Osborne lessons bw

Two U-turns, plus a devolution revolution

Top lineThe Chancellor’s Autumn Statement and Spending Review package contained two key changes to the direction of policies announced only four months ago. The first, and highest profile, is the reversal of the previous decision to cut the main tax credits, at a cost of £9.4bn over the five years of the Office for Budget Responsibility’s forecast.

No less significant, however is the change in direction over the planned rate of cuts to Whitehall budgets. These are now expected to come in at £10bn in real terms by 2019-20, compared to the £17bn cuts pencilled in as recently as July, and the figure of £40bn at the Coalition’s last budget in March. This easing could be interpreted as a signal that central government has now been pared back to its political and practical limits.

Some of the cost of these two changes is met from an even more benign economic outlook than was the case just a few months ago, automatically raising forecasts of tax receipts and reducing debt interest payments. But the remainder comes from policy decisions, such as a levy to fund apprenticeships, increases to stamp duties on the purchase of second homes and further behind-the-scenes cuts to welfare later into the parliament.

The other highly significant policy change, although not explicitly a U-turn, was a declared intent to devolve more financial priority-setting to local authorities. In a classic case of a policy designed to dissipate opposition to high-profile cuts, English councils will, over the course of this parliament, obtain full control over business rate receipts and greater ability to raise council tax, but they will also lose their direct government grant and gain responsibility for the delivery of key front-line public services, starting with adult care but potentially widening to primary health care and even housing benefit for the elderly.


Whitehall priorities

Wednesday’s announcement included the allocations between government departments for the financial years 2016-17 to 2019-20. The winners in terms of current spending were the defence and intelligence departments, which saw cumulative real increases over the spending review period of 2.3 and 17 per cent respectively (although the latter from a low base).  The NHS is also a winner, securing a 3.3 per cent real terms increase over the forecast period, more than they had asked for in their own 5-year plan. International Development also does well with a 21 per cent increase, in line with previous commitments, a fact that did not go unnoticed by some elements of the right-wing tabloid press.

The biggest loser is the Department for Communities and Local Government, which sees a 29 per cent decrease in its budget by 2019-20, as grants to local authorities are phased out. Transport also sees a large cut – 37 per cent – but this is only their running costs: transport was the winner in terms of capital infrastructure expenditure, rising to £61bn over the parliament to fund HS2 and an ambitious programme of road and rail improvements.  Other significant losers are the Departments for Business, Innovation and Skills, Energy and Climate Change and Environment, Food and Rural Affairs which see cumulative real terms cuts to their programmes of 17%, 16% and 15% respectively over the spending review period.


Policy priorities

The official theme for the day was “security”, be that national security, economic security, energy security, cyber security, household security or just simply “securing the economic recovery”. Just in case the message was not clear, even the more technical official documents had mandated “security” subheadings in each section of their text, regardless of whether the subject under discussion was, say, Culture, Media and Sport budget allocations, or the Home Office.

There were high-profile announcements on housing, including a doubling of the housing budget from 2018-19, designed to deliver at least 400,000 more affordable homes, an extension of the Right to Buy scheme to Housing Association tenants and a new Help to Buy scheme focussed on higher-priced homes in London.

Housebuilders would further be supported with the release of brown field public sector sites for 160,000 homes and investment in a new garden city at Ebbsfleet. At the same time, investment in buy-to-let properties and second homes was made less attractive by the imposition of an additional 3 per cent stamp duty on purchases.

Local authority responsibilities are set for a major shake-up with the publication of a consultation paper next year on devolving responsibility for a number of frontline services traditionally outside their domain, with suggestions including public health, the administration of pensioner housing benefit and transport capital projects. The Autumn Statement also committed to the phasing out of the revenue support grant, options for councils to switch capital receipts to some types of current spending, the introduction of a precept for social care and 100% business rate retention, suggesting a structural change to the way local government is financed away from central support towards greater local accountability particularly for community services and business policy.


Winners and losers

Major new sources of taxation are the introduction of a levy on employers to fund apprenticeships, set to raise over £3bn annually by 2020-21. People buying second homes and investing in buy-to-let properties will also lose out through the introduction of a new stamp duty land tax rate on additional properties, which will bring in over £800m annually by the end of the parliament.

Other losers are housing association tenants claiming housing benefit: significant government savings come from aligning housing benefit for social tenants with the private sector equivalent, which will save £220m annually by 2020-21. Higher earners will lose eligibility for childcare support, saving £125m annually by 2020-21. Pensioners in receipt of savings credit also lose out through a tightening of the eligibility criteria and a welfare saving is achieved by aligning Universal Credit rates with the increase in the minimum wage. The renewable heat incentive is made less generous, saving £690m annually by 2020-21 and further savings of around £270m each year are achieved by retaining the diesel supplement for company car taxation to 2021. There are also – as has become customary – significant projected savings from clamping down on tax avoidance and bringing more of the administration of taxation on-line.

On the winners side, small businesses get an extension to the doubling of small business rates relief and tax credit claimants are granted a reprieve in 2016, with a reversal to the previously announced changes. However the spending review still assumes a significant fall in tax credit payments later in the forecast period – total spending on tax credits is expected to fall from £29.1bn in 2015-16 to £23.7bn in 2020-21 according to the OBR.

Indeed while the specific measures announced in the Autumn Statement increase welfare spending by £3bn in 2016-17 as compared to July, the same budget line scores a welfare saving of 0.3bn by 2020-21, implying that there has been a new policy decision behind the scenes to tighten universal credit eligibility in future years to make up. Tax credit recipients have been granted a reprieve, not a release.

While the full budgetary effects of the proposed “devolution revolution” to English councils have not yet been worked through, the freedom to introduce a new council tax precept to pay for adult social care suggests that council tax bill payers might also start to see themselves the losers of this year’s Autumn Statement decisions.


Economic forecasts

The Office for Budget Responsibility’s forecasts of real GDP growth have been relatively stable over the course of 2015, at least compared to earlier years. The latest projections are for the economy to grow a notch faster in 2016 and 2017 than previously anticipated, reflecting an expected boost to the economy from the slower pace of cuts and also the positive effects of a higher-than expected growth in the working-age population driven by higher net inward migration.
Thereafter however growth will fall back a little more than previously thought due to the effect of population ageing on the employment rate and other minor changes to the underlying model, but is still projected to grow comfortably at around its trend rate for the foreseeable future (Chart 1)

Chart white 1
It’s also worth noting that in the last forecast the official estimates of the performance of the economy in the years immediately after the financial crisis have been revised upwards. Real GDP is now estimated to be around 2 per cent higher at the end of 2012 than it looked at the time, meaning that the downward revision to forecasts that occurred in 2013 now looks overly gloomy.Inflation forecasts are little changed as chart 2 shows, although the net effect of a number of small adjustments such as the further fall in oil prices and sterling’s depreciation, means that in the near term, the return to the Bank of England’s 2 per cent target is expected to be a touch slower than expected in July.
Chart white 2
Meanwhile, there remains no let-up in the ability of the labour market to support job creation, with employment forecasts revised upwards for the fifth consecutive year, expecting to surpass 32 million by the end of the decade (Chart 3).Despite much recent debate over the “productivity paradox”, the labour market is now starting to do what might be expected at this stage in the cycle, with both productivity and real wages starting to grow strongly, suggesting that further increases in the number of people in employment may start to slow. The Office of Budget Responsibility suggests that spare capacity in the economy will be used up by early 2018, after which point further wage rises might be a cause for concern. However this will be alleviated by employers seeking to pass on the cost of the apprenticeship levy onto their employees through lower wage rises.
Chart white 3
Chart 4 suggests a big hike in stock of government debt, but this is due to a technical issue, namely the reclassification of housing associations to the public accounts. The underlying picture, however, remains unchanged from July, namely that debt peaks in 2014-15 as a proportion of GDP, allowing the government to meet one of its fiscal targets.
Chart white 4
In this year and next, the downward trajectory of the stock of debt is driven by privatisation income, which compensates for the underlying gap between revenue and expenditure.However by 2016-17 changes to the underlying balance begin to bear fruit, bringing the stock of debt down each year. Over the course of this parliament, the largest single measure to fill the gap between revenue and expenditure remains the cuts to government departmental budgets, which contribute around £10bn of savings (down from £17bn in July) or around half of the total required.

The next most significant measure to eliminate the deficit comes from cuts to welfare which despite the U-turn over immediate tax credit cuts, will contribute around a quarter of the total savings required through a phased reduction in the generosity of the Universal Credit over the course of the parliament. Whilst failing to meet its self-imposed welfare cap in the short-term, the government therefore remains on track to keep welfare spending within that ceiling by the end of the parliament.

However, since the July forecast, both of these proposed deficit-fixing measures have been reduced in size, made possible through an increase in projected receipts from income tax and national insurance contributions as the long-anticipated rises in productivity and wages push more people into higher tax brackets. Towards the end of the parliament, it is the increase in revenue from specific tax decisions (as detailed in the ‘winners and losers’ section) that plays a bigger part in the improvement to the overall fiscal position, with capital spending remaining roughly constant overall.

The government books have also benefitted from changes in monetary policy expectations: recent announcements from the Bank of England have further pushed out expectations of interest rate rises and increased the timeframe over which the Treasury can expect to receive income from the Bank’s holding of government gilts as part of the Asset Purchase Facility.

Taken together, these measures mean that the government is also on track to meet the other main part of its fiscal mandate, namely to run a surplus in 2019-20 and thereafter, in “normal” times. However, after taking account of the cyclical effects, the budget moves into surplus earlier, as shown in Chart 5.

Indeed the cyclically adjusted budget deficit forecast has improved slightly in the months since July: the first time that the lines on the graph have moved to the left between forecasts in the Office of Budget Responsibility’s history.

Chart white 5
Points to watchAs in the past, many of the underlying assumptions made to these forecasts depend on circumstances beyond the government’s control. In particular, the presumed path of interest rate rises has significant impact on the fiscal forecasts by altering the cost of debt repayments, which in turn is linked to movements in prices which may be affected by, for example, to the level of oil prices and the value of sterling. Instability due to the forthcoming EU referendum has not explicitly been factored in to the forecast. Moreover estimates of the “output gap” are notoriously unreliable in real time; a small difference here can have a big effect on the presumed performance of the economy. And finally, the ability of government to actually deliver on planned spending cuts (or expenditure plans) may be over optimistic.

Since its creation in 2010, the OBR forecasts have been subject to a number of errors, leading the OBR themselves to state that if their central forecasts are as accurate as official forecasts have been in the past, then the likelihood of the government being able to run a surplus in 2019-20 is only 55%.

In policy terms, the greatest grey area concerns local government financing and, indeed, the response of the Scottish and Welsh devolved administrations to their new fiscal powers. It may be that future budgets are charting revenue and expenditure patterns where the decisions made are increasingly outside the Treasury’s own control.

Written By

Kitty Ussher