Are the UK Government’s Deficit Reduction Plans Realistic? Part 2
This is the 2nd in a 3 part examination of the UK Government’s deficit reduction plans and its chances of success. It’s largely based on information presented by the British Chancellor George Osborne in his Autumn Statement delivered on 3rd December 2014 as well as some historic data that is publicly available.
Whilst focused primarily on economic arguments, some ill-conceived socio-economic policies are clearly hindering deficit reduction. Using basic due diligence on the plans proposed by the Coalition Government, it’s clear significant structural reform in the public sector is urgently needed. Few reforms have been delivered over the last 5 years, except by Local Government.
Part 1 reaffirmed the need to tackle the huge public deficit that exists in Britain (￡91 bn. forecast for March 2015). It highlighted the importance of controlling spend because future demographic and economic changes will make servicing ￡1.5 trillion of debt very challenging. The chaotic policies pursued by both Labour and the Coalition governments have hindered deficit reduction. Projected rises in income tax, national insurance and VAT receipts contained in the Chancellor’s Autumn Statement appear to be very optimistic. Reducing the deficit to zero by 2018/19 will depend on reducing public spending or raising the tax burden.
Raising taxes might seem like an easy fix but this would simply preserve the structural (inefficient) state of our public finances. Tax has to be fair and reasonable for citizens to willingly comply with the rules. Unfairness and punitive taxes have consequences, as King John discovered in 1215; the year Magna Carta was imposed by his Parliamentary Barons. Bad taxes will not solve our structural funding gap. By the same token, cuts to welfare and public spending have to be managed responsibly and fairly. But over the last 7 years, Parliament has relied on higher taxation rather than structural reform and there’s no King John to blame for this, just Parliament and our elected politicians.
Real Limits to Tax Yields
Nearly 55% of the ￡60 bn. deficit reduction to date came from additional taxes (see Part 1 - The Deficit Challenge). This compares with just 20% stated by Government in the 2010 Coalition Agreement (the other 80% was to have come from spending cuts).
Efforts to raise extra amounts of tax will prove difficult. The tax burden on average British households is already significant and quite regressive. It’s not helped by real wage levels still being nearly 6% lower than in 2008.
British politicians are reluctant to raise the basic rate of income tax, preferring to raise indirect taxes like VAT or the top rate of income tax. Recently there has been talk of introducing new taxes on wealth (capital taxes) such as a Mansions tax. Taxing capital is notoriously difficult and rarely produces sustainable tax revenues but it can trigger a ‘flight’ of capital.
Plenty of Euro countries saw large amounts of capital flee after their Governments took drastic measures to raise taxes and cut spending. This has created economic stagnation on an epic scale not seen since the 1930’s. There is growing doubt this capital flight can be reversed and if heavily indebted members are forced to leave the Euro zone, the Euro project may collapse.
Raising annual taxes on property (the banded Council Tax system) has been more successful, but only when the tax can be afforded by households out of regular ‘after-tax’ income, including people on modest incomes (e.g. pensioners).
The notion of raising perhaps ￡3 bn. of new taxes on ‘mansions’ valued over ￡2m., is fraught with practical difficulty. Labour suggests owners who can’t meet the cost could defer payment until the home is sold or the owner dies. This would create a ‘cottage industry’ for bureaucrats in the Land Registry and HMRC. It would destroy the efficient transfer of property in Britain; undischarged tax dues would need to be settled before ownership could pass to a new buyer. The Tax Man would become an unwitting link in the property-chain. You couldn’t design a more complex and impractical taxation policy if you tried. If owners can’t afford to ‘pay-as-you-go’ then the policy is clearly ‘unfit for purpose’. It would be open to abuse by both property owners and the apparatus set-up to manage it.
For basic rate tax-payers on salaries above about ￡10,500 per year, their marginal rate is 32%, including social security contributions. With real-incomes falling since the Banking Crisis, higher taxes (direct or indirect) will not yield much additional tax from average households. This is because any extra tax would have immediate consequences on people’s spending patterns. Changes to consumption would quickly impact economic activity and employment across the country.
The incentive to avoid tax is greatest for people paying the top rate of tax – currently 47% for salaried workers earning more than ￡160,500 per year (including 2% social security contributions). Taxing investment income (or income from capital) is more complicated as there are various Government schemes available to lawfully reduce the effective tax rate (including ISA’s) to between 0% and 37.5%. Similar complex arrangements exist for realised capital gains. Taxing unrealised capital gains (as would apply to some caught by a Mansion tax) takes the principle of fair taxation into a new parallel world of theoretical profits. This bears all the signs of a desperate Chancellor with nowhere else to go.
The ‘tipping point’ where tax avoidance and planning are triggered that leads to a net reduction in overall tax receipts, depends on what individuals believe the State offers them in return. This includes tangible benefits (the NHS or property rights) and less tangible entitlements such as protection under the law and democratic freedoms. Some highly taxed countries, Sweden for example, provide generous social benefits. This actually makes their ‘tipping point’ relatively high at about 50% (though their top tax rate is 56.9% with a base rate of -0.1%). In Britain historic studies suggest the ‘tipping point’ is in the low to mid 40’s %. However, with higher indirect taxes (including taxes on property) along with the sharp decline in State provided social benefits, the UK ‘tipping-point’ has almost certainly slipped by a few percentiles. This will be especially true of the young who see little prospect of generous welfare provision in their lifetime and won’t want to pay the levels of taxation paid by their parents or grandparents.
Tax from top rate payers declines sharply when the top rate rises above the ‘tipping point’. Rates above 50% in Britain are known to have a disproportionate negative effect on private sector investment, job creation and economic growth as well as in net tax receipts.
Raising the top rate of tax can have a pervasive negative effect on the economy. It quickly impacts businesses in the service sector and particularly workers on low wages. Service based employment depends on the prosperity of higher income groups. This has a direct and immediate impact on the earnings of many lower paid people. This may be counter-intuitive, but ask the owner of a high street restaurant what happened when the UK’s top tax rate went up to 52% between 2010 and 2013. You’ll begin to understand the impact high tax rates can bring for those on modest wages working in the service sector (includes child carers, cleaners, shop assistants, hairdressers, waiters/waitresses, hotel and theatre/concert workers, etc.).
Tax Avoidance – Symptoms of A Failed Tax System?
High tax rates will always encourage tax avoidance by the rich. There’s no public support for those who evade taxes (criminal behaviour), such as those who hold income in undeclared foreign bank accounts. Their funds are largely idle and do absolutely nothing to generate economic activity in the UK. But all UK Governments have been complicit in encouraging tax avoidance and even evasion – a clear sign our rates may be too high.
Not as strange as it sounds – recent Governments have all used special measures to encourage selective lawful ‘avoidance’, whether through the use of tax relief on pension contributions or tax sheltered saving vehicles such as ISA’s. Other less familiar measures, such as the Enterprise Investment Scheme and Non-Domiciled Residency, benefit the better-off who can pay for tax advice. Complex arrangements that favour the very well-off are of questionable economic value; they create a very un-level playing field for hard working and aspiring people denied access to these schemes. All this tells us is that our top rates are ‘economically disruptive’. Governments have introduced a host of socially useless tax avoidance measures that favour some people at the expense of others.
Encouraging people to structure their tax affairs so as to avoid tax is clearly a socially useless activity. But, this is what our politicians do when they implement (or threaten to implement) high tax rates. It reduces the net tax raised by the Exchequer and forces the average citizen to make up the shortfall. Politicians who play the tax raising card could not be more foolish if they tried - it’s a bit like promising Turkeys in September better feed if they’ll vote for Christmas. Some may be fooled but not all!
This has become the conventional way of working in the UK Treasury for more than 70 years – adding thousands of pages of tax rules and complex measures to appease disgruntled groups and attempt to fix past errors! A top rate of 50% might seem reasonable to comfortable, well-connected people in safe and secure employment; able to participate in ISA’s and tax-efficient Pension schemes.
The reality for a growing number of Britons is stagnating and unpredictable earnings, uncertain employment prospects and shrinking social provision by the State. As people are forced to become self-reliant, paying large amounts of tax to the State no longer seems fair and reasonable. The post-war consensus is broken and 50% tax really looks quite punitive. After all no Tiger economy imposes tax rates even close to this. One must question Who in Britain today benefits from high tax rates? Not the rich, not the poor, so who? With Parliament so ineffectual at forcing through public sector reforms, only Ministers with large Whitehall departmental budgets can be the current beneficiaries of taxpayers’ largesse? Perhaps they need to be reminded who’s boss?
Tackling the remaining deficit quickly and effectively will depend on cuts to public spending rather than higher taxation, whatever our politicians may bravely claim. Before examining structural reforms to our public services in Part 3, we must look at the potential for delivering further cuts to welfare spending.
Trends in Welfare Spend since 1996/97
The following Tables show how the two main categories of welfare spend have changed over the last 19 years. The figures in Table 1 show spend as % of GDP for each category and in total. Table 2 shows the same categories as % of total public spending.
Pension costs have risen sharply (by about 100% in real terms over the 19 years; from ￡72 bn. to ￡147 bn. @ 2013/14 prices). More worrying is that the relative % continues to grow as a proportion of total public spending and now exceeds 20%. Whilst the % of GDP has fallen slightly over the last 2 years, the unfunded nature of the universal State Pension scheme makes it a heavy burden on future generations. In just 19 years the share of GDP has grown by a staggering 41%. Of course the real value of pensions paid by the state has gone up much less than this so the increased % reflects a rapidly ageing population and rising life expectancy.
Welfare spend on the other hand has risen by about 15% in real terms; from ￡94 bn. to ￡108 bn. @ 2013/14 prices. Much of this rise reflects a growing population, suppressed wage levels since 2007 and a sharp increase in demand for in-work benefits, which we will return to shortly. The sharp fall as a % of both GDP and total public spending shows how some recent political rhetoric has been very misleading.
Quite a sharp fall in welfare spend happened after 2010 despite the growing cost-of-living crisis facing many households and stagnant national minimum wage levels for at least 2 years. The Coalition puts this fall down to a net extra 1.8 million jobs created since 2010; but many of these new jobs pay below the national average wage, so are likely to have moved from out-of-work to in-work benefits. Also housing benefit rules and rules that qualify people for incapacity benefit were changed so this too has contributed to the sharp fall since 2013.
Failure to Manage State Pension Provision since 1948
A rise in life expectancy is something to be celebrated, as are the causes – better healthcare, medical advances, greater prosperity and safer working conditions. However, until very recently the state retirement age (the point at which one could draw the state pension) had not changed since the scheme was introduced in 1948. In 1948 life expectancy for men was 66 and for women 71. Today men on average can expect to live to 79.5 and women to 82.5, a rise of 20.5% and 16.2% respectively.
The UK’s current universal state pension scheme is based on a social insurance model laid out in the 1942 Beveridge Report – Social Insurance and Allied Services. Legislation was passed in 1946 and the universal state pension came into effect in 1948 with men entitled to the state pension from age 65 and women from age 60. The age discrepancy reflected the work-life differences that existed between the sexes at the time. The universal state pension is non-funded so costs are met out of current taxation.
In a funded scheme there would be a statutory duty on Scheme Trustees to periodically test the adequacy of the fund to meet future obligations. Because it’s unfunded, this duty does not apply to the State Pension. But as we can see from Tables 1 and 2 above, the escalating cost of Pensions is a legacy of failed stewardship by successive Governments throughout the second half of C20th.
Whilst the working population grew and real earnings increased after the War, the burden of pensions paid to people living longer didn’t cause undue concern. But times change and rather belatedly the last Labour Government commissioned a study by Lord Turner and subsequently increased the state retirement age - phased over the coming decades. Those born in the 1990’s are unlikely to qualify for a state pension before they reach 70. From 2020 the qualifying age will be the same for both men and women (66). The Treasury must also review changes in life expectancy every 5 years, so the state pension age can be raised accordingly.
It looks like taxpayers will be funding state pensions worth at least 8% of GDP annually – a rise of more than 41% since 1996/97 (see Table 1 - Welfare Spend as % of GDP above). But as more baby-boomers reach state pension age this percentile could grow to unaffordable levels, probably exceeding 10% of GDP. This would place a huge and unsustainable burden on taxpayers and force savage cuts on other public services. Today pension costs account for 20% of total public spending (c. ￡150 bn. annually). If the burden did increase to 10% of GDP that would represent about 25% of total public spending at current levels. We can probably regard this ‘cost’ as a protected item since politicians are unlikely to attempt to reduce the absolute value of the state pension.
One way to manage this cost in time may be to address the unfunded status of the universal state pension scheme; in effect making sure obligations to pay current taxpayers when they reach retirement age are at least partly met from ring-fencing today’s tax receipts and investing these into a fund that will provide an income to pay pensions in the future. This would certainly help provide long-term financing for future public infrastructure projects and would be much cheaper for Government than the notorious Private Finance Initiative (PFI) arrangements set up with the Banks by the last Labour Government. We’ll return to these public-private financing arrangement in Part 3 as it’s an area needing radical reform.
Another area worth examining is pensions for public sector workers. Changes have been made to pension entitlement, with some public bodies raising the retirement age and employee contributions. But these reforms have not been extended to all public sector workers. Of particular concern are unfunded pensions enjoyed by Whitehall civil servants and some other public workers, such as front-line police and military personnel. These schemes need to be reformed. Even if politicians decide this won’t involve asking members to contribute, it’s an anachronism to exempt a public body in 2015 from the need to fund future pension obligations earned today in full.
This anomaly distorts the true costs of employing public sector workers in some bodies compared to others. All public sector pension obligations should be fully funded – the lack of transparency has no place in our public accounts in 2015. Bringing all public bodies into line would increase the employment costs by several ￡ billions each year, but with appropriate stewardship of the funds, they could be invested in viable UK infrastructure projects that produce income to pay for future pension obligations.
Where will Spending Cuts Come From?
In very broad terms, resource and capital spending across the public sector in 2013/14 was made up of the following major items (with protected spend areas (P) shown individually):
The NHS, Education and International Development Aid (totalling ￡231 bn.) have been protected by the Coalition, so spending cuts had to be found from other areas. If we add to these interest paid on the National Debt (￡47 bn.) and State Pension costs (￡143 bn.), this totals ￡421 bn. for 2013/14. That leaves just ￡293 bn. of unprotected spend, representing 41% of total public spending.
If the OBR’s projections for increases in tax receipts (shown in Part 1) are judged unrealistic then as much as c. ￡90 bn. of cuts still need to be found to balance the deficit. That’s 31% of the budget allocated to ‘unprotected’ spending departments. This would amount to ￡23 bn. in extra savings to be found every year over the next 4 years – that’s about 4 times the average annual saving achieved by the Coalition in the last 5 years.
A lot of spending cuts to date have come from departments managing outsourced spend or welfare payments – in effect third party expenditure. Although public sector headcount reported by the ONS has fallen from 6.1m in 2010 to 5.4m by mid-2014 (a net reduction of 700,000 since 2010), some generous severance payments have helped keep annual spend figures high, along with the deficit too. Real savings are typically seen 12-24 months after the job-holder has departed. This goes some way to explain why productivity in the UK has not risen in this recovery and why the productivity gap is still quite large.
Many job cuts have been voluntary; people opting to take ‘early retirement’ or ‘career change’. In many cases replacements were not appointed at the same grade or salary. Of course ‘real’ job losses are occurring and these will account for a growing proportion of the shrinking public sector workforce in coming years. By 2018/19 a further 400,000 public sector jobs are likely to have disappeared (IFS Briefing Note BN145, published Feb. 2014).
Did the 2014 Autumn Statement provide guidance on where spending cuts might come from?
Apart from inevitable reductions to resource spend (particularly staffing levels) other targets include welfare and capital expenditure. It’s possible to work out where the Chancellor expects savings to come from between 2014 and 2020 (see 2014 Autumn Statement Chart 4.9: Sources of deficit reduction). Most cuts are expected from resource spend (approximately ￡70 bn. by 2019/20 expressed at 2013/14 prices). Further welfare savings are expected to contribute nearly ￡19 bn. annually and capital spend a very modest ￡2 bn. This makes up the ￡91 bn. needed to balance the books.
So far in this election campaign, only about half these amounts have been quoted by the Conservatives - ￡30 bn. from resource spend and a further ￡12 bn. from welfare spend (by 2017), with ￡5 bn. coming from reducing tax avoidance (technically this is not a spending cut, it’s raising extra taxation). So there’s at least another ￡44 bn. unaccounted for. Perhaps the parties are hiding plans to raise additional taxes after 7 May 2015? Of course it’s unclear that more taxes will actually have the desired effect as they could hinder growth prospects and reduce net tax receipts.
Let’s look at obstacles to delivering another ￡19 bn. of annual savings from the welfare budget (or ￡12 bn. by 2016/17 based on the Conservative’s declared target).
Planned Cuts to Welfare
Significant cuts to total welfare spend (c. ￡112 bn. in 2013/14, excluding pensions) could simply push problems from one Whitehall department to another.
This was seen when Westminster failed to adequately fund social care in the community; a responsibility that rests with Local Governments but is funded by Central Government. This led to a sharp rise in hospital admissions and long-term stays for elderly people unable to secure support for care at home. It shows that at least two Whitehall departments failed to work together to implement a joined-up plan. If nothing else, this gives citizens good reason to doubt that Government and Westminster officials are capable of implementing change successfully when it has a direct impact on people’s lives. We’ll return to the dysfunctional way in which Whitehall departments and many public bodies are organised and run in Part 3.
If we conclude that pension costs can’t be reduced in the short-term, then welfare looks to be the most likely target for further cuts with a strong focus on in-work benefits.
In 2012/13 Housing Benefit payments amounted to ￡24.5 bn – of this ￡17.9 bn. was paid to people of working age. The level of support given to working age recipients has risen by ￡7 bn. (61%) in real terms since 1996/97.
Any further cuts to Housing Benefit will require wider policy measures to ensure the burden of support is shared equitably in a market that currently operates to the detriment of both the taxpayer and workers earning less than a living wage. The limited thinking about strategic housing policy that has characterised Governments in the modern era is having dire consequences on in-work welfare dependency, particularly for prosperous cities in the South East. This failure is directly responsible for the substantial increase in Housing Benefit costs – adding ￡7 bn. of taxpayer funded expense since 1996/97.
In addition to the ￡17.9 bn. of Housing Benefits paid to those of working age, Income Support and Personal Tax Credits accounted for another ￡32.8 bn in 2013/14. To bring the % of GDP back to 1996/97 levels a combined reduction for just these three welfare benefits would need to be c. ￡9.7 bn. This is only half the planned welfare savings shown in the 2014 Autumn Statement.
The Biggest Obstacle to Cutting Welfare Spend: Real Wage Stagnation
In real terms UK’s GDP has recovered to 2007/2008 levels. On initial examination, it’s encouraging to see the proportion of wages as % of total GDP has also grown. This shows many beneficiaries are working people, in most cases earning modest wages. Unfortunately, once we account for the net increase of 1.8m in UK jobs since 2010, real average pay per worker has still not recovered to 2007 levels. This severely limits the scope for further cuts to in-work welfare spending.
With just under 1m school and university leavers each year, this 1.8m of extra jobs over 5 years is hardly remarkable, particularly now retirement by a given age for many employees has been abolished. The lack of extra taxes received by the Exchequer from these new jobs (see Part 1 - Taxes Raised table) shows many are low paid.
Reliance by a large and growing number of adults on “in-work” welfare payments confirms both private and public sector organisations are not paying the level of wages needed to cover the costs of living in Britain today. A growing number of workers have come to rely on the State to subsidise low wages paid by their employers.
Expecting people to accept pay well below living wage levels and forcing them to turn to the State for in-work welfare assistance is ludicrous; it serves no useful socio-economic purpose. In fact by preserving pay below ‘economically viable’ levels, we are probably engineering the creation of a low wage economy for a growing number of our citizens. This has a root to stem effect and will supress earnings amongst professionals and executives over time.
Replacing the Minimum Wage with a Living Wage could deliver substantial cuts in welfare spending. All of us should be prepared to pay the ‘economic’ price for goods and services we buy. This ‘economic’ price needs to reflect the commercial (i.e. unsubsidised) price for work being done to deliver goods and services to us.
The Coalition claims it will “continue to reform and take tough decisions on public sector pay, while it continues to reduce the current budget deficit until 2017-18 and would expect to deliver commensurate savings.” But plans to freeze pay amongst public sector workers, or to raise these at rates much below inflation over the next 3 years are unrealistic. Many public sector workers are amongst the lowest paid in Britain today and have endured real pay stagnation for several years.
Pay increases for both public and private sector workers over recent years often represented awards for experience and performance alone – they are not a substitute for maintaining parity with the rising costs of living in Britain, despite what Ministers may claim.
Stagnant wages and the threat of cuts to in-work welfare assistance means low-paid workers face real challenges meeting the costs of living. Raising the minimum wage (currently ￡6.50 per hour) to the living wage (between ￡8 and ￡10 depending on where you live) may become a crucial policy if the next Government is serious about cutting welfare spending in a meaningful and joined-up way.
Raising the minimum wage would also help address successive Governments’ failure to provide affordable housing. It should encourage developers to regard affordable housing as a viable commercial proposition, so achieving two policy objectives simultaneously. But this would require some joined-up thinking by several Whitehall departments and based on recent experience this might need to wait for these departments to be radically reformed.
In the last part of this 3-part examination I look at the obstacles to cutting departmental spending (excluding welfare, which is discussed above) and the urgent need to reform public sector organisations so they work better for citizens.
Author: Simon Rydings
Part Two of Three: A Critique on the UK Government’s Deficit Reduction Plans