The strength of the economy matters for the public finances
Summary: It makes no sense to think about the deficit without thinking about the size and strength of the economy.
A Newsnight report on the public finances last night was illustrated with a chart seemingly showing high spending causing the deficit. It was drawn from an IFS report issued yesterday, but it could well have come from any official document since at least 2010.
In the report the chart is puts into words: “the enormous deficit caused by the financial crisis was due to tax receipts falling and – to a much greater extent – spending increasing, as a share of national income”. And Newsnight also observed “Spending cuts have done most work in closing the deficit”.
But looking at this chart alone confuses effect with cause.
The key point is that spending and revenues are shown as a share of GDP. But what happens to GDP is the critical determinant of public finance outcomes. Receipts collapsed when the economy collapsed. On this chart the line for receipts as a share of GDP is fairly stable, because both receipts (the numerator) and the economy (the denominator) collapsed. In contrast, the expenditure line rises abruptly less because the spending numerator increased in cash terms (though it did), but more because the GDP denominator collapsed.
A more direct way to look at what is going on is to remove GDP from this analysis and look at receipts, expenditure and the deficit in their own right, i.e. in cash terms.
The first chart (A) shows a standard presentation of revenue, expenditure and the deficit; the second (B – done biggest as it’s the key chart) shows the annual changes in each of these measures. On (B) expenditure has been further divided into transfer expenditures (pensions, benefits, tax credits etc, which can change as a result of changes in the economy as well as a result of policy) and final expenditure (which is more directly under the control of government, covering wages of public sector workers, government procurement of goods and services and government investment). The third chart shows changes in the deficit against changes in GDP .
A: public sector finances – levels, £ billion
B: public sector finances – annual change, £ billion
C: GDP and the deficit – annual change, £ billion
Source: ONS, OBR and TUC calculations
[The public finance figures are presented so that the components add up in an accounting sense. So the deficit on (A) is shown as negative. On (B) when the deficit deteriorates the sign is negative (grey diamond below line) and vice-versa; increases in revenues (yellow) have a positive sign and increases in spending (light and dark green) have a negative sign.]
There are basically four distinct post-crisis episodes
1. Global recession causes public sector finances to collapse
The main change comes in 2008-09 when the deficit widens sharply. This is driven mainly by tax revenues collapsing. Having increased by 29bn in 2007-08, they fell by £15bn in 2008-09 – that is, a downward change of £44bn (the yellow column turns negative). At the same both transfer and final spending expanded:
- Transfers rose following the increased benefit bill as people lost jobs and as tax credit payments rose supporting people in work
- Final spending rose as part of the G20 stimulus effort, which was aimed at capital spending and other current spending including scrappage schemes for cars. Some support for the financial sector probably scores here as well, though the accounting treatment of these interventions is complex.
- Note also that a part of the reduction in taxes followed from the VAT cut from 17½% to 15%, which was in place from start of December 2009 to the end of December 2010.
Overall, expenditure grew by an additional £21bn, from an increase of 35bn in 2007-08 to 56bn in 2008-09. In total, the deficit increased by £65bn over the year – with the change in tax revenues twice as important as the change in expenditure in explaining that change.
In the next year (2009-10) the deficit continued to deteriorate sharply as the recession intensified and likewise the decline in tax revenues; spending was still increasing, but by less than in 2008-09.
2. The deficit improves as the economy recovers
Then in 2010-11 the improvement to the deficit (diamond above line) was driven mainly by a sharp turnaround in government revenues. This followed the economic recovery that resulted from the G20 stimulus, though the VAT cut was also reversed from January 2010.
3. Spending cuts hit economy harder than expected
But spending cuts had already kicked in from 2010-11, particularly in final expenditure (with dark green vanishing). As (C) shows, GDP growth (or cash increases to GDP) was (were) set back. Yellow tax revenue gains fade nearly to nothing by 2012-13 and transfer spending kicked back in likely also as a result of the deterioration in economic conditions. The sum of the parts was a resumed deterioration in the deficit in 2012-13 (diamond back below line).
4. Spending cuts are reversed
So policymakers sensibly changed course. With the arrival of Mark Carney at the Bank of England a new monetary policy framework was announced, various schemes to support bank lending (and reignite the housing market) were implemented, and spending cuts became (modest) final spending increases from 2013-14 (dark green is back). From then on an (only) moderate economic recovery was sufficient to revive tax revenues and the public finances improved in every year through to the present.
Note two things though. The IFS observe in the opening paragraph of their report, the “weakness” of the recovery overall is “striking”. While spending has not been cut in cash terms over recent years, it’s a very different story in real terms and per head of the population. The IFS show ‘departmental spending per person’ (in 2016-17 prices) has been reduced to £5,460 per person in 2016-17 from £6,460 in 2009-10 – i.e. by a colossal 15%. And there’s more to come.
The mood music of the Newsnight piece was that austerity was going to get even tougher to impose in coming years. In some ways the IFS were offering a way out, observing that the present deficit of 3% of GDP was not a very big deal in historical perspective (chart below) and noting that the Conservative government had not been able to make the cuts it championed in their 2015 manifesto.
But really that’s not the point. The conventional wisdom underpinning this analysis is still back to front.
Cutting spending did not repair the public finances, the economy repaired the public finances.
Cutting spending hindered rather than supported the economy. Spending on the NHS, on education on public sector salaries is not only desperately needed, it will support the economy. And if it supports the economy it will support the public sector finances. Strikingly the biggest surpluses on the chart above were recorded over 1948 to 1950. I wonder what they were doing back then?