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.