October Budget 3: In presenting a macroeconomic fiscal stance, Rachel Reeves and Labour need to talk about improving public services rather than book balancing

 

Most of this series will be about the economics behind the budget. So far we have had why tax increases rather than economic growth is how to end austerity. Later posts will look at fiscal rules, public investment and what tax rises are possible within the Chancellor’s commitments. This post is more political. It looks at the extent to which Labour can blame tax rises and continuing poor public services on the last government, and how Reeves needs to frame her forthcoming budget.

As is well known, the 2010 Coalition government did a highly effective job in placing the blame for its own spending cuts on the previous Labour government. As a consequence, and incredibly, more voters blamed Labour than the Coalition government for spending cuts. It was incredible given the macroeconomic reality was very different (see here and initial link to my article). Given the reality of the terrible economic record of the 2010-24 Conservative government, it is quite understandable that the current Labour government wants to place the blame for its unpopular decisions on the last government where it can.

A lot of the criticism of this attempt by Labour is based on vibes. It makes Labour seem gloomy, it is argued, whereas what people want is hope and optimism (usually adding references to the Harris campaign in the US). I prefer to think about the different contexts of 2010 and 2024. In 2010 voters were still recovering from the major shock of the Global Financial Crisis, and were seeing the start of the Eurozone crisis, after a previous decade of what looks by today’s standard pretty good times. In contrast, the whole 2010-24 period has been pretty gloomy in terms of real wage growth and public services.

In 2010 there was therefore a single bad economic event that everyone experienced, and it was natural (though wrong) for ‘low information’ voters to blame that on the government in power at the time it happened. With the Eurozone crisis constantly in the news, and seeing it generally portrayed (wrongly in most cases) as a crisis caused by fiscally profligate governments, it was easy for the Coalition government to argue that it too was having to deal with a fiscal crisis caused by the previous profligate government, and easy to suggest it needed austerity to avoid a market crisis like that happening in the Eurozone. As I have noted so many times, most of the media were happy to promote or go along with this narrative.

The clearest example of this Labour government trying to do something similar was Rachel Reeves statement on 29th July, where she talked about how the fiscal situation she inherited is even worse than the OBR had thought, and outlined the cuts she was making as a result. What evidence we have suggests she failed to transfer the blame for this on to the previous government (source and details).

Since the election Labour support has fallen and Conservative support has risen in the polls, such that the Conservatives are just 4% behind in a recent poll. While it must be true that a lot of this is due to the unpopularity of ending the pensioner winter fuel payment [1], this is also a continuation of a trend that began well before the General Election, a point I will come back to later.

So why is Labour not succeeding in transferring blame to the last government when much of that transfer of blame is justified, while in 2010 the Coalition government succeeded in doing so when it wasn’t justified? There is an obvious caveat and also a partial explanation. The caveat is that it is too early to tell. The Coalition’s ‘it is all Labour’s fault’ was a theme pursued relentlessly for years. The partial explanation is that much more of the media will resist that transfer of blame today compared to the period from 2010. It is also possible to argue, as I suggested here, that this transfer of blame might have worked if Reeves had simply reversed recent Conservative tax cuts rather than hitting pensioners, because then the association with past actions would have been clearer.

However I think there is another explanation, which has an important political lesson for the October budget. Even before 2010, the Conservative party managed to convince many voters (again erroneously) that reducing the government budget deficit was the economic problem, and they had considerable support in that from the Labour Chancellor as well as the media. The Eurozone crisis, and the global turn to austerity in 2010, appeared to back them up. So cutting the deficit was what the Coalition were elected to do.

In contrast, this Labour government was not elected to reduce a huge budget deficit. It was elected, in large part, to fix the NHS and other public services. A 'senior Labour source' said recently that Labour were elected 'first and foremost to sort the public finances'. This is nonsense. The election campaign was not about the public finances, as it was in 2010. What the public were concerned about was the NHS. As a result, justifying cuts to fill ‘black holes’ rather than to improve public services was never going to be popular, because that is what the Conservative government did repeatedly and voters wanted a change.

In this respect it is important to ignore what much of the media writes or says. Journalists are obsessed by what they call black holes in the public finances. The term black hole is mediamacro for a gap between a forecast for the government’s deficit and what the government’s chosen fiscal rule says that number should be. [2] This black hole is the slender reed on which to write speculation about what a future budget may contain in the way of tax or spending changes.

Understandably, people tend to care much more about tax increases or spending cuts than black holes. Journalists know this, which is why the ridiculous term black hole is used in the first place. It is designed to transform what is in reality a highly uncertain forecast about budget arithmetic related to something largely artificial into a number that readers should regard as very important and potentially even dangerous. Of course it is neither very important nor dangerous.

Such tricks might get an article read but it doesn’t stop most people thinking poorly of a politician that cuts spending or raises taxes just to fill a black hole, unless there is a general consensus that this black hole threatens a crisis. What the Conservatives did from 2010 onwards, with the help of Labour, the media and the Eurozone crisis, was create that consensus. The consensus today (if you exclude the Conservatives) is that public services need fixing, and not that we are facing a fiscal funding crisis. Attempts by Labour’s Leader of the House to suggest that the financial markets would have reacted badly if Labour had not immediately filled part of the black hole they discovered were met with general and justified derision. Suggestions that cuts were required immediately to fill an unexpectedly high in year deficit are also economic nonsense.

The script for the Budget at the end of October is already being written by the media. Rachel Reeves will increase taxes to fill the part of the black hole she failed to fill in her recent statement. It would be a big mistake if the Chancellor followed this script. As one of the main thing most voters want to see from Labour is an improvement in public services, it would be much better to justify tax rises as enabling additional public spending rather than filling black holes.

What economists call balanced budget increases in public spending, higher spending matched by tax increases, are likely to be popular among most voters when public services are under stress, particularly if those tax increases mainly hit the better off. The 2017 election campaign clearly shows this, and public service provision has deteriorated significantly since then. In contrast, Labour lost votes during the last campaign, in part I suspect because they kept to what Marc Thomas calls their small target strategy, when many voters were looking for something more substantive. They are still looking.

Taxes are bound to rise in October’s budget, and the Conservative opposition will say I told you so. The way to respond to that is not to talk about black holes that Labour inherited, but talk about the woeful state of public services Labour inherited, how Labour are beginning the long process to restore those services, and that this process requires those with broader shoulders to contribute more to enable that to happen. That is what Labour governments are elected to do, and they are popular when they do it.

[1] Why was cutting the winter fuel allowance so unpopular? After all, it is absurd to give wealthy pensioners hundreds of pounds every winter for something they can easily afford. Some of this is just the power of this voting group. But a real problem I suspect is that there is a large group of pensioners whose income is above the level at which they can obtain pension credit, but below a level where it is easy to save in summer months to prepare for higher winter fuel bills, particularly after recent increases in food prices. The UK state pension is low compared to most other countries. I cannot see any reason why the allowance shouldn't be taxed. 

[2] Which in turn is based on a forecast for GDP, as fiscal rules tend to have GDP in the denominator.

October Budget 2: How much do UK taxes need to rise to end public spending austerity?

 

Austerity is a term used in many different ways, but this post will involve numbers, so I need to be precise about what I mean by ending austerity. I want a measure to capture how the provision of public services (including welfare provision) is significantly poorer than people might expect given general levels of prosperity. Note that this definition makes austerity about the level of public services, and not their rate of change. Many people use austerity as shorthand for cuts to public spending, and particularly the period from 2010, but it makes more sense here to treat austerity as reflecting the level of public services relative to some norm defined by general levels of prosperity.

We know we are currently living in a period of public sector austerity by looking at sector specific indicators: hospital waiting times are unusually high, court cases are being delayed for months or years, and so on. (For a detailed analysis covering four key sectors, see this Institute for Government report.) However it is much more difficult to know how much extra spending is required to get all those indicators back to more normal levels.

Some of the spending required to restore public services may be in the form of a one-off increase in public investment, to make up for a lack of investment over the past 14 years. As John Burn-Murdoch showed here for example, investment in the NHS collapsed after 2010. There are excellent reasons why one-off or ‘catch-up’ increases in spending should be financed by borrowing rather than tax increases, while permanent spending increases should be matched by higher taxation. As a result, my focus in this post is on permanent rather than one-off increases in public spending. I will discuss public investment in a later post after talking about fiscal rules.

The aggregate measure I will focus on is public social spending as a share of GDP [1], as defined by the OECD, which I talked about at length in an earlier post. This mainly includes public spending on health and welfare (including state pensions), but excludes education and defence. [2] According to OECD data, UK public social spending was 23.1% of GDP in 2010. I will use this number as a date specific baseline level of public social spending which clearly cannot be described as austerity. It is date specific because this number needs to be updated over time because of trends in health spending.

UK health spending as a share of GDP roughly doubled from 5% to 10% between 1980 and 2010. The reasons why, in order to provide the same level of services, spending on health as a share of GDP needs to rise over time are well known, and include a steadily ageing population. The share of health spending in GDP has also been rising over time in most other countries. It therefore seems reasonable to assume that to maintain 2010 standards of provision, and ignoring the pandemic, this share of health spending in GDP would have needed to increase to around 12% by 2022. In contrast, actual UK health spending as a share of GDP remained pretty flat between 2010 and 2019 (before the pandemic), but the quality of health services clearly deteriorated over that period, as waiting times data shows.

That would imply that austerity free public social spending would have been around 25% of GDP in 2022. OECD data has actual public social spending at 22.1% of GDP in 2022, suggesting a gap of about 3 percentage points of GDP between levels of public spending and what is required to get back to 2010 standards i.e. to ‘end austerity’. UK GDP in 2022 was £2270 billion, so 3% of GDP in 2022 is about £70 billion. If either the GDP share of education or defence (not included in the OECD’s definition of social spending) also needs to rise, then the spending gap will be above 3% of GDP..

Unfortunately the UK’s current position is even worse than this, because the forward plan the current Chancellor has inherited involves austerity getting worse, not better. As was widely discussed during the election (and which was first noted in this blog back in March 2023) the previous Chancellor pencilled in additional cuts to spending over the next five years, to make his tax cuts look affordable. Total current public spending as a share of GDP is set to fall from 44% in 2024/5 to 42.5% in 2028/9. That could mean that 1.5% of GDP of social spending needs to be added to the 3% noted above to end austerity in five years time, giving us 4.5% of GDP’s worth of additional public spending (over £100 billion) required to end austerity.

Perhaps this number can be reduced because Labour can find some areas of wasteful public spending that the previous government was reluctant to cut for ideological reasons. Perhaps additional investment in the public sector, and even public sector pay increases, can improve public sector productivity. But a strong argument can also be made for increasing the share of GDP going to education and defence, which would raise this number. Finally these are, off course, ballpark numbers designed only to give a rough idea of magnitudes required.  

Higher public spending that is temporary, even if temporary means a decade or two in duration, can and generally should be paid for by higher borrowing. However the additional public spending required to end austerity is permanent, and that means it needs to be matched by higher taxes. That in turn implies taxes as a share of GDP need to rise as a share of GDP by a similar amount to public spending [3]

The OBR in their last forecast estimated that taxes as a share of GDP (national accounts definition) will be 37% in the financial year 2028/9. We are frequently told that this share is at record levels, but it is almost never said why this has to be so. As I explained here the trend rise in health spending is bound to mean the share of taxes in GDP keeps rising, because since the end of the ‘peace dividend’ there is no offsetting major area of public spending where spending is steadily declining. We should therefore ignore past UK history as an indicator of what taxes should be. If the Chancellor keeps the current falling debt to GDP rule (see a later post on the fiscal rules on why she shouldn’t) then under the last OBR forecast to get public spending up by 4.5% of GDP would require total taxes to rise to become 41.5% of GDP by 2028/29.

If that seems incredibly high, it is still below the level of taxes as a share of GDP in France, Austria, Finland, Belgium, Italy and Denmark in 2022, and it is likely that a few other European countries will be above 41.5% by 2027. Comparisons with the US, and therefore the whole of the OECD, are meaningless because US taxes don’t pay for universal healthcare.

Of course Reeves is not going to raise taxes on that scale in one budget. However, ending public sector austerity should be a realistic target for Labour to aim for over a ten year period. Labour’s mission on health should involve getting back to how Labour left the health service when it was last in office. If they want ten years in office it makes political sense to raise taxes and spending sooner rather than later. The problem the Chancellor has is that an increase in taxes of the order of magnitude required to end austerity is very hard to achieve while keeping her commitment not to raise income taxes, employees NIC or VAT.

I will look in more detail at what taxes Reeves could raise in a future post. The next post in this series will be about whether some of those tax increases can be avoided by adopting better fiscal rules, on why changing the current rules would be sensible anyway, and how that process should start in October.

[1] The reason I divide public spending by GDP was explained in my first post on the October Budget.

[2] Defining permanent, non-austerity levels of spending in both education and defence is more difficult because the former is influenced by demographic swings, and the latter by medium term but hopefully not long term threats.

[3] Matching tax increases to current and permanent spending increases makes sense over the medium term when output is at a level that ensures inflation is constant, so that what is added to aggregate demand in terms of higher public spending is taken out by higher taxes.