Fixing the public finances: eight years of pain? Carl Emmerson Presentation at IFS public economics lecture, London 17 December 2012 http://www.ifs.org.uk/projects/401 © Institute for Fiscal Studies IFS hosts two ESRC Research Centres

What are the objectives of fiscal policy? Resource allocation public goods externalities Distributional objectives between individuals between generations Smooth output fluctuations automatic stabilisers discretionary stabilisers © Institute for Fiscal Studies

What are the constraints on fiscal policy? Intertemporal budget constraint Should be consistent with macro stability and sustained economic growth internal vs. external borrowing taxes are distortionary Should consider intergenerational equity avoid excess debt and borrowing © Institute for Fiscal Studies

Why is fiscal discipline hard to achieve? Temptation to spend more / cut taxes leads to deficit bias Political business cycles play a role risk of losing the next election means policymakers place too little weight on the future cost of current borrowing Imperfect information often unclear where in the economic cycle we are, therefore how much spending/revenue is structural (permanent) or cyclical (temporary) © Institute for Fiscal Studies

How can fiscal discipline be improved? Make explicit what the government views as desirable policy Make sure policymakers’ incentives are better aligned with the optimal outcome change payoff structure to increase the cost to the government of deviating from desirable policy Trade-off between delegation and discretion delegation: increases credibility and reduces political risk discretion: enables policy makers to respond to shocks © Institute for Fiscal Studies

The Chancellor’s fiscal framework Rule 1: balanced structural current budget by end of forecast horizon advantage: forward-looking not inappropriately constrained by past borrowing performance disadvantage: easy continually to add an extra year of fiscal squeeze in last year of forecast horizon Rule 2: debt as a share of GDP falling in 2015–16 not a sufficiently constraining fiscal target in the longer term sensibly, Chancellor plans to announce a debt target “once the exceptional rise in debt has been addressed” Independent “Office for Budget Responsibility” to produce official macro and fiscal forecasts increased transparency, intended to eliminate any suspicion that forecasts politically motivated © Institute for Fiscal Studies

The problem? 7 Sources: OBR; Author’s calculations. © Institute for Fiscal Studies Sources: OBR; Author’s calculations. 7

The problem? 8 Sources: OBR; Author’s calculations. © Institute for Fiscal Studies Sources: OBR; Author’s calculations. 8

The cure (December 2012): 9.2% national income consolidation over 8 years (£143bn) Dec 2012: 8.2% national income (£129bn) hole in public finances © Institute for Fiscal Studies Sources: HM Treasury; OBR; Author’s calculations.

The cure (December 2012): 9.2% national income consolidation over 8 years (£143bn) Dec 2012: 8.2% national income (£129bn) hole in public finances 85% 15% © Institute for Fiscal Studies Sources: HM Treasury; OBR; Author’s calculations.

The cure (December 2012): 9.2% national income consolidation over 8 years (£143bn) Dec 2012: 8.2% national income (£129bn) hole in public finances 85% 81% 19% 15% © Institute for Fiscal Studies Sources: HM Treasury; OBR; Author’s calculations.

Tax and spend forecast to return to pre-crisis levels © Institute for Fiscal Studies Sources: OBR; Author’s calculations. 12

Tax and spend forecast to return to pre-crisis levels © Institute for Fiscal Studies Sources: OBR; Author’s calculations. 13

Dealing with the problem in 2017–18 and meeting the fiscal mandate © Institute for Fiscal Studies Note: PSNB excludes impact of transfer of Royal Mail Pension Fund assets. Sources: OBR; Author’s calculations.

Dealing with the problem in 2017–18 and meeting the fiscal mandate Fiscal mandate: “cyclically adjusted current budget balance by the end of the rolling, five year forecast period” © Institute for Fiscal Studies Note: PSNB excludes impact of transfer of Royal Mail Pension Fund assets. Sources: OBR; Author’s calculations.

Dealing with the problem in 2017–18 and meeting the fiscal mandate Fiscal mandate: “cyclically adjusted current budget balance by the end of the rolling, five year forecast period” © Institute for Fiscal Studies Note: PSNB excludes impact of transfer of Royal Mail Pension Fund assets. Sources: OBR; Author’s calculations.

Dealing with the problem in 2017–18 and meeting the fiscal mandate Fiscal mandate: “cyclically adjusted current budget balance by the end of the rolling, five year forecast period” © Institute for Fiscal Studies Note: PSNB excludes impact of transfer of Royal Mail Pension Fund assets. Sources: OBR; Author’s calculations.

Dealing with the problem in 2017–18 and meeting the fiscal mandate Fiscal mandate: “cyclically adjusted current budget balance by the end of the rolling, five year forecast period” © Institute for Fiscal Studies Note: PSNB excludes impact of transfer of Royal Mail Pension Fund assets. Sources: OBR; Author’s calculations.

On course to miss the debt target Supplementary target: “public sector net debt as a percentage of GDP to be falling at a fixed date of 2015–16 ” Source: OBR. © Institute for Fiscal Studies

6–year squeeze on public service spending 17.0% cut over 8 years 9.0% cut over 2 years © Institute for Fiscal Studies Note: Figure shows total public spending less spending on welfare benefits and debt interest.

Real change in resource DEL –9.3% –10.8% –16.9% –1.6% –6.9% Note: Figure shows resource Departmental Expenditure Limits (DELs) including depreciation under current policies, assuming no further changes to welfare policies or total government spending. © Institute for Fiscal Studies

Spending Review to come early next year Total DEL Of which: NHS Schools Aid Other DEL Real percentage change in resource spending between 2010–11 and... ... 2014–15 –9.3 ... 2015–16 –10.8 ... 2017–18 –16.9 Source: Crawford (2012). © Institute for Fiscal Studies

Spending Review to come early next year Total DEL Of which: NHS Schools Aid Other DEL Real percentage change in resource spending between 2010–11 and... ... 2014–15 –9.3 2.9 0.6 31.0 –18.3 ... 2015–16 –10.8 ... 2017–18 –16.9 Source: Crawford (2012). © Institute for Fiscal Studies

Spending Review to come early next year Total DEL Of which: NHS Schools Aid Other DEL Real percentage change in resource spending between 2010–11 and... ... 2014–15 –9.3 2.9 0.6 31.0 –18.3 ... 2015–16 –10.8 34.0 –20.9 ... 2017–18 –16.9 Source: Crawford (2012). © Institute for Fiscal Studies

Spending Review to come early next year Total DEL Of which: NHS Schools Aid Other DEL Real percentage change in resource spending between 2010–11 and... ... 2014–15 –9.3 2.9 0.6 31.0 –18.3 ... 2015–16 –10.8 34.0 –20.9 ... 2017–18 –16.9 2.9? 0.6? 41.7? –31.5? Source: Crawford (2012). © Institute for Fiscal Studies

Summary Considerable uncertainty remains Permanent hit to public finances from financial crisis estimated at £129 billion a year (in today’s terms) Response is a planned £143 billion fiscal tightening by 2017–18 Eight years from April 2010 imply the tightest eight-year squeeze on ‘public service’ spending since at least end of Second World War Spending Review in early 2013 to set departmental budgets for 2015–16 total real cut to ‘unprotected’ resource DEL since 2010–11 of 20.9% Further real cuts to departmental spending to come in 2016–17 and 2017–18 without tax increases or welfare cuts then if NHS, schools and aid still protected, ‘unprotected’ resource DELs would face cumulative cut of 31.5% since 2010–11 cutting resource DELs at the same rate as over the SR2010 period (7% real cut over the two years) would require £4 billion of tax increases/welfare cuts and would still leave ‘unprotected’ resource DELs facing a cut of 29.7% since 2010–11 Considerable uncertainty remains © Institute for Fiscal Studies

Fixing the public finances: eight years of pain? Carl Emmerson Presentation at IFS public economics lecture, London 17 December 2012 http://www.ifs.org.uk/projects/401 © Institute for Fiscal Studies IFS hosts two ESRC Research Centres