The budget deficit: Key issues for the 2015 Parliament

The major parties fought the 2015 General Election with fiscal policies more different than at any other election since 1992. But they have all pledged to return the public finances to balance, albeit with different targets for deficit and debt reduction.

Experience from the last Parliament suggests that balancing the books requires more than just steely determination and a strong stomach for spending cuts: control over the budget deficit is not as firmly in the Government’s control as the public may believe.

As events unfold we may see the Government’s ambitions for the public finances held hostage to or blessed by economic fortune.

Chart 1: June 2010 forecasts and eventual outturns

Public spending has been broadly cut to plan, but receipts have undershot forecasts

% difference between June 2010 forecasts and eventual outturns, excluding policy and classification changes

Chart showing public spending and and receipts

Expectation and reality

In June 2010, the previous Government made plans that were expected to bring the deficit –the difference between public revenues and expenditure – down to just under £40 billion by the last financial year of the Parliament.

As it turned out, a deficit of around £90 billion was left. Why, in spite of the Government’s firm plans for the public finances, did the deficit exceed initial expectations?

Look after the spending…

The larger than expected deficit cannot be blamed on profligacy: the previous Government broadly kept to its public spending plans.

Unsurprisingly, spending was controlled most effectively in areas where the Government exercised the most control: departmental spending, controlled by the Treasury, was largely managed to plan, although there was some shifting between day-to-day and capital spending.

By contrast, spending deviated from plans in areas where the Government holds less direct power, or where expenditure was partly dictated by economic conditions, such as welfare.

Fortuitously, these deviations largely balanced out: for instance there were lower than expected debt interest payments but slightly higher than expected social security spending.

…but will the taxes look after themselves?

Although public spending broadly turned out as planned, revenue fell short of expectations: after allowing for policy changes, public sector tax receipts were over £50 billion lower in 2013/14 than forecast in 2010, with the weaker-than-expected performance of the economy accounting for the vast majority of this shortfall.

The previous Government’s experience illustrates how much harder it is to control tax receipts than it is spending: once levels and rates of tax are set, the revenues that roll in are strongly influenced by the economy’s performance.

Take employment taxes for example: income tax receipts and National Insurance Contributions (NICs) were around £25 billion lower in 2013/14 than expected in 2010.

Although employment has increased faster than predicted, earnings growth has been weaker. Coupled with increases to the personal allowance, this has meant that income tax and NICs have not performed as well as originally expected.

Chart 2: Change in employment and real terms labour taxes

Employment growth has not led to equivalent increases in labour taxes

% change in employment and real terms labour taxes

Chart showing % change in employment and real terms labour taxes

Blown by the economic winds

If economic conditions deteriorate over this Parliament, the Government’s determination to meet its deficit target may be tested.

Would it tighten fiscal policy still further if the economy underperformed, in a way that the previous Government did not?

Or would it simply let budget balance wait for another Parliament?

By contrast, if the economy performs better than expected it may be much easier for the Government to meet its deficit targets. The amount of spare capacity in the economy – that is, the difference between the existing size of the economy and its potential size – plays an important role in determining how easily the deficit can be reduced.

The further the economy is operating below its limits, the more scope there is for it to grow sustainably, and hence the more scope there is for the deficit to disappear ‘naturally’, as opposed to being tackled directly through fiscal consolidation.

If measuring the size of the economy is difficult, estimating its potential size is even more so. It is therefore unsurprising that estimates vary widely amongst forecasters, ranging from an economy with plenty of spare capacity to one even now running beyond its potential.

Spare capacity may be empirically elusive, but it will be important for the Government’s plans. If the economy is significantly under capacity, the Institute for Fiscal Studies’ 2015 Green Budget estimated that a fiscal tightening of only 1.2% of GDP could potentially eliminate the deficit in this Parliament.

The Office for Budget Responsibility’s estimate of the output gap implies that a significantly larger fiscal tightening of 3.8% of GDP would be required to reach the same point. 

When the Government’s fiscal performance is assessed in five years’ time, it will be the strength of the economy over the period that will ultimately determine whether it gets a positive review.

Deficits and debts – what’s the difference?

The government’s deficit is the difference between its revenues and its expenditure: a “large deficit” implies that expenditure substantially exceeds revenues.  The deficit must be measured between two particular periods in time (e.g. at the beginning and end of a financial year).

The government’s debt is the total amount it owes. Deficits add to the total stock of debt over time. Debt must be measured at a particular point in time (e.g. the end of a financial year). Both debt and deficit are often expressed as a proportion of the country’s annual economic output (GDP). Provided the economy is growing quickly enough, it is possible for the debt or deficit to be rising in cash terms, but falling as a proportion of GDP.

Party Lines

  • Conservatives: will eliminate the deficit by reducing Government spending by 1% in real terms for the first two full financial years of the Parliament, from 2018/19 spending begin to grow in line with inflation
  • Greens: (…) closing the deficit not a main objective of economic policy but would “borrow on good terms” to fund investment
  • Labour: will cut the deficit every year and “balance the books” as soon as possible
  • Liberal Democrats: debt will fall as a percentage of national income and budget deficit will be eradicated by 2017/18
  • SNP: (…) enshrine in law key principles of future financial management, including elimination of the deficit and balanced current account spending
  • UKIP: (…) committed to reducing the deficit

 

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