

8 Ev 22 Back

9 Q 1 Back

10 Q 2 Back

11 Qq 1, 64, 65, 373-375, 609, 610, 685, 686, 759, Back

12 Qq 774-782 Back

13 Qq 180, 193 Back