Note: in retrospect (November 2015) I should have left out the extremely complicated – but very pretty! – graphs!
The political debate currently centres on the narratives of economic growth and the cost of living, but the issue of deficit reduction has not gone away. Ahead of the election, the coalition will trumpet its progress in reducing the budget deficit. All three parties are sure to have fiscal targets for the next parliament, with Labour keen to win back trust on managing the public finances, and the coalition parties keen to outdo them. The particular choice of target will have huge implications for public services, welfare and taxation.
There are several ways to measure the deficit, as I described last year. We can account for temporary weakness in the economy (in theory); long-term investment that can be paid for by future taxpayers; and interest on the national debt.
Breaking down the differences between these measures (all calculated by the Office for Budget Responsibility for Budget 2014), we can also show the composition of the overall deficit:
The overall deficit is shown by the dark blue line, and is forecast to be 5.5% of GDP this year. The graph shows that 29% of the overall 2014-15 deficit is from investment (grey); 18% from a weak economy (blue); a whopping 47% from debt interest (orange); and 5% from the residual – a fundamental disparity between taxes and the current size of the state (yellow).
So for 2014-15, even if we exclude investment, debt interest, and the effects of an economy operating below potential, a (small) budget deficit remains. But from 2015-16, the choice of deficit measure becomes more important. The graph below presents the same data in a slightly different way to help demonstrate this. For an absolute surplus, the yellow column needs to exceed the entire stacked column; for a current budget surplus that accounts for the state of the economy (the coalition’s deficit goal), it only needs to exceed the orange part.
Even with some slack remaining in the economy, if we excluded both investment and debt interest we would reach a surplus in 2015-16, though it’s rare to exclude both at once. In effect, the next few years will be about redirecting spending and/or raising taxes to fund debt interest. If it weren’t for the national debt (much of which comes from the financial crisis and recession), there would be no structural deficit next year.
By 2016-17, the primary budget – which includes all spending except debt interest – is in surplus.
And by 2017-18 taxes sufficiently exceed regular current spending to cover debt interest too (the yellow bar being larger than the orange one). The cyclically-adjusted current budget will be in surplus, and this is the fiscal target used by the coalition and preferred by both the Liberal Democrats and (with a slower timetable) Labour for the next parliament. In fact, a balanced budget by this measure would be overshot by £13.9 billion. Even assuming a surplus is desirable, and the need for a margin of error, this surplus seems unnecessarily large given that the coalition’s fiscal mandate and supplementary target of a falling debt:GDP ratio will both have been met.
Another form of surplus is reached in 2018-19, this time using the overall deficit – with taxes exceeding regular spending, debt interest and investment too, even without the small adjustment for the state of the economy. The Conservatives wish to see such an absolute surplus. The national debt will go down in absolute terms if this happens, but proponents of an absolute surplus need to explain both why this is the best way of reducing the debt:GDP ratio, and “why that speed of reduction in the debt:GDP ratio is the one you think we must have”. With low productivity, a pressing need for growth-boosting infrastructure investment and a cost of government borrowing expected to remain low, the case for such a surplus does not look strong.
Sticking with the cyclically-adjusted current budget measure – the preference of the current government, Liberal Democrats and Labour – the Budget proposes a surplus of £31.3 billion in 2018-19 (more than is raised from council tax, for comparison).
According to the IFS (pre-budget) the government’s plan is for £33 billion of departmental spending cuts between 2015-16 and 2018-19. Welfare cuts or tax rises have been suggested to take some of this strain. However, none of this appears necessary to achieve the coalition’s fiscal mandate, which does not require a £31 billion surplus. The outlook for public services and an ageing population would look much less negative if this surplus were closer to zero and public spending was therefore brought down to 40%, rather than 38%, of GDP. And even if the proposed departmental spending cuts go ahead, the money saved could go to doubling public capital investment, or be reinvested in quadrupling the science and adult skills budgets (as the SMF has argued), rather than delivering an absolute instead of current surplus.
Reportedly, ONS accounting changes are set to reduce the current budget deficit (in the short-term), and there is also the much desired possibility that the economy has more potential than is currently thought. Both of these might make it easier to reach a cyclically-adjusted current budget surplus. Offers to the public at the election, and the agenda of the next government, will depend on all these figures. All parties must carefully consider what fiscal target they adopt and what is needed – and what is not needed – to get there.
Originally published at https://centreforumblog.wordpress.com/2014/04/10/adam-corlett-sod-the-surplus/