The three trade-offs facing a chancellor

In 2013 the Fabian Commission on Future Spending Choices set out its proposals for the 2015 spending review. The commission identified three trade-offs which any chancellor must face – the balance between the present and the future; between tax and spend; and between more or less inequality. This extract from the 2013 report proposes how any chancellor should strike the right balance.

Trade-off 1: prioritise the future or the present?

Fiscal sustainability

In thinking about the public finances today, we should be mindful of the needs of future generations. We believe it is right to borrow to mitigate the effects of economic crises and to create assets for the future but that, in general, a high and rising level of public debt is undesirable. In particular, if policymakers were to maintain debt at today’s levels on a permanent basis, while there might be few consequences in normal times, the UK would not have room for manoeuvre should another major fiscal crisis occur. As a commission we are committed to sustainable national debt and support the goal of returning public debt towards pre-crisis levels over decades. New fiscal rules should be developed to create a transparent means of monitoring progress towards that goal.

Meeting conditions regarding sustainable debt (over each economic cycle) should be a long-term priority, which should not be set aside by the short-term temptation to cut taxes or spend more. From the perspective of paying off debt, it does not matter whether stable finances are secured by restricting spending or increasing taxes. Both high and low spending alternatives are compatible with fiscal responsibility. However, the prognosis for public debt would become a great deal easier if higher rates of trend growth could be achieved and, in part, this depends on growth-oriented spending choices: we believe that decisions about future levels and composition of spending should be taken with growth in mind.

Future or present oriented spending?

Responsibility towards the future is not just a question of debt, but also of the balance of expenditure. There is a difficult trade-off to make between present-oriented and future-oriented spending. At a detailed level, within many policy areas, there is an import balance between ‘early action’ and meeting needs as they present themselves. However, there are also major choices in the broad allocation of resources across spending areas.

Spending on ‘the present’ includes pensions and healthcare, which are skewed towards older age groups. We strongly support spending in these areas as part of a strong welfare state which smoothes resources over people’s lives, mainly on a universal, collectivist basis. Expenditure in these areas is also very popular and provides a stable source of economic demand. However, with rising pressures in these fields, there is a risk that future-oriented spending will be squeezed out. This spending includes expenditure on children and young people, skills, innovation and long-term infrastructure and can be expected to increase future wellbeing and economic output. In addition, further government spending may also be needed in order to decarbonise the economy, to complement tax and regulatory policy.

The trade-off between present and future oriented spending will pose immediate dilemmas for a 2015 government, which will inherit plans to spend considerably less of our national income on

education and capital spending than was the case before the crisis. In 2007/08 education spending stood at 5.4 per cent of national income and the OBR projects it will sink to 4.5 per cent by the end of this decade (education spending will not have been lower since the early 1960s). Similarly, gross capital investment in 2017/18 is projected to be 2.8 per cent of GDP, which is below the average for the 1990s and 2000s and far beneath levels seen from the 1950s to 1980s. Sticking to this low level of public investment will have a significant long-term effect, unless the money can be substituted by increased private investment.

We believe that, over time, governments should seek to increase future-oriented spending as a share of national income from its current low levels. This should ideally be the aim for a 2015 government, although it will face heavy constraints in achieving this; in practice preventing further decline might be a realistic first objective. In the short term a future government might choose to treat spending on capital, skills and economic programmes no less favourably than the NHS. Over the long term, in order to increase future-oriented spending, it may be necessary to identify ways to rein in rising costs of healthcare and old-age social security at the margins, while maintaining good quality, universal provision. But future governments may also need to accept that more future-oriented spending will not be possible unless overall expenditure rises as a proportion of GDP.

Trade-off 2: restrain spending or increase tax relative to GDP?

The overall level of spending and taxation is the sum of hundreds of spending and revenue streams. From a ‘bottom up’ perspective, it is important to debate the desirability of different levels of spending and taxation in each of these areas. But we also need to look ‘top down’ to ensure that the future direction of spending and taxation policies are fiscally and politically sustainable.

Spending

Levels of spending are political choices but there are also practical constraints. There are upward pressures on public spending which mean that the ‘default’ is for public provision to cost more over time, not just in real terms but as a proportion of GDP. These pressures include demographic change and increased public demand for services as a consequence of growing prosperity. Rising costs in the public sector also create upward pressure on spending, although that can be partly countered by robust efforts to improve performance, productivity and value for money. This all means that over the long term, if public spending is to remain roughly stable as a share of GDP, there will need to be a reduction in the generosity or coverage of entitlements, relative to national income.

In some cases outcomes would simply be worse as a result. For example people with low incomes would be poorer and less able to secure good healthcare. But in other cases there would be a rise in private sector provision, either in a gradual, unplanned fashion as users of services made individual choices that public provision was inadequate; or as the result of policy decisions, for example to cease providing an entitlement on a universal basis. In this case all the same upward pressures would continue to exist, they would just effect private sector consumption rather than public spending. People would have to pay one way or another, through higher taxes or higher personal charges. In some cases the idea of most people topping up public provision with their own arrangements is well established and unproblematic: it is desirable for people to save for a pension or insure themselves against loss of income beyond what the state is able to offer. But with respect to public services, growing private involvement would not only be less equitable it would probably be less efficient, as the United States’ experience of healthcare demonstrates.

If possible we wish to avoid moves in this direction and so we are open to the possibility of moderate increases in expenditure as a share of national income over the long term. This will not avoid the need for tight controls on spending and tough action on public sector performance. However, it will only be possible to contemplate spending rising by more than GDP once deficit reduction is complete. In the meantime, the choice facing policymakers is the pace at which spending lags behind economic growth.

Taxation

While there are clear upward pressures on public spending, the prognosis for taxation is more balanced. In the short term, with no changes to tax policies, an economic recovery should lead to a cyclical increase in revenues, although it is hard to predict how growth will feed through into tax-generating activity. Over the long term there are downward and upward pressures on revenue which roughly balance out. Over time revenues can be expected to rise as a share of national income due to ‘fiscal drag’ (the practice of linking tax thresholds to inflation not earnings). However, the OBR also highlights a number of areas where existing revenue streams may decline (eg oil and gas revenues, transport taxes, environmental taxes, tobacco duties, corporation tax).

Future governments will need to decide whether tax changes should be broadly fiscally neutral or whether it is possible and desirable to gradually increase the overall tax share. This would be necessary if governments wish to both increase spending to reflect rising pressures and achieve sustainable public debt. There are likely to be significant political and practical constraints to a move in this direction, after 25 years of fairly stable levels of tax as a share of national income. However, a comparison with other advanced economies shows that the UK raises less revenue than many of its peers.

We believe that a moderate rise in taxation may well be the better option, when compared to the consequences for spending and outcomes of the alternative. This is a long term choice although some decisions on the tax share are likely to be needed in the first half of the next parliament.

Trade-off 3: how much to prioritise addressing inequality?

Governments can equalise life chances and standards of living in three ways: by levelling-up opportunities through investment in the capabilities of individuals and communities; by shaping the working of the market economy so rewards are distributed more evenly; and by redistributing through social security, public services and taxation to equalise wellbeing in spite of market inequalities. The first and third of these strategies (which often overlap) entail significant public spending. Although options other than spending (eg market reforms or making taxation more progressive) have an important role to play, the evidence we have heard has convinced us that adequate levels of public spending, distributed in a way that takes account of social needs, remain an essential means of achieving a more equal society.

The scale of government action to address inequality is linked to both overall levels of spending and also to the composition of that spending. Our recommendation that resources should be refocused towards ‘early action’ and, more generally, towards ‘future-oriented’ budgets has the potential, if the money is spent well, to reduce inequalities in life chances.

The allocation of resources

Public spending, as well as having universal aspects, should benefit people from low income groups more than anyone else: not only do poorer families typically receive more public support, but any specific level of resource is expected to make a greater difference to their lives, compared to those of people who start with more. However, for decades policymakers have discussed the ‘inverse care law’, the insight that those who need the most support often experience the lowest standards. This

is partly explained by the ‘sharp elbows’ of higher income groups, but it can also be put down to the allocation of public money, which does not fully reflect the higher need for services linked to social disadvantage. Both the Labour and coalition governments have attempted to counter this phenomenon: for example Labour established children’s centres and academy schools in low income neighbourhoods first; while the present government has introduced a ‘pupil premium’ in schools and a new university funding system which each target funding to children from low income families.

However the coalition has also reduced the account taken of deprivation in its geographic allocation of resources for both health and local government (Labour in government had increased both). This stores up problems for the future and a 2015 government should seek to reverse these changes, where it makes sense and within existing spending totals. Future reforms to needs-based allocations should seek to establish wide agreement on the nature of varying needs and costs, to avoid this topic becoming excessively politicised. Demographics, population scarcity and social disadvantage all need to be weighted, alongside geographic variations in the costs of service delivery.

Social security

The coalition government has made significant reductions to social security, which can be expected to increase levels of poverty – although pensioners have been exempted. However, there are also long-term problems with social security that are less widely recognised: the underlying design of legislation will drive up poverty and inequality over time unless action is taken. This is because the law increases non-pension benefits in line with prices, which normally rise by less than average earnings. We do not believe that an assumption of rising poverty should be designed into long-term social security policies.

Many people assume that spending on social security is on an upward trajectory. However on the basis of current policies, social security will decline as a share of national income (notwithstanding the upward pressures on pensioner entitlements). By contrast, the Department for Work and Pensions forecasts that linking benefits to earnings not prices (which would lead to stable levels of inequality in the absence of other changes) implies social security spending rising slightly in the years after the austerity cuts are complete. This illustrates the trade-off between the government’s fiscal position and the extent to which policies mitigate inequality.

It will only be possible to combine spending a smaller proportion of GDP on social security with stable or falling levels of inequality by reducing demand for social security. In the short term we hope this might be achieved if better than expected economic growth leads to savings from labour market related social security. In the longer term structural economic reforms would be needed. For example, higher levels of pay, increased employment and more affordable housing could all reduce spending as a share of GDP (any increases in public spending in achieving these reforms should be more than offset by reduced social security and higher taxes). In each case to reduce inequality the savings arising from the reforms could be recycled into paying for more generous entitlements while maintaining the forecast level of spending.

However none of these structural reforms would generate significant savings in the short term. This means that in the early years of the next parliament adopting a more generous approach will be very hard. In our view there is very little room for manoeuvre with respect to further reductions in entitlements, since we would be concerned to see any measures introduced which would further reduce the living standards of people with low incomes; we also want to see the universal principle retained as an important component of social security. There are only a very limited range of reductions we think could be contemplated.