Over the past few days, questions have emerged about the Liberal Democrats’ proposals for fiscal consolidation. Liberal Reform felt it would therefore be helpful to clarify what the challenges are, to explain how some of the figures are derived and to help people understand what the scale of the problem is.
Which deficit are we cutting and how much does it cost?
All three political parties have committed to eliminating the budget deficit over the next parliament. There are two things that divide the parties, however:
- The speed of the consolidation – in what year will the budget be balanced
- The definition of the “budget deficit.”
The Liberal Democrats have committed to eliminate the budget deficit by 2018-19. The Labour Party have postponed consolidation to 2020 and the Conservatives are being vague about when in the next parliament the budget will balance. The Lib Dems position reflects current government plans.
More importantly, the three parties are focusing on a different deficit:
- The Conservatives wish to eliminate the overall deficit – the difference between government income and government outgoings (known as “Public Sector Net Borrowing” or PSNB)
- Labour wish to eliminate the cyclically-adjusted current budget, also known as the “structural deficit” – that part of PSBN that is not due to the current state of the economy but would exist even if output were back to trend.
- The Lib Dems wish to eliminate that part of the cyclically-adjusted current budget that does not include investment spending – that is to say, eliminating the structural exempting “borrowing for investment”.
These difference matter. The 2015-16 deficit on these different calculations is as follows:
- Conservative: £75.9bn
- Labour: £68bn
- Lib Dem: £49.4bn
These figures are the OBR’s prediction for next year’s budget deficit, which the next parliament will need to close. Note that they may be revised in the budget on 18th March 2015
On the face of it, this leaves the Lib Dems needing to find £49.4 billion of spending cuts and tax rises.
However, according the Lib Dem website:
Next year, the government will make £20bn of efficiency savings, including:
- £1.9bn on advertising, consultants and temporary agency staff
- £1.7bn by making large projects on time and within budget
- £600m by selling empty government buildings
These “efficiency savings” would reduce the remainder of the consolidation needed to close the deficit to £29.4 billion. However, it is notable that the website only specifies how £4.2 billion is to be achieved. Members and voters would have more confidence in those £20 billion of savings if further details were available.
Conversely, The Institute for Fiscal Studies note that:
…in a June 2014 speech, Nick Clegg suggested that only investment that ‘enhances economic growth or financial stability’ would be excluded from headline borrowing when calculating the Liberal Democrats’ measure of the current budget. This could imply a tighter fiscal stance than under the standard definition of the cyclically adjusted current budget.
Spending cuts versus tax rises
At least as important as the scale of the fiscal consolidation is how we go about it – what taxes we raise, what spending we cut, and it what proportion. It is this last that has prompted much of the debate in recent weeks.
It is widely recognised by economists that how fiscal consolidations are structured is a key factor in achieving successful and lasting reductions in the debt-to-GDP ratio. Economists also agree that fiscal adjustment packages that are made up primarily of spending cuts are more likely to lead to lasting debt reduction than those composed of tax increases, and that they are less likely to trigger another recession. There is also research that suggests that fiscal adjustments based mostly on the spending side are less likely to be reversed.
More specifically, there is a strong consensus around the view that developed economies recover most quickly where fiscal consolidation is based on 80% spending cuts and 20% tax rises. This is why, in 2010, the Chancellor committed the Coalition to roughly that approach. It was, he explained, “supported by the international evidence, compiled by the Organisation for Economic Cooperation and Development, the International Monetary Fund and others…” Since the early 1990s, this has been amply demonstrated in Sweden, New Zealand and Canada, none of which was obviously a hotspot of zealous economic neo-liberalism.
How do the Lib Dems plan to eliminate the deficit?
Recently the Lib Dems announced that they would aim for a 60:40 ratio between spending cuts and tax rises. This in turn led some people to propose an alternative, 50:50 balance. The following table compares the balance of spending cuts and tax rises under three scenarios:
- International best practice
- The Liberal Democrat proposal
- Alternative proposal.
We further factor in the assumption that the Lib Dems have already found £20 billion of savings.
However, the Liberal Democrats have also made a number of additional spending promises that need to be added to the list. Any additional spending must be met either with an alternate cut or a further tax increase. These additional spending commitments include:
- Increase the personal allowance to £12,500 by 2020–21
- £250 bonus for anyone receiving the carer’s allowance/premium for a continuous 12 months
- Offer free childcare for all 2-year-olds, paid for by abolishing the married couple’s tax allowance
- Two-thirds discount on bus travel for 16- to 21-year-olds
- Extra £1 billion of spending on the NHS.
Summary
If the Lib Dems wish to fund 40% of fiscal consolidation from 2015 from tax increases, this will require around £20 billion of new taxes. If the alternative proposal succeeds in persuading the party to increase this to 50%, the new taxes required will be £25 billion. To this needs to be added the cost of the above promises.
Just one of these promises – increasing the personal allowance from £10,500 to £12,500 – will cost £10 billion. Ignoring all other potential spending promises, this adds a further £10 billion that needs to be funded by cuts or tax rises elsewhere. That leaves the Lib Dems looking for £30 billion of tax rises, while the alternative proposal would require £35 billion of tax rises.
These are phenomenally large sums of money. Considering the balance of government income (see chart), the vast majority of this will fall on ordinary people.
Photo by James Cridland james.cridland.net
* Tom Papworth is a member of Waltham Forest Liberal Democrats