Andrew Lilico: Examining New Labour's second spending spree

Andrew Lilico is the Chief Economist of Policy Exchange.  The new Policy Exchange research note, “Controlling public spending: the scale of the challenge”, was piublished yesterday.

There have been two separate surges in spending under Gordon Brown: the first rise took spending from of 36.3% of GDP in 1999/2000, to 41.3% by 2005/6. Arguably this is what the Government had been elected in 1997 to do. Spending then stabilised – remaining at 41% of GDP until 2007/8.  But since then an unprecedented second surge has begun. In 2008/9 public spending rose to above 43% of GDP. The 2009 Budget envisages spending rising to 47.5% of GDP in 2009/10 and the 48.1% in 2010/11 – a rise of more than 7% of GDP in just three years.

Even this is based on rosy assumptions – spending is likely to hit a record of over 50% of GDP. The Budget’s forecasts for public spending as a share of the economy are based upon highly optimistic forecasts about growth. For example, the IMF thinks that by 2010 the UK economy will be 2.2% smaller than the Treasury thinks. Taking just this difference in growth, that implies 2010/11 spending of 49.2% of GDP. That’s a rise of 8.2% in just three years - larger even than the wild rises of the 1970s. That would bring the total spending increase since 1999 to a stunning 12.9%. The European Commission also predicts a bigger increase than the Treasury. It forecasts that its (rather broader) measure of public spending will rise from 44% of GDP in 2007 to 52.4% of GDP in 2010 – a rise of 8.4% over three years, and an increase of 13.2% since 1999. The further out the projection, the more rosy the Treasury forecast looks: e.g. the independent forecasters surveyed by the Treasury think that by 2011 the economy will be 3% smaller than the Treasury estimates.

The second surge in spending is huge - in both historic and international context.  The surge in public spending is much bigger than during the last two recessions. It is even bigger than the loss of control which led to the IMF bail-out in 1976. Compared to other countries, our public spending rise is bigger - despite similar or worse economic problems elsewhere.

Only a third of the second surge in spending is the result of the recession – most simply reflects a choice to increase Government consumption spending.  Between 2007/8 and 2010/11 spending is forecast to rise by £119 billion. But little more than a third (38%) of this increase in spending reflects the costs of the recession – like rising social security bills, and higher debt interest. None of the cost of the banking bailout is included in the total. About 6% of the increase is related to an increase in capital spending – which you could argue is a sort of Keynesian “public works” programme. That still leaves 56%, over half of this increased expenditure, which is the result of chosen increases in consumption expenditure. £19 billion of this is current spending on the NHS, £9 billion is Education and £41 billion goes to other departments.

Why splurge next year, only to cut back?  Given that the Treasury argues the UK will have started growing by late 2009, and that most of the spending has nothing to do with combating the recession, it’s difficult to see the case for continuing to increase spending into 2011. In fact the 2009 Budget acknowledges that the increase will be swiftly followed by cuts after the election: between 2010/11 and 2013/14 public spending will be cut by 2.5% of GDP, then there will be a further tightening (either spending cuts or tax rises) of 3.5% of GDP in the years to 2017/18. The Treasury’s own estimate of the remaining structural deficit is £50 billion. Its own panel of forecasters’ estimates suggest a remaining deficit of £70 billion. The current phase of fiscal tightening is 80% spending reductions, and we can expect later tightening to be similarly focused on spending reductions (as all evidence from past fiscal consolidations is that only spending reduction-based consolidations are successful). Thus we can expect that if Labour is re-elected, it will institute further cuts of at least £40 billion-£60 billion, and perhaps as much as £70 billion. If opposition parties are serious in their stated intention to be tighter in spending than Labour, that means that spending reductions greater than this — more than £70 billion — should be under consideration as a minimum first step.

There should be an emergency budget after the next general election to call off the planned increase in spending.  It is much easier not to raise spending than it is to cut it later. The next general election must be held by 3 June 2010, but is likely to be earlier. If we just abandoned the discretionary increases in consumption spending (i.e. still allowing social security etc to rise) between this financial year (April 2009/10) and the financial year (April 2010/11) we would save £21.6 billion. If discretionary spending were frozen at the 2008/9 level now, we would say more than £50bn in the first year.

Did people think public spending in 2007-2008 was too low? Even before the second surge in spending, public opinion had shifted against ever-higher spending. According to the British Social Attitudes survey, as late as 2002, 63% of people supported higher tax and spending, while 35% wanted the same level or less. But by 2007 only 42% wanted more tax and spending, while 54% wanted the same or less. Public attitudes are likely to have shifted further since then. The Government has already announced that it will increase tax for everyone earning more than £20,000 a year by raising NI contributions.

Higher spending will reduce the rate of growth: An ECB study by Afonso & Furceri (2008) found that  “a percentage point increase in the share of total revenue (total expenditure) would decrease output by 0.12 and 0.13 percentage points respectively for the OECD and for the EU countries” –Mo (2007) writing in Fiscal Studies finds an even higher figure: “a 1 percentage point increase in the share of government consumption in GDP reduces the equilibrium GDP growth rate by 0.216 percentage points”.  In other words, a 10% GDP rise in spending could cut growth by 1-2% a year.

We are unlikely to tax our way back to stability.  The Government has already announced that it will increase tax for everyone earning more than £20,000 a year by raising NI contributions. The Treasury thinks a 1p increase in the basic rate of tax raises about £4 to £5 billion, so trying to fix the £175 billion a year deficit without controlling spending would require absurdly high tax rates.

The risk of a crisis is rising:  the 2009 Budget predicts record borrowing: 12% of GDP (£175 billion a year) and a doubling of the national debt. Many analysts think even this is too optimistic and Standard and Poor’s have already warned that the UK’s credit rating may be downgraded, which could spark a vicious circle of rising borrowing costs and higher borrowing. If we do not think that the UK will return to strong growth, and we think that oversized public spending will hold back growth, then it is essential to put the public finances back on a sustainable footing more quickly. The best place to start is by cancelling the planned rise in discretionary government consumption spending.

So why put off until tomorrow what needs to be done today?  The effect of freezing spending on everything other than social security, tax credits debt interest and capital is simply to move us more quickly towards fiscal stability. It would not represent a spending “cut”, but instead a choice not to increase discretionary spending which has nothing to do with the recession. It would simply accelerate the slowdown in spending which the Government itself acknowledges needs to happen.