06 Nov 2010 | Economy

Public Spending Squeeze 

 David Smith questions whether this is good or bad.

Most of us are becoming accustomed, reluctantly, to paying more tax. VAT will go up to 20 per cent in January 2011; its temporary cut from 17.5 to 15 per cent having been reversed in January 2010. Capital gains tax rose in the budget from 18 per cent to 28 per cent for some individuals (depending on that individual’s total income and gains). The new 50 per cent top rate of tax was introduced in April and all higher rate taxpayers face a significant squeeze on their allowances. Employee National Insurance rates will rise by one per cent next April.

Higher taxes, however, represent only a small helping of the large dose of unpalatable medicine the government is administering. George Osborne has adopted an 80-20 approach (or more precisely 77 to 23 per cent), for correcting the budget deficit. Painful though they seem, higher taxes account for only one-fifth of the planned fiscal consolidation. Four-fifths of the adjustment will come via public spending.

It is on spending, the product of fierce negotiations between the Treasury and government departments over the summer, that most political heat is being generated. The Treasury set the tone by asking some Whitehall departments to come up with solutions giving cuts of as much as 40 per cent over 3-4 years. The Institute for Fiscal Studies says the cuts, most of which will begin to take effect from April, will be the deepest in the post-war period.

Public sector unions have warned that the consequences for public services will be devastating, while opposition politicians, led by the former education secretary Ed Balls, say the cuts will force up unemployment and could drive the economy back into recession, for which the coalition government would take the blame.

For investors, there are two central questions. The first is whether the coalition will be able to achieve its cuts. The second is whether the recovery can survive them. Plenty of governments have talked tough on cuts, most notably the Thatcher government in the early 1980s, only to fail to deliver. This one appears to mean business, and has a record budget deficit and the need to get the pain out of the way before the end of the coalition’s first term to stiffen its resolve. Only time, however, will tell.

The bigger question is whether the recovery can survive the ’cuts‘. People may be surprised to learn that despite all the bloodcurdling talk, the government’s total managed expenditure will rise from £669bn in 2009-10 to £757bn in 2015-16. Of course that includes a rising bill for government debt interest and is not inflation-adjusted. After the spending feast of the 2000s, this is something closer to famine. The Office for Budget Responsibility projects some 490,000 public sector job losses. Businesses which have come to rely on lucrative public sector contracts, including many quoted companies, will feel the cold wind of austerity.

So the private sector will have to work harder. Can it do it? In the 1990s, when there was a similar cut in public sector employment, private firms more than made up the difference and there was overall growth in jobs. In that decade the economy recovered in the face of a big public spending squeeze. The question is whether this can happen again in the current, post-crisis economy. The government thinks it can and I tend to agree. But the debate will not go away.

This article was written and based on information correct as at September 2010.

David Smith
David Smith is economics editor and an assistant editor and policy adviser on The Sunday Times and visiting professor at Cardiff University. His latest book is The Age of Instability: The Global Financial Crisis and What Comes Next.