Why is cutting public spending so difficult?

Martin Wheatcroft FCA, external adviser on public finances to ICAEW, assesses what options the government has to reduce the gap between receipts and expenditure.

Despite rolling back £32bn out of the £45bn of tax cuts announced in the mini-Budget, Chancellor of the Exchequer Jeremy Hunt is expected to announce tax rises as well as spending cuts when he sets out the Government’s Autumn Statement and medium-term fiscal plan on 17 November. 

The consensus is that he needs to find around £50bn a year to reduce the gap between receipts and expenditure if he wants to get the public finances back under control and provide himself with some headroom in case the situation deteriorates further. This could include extending beyond April 2026 the freeze in personal tax allowances announced by Prime Minister Rishi Sunak when he was Chancellor, as well as scaling back the ‘levelling up’ agenda of former Prime Minister Boris Johnson.

You’d think trimming 3% or so off an annual public spending bill of over a trillion pounds a year wouldn’t be that difficult, but each of the main options for cutting spending in the medium term are unpalatable and politically challenging:

  • Real-terms cuts in pensions and welfare are possible but difficult to deliver politically during a cost-of-living crisis, as previous Prime Minister Liz Truss discovered when she was forced to deny she was planning to abandon the triple-lock mechanism. 
  • Real-terms cuts in public sector pay are likely but come with the prospect of much greater disruption from industrial action and increasing difficulties in recruiting and retaining staff. 
  • Cutting investment in infrastructure and capital programmes is the easiest option to achieve but comes with risks to future economic growth and business investment.
  • Greater efficiency is possible but practically difficult to deliver, with significant project delivery risks and the need for sufficient capital investment to be successful.
  • Higher fees and charges are possible but risk a political backlash.
  • Lowering public service outputs or quality is possible but there are practical limits to how far you can continue to cut funding for many public services without adverse effects.

Forecasts for public spending

Total managed expenditure is budgeted to amount to £1,087bn in the current financial year ending 31 March 2023 (2022/23), equivalent to approximately £1,340 per month for each of the 67.5m people who live in the UK, or £3,220 per month for each of the 28.1m UK households.

Based on inflation assumptions decided on back in March, the Office for Budget Responsibility (OBR) projected that total spending would experience a real-terms cut of 1.2% to £1,100bn in 2023/24, and then real-terms increases of 0.5% to £1,127bn in 2024/25, 1.4% to £1,166bn in 2025/26 and 1.4% to £1,206bn in 2026/27. 

Forecasts for total spending are expected to be revised upwards by the OBR when it reports on 17 November. They will need to reflect higher rates of inflation, significantly higher interest rates, and the cost of the energy support packages announced in May and September 2022 (amended in October). The Institute for Fiscal Studies’ high-level forecast following the mini-Budget suggested that these factors could increase total spending to £1,185bn in 2022/23, £1,201bn in 2023/24, £1,165bn in 2024/25m £1,192bn in 2025/26 and £1,233bn in 2026/27, up £98bn, £101bn, £38bn, £26bn and £27bn respectively from the OBR March forecast.

Fiscal targets

When former Chancellor Kwasi Kwarteng announced on 23 September that he was scrapping the fiscal targets approved by the House of Commons in January this year, he was continuing a pattern of abandoning a succession of fiscal targets as it becomes clear that they have not been, or cannot be, met. Abandoning the existing targets without announcing new ones to take their place is likely to have been one of several contributory factors to the adverse reaction by markets to his proposals.

The latest set of abandoned fiscal targets required each five-year fiscal plan to aim for both a current budget surplus and for a falling debt to GDP ratio by the third year of each forecast period. Kwarteng had been under pressure to replace these with a more realistic fiscal target based on the debt to GDP ratio starting to fall by the fifth year of each forecast period. It is likely that the new Chancellor will adopt this or an even stricter set of targets in the hope of regaining credibility lost by the UK Government over the past few weeks.

Assuming that £43bn of the £45bn annual tax cuts announced in the mini-Budget were implemented, the Institute for Fiscal Studies (IFS) estimated that achieving a falling debt to GDP ratio after 2026/27 would require annual tax rises or public spending cuts of £62bn by 2026/27, equivalent to 5% of total spending that year. On 17 October, the Chancellor brought this estimate down by £27bn, reversing a further £21bn of the mini-Budget tax measures and adding back £6bn a year by cancelling the previously planned one percentage point cut in the rate of basic income tax from April 2024. 

This would suggest that the gap remaining to be filled with other tax and spending measures could be in the order of £35bn a year, equivalent to around 3% of total public spending in 2026/27. Adding in a further £10bn to £15bn of tax rises to provide headroom brings this to around £50bn in total.

The IFS highlighted significant risks in its forecast, which assumes that inflation does not persist in the medium term and that economic growth remains below 2%, consistent with the post-financial crisis trend. The IFS also based its forecast on a relatively shallow recession and highlighted how dependent it was on the level of interest rates, which at that point had spiked in response to the mini-Budget. These risks could easily increase the size of the gap between forecast receipts and spending that the Chancellor needs to fill. The Chancellor will be hoping that government borrowing costs continue to moderate following the appointment of Rishi Sunak as Prime Minister, providing the Government with some headroom in the official fiscal forecast.

What makes up public spending?

Budgeted public spending of £1,087bn in the current financial year ending 31 March 2023 can be broadly split between £295bn (27%) on pensions and welfare, £252bn (23%) on health and social care, £436bn (40%) on public services, and £104bn (10%) on debt and other interest. 

Spending on public services other than health and social care is budgeted to comprise £126bn (12% of total spending) on education, £59bn (5%) on defence and security, £47bn (4%) on transport, £43bn (4%) on public order and safety and £161bn (15%) on all the other services that central and local government provide.

These numbers are on a fiscal basis as presented in the National Accounts, in accordance with statistical standards that include capital expenditure net of depreciation. They exclude long-term expenditures such as accrued public sector pension obligations that are reported in the IFRS-based Whole of Government Accounts. They are also net of approximately £55bn in fees and charges and £5bn from the proceeds of asset sales.

Hands tied on spending

As the Prime Minister and Chancellor look for potential savings, they are finding that their hands are tied by the financial commitments made by successive governments, especially since the second world war. These commitments created the welfare state we know today, with pensions, welfare benefits, health and social care together now making up half of total public spending. Since the last general election this government has added to these commitments, including a significant expansion in eligibility for adult social care and increasing the value of state pensions through the triple lock mechanism. 

Under the long-standing ‘pay-as-you-go’ approach to funding government activities, no money is set aside to meet financial commitments made. Instead, tax receipts, cost savings or additional borrowing are used to pay for financial commitments as they fall due each year. There is no sovereign wealth fund to cushion the blow or to dip into.

The principal challenge for the Chancellor in looking for savings is that more people are living longer. The number of pensioners is expected to increase by 3.3m or 27% from 12.2m to 15.5m over the next 20 years, despite an increase in the state pension age from 66 to 67 over that time. This is driving up the cost of the largest line items within the overall budget: the state pension, the NHS, and social care budgets, over a period when the working age population, the group that pays the most in taxes, is projected to increase by just 4%.

The impact of a growing number of pensioners makes the job of finding savings that much harder, as the savings need to be proportionately larger from other parts of the budget. 

Any savings are also on top of hoped-for efficiency savings that have already been incorporated into departmental budgets to stay within the existing spending envelope, as well as dealing with rising procurement costs, higher energy bills and pressure to increase public sector salaries.

Pensions and welfare – £295bn or 27% of budgeted spending

Pensions and welfare spending can be broken down between £121bn for the state pension and pensioner benefits, £48bn in incapacity and disability benefits, and £126bn in working age, child and other welfare benefits and social protection.

Pensions spending is expected to increase over the next five years from a combination of a 1.1m or 9% increase in the number of pensioners and the ratchet effect of the Government’s triple-lock manifesto commitment to raise the state pension in line with whichever is higher: earnings, inflation or 2.5% .

One option to save money compared with existing forecasts would be to restrict the increase in state pensions to below inflation, either by abandoning the triple lock in this Parliament or not re-committing to it beyond the next general election. However, while Rishi Sunak was able to suspend the triple lock in April 2022 on a one-off basis, it is likely to be extremely difficult to find the political support needed to cut the state’s contribution to pensioner incomes in real terms sufficiently to offset a 9% increase in pensioner numbers over the next five years, or a 27% increase over 20 years.

The government could accelerate planned increases in the state pension age, currently set to go from 66 to 67 by 2028 and to 68 by 2046, although to do so might break a promise to give at least 10 years’ notice to those affected. Another option might be to reformulate the triple-lock mechanism, removing the ratchet effect by making it cumulative. This would see above-earnings rises in one year offset by below-earnings rises in subsequent years, subject to not falling below inflation or 2.5% in any particular year.

Real-term cuts in incapacity and disability benefits would also be politically unpalatable, as would further restricting eligibility criteria, even if pencilled in for subsequent years. Several commentators have suggested that the recent rise in the number of people suffering from health conditions and withdrawing from the workforce is because of NHS treatment backlogs that have been exacerbated by the pandemic. One way of cutting the cost of these benefits would be to provide additional funding to the NHS in the short to medium term, which would add rather than subtract from spending in the next few years, even if there is a positive financial benefit in the longer term.

That leaves welfare benefits for those of working age and children, where the IFS has suggested that indexing the uprating of working-age benefits in April 2023 and April 2024 to earnings rather than inflation could reduce the annual welfare bill by £13bn by 2026/27 when compared with existing forecasts. The risk here is that a recession could see the number of claimants rise significantly even if it were possible to cut the amount paid out to each claimant in real terms. Again, proposing real-terms cuts in the financial support offered to the poorest households of this scale during a cost-of-living crisis is likely to be politically challenging.

Another option would be to increase the minimum wage given that more than half of any wage increase would be recovered from claimants on universal credit. This is likely to be difficult to implement in the next couple of years given the current cost-of-doing-business crisis, but it might be possible to pencil in a rise in the second half of the fiscal period. 

One area where money could be saved is in tackling fraud and error, with the Department for Work and Pensions estimating that overpayments amounted to £8.6bn in 2021/22, partly offset by underpayments of £2.6bn. However, to do so effectively would likely require a significant simplification of the welfare system, a politically challenging task given this would involve both winners and losers.

Health and social care – £252bn or 23% of total spending

The budget for health and social care this year comprises £211bn for the NHS and other health care, and £41bn for social care, which are both driven by the number of pensioners and the level of long-term health conditions in the adult population in particular.

The focus in recent years has been to constrain the rise in spending on health care on a per patient basis through a combination of greater efficiency and constraining staff pay, while social care funding has been restricted to constrain supply. This has seen a decline in service standards in both health and social care, exacerbated by the pandemic. While there are opportunities to find savings by tackling waste and improving efficiency further, this will be difficult without greater capital investment in hospitals, primary care facilities and digital technology.

In practice, staff shortages, rising drug prices, and a weak pound are likely to add to cost pressures on the health budget, at the same time as calls grow to address poor performance across all areas of service delivery, including ambulance waiting times, long waiting lists for treatment and inadequate cancer outcomes, as well as expanding coverage in areas such as mental health.

Social care spending is also under pressure, not only because of rising pensioner numbers but also because of an expansion of eligibility for adult social care announced by former Prime Minister Boris Johnson. His successor, Prime Minister Liz Truss, made a commitment to retain this expansion despite abolishing the health and social care levy that was going to fund it, adding to size of the problem. There are strong arguments for increasing spending on social care in the near-term to relieve pressure on the NHS.

Potential savings in the short-term are likely to be through pay restraint, and in the medium-term through greater use of technology and consolidation of services. Deferring the introduction of the social care cap could ease funding pressures for a time but would not help the Chancellor achieve his targets in the longer-term. He could save some money compared with existing plans by indexing or otherwise increasing eligibility thresholds for social care over time. 

Risks include a further worsening of health outcomes and service standards, a potential collapse in services over this and subsequent winters, and industrial action.

Education – £126bn or 12% of budgeted spending

Education spending this year is estimated to comprise £53bn on secondary education, £34bn or so on primary and pre-school, £27bn on universities and higher education, and £12bn on training, further education, and other education services. 

While the falling birth rate is expected to reduce the numbers attending primary schools by around 10% or so over the next five years, the numbers going through (more expensive) secondary schooling are still increasing. In the near term, primary and secondary schools are already struggling to cope with a national pay settlement this year that was higher than allowed for in their existing budgets.

Restraining staff pay and constraining staff numbers are likely to be the main focuses of any cost savings that might be achievable from the schools’ budget, for example by increasing class sizes or merging schools – particularly at primary level. However, teacher shortages, particularly in science, technology, engineering, and mathematics, may make cutting pay in real terms difficult to achieve. 

University student numbers are expected to grow by around 6% over the next five years, although the per head cost should come down as inflation increases the numbers who earn over student loan repayment thresholds. The changes in student loan terms that extend the period over which repayments are made should also reduce the cost per student, although these are already built into the existing forecasts.

Capping student numbers and reducing the eligibility of some courses for student loans are being explored as one way of cutting the cost of higher education. However, higher inflation also makes the cash freeze in the cap on university student tuition fees increasingly unsustainable, especially as there are limits on how much further universities can continue to recruit sufficient numbers of international students to make up for real-term cuts in funding for UK students.

The challenge for a government looking for economic growth is that the general consensus is that more not less investment in skills is needed. Investment is especially required in technical education at secondary level and in further education and training for adults. There is also a strong case for extending pre-school provision to support parents back into the workforce (in addition to its educational benefits). 

Potential savings in the short term are through pay restraint, in the medium term through school consolidation, and in the longer term as a function of a lower birth rate. Risks and challenges include the competitiveness of the UK economy.

Defence and security – £59bn or 5% of total spending

Defence and security spending in 2022/23 comprises £52bn on defence and armed forces, £5bn on the security services and counter-terrorism policing, and £2bn on war and armed forces pensions.

Over the last fifty years, successive governments have been able to ‘raid’ the defence budget to find money for the rising costs of pensions, health and social care. This is no longer possible given the UK’s commitment to NATO since 2006 to spend a minimum of 2% of national income on defence and security.

In practice, defence spending is expected to increase in the near-term to cover the effect of higher-than-forecast inflation and a weaker pound on the procurement budget, in addition to the costs of providing military aid to Ukraine. These cost pressures are likely to absorb the first stages of the commitment made by former Prime Minister Liz Truss to increase spending on defence and security to 3.0% of national income by 2030.

Pay restraint could help offset some of the rise in spending a little in the short-term but would be politically difficult to sustain over the medium- to long-term, especially if the armed forces continue to struggle to recruit the new soldiers, sailors and aircrew they need. Theoretical savings from better procurement are always discussed, but rarely achieved – at least not in aggregate as cost overruns tend to outweigh any cost savings realised.

There are unlikely to be any potential savings in defence spending. In an increasingly unstable global security situation, most risks primarily relate to not spending enough.

Transport – £47bn or 4% of total spending

Transport spending in 2022/23 is budgeted to comprise £25bn on the railways, £13bn on roads, £6bn on local transport and £3bn in other transport-related expenditures. This includes significant amounts of capital expenditure and is net of passenger fares.

Capital investment in transport infrastructure was a big component of the levelling-up agenda, with a 10% uplift in capital budgets in the 2021 Spending Review. Unfortunately, inflation in construction costs has more than offset this boost in spending, imposing a scaling back of levelling-up ambitions and the potential returns from economic growth unless the government decides to increase the budget to compensate.

Governments looking for spending cuts have often looked at the transport budget as it is relatively easy to defer or cancel capital programmes or cut back on road maintenance in order to achieve a particular financial outcome. With the train companies back in public ownership, cutting back on train services is also an option, as would raising fares on public transport by more than inflation later in the forecast period. 

Further reductions in the scope of HS2 and other rail investment programmes have been mooted as options to save money, or at the very least restrict the level of budget overruns that would otherwise require additional funding. 

The problem with cutting back on investment in transport is that it is one of the key levers available to government to unlock private sector investment and drive economic growth. There is also a risk to business confidence (and hence business investment) if the UK is not able to deliver major infrastructure programmes it has previously committed to.

Potential savings include pay restraint, cutting back on road maintenance, fewer train services, cutting back on road and rail investment programmes, and potentially cutting back or means testing free public transport provided to pensioners. Road charging and higher train fares are also options. Risks are the economic damage of continued industrial action and weaker economic growth, particularly in regional economies outside London and the South East.

Public order and safety – £43bn or 4% of total spending

Spending on public order and safety in 2022/23 is budgeted to comprise £23bn on policing, £8bn on the court system, £7bn on prisons, £3bn on fire and rescue services, and £2bn on border control. 

Cuts in spending on police, courts, prisons and fire services delivered over the past decade were in the context of falling crime and a preceding decade of rising pay and investment. The current context is very different, with crime rising, significant delays in the courts, severe prison overcrowding, and heightened concerns about fire safety since the Grenfell fire. 

The existing budget includes funding for reversing cuts in police numbers since 2010 but significant problems in the court system is likely to need additional funding. Police and prison staff recruitment challenges mean it will be difficult to restrain pay rises into the medium term.

Potential savings include pay restraint, cuts in planned police numbers, and greater use of technology. Risks include rising crime, failed prosecutions, issues with prison safety and the quality of rehabilitation, and underperforming emergency services.

Other public services – £161bn or 15% of total spending

Spending on ‘everything else’ goes across a large number of budget headings, including £30bn on industry and agriculture, £19bn on research and development, £12bn on international development and aid, £11bn on housing, £10bn on waste management, £9bn on the EU exit settlement (which will reduce significantly in future years), £8bn on culture, recreation and sport, £5bn on the BBC and Channel 4, and £2bn on foreign affairs among numerous other public services. These budget headings include most local public services outside of social care and transport, in addition to central government departments, the devolved administrations and around 500 other public bodies.

Despite a decade or so of ‘austerity’ spending restraint, there should be plenty of opportunity to find savings in many public services. Better use of technology could help improve services as well as enable them to be delivered at lower cost. However, delivering services at significantly lower cost typically requires the successful delivery of technology and restructuring programmes that carry significant financial and political risks, as well as requiring additional investment in the short-term. The more that is attempted, the higher the risk of overruns or failed attempts.

There are also significant opportunities to reduce losses incurred from fraud or waste, although this also requires investment in improving governance, processes, and financial controls at all levels of government.

Even where savings are achieved, the impact on overall government spending is limited – even if you could cut every single budget in this category by 5%, this would only reduce total spending by 0.75%.

Some budget headings are discretionary and so could in theory be reduced by much greater amounts, for example spending on research and development or funding for the arts. However, these types of spending tend to be important to delivering on other government objectives, such as fostering economic development, regenerating deprived communities, or supporting key industries such as tourism – in addition to being considered important activities in their own right.

There has been some discussion about cutting the size of the civil service, which at 510,000 is about 9% of the overall public sector workforce. Bringing total numbers down by 91,000 or 18% to the pre-Brexit position as mooted by some in government is likely to be extremely challenging to deliver in practice. Not only does the government need to deliver additional requirements such as for customs and border control, international trade negotiation, and other previously shared responsibilities that have reverted to the UK, but the events of the past few years have highlighted how government has struggled to deliver on its policy priorities. 

The three largest departmental workforces are the Department for Work & Pensions (DWP) at 94,000, the Ministry of Justice (MoJ) at 87,000 and HM Revenue & Customs (HMRC) at 71,000. In theory, the automation of manual processes and the replacement of systems that currently require extensive manual intervention could enable cuts to be made in staff at all three departments, especially the DWP. However, the risks of making major systems changes, a court system under extreme pressure, and the risks to tax revenue of cutting staff significantly in the near-term, as well increased risks of fraud and error, makes this far from a cost-free choice.

There are also political difficulties in cutting non-staff areas of these budgets, such as agricultural subsidies where there are vocal constituencies likely to object to significant reductions in the amounts paid.

One budget heading that has already been cut is spending on international development, which is now set at 0.5% of national income, with a plan to return to the previous level of 0.7% of national income once the public finances are in better shape. Some members of the governing party have suggested reducing this below 0.5%, despite a manifesto commitment to keep to the 0.7% target. There have also been suggestions that the accounting goalposts could be moved to include existing domestic spending in the UK to be classified as international development, enabling the government to reduce the amount spent outside the UK.

Another area where costs are rising are public sector pensions, as former public servants are also living longer, with pensions-in-payment contractually linked to rises in the consumer prices index. Ironically, the switch in the last decade from final salary to average salary calculations reduces the effect that constraining public sector pay has on the eventual bill. Public sector pensions are relatively generous compared with the private sector and cutting the accrual rate for pension entitlements could save substantial amounts in the longer-term, assuming this could be successfully negotiated with the unions. This would allow for higher base salaries, which might help with recruitment given pensions benefits are often undervalued by recipients.

Potential savings again include pay restraint, cutting staff numbers, cutting public sector pension benefits, procurement savings, property consolidation (already underway), technology, cutting discretionary spending, greater use of outsourcing, cutting capital programmes including infrastructure. Risks include a further deterioration in the quality of public services, problems in delivering technology and transformation programmes, failure to achieve key government objectives that depend on effective public services, poor morale affecting the effective delivery of services, and the potential that any cuts in staff numbers will be reversed as governments make new commitments.

Interest – £104bn or 10%

The interest budget in 2022/23 comprises £83bn of debt interest and £21bn of other interest, principally on local authority and other funded public sector pensions. (No interest is recorded in the fiscal numbers on the much larger amount of unfunded pension obligations).

Public sector net debt has more than quadrupled over the last fifteen years from £0.5tn in 2008 to £2.4tn today, but ultra-low borrowing costs over that time has kept the cost of servicing that debt down to historically low levels.

The Debt Management Office within HM Treasury has been able to extend maturities to an average of around 15 years, locking in very low interest rates as it has raised or refinanced debt over the last decade. However, the Bank of England’s quantitative easing programme of gilt purchases has in effect swapped a substantial proportion of this fixed rate debt into variable rate central bank deposits, making the public finances much more sensitive to increases in official interest rates. The Debt Management Office has also been successful in hedging the low levels of inflation we have experienced over the last decade through the issue of bonds that rise in line with the retail prices index. However, this goes the other way in periods of higher inflation, with increasing liabilities on index-linked gilts offsetting the inflationary benefit of a faster growing denominator on the debt to GDP ratio.

The IFS expects debt interest to increase by £23bn to £106bn in the current financial year, primarily as a consequence of higher interest rates and higher inflation on index-linked debt. Even with inflation coming down in the next year or two, it still expects debt interest in 2026/67 to be £106bn, more than double the £51bn forecast by the OBR in March.

The two main levers for restricting rises in the debt interest bill are to keep borrowing down, which implies higher taxes or lower spending compared with the current path and to keep interest rates at the lowest level possible by regaining credibility with the markets, which also implies higher taxes or lower spending. Some commentators have estimated the benefit of the change in Prime Minister as being between £6bn and £12bn in lower annual interest charges than they might otherwise have been the case.

Some commentators have suggested that the Bank of England could implement non-interest paying tiered reserves, in effect arbitrarily ceasing or reducing the base rate payable on a proportion of deposits held by (mostly UK) banks and financial institutions. This would reduce the cost of borrowing on that element of the public debt, but one risk is that the overall interest bill might end up being higher depending on how banks and debt markets responded to such a significant change in monetary policy.

One ‘creative accounting’ approach would be to change the debt measure in the debt to GDP ratio used in fiscal targets. This was amended a few years ago to exclude the rising amounts of debt being taken on by the Bank of England to fund quantitative easing and Term Funding Scheme low-cost loans for high-street banks. Reverting to the headline measure for public sector net debt would contribute to the debt to GDP ratio falling as quantitative easing is unwound and Term Funding Scheme loans are repaid.

Potential savings – none compared with current plans, absent the more radical suggestion of tiered reserves. However, the extent of the cost increase can be limited through improved fiscal credibility and constraining the amount of borrowing.

Other options

More radical options are possible, but these are likely to be extremely difficult without substantial political support from the public, such as that provided by a general election mandate.

For example, privatisation could move responsibility for some taxpayer funded services that are currently provided by public bodies to the private sector. The challenge here is that some public subsidy may still be needed even after privatisation, reducing the amount of any saving to the taxpayer. This would likely increase the burden on those of working age who would have to pay to use any service that was privatised, while still paying through their taxes for pensioners, children and the less well-off to use that service. There is also a risk that the overall cost to the public is higher, given that the bulk purchasing effect of procuring services collectively could be lost depending on the business model chosen.

Historical precedence is not helpful here, in particular the privatisation of the railways in Great Britain in 1996. This ended up being renationalised unintentionally following track-owner Railtrack’s collapse in 2002 and the failure of the train operating company franchise system in 2020. Trying again would be a ‘brave’ choice politically even if it might be possible to reduce the level of public subsidy required with a different financial model.

Other radical options include ending the provision of some public services or scaling them back significantly, but in most cases the political backlash could be significant in comparison with the level of savings that might be possible.

Long-term reform

One of the reasons the UK is in a difficult fiscal situation is the short-term focus of successive governments that have continued to add to the nation’s financial commitments without setting aside funding to pay for them. This has made the public finances increasingly less resilient to face economic shocks such as that seen in the financial crisis a decade and a half ago, the pandemic over the past two and a half years, and the cost-of-living crisis that we are currently going through.

While finding savings in the short-term is likely to be extremely difficult, over a long period there are more options to reduce the cost of the state. A good example is social care, where it might be possible to establish long-term insurance arrangements for those currently in their 20s and 30s that would eventually – in 40 to 50 years’ time – significantly reduce the level of public funding required. Similarly, the state pension could be replaced for those now entering the workforce by collective defined contribution pension funds such as those seen in other countries.

For example, Australia has strengthened its public finances significantly with reforms such as replacing unfunded defined benefit pension schemes for federal employees with defined contribution pension funds, and the establishment of a sovereign wealth fund to support the payment of pensions and welfare benefits.

Conclusion

Prime Minister Rishi Sunak and Chancellor of the Exchequer Jeremy Hunt have a difficult task in trying to reduce the gap between receipts and expenditure. Politically it will be difficult to raise taxes, but there will also be political, financial and operational consequences and risks in how they choose to cut spending. And with an increased focus by the markets on the credibility of their plans, there will be less room to pencil in optimistic ‘anticipated’ savings into the later years of the five-year forecast period.

The first challenge they face will be in how to reengineer the energy support schemes for both households and businesses from April 2023 onwards. As these are time limited, this won’t help bridge the gap in later years, but it will enable them to be more targeted in how support is provided over the next couple of years, as well as potentially reducing the overall cost that needs to be funded by long-term borrowing.

Each of the main options for cutting spending in the medium-term are unpalatable and politically challenging:

  • Real-terms cuts in pensions and welfare are possible but difficult to deliver politically during a cost-of-living crisis, as previous Prime Minister Liz Truss discovered when she was forced to deny she was planning to abandon the triple-lock mechanism. 
  • Real-terms cuts in public sector pay are likely but come with the prospect of much greater disruption from industrial action and increasing difficulties in recruiting and retaining staff. 
  • Cutting investment in infrastructure and capital programmes is the easiest option to achieve but comes with risks to future economic growth and business investment.
  • Greater efficiency is possible but practically difficult to deliver, with significant project delivery risks and the need for sufficient capital investment to be successful.
  • Higher fees and charges are possible but risk a political backlash.
  • Lowering public service outputs or quality is possible but there are practical limits to how far you can continue to cut funding for many public services without adverse effects.

Over the last fifteen years, successive governments have been able to borrow their way out of trouble even as debt has mounted, and the resilience of the public finances has weakened. That era is no more, with providers of finance to the UK Government now asking much more challenging questions about how the government can pay its way.

Tough choices will need to be made.

Martin Wheatcroft FCA is a strategy consultant, adviser on public finances, and the author of Simply UK Government Finances 2022/23.

This article was originally published by ICAEW.

Why good governance is more than words on a page

Governance failures are all too common in local government, but what can you do to make sure they don’t happen on your watch? Alison Ring, director of public sector and taxation at ICAEW, explains why good governance must be ‘lived and breathed’.

Recent headlines have highlighted the importance of good governance in ensuring the financial and reputational health of local authorities.

At one council, there were “serious failings in governance” arising from a control failure involving the signing of blank cheques, leading to a loss of £238,0000. Meanwhile, at one city council, inspectors questioned the composition of its boards stating: “Where it continues to use councillors on the boards of its subsidiary companies, it should ensure that the non-executives (including councillors) on the relevant board have, in aggregate, the required knowledge and experience to challenge management.”

An inspection report at another city council discovered “serious failings … in both governance and practice” and criticised the “corporate blindness that failed to pick this up and remedy the position”.

Seven principles of good governance

Failures such as these have led to reminders from CIPFA and others about the importance of ensuring that a local code of governance is in place. As recommended by the 2016 Governance Framework, your code should set out how the authority’s arrangements work towards meeting the seven principles of good governance set out in the framework.

Unfortunately, as CIPFA has commented, “… many authorities do not have a local code and instead rely on their annual governance statement to describe their governance arrangements. Some local codes that CIPFA has seen are not fit for purpose”.

Governance failures are all too common, so what can you do to make sure they don’t happen on your watch?

Putting a code in place is only the start. After all, some of the most egregious governance failures in recent times have occurred in local authorities with a local code that was full of structures, processes and procedures designed to ensure that risks were being managed, and public money protected.

Designing a delegated authority framework, financial controls to prevent fraud or error, or setting up an audit committee to scrutinise your finances are only the table stakes. In practice, governance only works if you live and breathe it every day.

Putting a code in place is only the start. Some of the most egregious governance failures have occurred in authorities with a local code  full of structures, processes and procedures designed to ensure that risks were managed and public money protected.

Structures and processes are there for a reason

There are many different ways to describe effective governance, but one of my favourites is from a colleague, who says that good governance is about ensuring the right people are in the right place at the right time, with the right information, asking the right questions to make the best possible decisions. This is a good rule of thumb to use in thinking about whether governance arrangements are working and how they can be improved.

Right people: do the people making the decisions have the right subject matter and financial expertise? Is there a diversity of perspectives to prevent group think? Are they able and confident enough to ask the right questions? Do you have a suitable number of people for the big decisions?

For example, are there independent lay members on your audit committee with external perspectives, financial expertise and the willingness to ask questions? Do you have a diversity of team members and perspectives in your executive team meetings? Are you inviting the most appropriate members of staff to present proposals? Have you received input from the team on the ground?

Right place: the meeting room (actual or virtual) is important because it can make a real difference to how decisions are made. The foundations should be in place to ensure meetings are productive and that information flows work well and support doing the right thing.

Right time: you need to make sure discussions to formulate, refine, recommend or approve decisions are held at the best point in time. Too late in the decision-making process, and there will be a reluctance to turn down sub-optimal proposals because of the time and effort already incurred. Too early, and proposals may not be fully developed and risks not properly assessed, letting though impractical ideas or resulting in you having to come back to the same decision again and again.

You also need to make sure there is sufficient time to properly consider a proposal, both in the time available in meetings to discuss it, but also in the time provided to decision-proposers and decision-makers to evaluate and respond. Deadlines should be set so people have sufficient time to think.

Just as importantly, time needs to be valued. Are you using people’s time effectively, making sure that decisions are being made or approved at the right level so that they have enough time for the most important decisions? Use the 80:20 rule to focus on the 20% of decisions with the most impact, and minimise the time spent on the 80% that are not so critical.

You need to foster a culture where it is acceptable to ask questions, sometimes even the stupid ones. You may not have thought of the right question to ask, but someone else may have if only they felt confident enough to ask it.

Quality of information

Right information: good governance lives or dies by the quality of information that forms the basis on which decisions are made. This is where finance has the biggest role to play, not only because you are often the gatekeeper through which key financial and strategic decisions are made, but also in your role in supporting operational decisions at all levels throughout the organisation.

Information must be of high quality and transparent. It should set out the downsides as well as the upsides, and – most importantly – must be understandable and focused. Too often we see budgets supported by extensive commentary on operational level detail best left to line management to decide, while providing scant explanation of the benefits and risks of multimillion pound capital programmes.

Right questions: asking the right questions is the most important element of any governance framework. Do decision-makers really understand what is going on? What is important to know? Who should I be talking with to get the answers? If you don’t ask the right questions, you are not going to get the right answers, or you might be satisfied with superficial information that doesn’t tell you what you really need to know. Ask questions that establish the facts, enable you to challenge and scrutinise, identify risks, prompt a thorough discussion and aid decision making.

Most importantly, you need to foster a culture where it is acceptable to ask questions, sometimes even the stupid ones. You may not have thought of the right question to ask, but someone else may have if only they felt confident enough to ask it.

Reappraising decisions

Making the best decisions involves rigorously evaluating what has been done before so that you can do better in the future. Are you continually appraising previous decisions, not only to learn from mistakes but also to learn from successes? Are you getting the right answers from the process that is your system of governance?

This is where the quality of oversight comes into its own. Are your formal structures playing their full role in challenging management to be the best you can be, both at the top level (for example, audit, finance and scrutiny), but also down through the organisation?

Is your finance committee challenging you about the accuracy of financial forecasts and projections? Is your audit committee asking what is being done to reduce errors in financial processes? Are your external auditors reporting to you and the audit committee on the quality of year-end working papers and providing feedback on required improvements?

Independent audit committee members with technical expertise can help by challenging decisions, acting as a critical friend to the council leader, their cabinet and the management team, and can provide financial education for councillors.

Your internal audit team can really help with evaluation, not only in their formal role examining the effectiveness of processes each year, but also by being a critical friend within the organisation as they kick the tyres across a whole range of different assignments.

Continuous improvement is key, as processes are never perfect. Are you actively seeking to improve the quality of decision-making? If key meetings are rushed, curtailing the opportunity for proper discussion of the merits of important decisions, can they be extended, or less important items moved to a different forum or dealt with much better by those close to the coal face? Are your budget documents up to scratch, providing the information management that cabinet and councillors need to make the best choices?

Good governance must be lived and breathed

Making sure you have a code of governance in place is important, but it is not enough on its own.

You and your colleagues need to live and breathe governance for it to be effective. Otherwise, your code will be just another document gathering electronic dust in the far reaches of your website. Enough to tick a box to say you have one, but not nearly enough to help you steer clear of avoidable disasters.

Martin Wheatcroft contributed to the writing of this article at the request of ICAEW. It was originally published in Room 151.

July boost to public finances doesn’t stop red ink

Fiscal outlook worsens as mid-year self assessment receipts fail to outweigh higher debt interest and the cost of energy support packages.

The monthly public sector finances for July 2022 released on Friday 19 August 2022 reported a provisional deficit for the month of £5bn, compared with a deficit of £21bn in the previous month as self assessment receipts boosted the cash position, supplemented by growing VAT and PAYE receipts. The latter helped add £7bn to the top line compared with this time last year, bringing total receipts for the month to £84bn, while current expenditure excluding interest of £79bn and interest of £7bn were each £3bn higher. With net investment unchanged at £3bn, the net improvement in the deficit for July compared with the same month last year was £1bn.

The total deficit for the first four months of the 2022/23 financial year was £55bn following revisions to previous months. This was £12bn lower than this time last year and £99bn lower than the previous year during the first pandemic lockdown, but £33bn more than the deficit of £22bn for the first four months of 2019/20, the most recent pre-pandemic comparative period.

Public sector net debt was £2,388bn or 95.5% of GDP at the end of July, up £46bn from £2,342bn at the end of March 2022. This is £621bn higher than the £1,767bn equivalent on 31 March 2020, reflecting the huge sums borrowed over the course of the pandemic, although the increase in the debt-to-GDP ratio from 74.4% on 31 March 2020 is less than that reported in previous months as inflation has added to nominal GDP.

Tax and other receipts in the first four months to 31 July amounted to £313bn – £31bn, or 11%, higher than a year previously. This included higher income tax receipts from wage increases and bonuses as well as the new higher rate of national insurance, together with additional VAT receipts from inflation in retail prices.

Expenditure excluding interest and investment for these four months of £311bn was level with the same period last year, as reduced spending on the pandemic (including furlough programmes) was offset by the spending increases announced in last year’s Spending Review, together with support for households to help with energy bills.

Interest charges of £44bn were recorded for the four months – £21bn or 92% higher than the £23bn in the equivalent period in 2021 – with inflation driving up the cost of RPI-linked debt in addition to the effect of higher interest rates.

Cumulative net public sector investment was £14bn. This is £1bn or 9% lower than a year previously, potentially indicating a slowdown in capital programmes given that the Spending Review 2021 had pencilled in significant increases in capital expenditure budgets for the current year.

The increase in net debt of £46bn since the start of the financial year comprises the deficit for the four months of £55bn less £9bn in net cash inflows, as inflows from repayments of taxes owed and loans made to businesses during the pandemic exceeded outflows to fund student loans, other lending and working capital movements.

Alison Ring OBE FCA, Public Sector and Taxation Director at ICAEW, said: “The latest numbers highlight the extent to which the fiscal outlook is worsening as the cost of borrowing rises, with record high energy costs, rapidly increasing prices and an economy close to recession expected to further drive up public spending in this and the next financial year.

“The UK’s deteriorating fiscal situation will make it hard for the new prime minister to deliver on promised tax cuts, invest in energy resilience and support struggling families and businesses over the winter, without breaching fiscal rules intended to ensure the long-term health of the public finances.”

Table with cumulative receipts - expenditure - interest - net investment = deficit - other borrowing = debt movement for the first four months of the financial year, together with net debt and net debt / GDP.

Apr-Jul 2019 £bn: 268 - 257 - 23 - 10 = -22 deficit + 10 = -12 debt movement; 1,767 net debt, 78.3% net debt / GDP.

Apr-Jul 2020 £bn: 234 - 347 - 15 - 26 = -154 deficit - 40 = -194 debt movement; 1,987 net debt, 92.6% net debt / GDP.

Apr-Jul 2021 £bn: 281 - 310 - 23 - 15 = -67 deficit + 2 = -65 debt movement; 2,200 net debt, 94.1% net debt / GDP.

Apr-Jul 2022 £bn: 313 receipts - 310 expenditure - 44 interest - 14 net investment = -55 deficit + 9 = -46 debt movement; 2,388 net debt, 95.5% net debt / GDP.

Caution is needed with respect to the numbers published by the ONS, which are expected to be repeatedly revised as estimates are refined and gaps in the underlying data are filled.

The ONS made several revisions to prior period fiscal numbers to reflect revisions to estimates. These had the effect of reducing the reported fiscal deficit for the three months ended 30 June 2022 by £5bn from £55bn to £50bn and increasing the reported fiscal deficit for the 12 months to March 2022 by £2bn from £142bn to £144bn.

This article was originally published by ICAEW.

Inflation adds fuel to the deficit as cost of borrowing soars

Economic pressures mount as the public sector deficit reaches £55bn in the first three months of the fiscal year.

The monthly public sector finances for June 2022, released on Thursday 21 July 2022, reported a provisional deficit for the month of £23bn, bringing the total for the first quarter of the 2022/23 financial year to £55bn.

The first quarter deficit was £6bn below this time last year, but £32bn higher than the £23bn reported for the first three months of 2019/20, before the pandemic.

Public sector net debt increased to £2,388bn or 96.1% of GDP at the end of June, up £46bn from £2,342bn at the end of March 2022. This is £595bn higher than 31 March 2020, reflecting the huge sums borrowed over the course of the pandemic.

Tax and other receipts in the first quarter to 30 June amounted to £228bn, £24bn or 11% higher than a year previously. This included higher income tax receipts from wage increases and bonuses as well as the new higher rate of national insurance, plus higher VAT receipts driven by higher retail prices.

Expenditure excluding interest and investment for the quarter of £234bn was £1bn higher than the same period last year, as reduced spending on the pandemic (including furlough programmes) was offset by planned increases in spending announced in last year’s Spending Review and by additional support to households to help with their energy bills.

Interest charges of £36bn were recorded for the three months, £17bn or 39% higher than the £19bn in the equivalent period in 2021, driven by rising inflation increasing the cost of RPI-linked debt in addition to higher interest rates. This reflects how the government’s hedge against low inflation – which saw interest charges fall even as debt quadrupled over the last 15 years – went into reverse, with the benefit (to the government) of debt inflating away more quickly offset by a higher cost of borrowing.

Net public sector investment in the quarter was reported to be £13bn, which is £1bn or 7% higher than a year previously.

The increase in net debt of £46bn since the start of the financial year comprises the deficit for the quarter of £55bn less £9bn in net repayments. This reflects the recovery of loans to banks through the Bank of England’s Term Funding Scheme and of loans to businesses via the British Business Bank (including bounce-back and other coronavirus loans), offset by outflows to fund student loans and other government cash requirements.

Alison Ring OBE FCA, Public Sector and Taxation Director for ICAEW, said: “The latest inflation-fuelled numbers will provide little comfort for the new Prime Minister, as at £55bn for the quarter to June, the deficit is more than double what it was before the pandemic.

“With inflation at a 40-year high and record energy prices this winter, the question facing the next Prime Minister and Chancellor will not be about whether or not to write another cheque to struggling families, but how big it will be.

Meanwhile, rising supplier cost inflation and public sector pay demands that are unlikely to be satisfied by a proposed 5% increase will put severe pressure on both operating and capital budgets. Combined with long-term demographic trends that continue to drive public spending higher, the likelihood is that any tax cuts promised during the Conservative party leadership campaign will end up being reversed in the years ahead.”

Table with public sector finance numbers for receipts, expenditure, interest, net investment, the deficit, other borrowing, the net movement in debt and net debt at the end of the period.

Apr-Jun 2019: receipts £195bn - expenditure £192bn - interest £18bn - net investment £8bn = deficit -£23bn - other movements £1bn = net movement -£24bn; net debt £1,767bn or 78.9% of GDP.

Apr-Jun 2020: £170bn - £268bn - £12bn - £22bn = deficit -£132bn - £51bn = net movement -£183bn; net debt £1,976bn or 91.9% of GDP.

Apr-Jun 2021: £204bn - £234bn - £19bn - £12bn = deficit -£61bn - £9bn = net movement -£70bn; net debt £2,205bn pr 95.1%.

Apr-Jun 2022: £228bn - £234bn - £36bn - £13bn = deficit £55bn + £9bn = net movement -£46bn; net debt £2,388bn or 96.1% of GDP.

Caution is needed with respect to the numbers published by the ONS, which are expected to be repeatedly revised as estimates are refined and gaps in the underlying data are filled.

The ONS made several revisions to prior period fiscal numbers to reflect revisions to estimates. These had the effect of reducing the reported fiscal deficit for the two months ended 31 May 2022 by £3bn from £36bn to £33bn and the reported fiscal deficit for the twelve months to March 2022 by £2bn from £144bn to £142bn.

This article was originally published by ICAEW.

Alison Ring: don’t waste the huge effort you put into annual accounts

Council finance teams put a lot of time and resources into preparing financial statements each year but often the results are impenetrable. A focus on streamlining and clarity can make a huge difference, writes the ICAEW’s public sector director.

Getting the annual accounts finished and out of the way is a relief to most finance teams. It is a major undertaking to put together what can be a couple of hundred pages of detailed numerical content and getting your auditors to sign off on it all. Understandably, there is a temptation to just upload it to the website, forget about it for another year and move onto the budget, that bid for levelling up funding, or the many other priorities that are pushing up your to-do list.

But are you getting a full return on the investment you make into your annual report? The answer is almost certainly “no”. Unlike their corporate equivalents, local authority accounts are notoriously “impenetrable” and a difficult tool to use in communicating with stakeholders on the financial story of the year and how you are making progress in delivering on your strategic objectives.

The last thing you want to do is to use a long, complicated, and difficult to understand document as a tool for accountability, while for readers the challenge in trying to understand the finances of many local authorities is daunting. Ahead of them might be a 250-page document with over 150 pages of difficult-to-follow financial statements. To put it bluntly, who has the time to read all of that?

Concise and streamlined accounts

This contrasts with annual reports such as that recently published by the Government Legal Department (a non-ministerial department), where the financial statements including notes take up only 15 pages of an 80-page document. This is a much better vehicle for understanding the financial performance and position of, admittedly, a simpler organisation than most local authorities – but an example of how being concise and streamlined can make accountability that much easier to achieve.

It is almost two years since the conclusion in the Redmond Review that local authority accounts are “considered impenetrable to the public”. As finance leaders in the local government sector, this should concern us all.

Your accounts should help residents, councillors and councils understand the financial performance and position of the local authority. They should be the cornerstone of the evidence-based decision-making and strong financial management, essential for effective delivery of public services.

Unfortunately, impenetrable financial reports achieve none of the benefits that a well-designed annual report is capable of. Not only do they sap the resources of finance teams in preparing information that is not going to be used effectively, but they mean other ways have to be found to provide the financial transparency that councillors and others need to represent the interests of local residents effectively. Or (as many councillors tell us) not to have a full understanding of the finances at all.

Don’t wait for CIPFA/LASAAC Code improvements

While there is a real need to reform the Local Authority Accounting Code and the example financial statements in the code guidance notes – and CIPFA/LASAAC are working on that – there is no need to wait for that to happen. Yes, the complexity of the local authority finance system doesn’t help, but even so I have yet to read a set of local authority financial statements where I did not think there was something that the preparers could have done to make them more understandable and concise, while remaining compliant with the code.

Some local authorities have already been able to streamline their financial statements to good effect. Fife Council, for example, has been able to reduce the length of its annual report including the management commentary to only 68 pages, while Southwark Council worked with its auditors to reduce their document to 133 pages, which is notably short for a large London borough.

One mistake is to treat the example financial statements as currently devised as a template, rather than as a reference document covering almost every conceivable scenario. We too often see local authorities including boilerplate disclosures from the example financial statements even when not relevant. CIPFA has published helpful accounts streamlining guidance that advises moving away from the example financial statements to reduce the length of the report.

It is important though when conducting a streamlining exercise that you consider the needs of users. Shorter for the sake of it is counterproductive if it means the accounts are non-compliant or even more difficult to understand. For example, nothing useful is achieved by tiny font sizes or merging notes that don’t relate to each other.

Consider instead how you can structure your financial statements effectively. For example, in most circumstances there is no need for three separate notes to the cash flow statement when there is room in the primary statement itself. Could you move the more detailed financial instrument and pension disclosures to the back of the report so that the main balance sheet notes flow together more seamlessly? Have you “weeded” your accounting policies note as much as you can? It is surprising how many local authorities report a policy for contingent assets when there are none that (apparently) need disclosing.

Think about what users require

Streamlining should not mean losing important information – instead, it gives an opportunity to focus on what is important. Take out accounting policies that merely restate GAAP, or long expositions of credit risk on immaterial exposures that do not aid understanding, and instead provide more insightful disclosures that are specific to your local authority, perhaps such as the financial performance of council-owned businesses. Tables and charts can be used to communicate concisely, without compromising on the quality of the information provided.

Have you provided what is really needed, such as why investments have been recognised at amortised cost rather than fair value (or vice versa)? Or how you have calculated your Minimum Revenue Provision (MRP)? Despite its importance to council tax calculations, a recent review of a sample of local authority accounts by the ICAEW found that many did not disclose the MRP policy or the key judgements made in its calculation and, in the few instances where there was disclosure, the language used was often so technical as to be incomprehensible. Getting rid of jargon can help make it easier for councillors and residents to use the accounts.

A foundation for financial conversations with stakeholders

Local authorities are in theory much more transparent than their private sector comparators. Listed companies do not have to publish their budgets or internal financial reports, debate their financial decisions in meetings open to the public, nor allow their stakeholders the ability to inspect their detailed books and records.

Despite that we often hear the view that local authority finances are much more difficult to understand – a classic example of how greater quantity does not equal better quality.

Making the annual report and accounts a foundation for your financial communication is one way of addressing the deficit in understanding, and a way of getting a better return on all the effort you put into them. A good annual report should be an annually updated reference work that is actively used as the go-to place to find your strategy, how you monitor progress against your objectives, how you are managing risks, and the strength (or otherwise) of your financial position, as well as telling the story of the year in words and numbers.

Doing so may also help you get on the front foot with the new Office for Local Government, which is likely to become an avaricious consumer of your performance data once it gets up and running.

While we hope CIPFA/LASAAC’s project to improve the presentation of local authority financial statements will put understandability at its heart, that does not mean you should wait for developments. Not only can you make your annual report that much more usable through streamlining disclosures and improving clarity (potentially saving time by making it easier to prepare in the future), but you have an opportunity to use it to support better quality dialogue with your stakeholders.

If you don’t feel comfortable in presenting your annual report to your councillors as the one financial document that they need to read each year, then I would suggest that you are not doing it in the right way.

This article was originally published in Room 151.

Economic storm clouds darken outlook for public finances

A slightly higher fiscal deficit for May and rising interest rates provide no comfort for the Chancellor as he considers how to respond to public sector wage demands.

The monthly public sector finances released on Thursday 23 June 2022 reported a provisional deficit for the month of May 2022 of £14.0bn, an improvement from this time last year, but still £8.5bn higher than May 2019, the year before the pandemic.

Public sector net debt increased by £21bn from £2,342bn at the end of March 2022 to £2,363bn or 95.8% of GDP at the end of May. This is £570bn higher than 31 March 2020, reflecting the huge sums borrowed over the course of the pandemic.

The deficit reported for the two months to May 2022 of £35.9bn was an improvement of £6.4bn from the deficit of £42.3bn reported for the months of April and May 2021, and £64.2bn better than the £100.1bn reported for April and May 2020. However, it was £19.8bn worse than the pre-pandemic deficit of £16.1bn for the two months to May 2019.

Tax and other receipts in the two months amounted to £147.5bn, £12.4bn or 9% higher than a year previously. This included higher income tax receipts from wage increases and bonuses as well as the new higher rate of national insurance, as well as higher VAT receipts driven by higher retail prices.

Expenditure excluding interest and investment for the year to date of £158.5bn was unchanged from the same period last year, as reduced spending on the pandemic including furlough programmes was offset by planned increases in spending announced in last year’s Spending Review and by additional support to households to help with their energy bills.

Interest amounted to £15.7bn in April and May, £6.1bn or 64% higher than the £9.6bn in the two months ended 31 May 2021, reflecting how higher interest rates and higher inflation are increasing the government’s cost of borrowing.

Net public sector investment in April and May 2022 was reported to be £9.2bn, which is £0.1bn lower than a year previously. This is slightly surprising given planned increases in capital expenditure as well as the subsidies given in the past two months to Bulb Energy, a failed energy supplier taken over by the government.

The increase in net debt of £21.2bn since the start of the financial year comprises the deficit for the month of £35.9bn less £14.7bn in net borrowing repayments. This reflects the recovery of loans to banks through the Bank of England’s Term Funding Scheme and of loans to businesses via the British Business Bank (including bounce-back and other coronavirus loans), offset by funding for student loans and other government cash requirements.

Alison Ring OBE FCA, Public Sector and Taxation Director for ICAEW, said: “A slightly higher deficit than expected in this month’s numbers and a rising interest bill will not provide any comfort for the Chancellor as he considers how to respond to public sector wage demands at the same time as attempting to build capacity for pre-election tax cuts next year.

The economic storm clouds hovering over the fiscal outlook, as living standards go into reverse and inflation erodes the extent of planned investment in local communities, are likely to make the government’s ambition to level up the country even more difficult to achieve.”

Table showing cumulative numbers for April and May 2022 and variances against the same period a year ago:

Receipts £147.5bn: £12.4bn or +8%
Expenditure (£158.5bn): £0.0bn
Interest (£15.7bn): (£6.1bn) or +39%
Net investment: (£9.2bn): £0.1bn or -1%
Deficit (£35.9bn): £6.4bn or -18%
Other borrowing: £14.7bn: £31.1bn or -212%
(Increase) in net debt: (£21.2bn): £37.5bn or -177%

Public sector net debt: £2,363.2bn: £170.1bn or +8%
Public sector net debt / GDP 95.8%: 0.5% or +0.5%

Caution is needed with respect to the numbers published by the ONS, which are expected to be repeatedly revised as estimates are refined and gaps in the underlying data are filled.

The ONS made several revisions to the prior period fiscal numbers to reflect revisions to estimates. These had the effect of increasing the reported fiscal deficit for the month of April 2022 by £3.3bn from £18.6bn to £21.9bn and decreasing the reported fiscal deficits for the 12 months to March 2022 by £0.9bn from £144.6bn to £143.7bn and for the year ended 31 March 2021 by £7.7bn from £317.3bn to £309.6bn.

Table showing receipts, expenditure, interest, net investment, deficit and net debt for April and May combined in 2019, 2020, 2021 and 2022 respectively.

For details, click on the link to the original article on the ICAEW website.

This article was originally published by ICAEW.

A Spring Statement dominated by inflation

Tax plans brought forward as Chancellor Rishi Sunak seeks to limit spending commitments and build fiscal headroom ahead of the Autumn Budget.

Inflation dominated the Spring Statement as the Chancellor added to his support package for households and businesses facing rapidly rising prices but held off giving any extra money for public services.

Despite a major tax cut from raising National Insurance thresholds, the OBR estimates that the measures announced by the Chancellor for the coming financial year will offset around a third of the fall in living standards. This will leave household budgets to take most of the strain of the rapidly rising prices, with the potential that the government will need to intervene again later in the year as the impact becomes clearer.

The biggest individual change in the government’s spending plans is the bill for interest on central government debt, which increases from £24bn in 2020/21 to £54bn this year and a forecast of £83bn for 2022/23. This is the biggest driver of an increase in the forecast deficit for next year from last October’s forecast of £62bn to a revised forecast of £99bn, despite an £11bn boost from restructuring the system for student loans that could see graduates paying back their loans almost up until retirement.

Despite the increase in the coming financial year, the OBR expects the deficit in the rest of the forecast period to be lower than before, with the projected deficits in the subsequent four years up to 2026/27 down from £62bn, £46bn, £46bn and £44bn to £50bn, £37bn, £35bn and £32bn – a net improvement of £11bn a year on average. 

Higher tax receipts are the primary driver of a reduced forecast for public sector net debt at 31 March 2027 of £2,480bn, down from a previous forecast of £2,567bn, but still £687bn higher than the £1,793bn at 31 March 2020. The impact on the debt-to-GDP ratio is greater, with lower cash outflows and higher GDP driven by inflation combining to reduce the ratio from a previous forecast of 88% in 2027 to 83%, reversing a significant proportion of the increase caused by the pandemic.

The OBR calculates that the Chancellor has about £30bn of headroom against his fiscal targets, giving him more capacity to provide additional support for households and businesses later in the year if he thinks it necessary. Given the uncertainties surrounding the potential impact of Russia’s invasion of Ukraine on the UK economy, it is perhaps understandable for Rishi Sunak to want to accelerate the reduction in debt in relation to the size of the economy and build greater fiscal resilience. However, he will be conscious of the risk of a recession if households cut back their spending in the domestic economy by too much.

Other than some welcome additional funding to tackle fraud, there was no significant additional funding for departments or local authorities who will need to stick within their original budgets set by the three-year Spending Review announced last October. This could result in ‘unplanned austerity’ as they seek to find savings to offset rising costs, in particular the government’s capital investment plans, where the cost of building infrastructure is likely to increase significantly, potentially jeopardising priorities such as levelling up.

Alison Ring, Director of Public Sector and Taxation, commented: “The story of the Spring Statement is inflation, which is driving a sharp fall in living standards and is causing the interest bill on public debt to multiply. The government has responded with a package of measures that the OBR estimates offset about a third of the decline, but this still leaves household budgets exposed to the effect of rapidly rising prices. The Chancellor’s focus on building up fiscal resilience suggests he may be trying to preserve some firepower for possible further interventions later in the year.

“With public finances in a better shape than previously forecast, the Chancellor will hope that he is going to be able to make good on his pledge to cut income tax in 2024.”

This article was originally published by ICAEW.

Spring Statement: what the new measures will mean

ICAEW Insights quotes me in an article on the Spring Statement 2022:

“Despite its impact on the government’s interest bill, there is a major benefit to inflation in that it helps bring down the debt-to-GDP ratio more quickly, providing the Chancellor more space to intervene to help with the cost of living,” Martin Wheatcroft, public finance adviser to ICAEW, explains.

According to the OBR, the new measures announced in the Spring Statement, along with the existing package announced previously, should offset around a third of the increase in costs that households are facing, leaving them with the burden of the other two-thirds, Wheatcroft says. “I think we should expect further measures from the Chancellor in the summer or autumn as the impacts on households become more apparent.”

Wheatcroft adds that it is likely that some of the announcements included in the Spring Statement were brought forward to ease tensions with backbenchers. “With members of his own party pressing for a delay in the NIC increase, I suspect the Chancellor felt pressure to bring forward measures that he may have been saving for later in the year, in particular his planned cut to income tax in 2024 and a tax plan that was likely set for a summer release ahead of the Autumn Budget.”

To read the full article, click here.

Public finances raise hopes for Spring Statement giveaway

February’s £13.1bn deficit was offset by revisions to prior month estimates, boosting public finances and putting further pressure on the Chancellor to provide more help to households and businesses facing rapidly rising prices.

The public sector finances for February 2022, released on Tuesday 22 March 2022, reported a deficit for the month of £13.1bn. This was an improvement of £2.4bn from the deficit of £15.4bn reported for February 2021, but £12.8bn worse than the £0.4bn deficit reported for February 2020.

The cumulative deficit of £138.4bn for the first 11 months of the 2021/22 financial year was £0.1bn less than that reported last month, as the £13.1bn deficit for February was offset by £13.2bn in revisions to prior month estimates.

Public sector net debt increased by £6.6bn from £2,320.2bn at the end of January to £2,326.8bn or 94.7% of GDP at the end of February, with tax and loan recoveries partly offsetting the deficit for the month. Despite that, debt is £192.4bn higher than at the start of the financial year and £533.7bn higher than March 2020.

The year-to-date deficit of £138.4bn compares with a cumulative deficit for the first 11 months of the financial year of £290.9bn in 2020/21 and £48.7bn in 2019/20. This was £25.9bn below the forecast published by the Office for Budget Responsibility alongside last October’s Autumn Budget and Spending Review 2021, with higher-than-forecast tax receipts being partially offset by higher-than-forecast interest charges on index-linked debt. Both are driven by higher rates of inflation, which takes more time to feed through to non-interest expenditure. This suggests that the deficit for the full year could end up somewhere in the region of £30bn below the official forecast of £183bn.

Cumulative receipts in the first 11 months of the 2021/22 financial year amounted to £826.0bn – £104.7bn or 15% higher than a year previously but £69.3bn or 9% above the level seen in the first 11 months of 2019/20. At the same time, cumulative expenditure excluding interest of £846.2bn was £65.1bn or 7% lower than the same period last year, but £127.4bn or 18% higher than two years ago.

Interest amounted to £69.2bn in the eleven months to 28 February 2022, which was £29.4bn or 74% higher than the same period in 2020/21, principally because of the effect of higher inflation on index-linked gilts. Interest costs were £17.8bn or 35% more than in the equivalent 11-month period ended 29 February 2020.

Cumulative net public sector investment up to February 2022 was £49.0bn. This was £12.1bn or 20% below the £29.7bn reported for the first 11 months of last year, which included around £17bn of COVID-19 related lending that the government does not expect to recover. Investment was £13.8bn or 39% more than two years ago, principally reflecting greater capital expenditures, including on HS2.

The increase in debt of £192.4bn since the start of the financial year comprises the cumulative deficit of £138.4bn and £54.0bn in other borrowing. The latter has been used to fund lending to banks through the Bank of England’s Term Funding Scheme, lending to businesses via the British Business Bank (including bounce-back and other coronavirus loans), student loans and other cash requirements, net of the recovery of taxes deferred last year and loan repayments.

Alison Ring OBE FCA, Public Sector and Taxation Director for ICAEW, says: “Today’s numbers show the impact inflation is having on the public finances as it continues to drive both tax receipts and interest costs higher. The deficit for the financial year is expected to be around £30bn lower than October’s official forecast of £183bn, while tomorrow’s Spring Statement forecasts could see a smaller deficit next year than the £62bn expected before the pandemic.

“Uncertainty about the impact of the war in Ukraine on the UK means it will be extremely difficult for the Chancellor to gauge the level of intervention needed to support households and businesses facing rocketing energy prices if he’s to avoid a recession that could permanently damage the economy and the public finances, and still leave room for tax cuts in the Autumn Budget.”

Table showing cumulative 11 month numbers and variances against prior year and two years ago. All amounts in £bn, with negative numbers in brackets (costs / negative variances).

Receipts 826.0: 104.7 +15% better than prior year; 69.3 +9% versus two years ago

Expenditure (846.2): 65.1 -7%; (127.4) +18%

Interest (69.2): (29.4) +74%; (17.8) +35%

Net investment (49.0): 12.1 -20%; (13.8) +39%

Subtotal Deficit (138.4): 152.5 or -52% lower than the prior year; (89.7) +184% higher than two years ago

Other borrowing (54.0): (8.5) +19%; (73.3) -380%

Total (Increase) in net debt (192.4): 144 -43%; (163.0) +554%

Also:

Public sector net debt 2,326.8: 197.3 or +9% higher than prior year and 542.8 +30% higher than two years ago

Public sector net debt / GDP 94.7%: 0.3% or 0% higher than prior year; 12.7% or +15% higher than two years ago.

Caution is needed with respect to the numbers published by the Office for National Statistics (ONS), which are expected to be repeatedly revised as estimates are refined and gaps in the underlying data are filled.

The ONS made a number of revisions to prior month and prior year fiscal numbers to reflect revisions to estimates. These had the effect of decreasing the reported fiscal deficit for the 10 months to January 2022 by £13.2bn from £138.5bn to £125.3bn and reducing the deficit for the year ended 31 March 2021 by £4.1bn from £321.9bn to £317.8bn.

Table showing receipts, expenditure, interest, net investment and the deficit by month from Apr 2021 to Feb 2022.

Click on link below to the article on the ICAEW website for a readable version of this table.

This article was originally published by ICAEW.

Boost to tax revenues is a dilemma for the Chancellor

January’s public sector finance surplus of £2.9bn was driven by a boost to tax revenues as inflation drove up VAT receipts and self assessment income grew, putting further pressure on Chancellor Rishi Sunak to increase support to households facing huge rises in energy prices.

The public sector finances for January, released on 22 February, reported a surplus for the month of £2.9bn. This was an improvement of £5.4bn from the deficit of £2.5bn reported for January 2021, but £7bn smaller than the £9.9bn surplus reported for January 2020.

Total receipts were £97.9bn in January, up from £76.0bn in the previous month.

Public sector net debt fell from £2,339.7bn at the end of December to £2,317.6bn or 95% of GDP at the end of January, with tax and loan recoveries supplementing the surplus for the month. Despite that, debt is £210.7bn higher than at the start of the financial year and £524.5bn higher than in March 2020.

The cumulative deficit for the first 10 months of the financial year was £138.5bn, compared with £278.7bn and £48.4bn for the same period last year and the year before that respectively.

This was £17.7bn below the forecast published by the Office for Budget Responsibility (OBR) alongside last October’s Autumn Budget and Spending Review 2021, although higher than forecast tax receipts were partially offset by higher than forecast interest charges on index-linked debt. Both are driven by higher rates of inflation, which takes more time to feed through to non-interest expenditure.

Cumulative receipts in the first 10 months of the 2021/22 financial year amounted to £741bn, £93.3bn or 14% higher than a year previously, but only £56.1bn or 8% above the level seen in the first 10 months of 2019/20. At the same time, cumulative expenditure excluding interest of £776.7bn was £58.8bn or 7% lower than the same period last year, but £122.2bn or 19% higher than two years ago.

Interest amounted to £59.6bn in the 10 months to January 2022, £25.4bn or 74% higher than the same period in 2020/21, principally because of the effect of higher inflation on index-linked gilts. Interest costs were £12.8bn or 27% more than in the equivalent 10-month period ended 31 January 2020.

Cumulative net public sector investment up to January 2022 was £43.2bn. This was £13.5bn or 24% below the £56.7bn reported for the first 10 months of last year, which included around £17bn of COVID-19-related lending that the government does not expect to recover. Investment was £11.3bn or 35% more than two years ago, principally reflecting greater capital expenditures, including on HS2.

The increase in debt of £183.2bn since the start of the financial year comprises the cumulative deficit of £138.5bn and £44.7bn in other borrowing. The latter has been used to fund lending to banks through the Bank of England’s Term Funding Scheme, lending to businesses via the British Business Bank (including bounce-back and other coronavirus loans), student loans, and other cash requirements, net of the recovery of taxes deferred last year and loan repayments.

Alison Ring OBE FCA, Public Sector and Taxation Director for ICAEW, said: “The strong tax receipts reported today will provide a welcome respite for the public finances, reducing the shortfall in the government’s income compared with its expenditure from previous forecasts. However, the deficit is still on track to be the third highest ever recorded in peacetime, while public debt is more than half a trillion pounds higher than it was at the start of the pandemic.

“The challenge for Sunak will be balancing the strong pressures on him to increase the support package for households facing rapidly rising energy costs and retail prices, with the need to strengthen the resilience of the public finances in the face of a great deal of economic uncertainty and increasing global security concerns. The Chancellor will be acutely aware that while inflation is adding to tax revenues today it will go on to add to public spending tomorrow”.

Table showing receipts, expenditure, interest, net investment, deficit, other borrowing the increase in net debt for the 10 months to Jan 2021 and public sector net debt and public sector net debt / GDP at 31 Jan 2021 together with variances versus prior year and two years ago.

Click on link at the end of this article to the version of this article on the ICAEW website which has a readable version of this table.

Caution is needed with respect to the numbers published by the ONS, which are expected to be repeatedly revised as estimates are refined and gaps in the underlying data are filled.

The ONS made a number of revisions to prior month and prior year fiscal numbers to reflect revisions to estimates. These had the effect of decreasing the reported fiscal deficit for the nine months to December 2021 from £146.8bn to £141.4bn and increasing the deficit for the year ended 31 March 2021 from £321.8bn to £321.9bn.

Table showing receipts, expenditure, interest, net investment and the deficit for each of the 10 months to Jan 2021.

Click on link below to the version of this article on the ICAEW website which has a readable version of this table.

This article was originally published by ICAEW.