The Public Spending Massacre

In my Money Week column this week, I've been discussing why Britain is goig to need far deeper cuts in public spending than most people yet appreciate. Here's a taster....

The political season kicks off in earnest this week, with both Labour and the Conservatives scheduled to hold their party conferences. Expect to hear plenty about the need for cuts in public spending. Promises will be made to trim waste. Efficiency drives will be launched by the minute. A few totemic big projects will be scrapped to show determination to get the deficit under control: if you were in the nuclear submarine business, you probably wouldn’t want to be relying too much on that British government order.
There’s only one problem. The politicians still aren’t levelling with the public about the scale and ferocity of the assault on public spending that will be needed. They probably aren’t even levelling with themselves. In reality, the cuts will need to be much harsher and much deeper than most people yet realise. There are three reasons for that. The UK economy can’t be squeezed for any more tax. The tax base is going to carry on collapsing. And at some point, the UK is going to need tax cuts if it is to have any hope of reviving its economy.
The scale of the fiscal hole that Britain has dug for itself is now so deep and so alarming that even is principle digger, the Prime Minister Gordon Brown, has been forced to promise to put down his spade. Speaking at the TUC conference, Brown finally conceded that the next government, whatever its colour, would have to start cutting spending.
That was inescapable. The government’s finances are plunging deeper and deeper into chaos with every month that passes. In August alone, the government posted a deficit of £16.1 billion, the highest recorded for that month since records began. In the first five months of this year, the deficit was £65 billion, and for the full-year the Treasury is forecasting a deficit of £175 billion, or 12.4% of GDP. The actual figures are likely to be much worse: they almost always are. The actual deficit could easily be more than £225 billion, making it by far the worst of any developed industrial nation.
Everyone knows that can’t continue. One in every four pounds the government spends is now borrowed money. It could soon be one in three. Over the medium-term, that spells financial ruin. At some point, tax and spending will have to be bought back into balance.
But how? There is an easy assumption that it can be achieved by a combination of raising taxes and gradually curbing expenditure. The figure of a 10% cut in public spending is bandied about as a rough guide to how much will have to be sliced. And yet, in reality, that is far too optimistic. The cuts will have to be much, much deeper than that. Here’s why.
First, forget tax rises as part of the solution. True, governments can put up taxes as much as they like. And they probably will. The hike in the top rate to 50% is just the start of it. But there is a big difference between raising taxes and raising more revenue. The Laffer curve, named after one of Ronald Reagan’s intellectual gurus Arthur Laffer, describes how, after a certain point, the more you raise taxes, the less revenue you get back in return. People leave the country, or decide it isn’t worth the hassle of working anymore.
The evidence suggests the UK has already reached that point. In a decade as Chancellor, Gordon Brown tried to raise taxes plenty of times. Most people have lost track of the number of stealth taxes introduced. But he wasn’t very successful is raising the percentage of GDP taken in tax. One of the best measures of this is Tax Freedom Day, calculated by the Adam Smith Institute, which works out the day on which you stop working for the government and start working for yourself. It takes account of all taxes, not just headline rates. In 2009, it was May 14th. Back in 1997 when Brown became Chancellor, it was May 25th. Back in 1979, when Mrs Thatcher became Prime Minister it was May 29th. Forty years ago, with Harold Wilson as PM, it was also May 29th. The message is very clear. Whatever the government does, tax revenues remain broadly stable at around 35% to 37% of GDP. To imagine that any government is going to suddenly be able to sweep another 10% of GDP into the tax net is fanciful. It isn’t going to happen.
Next, the big problem right now is that tax revenues are collapsing. Take those August figures, for example. Tax revenues were down by 9.2% year-on-year. Corporation tax receipts were down by a whopping 49%, but VAT was also down by 13% and income tax down by 12.5%. What makes anyone think that this process is about to suddenly stop? Britain is heavily dependent on financial services, and profits in that sector will be squeezed for years to come. Lower profits equals lower taxes. As unemployment rises, income tax will fall further. In truth, Britain’s tax base was built on the froth of the finance and property markets. There is no reason why it shouldn’t continue to fall – and every pound that slips out of the tax net adds to the deficit.
Thirdly, at some point the UK is going to need to start talking about tax cuts, not rises. Even once the recession is over, the outlook for the UK economy is bleak. Growth of more than 1.5%, looks unlikely, and that won’t keep unemployment from rising. At some point, the UK will have to embark on an enterprise recovery, based on encouraging entrepreneurs and foreign investors to start building new industries. That simply isn’t going to happen while the UK is one of the highest-tax economies in Europe. It will take a radical programme of tax-cutting. And those tax cuts will have to be paid for out of lower state spending.
Whether any political party has the courage to push through cuts on the scale needed remains to be seen. They certainly aren’t talking about it yet – and it may well end up being the bond market or the International Monetary Fund that have to wield the axe.