Tax and Spending in the 2020s

Abstract

the uk stands at a potentially critical juncture in the evolution of the shape and size of the state. Eight years of spending restraint—and, in many areas, cuts—mean many public services are finding it difficult to continue to meet demand without compromising the quality of the service they offer. Continued cuts to welfare benefits are squeezing the living standards of those on the lowest incomes and are predicted to lead to rising rates of child poverty. At the same time, the ageing population is putting growing pressure on health and social care spending and on state spending on pensioner benefits, while economic changes are straining the tax system's ability to raise revenue. These trends would have had to be addressed at some stage, but Brexit adds new challenges and arguably some opportunities too, and could be a catalyst for a more fundamental review of the role of the state in the UK (as suggested, for example, by Christopher Bickerton).1 Indeed, the Brexit challenge has arisen just as, for the first time in many years, the two main parties offered markedly different visions for the UK state at the 2017 general election. But Brexit is occupying a huge amount of ministers’, officials’ and parliamentary time, leaving little scope to think about and address other looming challenges. This chapter examines recent and predicted economic and fiscal trends in order to assess the choices facing the current and future UK governments about what levels and scope of tax and spending the UK should have after Brexit. Section 2 describes the changes to tax and spending that have occurred over the past eight years, setting the scene for the decisions to come. Section 3 examines the longer-term pressures facing the UK's public finances from an ageing population and other economic changes. These have been known about for some time—and long pre-date the vote for Brexit—but previous governments have not fully got to grips with them. Section 4 outlines the additional problems and opportunities posed by Brexit before section 5 considers how the current and future UK governments might react. Section 6 concludes. The focus throughout this chapter is on the fiscal constraints and trade-offs that will face any UK government and shape their decisions about tax and spending. Following the financial crisis, it was clear that there was a large hole in the UK's public finances. At the depth of the crisis in 2009–10, UK public borrowing reached 9.9 per cent of national income, a level unprecedented in the postwar era. New economic forecasts showed the UK economy was expected to be smaller and grow less quickly than had been expected before the financial crisis. Successive forecasts have suggested an increasingly weak outlook as productivity growth in the UK has failed to recover. The composition of economic growth is also expected to be less tax-rich, particularly because the financial sector—which had generated a disproportionately large share of tax revenues pre-crisis—was especially hard hit. This was the background against which the Conservative-Liberal Democrat coalition government, David Cameron's majority Conservative government and then Theresa May's minority Conservative administration embarked on and then ramped up a programme of tax increases and spending cuts to reduce public borrowing. The initial objective was to eliminate the current budget deficit—in other words, to ensure that the government borrowed only to invest. This was similar to the objective that the Labour government had set itself before the financial crisis. But the target for reducing public borrowing was extended after the 2015 election, with then Chancellor George Osborne committing to eliminate public borrowing altogether. This is a target that Philip Hammond has remained committed to, although he has extended the timescale for achieving this objective to the ‘mid-2020s’. The package of measures implemented since 2009 to help reduce public borrowing has been weighted towards spending cuts, with tax rises playing a smaller part. Since 2009–10, spending on public services has been cut by about 10 per cent in real terms.2 But population growth means spending per person has been cut by about 15 per cent in real terms. These cuts have been particularly concentrated on some specific areas of public services, with other areas having been protected. As a result, the shape of the state has changed. Spending on the justice system—from prisons to the courts—and on local authority provided services has been cut relatively sharply. Meanwhile, spending on the NHS and overseas aid has been increased and spending on schools has been protected. The share of total departmental spending devoted to health rose from 27 per cent in 2010–11 to 34 per cent in 2017–18 and the plans set out in the October 2018 Budget imply that this will rise further—to 38 per cent—by 2023–24. This protection of the NHS relative to other areas of public spending continues a long-running trend in the UK, driven both by the growing health needs of the ageing population and rising expectations of what the NHS should provide. The share of national income spent on health increased by 4.1 percentage points between 1953–54 and 2015–16, while total public spending fell by 0.7 per cent of national income.3 Cuts have also been made to benefits paid to working age people, while benefits for pensioners have been protected and—in some areas—made more generous. These choices made about how to allocate scarce spending have reshaped what the state provides, with UK public spending increasingly focussed on health and social care services and transfers to pensioners. Some taxes have been increased since the financial crisis. The coalition government announced tax increases worth £64 billion a year for the Exchequer.4 This included, for example, raising the main rate of value added tax from 17.5 per cent to 20 per cent. But these were offset to a large degree by tax cuts elsewhere. In particular, the annual level of income that is exempt from income tax (known as the personal allowance) has been increased significantly, the headline rate of corporation tax has been cut from 28 per cent in 2010 to 19 per cent (and is due to be cut further to 17 per cent in April 2020) and fuel duty has been frozen, rather than rising with inflation. The latest official forecasts suggest that the UK tax system will generate tax revenues this year totalling 34.6 per cent of national income. Other sources of revenue are expected to generate a further 2.4 per cent of national income,5 leaving the public sector needing to borrow 1.2 per cent of national income (or £25.5 billion) to bridge the gap between receipts and spending. But the government faces difficulty—and thus important choices—in eliminating this remaining borrowing. Eight years of spending cuts have left some public services struggling to cope with the demands they face. For example, levels of violence in prisons have risen markedly, ultimately prompting Mr Hammond to allocate additional funding to recruit more prison officers. Local authorities are having to devote a growing share of their budgets to fund adult and children's social care, at the expense of other services. Tax revenues have also become increasingly reliant on the income and behaviour of a relatively small group of high-income individuals. Projected socioeconomic trends are also likely to compound, rather than ease, the problems, as the next section discusses. The latest official long-term projections for UK tax and spending suggest that—rather than falling—public borrowing is likely to rise over the next decade unless changes are made to public policy.6 This will pose a problem not only for a government—like the current one—which is committed to eliminating borrowing, but to any UK government that hopes to keep the UK's public finances on a sustainable course. Like many other ageing advanced economies, the pressures of an ageing population on public services and welfare spending will ramp up sharply in the 2020s and 2030s, as Figure 1 shows. The Office for Budget Responsibility (OBR)—the UK's independent fiscal watchdog—has estimated that public spending, excluding debt interest spending, is likely to rise from 36.4 per cent of national income this year to 37.7 per cent by 2030–31, as Figure 2 shows. This increase is mainly driven by projected increases in spending on health (+1.7 percentage point), state pensions and pensioner benefits (+0.3 percentage point) and long-term care (+0.2 percentage point). These upward pressures are expected to be only partially offset by a fall in spending on education (as the share of the population of school age falls) and a fall in spending on working age benefits. Other economic trends are depressing tax receipts.8 The depletion of North Sea oil, declining rates of smoking and the increasing fuel efficiency of vehicles are expected to lead to declining revenues of off-shore corporation tax, tobacco duties and fuel duties, respectively. Changes to working patterns—in particular, the growing prevalence of self-employment—are also reducing the average effective tax rate on earned income. The latest long-term projection from the OBR suggests government receipts, excluding debt interest, are likely to fall slightly from 36.2 per cent of national income in 2018–19 to 36.0 per cent by 2030–31. Without changes to policy, these trends in spending and revenues would imply public borrowing rising to 3.3 per cent by 2030–31 and continuing to rise thereafter. These projections factor in the recent announcement of an additional £20 billion a year of funding for the NHS. But they do not make allowance for other objectives that the government has mentioned, such as reforming the funding of social care or addressing what Theresa May has described as the UK's ‘broken housing market’. Previous governments have known about these pressures but not fully addressed them. But ignoring the issue and leaving public services and the tax and welfare systems unchanged will become increasingly untenable. The OBR's latest projection for public borrowing is clearly not in line with the current government's objective of eliminating public borrowing. It is also likely to be an unsustainable path even for a government that was happier to maintain a somewhat higher level of public borrowing and debt. While it is difficult to know exactly what the maximum sustainable level of borrowing and debt for the UK is,9 annual borrowing in excess of 10 per cent of national income probably would not be. This leaves the current and future governments with three options: to pare back the scope of public services and benefits, to raise taxes, or to accept a higher level of public borrowing. It is difficult to predict exactly how Brexit will affect the UK economy and public finances, not least because—at the time of writing—it remains unclear what sort of deal can be agreed both by officials in Brussels and the UK Parliament. However, the vast majority of economists predict that Brexit—in whatever form it occurs—will raise additional barriers to trade between the UK and the EU and so harm economic growth over the long-term. On the basis of these sorts of forecasts, it has been estimated that public borrowing could be up to £49 billion a year higher as a result of Brexit than it would be if the UK remained in the EU.10 This includes the budget boost that would come from no longer having to contribute to the EU budget. In the short-term the UK government may also face additional costs in setting up new systems and institutions to replace those currently shared with the EU. Whitehall departments are estimated to have spent over £300 million on Brexit preparations in 2017–1811 and Philip Hammond set aside more than £3 billion for this purpose, but the eventual costs could be much larger. Adjusting to a new relationship with the EU will require not just money but also a considerable amount of time from public sector employees. For example, creating a new customs system would require coordination across thirty government departments and over 100 local authorities.12 In principle, Brexit also provides opportunities to change aspects of the UK's tax policies which were not possible as a member of the EU. For example, outside the EU the UK would be able to change value added tax (VAT) and potentially sign new free trade agreements to reduce tariffs on imports from some non-EU countries. But in practice, these would be unlikely to help address the fiscal challenge that the UK already faces and could weaken the public finances further. For example, most of the restrictions imposed by the EU on VAT policies limit the government's ability to cut VAT or introduce new exemptions. Consequently, the main result of Brexit is likely to be greater pressure on government to reduce VAT or to complicate the system further by introducing new lower rates for certain goods or services. The Vote Leave campaign, for example, advocated the benefits of being able to cut VAT on fuel. Such reforms might be politically popular but would do nothing to help address the looming fiscal pressures and would be economically inefficient. Brexit also offers the opportunity to amend certain EU-set rules and regulations to better suit the needs and preferences of the UK. The eurosceptic thinktank Open Europe suggests that deregulation could reduce costs to businesses and boost UK economic output by up to 0.7 per cent (or £12.8 billion a year).13 However, that saving could be on the high side of what is politically feasible, as such deregulation would come at the cost of reduced protection for workers and the environment. The figure assumes, for example, that a post-Brexit government would scrap the agency workers’ directive, which guarantees the same pay and conditions for agency workers as for permanent employees doing the same job in the same organisation. Future UK governments may also—for the first time in decades—be able to negotiate new free trade agreements directly with other non-EU countries. As a smaller entity with fewer conflicting priorities, the UK may be able to strike free trade agreements that would not be possible for the EU as a whole. However, the UK may have less bargaining power acting alone than it would in concert with the twenty-seven other EU member states. Whether or not such trade deals are likely to be quickly concluded, most economic analysis suggests the benefits to the UK economy would be relatively modest. For example, concluding a ‘broad and deep’ trade agreement with the US has been predicted to boost economic output by around 0.2 per cent.14 In addition to these opportunities that are newly opened up by Brexit, some have argued that Brexit provides new impetus for other reforms to UK domestic policies that could tackle the UK's low rate of productivity growth, which has made the fiscal arithmetic more difficult. For example, Brexit could be a necessary catalyst to reforming employers’ attitudes to training their workers—and thus addressing the UK's long-running skills shortage. It is important to note, as Swati Dhingra does in her chapter on Brexit and the future of trade elsewhere in this issue, that since the referendum exactly the opposite has happened: training has been cut. But this is not really a guide as to what will happen over the long-term, once new migration rules have been finalised and the ready supply of European migrants restricted. Others argue that the ‘decade of disruption’ expected in the 2020s provides an opportunity for major changes to produce a fairer and stronger economy.15 However, while such reforms could boost productivity in the long-term, which would ultimately increase tax revenues, they would be likely to cost money in the short-term. The House of Commons Defence Select Committee has suggested that the UK needs to increase its military capabilities to secure its place on the world stage and Theresa May has said that spending on research and development needs to be increased to ensure the UK remains a world leader. The government has already announced it will spend an extra £2.3 billion on research and development by 2021–22. Meeting the Defence Select Committee's recent suggestion that the UK should spend an additional 1 per cent of national income on defence would mean raising defence spending by around £20 billion a year. To raise this amount of money from taxation would require—for example—a 4 percentage point rise in the basic rate of income tax. But any plan to increase (or even maintain) the size of the state would be in conflict with the proposal that some have put forward, whereby the UK should seek to compete aggressively with the EU by cutting taxes and relaxing regulations. This vision for the post-Brexit UK economy has been dubbed ‘Singapore on Thames’, alluding to the economic model adopted by the south-east Asian city state that helped transform it from a relatively poor tropical port into one of the world's richest countries. Implementing such a proposal would require the size and scope of the UK state to be radically scaled back. But there is no clear public support for such an idea: indeed, the proportion of people in the UK saying they would be happy to pay more tax to fund public services has been growing and now exceeds the numbers who say they are happy with the status quo. Taken together, the most optimistic assessments by mainstream economists suggest that the new opportunities opened up by Brexit will do little or nothing to tackle the fiscal difficulties that face the government, described above. Most economic analyses suggest that Brexit will result in lower economic growth, which would exacerbate, rather than mitigate, the pressures. Brexit could prove a watershed moment for re-examining important domestic economic policies—such as on training and infrastructure investment. Such reforms could provide a welcome boost to productivity growth and ease some of the fiscal problems of the ageing population. But such policies would likely require upfront investment at a time when implementing Brexit is likely to take up a significant amount of civil servants’ and politicians’ time, and place additional demands on the public purse. Previous governments have regularly used two tactics to help cut borrowing by raising tax revenues in a way that is little noticed by the electorate. First, they have tended to raise tax thresholds less quickly than incomes have grown, dragging an ever larger share of people's incomes into tax. But this effect—known as ‘fiscal drag’—raises less revenue the slower is economic growth. The OBR has estimated that fiscal drag raises revenues by around 0.17 per cent of GDP (or £3.6 billion in today's terms) each year. Second, governments have been fond of announcing anti-avoidance measures aimed at closing tax loopholes to raise revenue. Between 2010 and 2017, governments announced over a hundred anti-avoidance measures, which together were expected to raise revenues by around £10 billion (or roughly 0.5 per cent of GDP) this year. However, the OBR has found that these measures sometimes have not raised as much as originally expected, not least because these measures target taxpayers who are already actively changing their behaviour to lower their tax liability. Past governments have also managed to free up extra resources for health spending by cutting the share of national income devoted to other services. The clearest example of this is the decline in defence spending that has occurred since the 1950s. The latest increase in health spending—confirmed in the October 2018 Budget—was paid for by an unexpected upgrade to the OBR's economic forecasts. However, future forecast revisions could go in the opposite direction. Extra money has also been freed up over the past thirty years by declining spending on debt interest costs. Public sector debt interest spending fell from 5 per cent of national income in 1980 to just over 2 per cent today (a difference of 3 per cent of national income, or over £60 billion a year, in today's terms). This decline was aided in recent years by the Bank of England's very loose monetary policy, which has reduced the interest rates charged on government debt. But it is highly unlikely that future governments will benefit from any similar further reduction—in fact, the reverse is more likely. More significant active choices are likely to be required over the coming years. The OBR estimates that future governments would need to announce measures that would increase taxes or reduce spending by 1.7 per cent of national income (or £36 billion a year in today's terms) every decade for the next half century if they want debt to stabilise at around 60 per cent of national income. That equates to, for example, a 6-percentage point rise in the main rate of VAT or wiping out almost the entire defence budget. Dealing with such a large fiscal hole is highly unlikely to come from one tax or spending change—it will take a whole raft of new thinking and policy on tax and spend. Tax and public spending after Brexit will be heavily shaped by economic and demographic trends that have long been anticipated in the UK. The ageing population is placing increasing demands on public services and pension spending. Trends towards greater self-employment, increased energy efficiency and declining oil reserves are threatening the ability of the current tax system to raise sufficient revenues. A decade of low productivity growth has made these issues more difficult. Dealing with these fiscal pressures is made harder by the fact that the UK has already undergone nearly a decade of fiscal restraint, involving significant cuts to spending on some public services and cuts to benefit entitlements for those of working age. As a result, there appear to be few areas where spending could easily be cut without affecting the scope or quality of what the state provides or requiring new ways of working to achieve more with less. Negotiations and preparations for Brexit have diverted government and civil service time away from addressing these problems. The Conservative government's lack of majority since June 2017 has also made it more difficult to pass legislation. As some have argued, Brexit could provide the political impetus to more radical reform of the UK tax system, public services and welfare than has been achieved in the past. But it is also expected to reduce UK economic growth and creates new short-term spending needs, which will limit the resources available to—for example—invest in education and training. To ensure longer-term fiscal sustainability, the OBR estimates that significant tax increases or cuts to the scale and scope of public services and welfare will be needed. This is likely to require more than simply relying on fiscal drag, clamping down on tax avoidance and incremental cuts to some public services. In the face of these fiscal challenges, the current government and those that follow face important choices about how to balance the books: how much to scale back the quality and scope of public services and welfare benefits, how much to raise taxes or accept higher levels of borrowing, and what role there is for active state intervention to try to boost UK productivity growth to reshape the economic outlook. Demographic trends mean these choices would always have had to be made, but Brexit adds to the challenges, provides some new opportunities and possibly also new impetus to consider more radical changes. I am grateful to Gavin Kelly, Nick Pearce and attendees at a conference hosted by the Resolution Foundation in May 2018 for comments on an earlier draft of this paper. The views expressed are those of the author and do not necessarily represent the views of the Institute for Government.