Spending Review 2010 - Treasury Contents


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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