Written evidence submitted by Policy Exchange
GENERAL POINTS
We are extremely supportive of the overall scale
and thrust of the Spending Review. We shall have some criticisms
to offer, below, of detailed points, but these should be read
in the context of strong overall support. Over the year prior
to the Emergency Budget, we argued that a discretionary consolidation
of around £100 billion was required, including around £80
billion of spending cuts. We argued that around £6 billion-£10
billion of this should occur in the year 2010-11, and that the
spending cuts should be front-loaded as much as was feasible.
Our view was, and remains (as we shall detail
further below), that early spending cuts are more likely to promote
growth (even in the short term) than to impede it and that even
though there is a general case to be heard for not raising taxes
(or even cutting them slightly) during large fiscal consolidations,
it is not in our view plausible that an 11% of GDP deficit offers
more stimulation to the economy than does a 10% deficit. We emphasize,
as we have emphasized throughout, that the key fiscal issue was
the excessive level of spending (not the deficit), and hence that
the rationale for the early 2011 VAT rise is less clear than for
early spending cuts, and that although we believe the evidence
suggests that cutting spending under current circumstances is
likely to promote growth, that should not be depended upon in
isolation—rather, we believe that it would be safest to
pair this fiscal tightening with additional monetary loosening
in the form of more quantitative easing.
Although we agree with the scale of the consolidation,
we believe that the offered "mandate"—to eliminate
the current (ie non-capital) structural deficit by 2015-16—has
no very clear virtue. We believe that the approach of focusing
on current spending, and placing no significance on total structural
deficits (including capital spending) reflects the bankrupt paradigm
of Gordon Brown's Fiscal Rules which manifestly failed to provide
any adequate discipline on government expenditure and deficits.
States are not businesses that depend on the product of investment
for their future revenues. States obtain revenue through taxation
on the wider economy, and thus there is no meaningful distinction
between state borrowing being used to pay for capital versus non-capital
spending. State capital spending is irrelevant to the long-term
sustainability of its fiscal position. The correct approach would
thus be to eliminate the structural deficit as a whole, not merely
the "current" part.
MANNER OF
THE SPENDING
REVIEW
Defining the broad parameters of the Spending
Review in the Emergency Budget several months previously worked
well by identifying the scale of the challenge publically. The
setting of a spending "envelope" undoubtedly focused
minds publically and in Whitehall. It also proved reassuring to
financial markets who were able to "price in" the anticipated
consolidation and avoided a sovereign debt crisis or ratings downgrade.
Policy Exchange was not formally asked for input
into the Spending Review process. We feel a more coordinated approach
to engaging relevant stakeholders could be useful in future SRs.
Our suggested approach prior to the SR for several key departments
was given in our report Controlling Public Spending: How to
Cut 25%.[19]1
We also published a response immediately following the SR.[20]
The limited effectiveness of the "Star
Chamber" perhaps demonstrates the importance of incentivising
departments to find sufficient savings. Previously successful
consolidations have involved allowing ministers to keep a proportion
of the identified savings to be "recycled" back into
their own budget (eg Canada in the 1990s). The prospect of membership
of a "Star Chamber" does not seem to have been an adequate
replacement for such financial incentivisation given the significant
number of "last minute" deals. In any case, this process
seems to have been overridden by political and time pressures.
We also believe there was significant confusion
over the objective of the Spending Review on a departmental level.
Much comment was made in the press about "25% cuts".
This took its lead from the Chancellor's Emergency Budget speech.
However, the meaning of this figure (the reduction in non-ringfenced
departmental expenditure limits) was never clarified. Some seemed
to assume this meant the total reduction in government expenditure—we
note that the actual figure in this connection (Total Managed
Expenditure) is only 3.3%. The precise perimeters of the 25% figure—what
was excluded and included in the ringfence, whether this figure
referred to current or total expenditure, for example—were
never well defined by the Treasury. As noted in our previous reports
on lessons from history and international experience, British
governments have often "talked tougher than they acted"
when engaged in fiscal consolidations, whilst in other countries
where fiscal consolidations were successful, more of a "what
you see is what you get" or "under-promise and over-deliver"
approach was taken.
RING-FENCING
We believe that the decision to ring-fence certain
departments was misconceived and resulted in much larger than
appropriate cuts being imposed in other areas. Specifically, it
was a mistake to ring-fence spending in areas where spending had
risen the most (in particular Health spending had risen by one
third over the previous Parliament alone), whilst imposing significant
cuts in areas where spending had not risen (such as defence).
A little-recognised consequence is that the proportion of total
departmental spending that will go on Health will rise rapidly
in the next few years.
We believe that the natural logic of the situation
should have been as follows:
— The problem is that spending is too high.
— Spending is too high because it has risen
too fast.
— It has risen too fast because of very
large rises in particular departments.
— Therefore, the least painful way to cut
back spending would be to cut it in the areas where it has risen
the most. (Of course, some cuts elsewhere might also be necessary.)
By way of illustration (without recommending
a particular figure at this point—which we see as fruitless),
if health spending had been cut by 10% then that would have left
it, in real terms, still above its 2007-08 level. We do not believe
that Health was regarded as significantly under-funded in 2007-08,
and we note that real GDP in 2010 will certainly be smaller than
it was in 2006. Such a cut would have reduced cuts in other departments
by around £10 billion—clearly allowing scope to avoid
significant cuts in defence and allowing lower cuts in many other
departments that had not previously experienced large rises.
We note that historically successful consolidations
generally did not have so many prior commitments and ringfences
before the spending review process began. We believe this may
have led to sub-optimal policy decisions and undermined the efficacy
of the review process. It is true that, although some consolidations
have involved cuts to health spending, that has been rarer than
cuts in other departments, but in these other cases health spending
had not risen so rapidly immediately prior to the spending cuts
programme beginning, and hence the scope to achieve material cuts
to health spending would have been far less than is the case in
the UK.
IMPACT OF
SPENDING REVIEW
ON LONGER-TERM
GROWTH
The key problem facing the UK economy is that
households are heavily over-indebted, having gambled on rapid
wage rises to service very high debts, particularly mortgage debt.
If households do not achieve rapid wage growth, they are likely
to begin defaulting on their mortgages, imposing large losses
on the banking sector and leading to the failure of a number of
banks. Because the UK government has (arguably ill-advisedly)
chosen to stand behind the bonds and deposits of a large portion
of the UK banking sector, failures of UK banks would lead to the
UK sovereign's guarantees of the banking sector being called upon,
threatening the sovereign's creditworthiness. This is the key
threat to the UK's creditworthiness—failure in the banking
sector—not, per se, the UK government deficit or the stock
of UK government bonds. Of course, because the UK sovereign has
been under threat in this way, it was very important for the sovereign
not to add to its already-over-extended position by failing to
reduce its annual borrowings, so it is good that the deficit is
being reduced. But the key danger remains the banking sector.
To enable households to service their debts,
the UK's medium-term growth prospects needed to be restored. The
most straightforward tool the government had to achieve this was
reducing the level of government spending. A host of academic,
central bank, and international institution studies on the effects
of government spending on economic growth rates have been conducted
since the 1970s, and the overall message is clear and unambiguous:
although modest levels of government spending can promote growth
(eg by guaranteeing property rights, public order, personal security,
and competition and reducing exploitation), above about 25% of
GDP government spending begins to reduce growth. It does not follow
that spending more than 25% of GDP is undesirable, of course.
Government spending promotes wider social welfare in many ways,
by assisting the poor, the elderly, the vulnerable, and others.
But as spending increases above about 25% of GDP there is a trade-off
between promoting these wider social welfare goals and reducing
the longer-term growth rate of the economy. The rule of thumb
(explored in our Controlling Spending and Government Deficits:
Lessons from History and International Experience)[21]
is that each additional 1% of GDP that goes on public spending
reduces the growth rate of the economy by about 0.1-0.15% per
annum.
In 2007-08 UK government spending was about
41% of GDP—a fairly typical level for the previous 40 years.
It then spiked up rapidly to 2009-10, to around 48% of GDP on
the standard GDP at market prices measure, over 50% on the standard
measure preferred by the OECD. The vast majority of this rise,
of some 7-10% of GDP in just two years, was unrelated to the recession,
as pointed out in our June 2009 publication Controlling Public
Spending: The Scale of the Challenge.[22]
Most of it resulted from continuing with the spending plans of
the 2007 Comprehensive Spending Review even though the wider economic
context had changed radically. That spending rise, some £90
billion in just two years, was the key driver of a structural
deficit of some £120 billion. Because it was structural in
nature, it would not have disappeared when the economy recovered—we
would have been stuck with government spending of some 48-50%
of GDP over the longer term.
Absent corrective action, a rise of spending
of 7-10% of GDP would have been expected to take around 0.7-1.5%
off the medium-term growth rate of the economy. So if the pre-2007
sustainable growth rate was 2.5%, the growth rate now would have
fallen to only 1-1.8% even before taking account of the damage
to sustainable growth arising from damage to financial market
functioning (both intrinsically and because of misconceived regulatory
responses). A halving or more of the sustainable growth rate of
the economy would have meant much slower real wage growth. With
slower real wage growth, unless there were high inflation, households
would have been driven into default, dragging down the banks and
potentially the sovereign.
The spending review takes spending down, as
a proportion of GDP, to around 40% by 2015-16, restoring some
0.7-1.5% to the sustainable growth rate of the economy. This should
be expected to promote growth in the short term, as well as the
longer term, for three key reasons:
1. Because the longer-term GDP growth rate is
more rapid, longer-term growth in (pre-tax) wages will be more
rapid, so households will be less likely to default in the short
term and more likely to be able to smooth their deleveraging.
(Loosely, we can say that they will consume more than otherwise,
but this should be understood as implying that consumption will
not drop as far as would otherwise have been the case—we
do not suggest that this fact will drive a short-term consumption
boom.)
2. Because spending cuts credibly constitute
the majority of the fiscal consolidation, there is less fear that
taxes will rise in the future to close the deficit. Whilst the
first factor meant that pre-tax wages would be higher, this second
factor means that post-tax wages will be higher. Able to keep
more of their own money, households will better be able to service
their debts and freer to reduce their consumption by less.
3. The third factor is much discussed in the
press, but in our view less significant, namely that because the
UK's deficit was very high and because other countries have faced
sovereign debt crises, there was a risk that the UK would be affected
by sovereign debt crisis contagion, with interest rates spiking
up as a consequence. Insofar as sovereign creditworthiness was
ever really an issue, we believe that the key driver was sovereign
commitments to the banks, and hence reflected in factors 1 and
2 above. Understood independently as an issue of the scale of
the UK's deficit, we believe that this was an issue (and the scale
was indeed potentially material (as argued in our April 2010 Report
The Cost of Inaction,[23]
a rise of 2% in interest rates was not out of the question), but
the first two issues were so serious that they dominated. Furthermore,
the first two issues fundamentally required spending cuts—tax
rises would have been positively counter-productive—whilst
this third issue could be partially addressed by large tax rises.
Because we believe that the first two issues are the key ones
and offer a different policy consequence—spending cuts and
the minimum feasible tax rises—we emphasize the lower significance
of this third factor.
Thus, overall, our view is that the Spending
Review has been a vital step in restoring the UK's sustainable
growth rate and hence reducing the threat to its creditworthiness
that widespread defaulting on mortgages threatened. Its scale
and balance were approximately correct, and although we regret
that the balance of spending cuts to tax rises is not greater
in the early years, have qualms about certain of the tax choices
(eg raising VAT rather than the Basic Rate of Income Tax—which
we argued would be less damaging to growth in our publications
in advance of the Emergency Budget)[24],
and believe that the decision to ring-fence the areas where spending
rose most at the expense of large cuts in areas where spending
had not risen, nothing in politics is perfect, and in our view
this Emergency Budget and Spending Review have been about as good
as it gets.
November 2010
19 http://www.policyexchange.org.uk/images/publications/pdfs/How_to_Cut_25_-_Oct__10.pdf Back
20
http://www.policyexchange.org.uk/images/publications/pdfs/Spending_Review_Response.pdf Back
21
http://www.policyexchange.org.uk/images/publications/pdfs/Controlling_Public_Spending_-_Nov_09.pdf Back
22
http://www.policyexchange.org.uk/assets/Pub_spend_3Jun.pdf Back
23
http://www.policyexchange.org.uk/images/publications/pdfs/The_cost_of_inaction.pdf Back
24
http://www.policyexchange.org.uk/images/publications/pdfs/Taxation__Growth_and_Employment_-_March__10.pdf Back
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