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.

ICAEW chart of the week: Provisional tax bands 2023/24

My chart this week illustrates how five or seven different personal tax bands are expected in the coming financial year, despite the top rate of income tax being abolished.

Column chart showing tax rates for 2023/24 by income level, based on the mini-Budget. 

£0 -> 100% take home pay
£12,570 -> 12% national insurance, 19% income tax, 69% take home pay

Box for withdrawal of child benefit
£50,000 -> 12% NI, 31% income tax, 57% take home pay
£50,270 -> 2% NI, 52% income tax, 46% take home pay

Box for no children / lower earning parent
£50,270 -> 2% NI, 40% income tax, 58% take home pay

End of boxes

£60,000 -> 2% NI, 40% income tax, 58% take home pay
£100,000 -> 2% NI, 60% income tax, 38% take home pay (withdrawal of personal allowance)
£125,140 -> 2% NI, 40% income tax, 58% take home pay

Amid market chaos it might be forgotten that the ‘mini’ Budget was primarily about reforming the personal tax system. In abolishing the 45% top rate of income tax from 6 April 2023 onwards, the Chancellor simplified the tax system by removing the personal tax band that currently applies to earnings above £150,000.

Despite that simplification, our chart this week highlights how the personal tax system remains quite complicated, much more than might be assumed based on just two rates of income tax (19% and 40%), two rates of national insurance (12% and 2%) and recent alignment in income tax and national insurance thresholds.

In practice, our chart is an oversimplification, as it does not attempt to incorporate welfare benefits and hence the full complexity of how people are ‘taxed’ as their incomes rise – for example the 55% taper rate at which universal credit is withdrawn from those on the lowest incomes. It also does not attempt to reflect the tax treatment on non-earned income such as dividends, interest and capital gains, nor the intricacies of how pension contributions or other tax reliefs are dealt with. 

Nor does it show the different rates of income tax applicable in Scotland, which currently has three more tax bands than elsewhere in the UK and is likely to continue to do so once the Scottish Budget establishes tax rates for next financial year.

Our chart assumes the thresholds for personal income tax and national insurance remain frozen as currently planned, illustrating how there is no tax to pay on the first £12,570 of earned income – the first band in the UK’s personal tax system.

From this point upwards, income tax of 19% (a 1% cut from the current rate) and employee national insurance of 12% (a reduction from the 13.25% in force until next month) are expected to apply in 2023/24, a combined rate of 31% that reduces take-home pay to 69% of each extra pound earned.

These rates apply to earnings up to £50,000, when a strange quirk of the tax system comes into play if you are a parent with a child or children receiving child benefit. Assuming child benefit is uprated by inflation in April, then the amount clawed back between £50,000 and £60,000 from the higher-earning parent is likely to be equivalent to somewhere in the region of an extra 12% (for one child) or 20% (for two children). The quirk is the misalignment between the £50,000 at which child benefit starts to be withdrawn through the tax system and the £50,270 point at which the 40% higher rate of income tax rate and 2% lower rate of national insurance of £50,270 come into force. 

This creates a small band where the higher-earning parent of one child faces a combined tax rate of 43%, followed by a band between £50,270 and £60,000 where a combined rate of 52% applies. Not shown in the chart is the even higher rates of tax for two children – 39% income tax + 12% national insurance and 60% income tax + 2% national insurance – or even higher for three or more children receiving child benefit.

For those without children, or for the lower-earning parent, there is a more straightforward jump as income exceeds £50,270, with an extra 21% taken as the income tax rate rises from 19% to 40%, partially offset by a 10 percentage-point reduction in national insurance from 12% to 2%.

Those without children and lower-earning parents should retain 58% of each pound of earnings over £50,270, as will higher-earning parents on incomes above £60,000. 

For earnings above £100,000 the personal allowance is withdrawn, creating an extra tax band between £100,000 and £125,140 where there is a marginal income tax rate of 60%, which with 2% of employee national insurance means retaining 38% of each additional pound earned within this band. The new top band is above £125,140, where income tax reverts to 40%, which combined with 2% of national insurance results in 58% being retained for each extra pound earned.

With the current 45% top rate of tax abolished, there is no further band for earnings above £150,000, meaning that all incomes above £125,140 are taxed at a combined rate of 42%, at least before taking account of tax reliefs that might apply.

There have been suggestions that the Chancellor intends to attempt to simplify personal tax bands further, perhaps by abolishing the 60% tax rate between £100,000 and £125,140 by allowing higher earners to retain the personal allowance rather than have it withdrawn. A less expensive option would be to align the child benefit withdrawal threshold with that for the higher income tax rate, getting rid of the mini-tax band for higher-earning parents on incomes between £50,000 and £50,270.

We will no doubt discover whether the government’s new-found zeal to simplify the tax system will continue, or if they will revert to the longer-term trend of adding in new complications to the tax system whenever a little extra money needs to be found.

This chart was originally published by ICAEW.

ICAEW chart of the week: Receipts and spending by age

My chart this week looks at how receipts and spending vary by age, a key driver for public finances that new Chancellor Kwasi Kwarteng will need to factor into his fiscal plans.

Column chart - showing receipts by age group per person per month above the line and spending below the line.

0-9: £150 (receipts) - £550 (public services and interest), £290, (pensions and welfare), £270 (health and social care), £380 (education)

10-19: £210 - £620, £320, £110, £750

20-29: £1,150 - £440, £120, £160, £110

30-39: £1,930 - £430, £150, £180, £30

40-49: £2,200 - £430, £170, £200, £20

50-59: £1,960 - £450, £190, £300, £10

60-69: £1,240 - £480, £340, £370, -

70-79: £800 - £640, £1,170, £600, -

80+: £600 - £730, £1,400 - £1,270

Average: £1,220 - £510, £365, £310, £155

Kwasi Kwarteng’s first Budget will be an emergency one, not only setting out his plans for the financial year commencing on 1 April 2023, but also re-opening the budget for the current financial year. It will be dominated by the emergency support package for individuals and businesses already announced, alongside starting to deliver on Prime Minister Liz Truss’s commitments to cut taxes and ‘shrink the state’.

The new Chancellor is likely to find that cutting public spending is not going to be easy given the increasing financial commitments made by successive governments since the Second World War on education, pensions, health and social care, the areas that now dominate public spending. He supported adding to those commitments only a couple of years ago when then Prime Minister Boris Johnson decided to expand eligibility for social care, and former Chancellor Rishi Sunak re-committed to the ‘triple-lock’ that guarantees increases in the state pension every year.

As our chart this week illustrates, receipts and spending vary significantly across age groups, with spending on education higher on the young, who pay very little in taxes, and spending on pensions, health and social care much higher for older generations who contribute less than the average, especially after reaching retirement age. This contrasts with the profile for those of working age who pay the most into the system while on average taking the least out.

Derived from an analysis from the Office for Budget Responsibility’s fiscal risks and sustainability report published in July, the chart shows how – before the emergency Budget scheduled for 21 September – budgeted tax and other receipts for the current financial year 2022/23 are equivalent to £1,220 per person per month, based on forecast receipts of £988bn and a population of 67.5m. This is below budgeted public spending of £1,340 per person per month (£1,087bn/67.5m people/12 months), with the deficit of £120 per person per month (£99bn in total) funded by borrowing.

Average receipts per person per month by age group are estimated to be in the order of £150, £210, £1,150, £1,930, £2,200, £1,960, £1,240, £800 respectively for those aged 0-9, 10-19, 20-29, 30-39, 40-49, 50-59, 60-69, 70-79 and 80+ respectively. These numbers include £115 per person per month of non-tax receipts spread evenly across everyone. 

Spending on public services and interest in the order of £510 per person per month, or £550, £620, £440, £430, £430, £450, £480, £640, £730 by age group, is less variable across age groups because it much of this spending is incurred on behalf of everyone, including £125 in interest, £73 on defence and security and £53 on policing, justice and safety for example.

Spending on pensions and welfare of £365 per person per month is less evenly spread, with £290 and £320 per month spent on those in their first two decades and £440, £430, £430 and £450 on those in their twenties, thirties, forties and fifties respectively. This increases to average spending per person per month of £480, £640 and £730 on those in their sixties, seventies and eighties or over. 

Health and social care spending of £310 is biased towards older generations, with per person per month spending of £270, £110, £160, £180 and £200 for the first five decades of life contrasting with the £300, £370, £600 and £1,270 spent on average on those in their fifties, sixties, seventies and eighties or over. 

As you would expect, education spending of £155 per person per month on average is mostly spent on the young, with around £380 per person per month spent on the under-10s, £750 spent on those between 10 and 19, £110 spent on those in their twenties, and £30, £20 and £10 respectively spent on those in their thirties, forties and fifties.

The reason this chart is so critical is because demographics are not in a steady state, with the ONS projecting that there will be an additional 3.3m pensioners in 20 years’ time, a 27% increase. This will have significant cost implications for this and future governments over a period when the working-age population – who pay most of the taxes to fund public spending – is projected to grow by just 4% in total. 

While a declining birth rate might relieve some of the pressure on education spending over the next 20 years, spending on the state pension, the NHS and on social care will grow significantly if the commitments made by the current and previous governments to provide for income in retirement, universal free health care and an increasing level of social care provision are to be met, at the same time as running public services to the standard required.

Kwasi Kwarteng’s predecessors have been able to cover the expanding share of public spending going on pensions and health and social care without raising taxes above 40% of the economy by cutting spending on public services, in particular the defence budget, which has declined from in the order of 10% of GDP to around 2% over the last half century. However, with defence already at the NATO minimum, and many public services under significant pressure to improve delivery, there is much less scope to find savings than there has been in the past.

This poses a very big challenge for the Chancellor as he puts together his medium-term fiscal plans. Economic growth needs to be much higher than it has been in recent years, not only to cover the cost of tax cuts that he hopes will generate that growth, but also to generate the extra tax receipts needed to fund pensions and health and social care as more people live longer lives.

This chart was originally published by ICAEW.

ICAEW chart of the week: Whole of Government Accounts 2019/20

We take a look at the government balance sheet at 31 March 2020 this week, following publication by HM Treasury of the long-delayed 2019/20 audited financial statements for the UK public sector.

Step chart showing public assets £2,129bn, liabilities of (£4,973bn) and net liabilities of (£2,834bn).

Fixed assets £1,353bn, receivables & other £195bn, investments £323bn, financial assets £268bn.

Financial liabilities (£2,207bn), payables (£201bn), pensions (£2,190bn).

Taxpayer equity (£2,834bn).

HM Treasury was up in front of the Public Accounts Committee (PAC) this week to be grilled on the Whole of Government Accounts (WGA) for the year ended 31 March 2020. The first question posed by MPs was why it had taken more than 26 months to publish the audited financial statements for the UK public sector, unlocking a tale of woe regarding the pandemic, delays in central government reporting, even greater delays in local government, and problems in implementing a new consolidation system. 

For all that, the PAC expressed their appreciation for the contents of the WGA, which comprises a performance report, governance statements, financial statements prepared in accordance with International Financial Reporting Standards, an audit report and a reconciliation to the fiscal numbers reported by the Office for National Statistics. The UK is one of the leading governments around the world in preparing comprehensive financial reports similar to those seen in the private sector, and is the only one to attempt to incorporate local government as well as central government and public corporations.

Our chart summarises the balance sheet reported in the consolidated financial statements at 31 March 2020, when there were total assets of £2,139bn, total liabilities of £4.973bn and negative taxpayer equity of £2,834bn. These numbers do not reflect the more than half a trillion pounds borrowed since then which are likely to see the 2020/21 and 2021/22 WGA move even further into negative territory. 

On the positive side of the balance sheet were:

  • £195bn of receivable and other assets, comprising £160bn of trade and other receivables due within one year, £22bn of receivables due in more than year, £11bn of inventories and £2bn of assets held for sale;
  • £1,353bn of fixed assets, consisting of £676bn for infrastructure, £459bn of land and buildings, £77bn of assets under construction, £41bn of military equipment, £60bn of other tangible fixed assets, and £40bn of intangibles;
  • £323bn of investments, including £126bn of non-current loans and deposits, £77bn in student loans, £36bn in equity investments, £22bn invested in the IMF, £38bn in derivatives and other, and £24bn in investment property; and 
  • £268bn of current financial assets, of which £118bn were in debt securities, £74bn in loan balances due within one year, £38bn in cash and cash equivalents, £13bn in gold holdings, £13bn in IMF special drawing rights and £12bn in derivatives and other.

On the negative side, there were:

  • £2,207bn in financial liabilities, comprising £1,266bn in government securities (gilts and Treasury bills), £560bn of deposits owed to banks, £179bn owed to investors in National Savings & Investments, £78bn in bank and other borrowings, £74bn in banknotes and £50bn in derivatives and other financial liabilities;
  • £201bn of payables, including £66bn of accruals and deferred income, £55bn of trade and other payables, £42bn in lease obligations, £34bn in tax and duty refunds payable and £4bn in contract liabilities;
  • £2,190bn in net pension obligations, of which £2,062bn were for unfunded pension schemes (NHS £760bn, teachers £490bn, civil service £309bn, armed forces £233bn, police & fire £197bn, other £73bn) and £128bn for funded schemes (local government £359bn less £253bn = £106bn, and other funded schemes £106bn less £84bn = £22bn). This balance does not include the state pension, which is treated as a welfare benefit and not a liability for accounting purposes; and
  • £375bn in provisions for liabilities and charges, including £157bn for nuclear decommissioning, £86bn for clinical negligence, £39bn for EU liabilities, £31bn for the pension protection fund and £62bn in other provisions.

Net liabilities therefore amounted to £2,834bn, reflecting the general policy decision taken by successive governments not to fund liabilities in advance, but instead to rely on future tax revenues and borrowing to provide cash as needed to settle liabilities and other financial obligations and commitments. As Sir Tom Scholar, Permanent Secretary at HM Treasury, informed the PAC, this minimises the investment risks the government might otherwise be exposed to if it were to invest in (say) the stock market.

Cat Little, Head of the Government Finance Function, set out plans to bring down the time to prepare the WGA, to within 24 months for the 2020/21 WGA and to within 20 months for the 2021/22 WGA. This remains a long way off the long-term objective of producing the WGA within nine months of the balance sheet date.

While the numbers in these financial statements are now more than two years old, they are still extremely valuable in providing a baseline for the financial position of the UK public sector as the country headed into the pandemic. It is well worth a read if you have the time.

The Whole of Government Accounts 2019/20 is available online.

This chart was originally published by ICAEW.

ICAEW chart of the week: Public finances by region 2020/21

The ICAEW chart this week highlights how every single region and nation in the UK was in deficit in the first fiscal year of the pandemic.

Our chart this week highlights how every single region and nation in the UK was in deficit in the first fiscal year of the pandemic.

The Office for National Statistics (ONS) recently released an analysis of government revenue and expenditure by region and nation of the UK for the financial year ended 31 March 2021 – the first year of the pandemic. 

This was a year that saw public spending balloon to £1,112bn from £884bn in 2019/20 as the government splurged cash in response to the arrival of the coronavirus. At the same time, taxes and other income fell to £794bn in 2020/21 from £829bn the year before, while unprecedented levels of support to businesses and individuals prevented a much greater collapse in tax receipts. The resulting deficit of £318bn was the largest ever in peacetime.

The chart illustrates how every region incurred a deficit in 2020/21, with a deficit per head of approximately £800 in Greater London (revenue per head £18,440/expenditure per head £19,240), followed by £1,640 in the South East (£14,020/£15,660), £3,360 in the East of England (£11,940/£15,300), £5,000 in the South West (£10,940/£15,940), £5,140 in the East Midlands (£9,860/£15,000), £5,920 in Yorkshire and The Humber (£9,620/£15,540), £6,220 in the West Midlands Region (£9,380/£15,600), £6,580 in Scotland (£11,780/£18,360), £6,780 in the North West (£9,800/£16,580), £7,960 in the North East (£8,700/£16,660), £8,180 in Wales (£9,060/£17,240) and £9,500 in Northern Ireland (£8,740/£18,240). These numbers compare with an overall UK average deficit of approximately £4,740 per person, comprising per capita revenue of £11,840 less per capita spending of £16,580 based on a population of 67.1m.

The deficit in 2020/21 was so large that even London and the South East, which normally supply substantially more revenue to the government than they receive back in expenditure, saw the reverse this time. (In contrast, for example, with the surpluses of £4,520 and £2,180 per head respectively in 2019/20.)

Inclusive of pandemic spending, most regions ended up benefiting from government expenditure and welfare support of between £15,000 and £17,000 per person in the year, the outliers being Scotland and Northern Ireland, where spending exceeded £18,000 and London where it exceeded £19,000 per head. There is much wider range in the average for taxes and other income, from less than £9,000 per person in in the North East and Northern Ireland (more than 25% lower than the UK-wide average) up to more than £14,000 per head in the South East and more than £18,000 per head in London (more than 50% higher than the UK average).

For the public finances 2020/21 was a landmark year, in which exceptional levels of expenditure and an extraordinarily large deficit led to a significant increase in public debt. Despite that – as our chart illustrates – there continue to be significant economic and fiscal disparities across the regions and nations of the UK.

This chart was originally published by ICAEW.

ICAEW chart of the week: VAT receipts by quarter

This week’s chart highlights how the VAT deferral scheme is almost entirely behind higher VAT receipts in recent quarters, providing a note of caution to recent media headlines welcoming bumper tax revenues.

Horizontal bar chart showing VAT receipts by quarter from Jan-Mar 2017 through to Jan-Mar 2022.

2017: £31.7bn, £30.3bn, £31.1bn,  £31.8bn (Oct-Dec)
2018: £33.2bn, £30.8bn, £33.5bn, £32.9bn
2019: £35.4bn, £32.2bn, £34.3bn, £34.2bn
2020: £29.2bn, -£0.4bn, £28.4bn, £34.2bn
2021: £39.4bn, £35.2bn, £40.2bn, £41.4bn
2022 Jan-Mar: £40.6bn

The ICAEW chart of the week is on the topic of VAT, illustrating the quarterly pattern of VAT receipts since 2017 according to the HMRC tax receipts and national insurance contributions monthly bulletin published on 26 April.

The chart highlights how VAT receipts have grown steadily since 2017 up until the start of the pandemic, with receipts in calendar quarters of £31.7bn (Jan-Mar), £30.3bn (Apr-Jun), £31.1bn (Jul-Sep) and £31.8bn (Oct-Dec) in 2017; £33.2bn, £30.8bn, £33.5bn and £32.9bn in 2018; and £35.4bn, £32.2bn, £34.3bn and £34.2bn in 2019. This was followed by a big dip in 2020, with £29.2bn in Jan-Mar 2020, a net negative outflow of -£0.4bn in Apr-Jun, £28.4bn in Jul-Sep and £34.2bn in Oct-Dec 2020. In 2021, VAT receipts strengthened, with £39.4bn, £35.2bn, £40.2bn and £41.4bn by quarter, followed by £40.6bn in Jan-Mar 2022, the last quarter of the 2021/22 fiscal year.

The significant drop in VAT receipts in 2020 was driven by a combination of the economic contraction caused by the pandemic, cuts in VAT rates for hospitality, and – most significantly – £33.5bn in deferrals under the VAT payments deferral scheme implemented at the time of the first lockdown in 2020. This is the primary driver of the negative VAT receipts in the Apr-Jun quarter 2020 highlighted in the chart.

The original intention was that VAT deferred from 2020 would be due by no later than 30 June 2021, however, further relief in the form of a monthly instalment plan allowed VAT-registered businesses to spread the payment of the deferred VAT over the rest of the 2021/22 fiscal year. This has boosted the last three quarters of VAT receipts shown in the chart.

HMRC reports that £31.3bn of the VAT deferred was carried forward in 2021/22, which would imply a swing between financial years in the order of £60bn. This is greater than the £56bn increase in VAT receipts seen between the £101bn recorded for the four quarters to March 2021 and the £157bn in the following four quarters constituting the 2021/22 fiscal year.

VAT receipts excluding the effect of the deferral scheme may therefore have decreased in the last four quarters, which is surprising in the context of rising prices and the end of the discounted VAT rate for hospitality.

Recent media headlines reporting a bumper tax windfall for the Chancellor should therefore be treated with some caution. While tax receipts in 2021/22 have been much stronger than expected, a significant element of the increase relates to the collection of VAT held over from the previous year and not to any genuine increase in underlying tax revenues.

This chart was originally published by ICAEW.

ICAEW chart of the week: German federal budget 2022

As Germany heads to the polls this weekend to elect a new federal parliament, the topic of the public finances has moved to centre stage. Our chart this week looks at the federal budget for 2022 and the current plan to sharply reduce the deficit from 2023 onwards.

German federal budget 2022

2021: revenue €307bn + borrowing €240bn = expenditure €488bn + investment €59bn

2022: revenue €343bn + borrowing €100bn = expenditure €391bn + investment €52bn

2023: revenue €398bn + borrowing €5bn = expenditure €352bn + investment €51bn

2024: revenue €396bn + borrowing €12bn = expenditure €357bn + investment €51bn

2025: revenue €396bn + borrowing €12bn = expenditure €357bn + investment €51bn

Source: Bundesministerium der Finanzen: 'Draft 2022 federal budget and fiscal plan to 2025'

The coronavirus pandemic has been accompanied by relaxations in both European and German constitutional limitations on the size of the federal deficit for 2020, 2021 and 2022, with Chancellor Angela Merkel of the Union parties (the Christian Democratic Union (CDU) together with Bavaria’s Christian Social Union (CSU)) and Finance Minister and chancellor-candidate Olaf Scholtz of the Social Democratic Party (SPD) setting out a plan earlier this year to reduce federal borrowing significantly by 2023.

As the #icaewchartoftheweek illustrates, the plan is to continue to run a sizeable deficit of €100bn in 2022 with tax and other revenue of €343bn being offset by €391bn in expenditure and €52bn in investment spending. This is a smaller deficit than the €240bn forecast for the current year (revenue €307bn – expenditure €488bn – investment €59bn) and the €131bn recorded in 2020 (not shown in the chart: revenue €311bn – expenditure €392bn – investment €50bn), both of which contained significant amounts of emergency spending in response to the pandemic. 

The hope is that revenues will recover in 2023 to €398bn at the same time as expenditures and investment return to pre-pandemic levels of €352bn and €51bn respectively to leave only a €5bn shortfall to be covered by borrowing. The forecast deficit for both 2024 and 2025 is €12bn, comprising revenue of €396bn in both years, less expenditure of just under €396bn in 2024 and just over €396bn in 2025 and investment in both years of €51bn. It is important to note that this is the budget for the federal government only and excludes the share of joint taxes going to Germany’s states (Länder) as well as expenditures funded from state and local taxation.

The challenge for the three principal candidates for the chancellorship: Olaf Scholtz of the SPD, Armin Laschet of the Union parties and Annalena Baerbock of the Green party, is in how to make promises to spend more on their respective priorities while maintaining the low levels of borrowing required by the constitution outside of fiscal emergencies. 

Major flooding earlier this year has put climate change at the top of the electoral agenda, with the need to increase investment to achieve net zero a key theme of party platforms. Together with promises to invest more in infrastructure and the need to cover the cost of more people living longer, higher defence spending and other financial commitments, there are significant questions about whether the path to near-budget balance can be achieved. Given the economic uncertainty, the prospect of returning to the pre-pandemic policy of paying down government debt seems unlikely, although that policy helped reduce general government debt from a peak of 82% of GDP in 2010 following the financial crisis. Despite the additional borrowing because of the pandemic, general government debt is still below that level at somewhere in the region of 75% of GDP – putting Germany in a much better fiscal position than many of its European neighbours, including the UK.

One candidate to be the next finance minister is Christian Lindner of the liberal Free Democratic Party (FDP), a possible partner in either a ‘traffic-light coalition’ of SPD (red), Greens (green) and FDP (yellow) or a ‘Jamaica coalition’ of the Union parties (black), Greens (green) and FDP (yellow) although this will of course depend on how the parties perform in the election on Sunday 26 September. Alice Weidel and Tino Chrupalla, joint leaders of the hard-right Alternative for Germany (AfD), and Janine Wissler & Dietmar Bartch, joint leaders of the Left Party (Die Linke), are considered unlikely to find their way into the federal cabinet in most scenarios.

Unlike in the UK, where a new prime minister customarily takes up residence in 10 Downing Street the next day, there is unlikely to be an instant change in national leadership. Chancellor Angela Merkel and most of her existing Union/SPD ‘Grand coalition’ cabinet are likely to stay in caretaker positions for several weeks or potentially months as fresh coalition negotiations between the parties elected to the Bundestag are concluded.

This chart was originally published by ICAEW.

Bad debts hit public finances as last year’s deficit is revised up to £325bn

Manifesto-breaching tax rise does not mean the end of the financial challenges facing the Chancellor in the run up to the Autumn Budget and three-year Spending Review on 27 October.

The public sector finances for August 2021 released on Tuesday 21 September reported a monthly deficit of £20.5bn, better than the £26.0bn reported for August 2020 but still much higher than the deficit of £5.2bn reported for August 2019. This brings the cumulative deficit for the first five months of the financial year to £93.8bn compared with £182.7bn last year and £27.2bn two years ago.

The Office for National Statistics revised the reported deficit for the year ended 31 March 2021 up by £27.1bn from £298.0bn to £325.1bn, principally as a consequence of recognising an estimated £21bn in bad debts on coronavirus loans to businesses.

Public sector net debt increased from £2,201.5bn at the end of July to £2,202.9bn or 97.6% of GDP at the end of August. This is £67.1bn higher than at the start of the financial year and a £416.8bn increase over March 2020.

As in previous months this financial year, the deficit came in below the official forecast for 2021-22 prepared by the Office for Budget Responsibility, which is likely to reduce its projected deficit of £234bn for the full year when it updates its forecasts for the Autumn Budget and Spending Review on 27 October. 

Cumulative receipts in the first five months of the 2021-22 financial year amounted to £347.1bn, £48.4bn or 16% higher than a year previously, but only £12.4bn or 4% above the level seen a year before in 2019-20. At the same time cumulative expenditure excluding interest of £391.8bn was £39.9bn or 9% lower than the first five months of 2020-21, but £69.2bn or 21% higher than the same period two years ago.

Interest amounted to £30.8bn in the five months to August 2021, £10.7bn or 53% higher than the same period in 2020-21. This was principally because of the effect of higher inflation on index linked gilts. Despite the much higher levels of debt than two years ago, interest costs were only £3.8bn or 14% higher than the equivalent five months ended 31 August 2019.

Cumulative net public sector investment in the five months to August 2021 was £18.3bn, including £0.6bn in estimated bad debts on coronavirus lending in the current financial year. This was £11.3bn less than last year’s £29.6bn for the five months to August 2020, which included £15.6bn for coronavirus lending that is not expected to be recovered. Investment was £6.0bn or 49% more than two years ago, principally reflecting a higher level of capital expenditure.

Debt increased by £67.1bn since the start of the financial year, £26.7bn less than the deficit as tax receipts deferred last year were collected and coronavirus loans were repaid.

Alison Ring, ICAEW Public Sector Director, said: “Today’s numbers from the ONS illustrate the significant financial challenges facing the Chancellor as he puts together next month’s Budget and three-year Spending Review while public sector net debt hovers at almost 100% of GDP. The additional billion pounds a month the Chancellor expects to generate from the new tax and social care levy from next April needs to be seen in the context of the £20.5bn shortfall in the public finances recorded in the past month alone.

“Meanwhile, the belated recognition of £21bn in bad debts from coronavirus lending is a reminder of the scale of support the government has provided to keep the economy going during the pandemic. The risk for the next few months is that higher-than-expected inflation, shortages on shelves and disruptions in gas and energy markets may push the post-pandemic economic recovery off course and require further interventions, making the challenge of repairing the public finances even greater than it already is.”

Image of table showing public sector finances for the five months to 31 August 2021 and variances against prior year and two years ago.

Click on link at end of post to go to the ICAEW website for 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 reducing the reported fiscal deficit for April 2021 from £26.0bn to £25.8bn, for May 2021 from £20.2bn to £19.8bn, for June 2021 from £21.4bn to £20.7bn and for July 2021 from £10.4bn to £7.0bn. The deficit for the twelve months ended 31 March 2021 was revised up from £298.0bn to £325.1bn.

Image of table showing summary public sector finances for each of the five months to 31 August 2021.

Click on link at end of post to go to the ICAEW website for a readable version of this table.

This article was originally published by ICAEW.

Public debt hits £2.2tn as Budget delay rumours swirl

A June deficit of £22.8bn resulted in public sector net debt reaching £2,218.2bn or 99.7% of GDP at the end of the first quarter of the 2021-22 fiscal year, fuelling speculation that the Chancellor may delay the Autumn Budget and departmental spending reviews.

The latest public sector finances released on Wednesday 21 July reported a deficit of £22.8bn for June 2021, as COVID-related spending continued to weigh on the public finances, albeit at a reduced rate. This is an improvement from the £28.2bn reported for the same month last year during the first lockdown but was still significantly higher than the £7.0bn reported for June 2019.

Public sector net debt increased to £2,218.2bn or 99.7% of GDP, an increase of £80.8bn since March 2021 and £420.5bn higher than March 2020 just fifteen months ago.

Cumulative receipts in the first three months of the financial year of £201.6bn were £29.5bn or 17% higher than a year previously, but this was only £6.4bn or 3% above the level seen a year before that in the first quarter of 2019-20. At the same time cumulative expenditure of £243.4bn was £26.0bn or 10% lower than the first three months of 2020-21, but £51.6bn or 27% higher than the same period two years ago.

The effect of higher inflation on index-linked gilts drove a jump in interest costs, which at £18.1bn in the quarter to June 2021 were £6.0bn or 50% higher than Q1 in 2020-21, albeit this was still £0.4bn or 2% lower than the quarter ended 30 June 2019 despite much higher levels of debt. 

Net public sector investment was slightly lower than last year with £9.6bn invested in the three months to June, down £0.3bn or 3% from a year before but up £1.7bn or 22% from two years ago. This combined to produce a cumulative deficit for the first three months of the 2021-22 financial year of £69.5bn, £49.8bn or 42% below that of the same period a year previously, but up £46.5bn or 202% from the first quarter of the 2019-20 financial year.

Debt movements reflected £11.3bn of additional borrowing over and above the deficit for the quarter, principally to fund coronavirus loans to businesses. Public sector net debt of £2,218.2bn is £245.5bn or 12% higher than a year earlier and £438.2bn or 25% higher than in June 2019.

The Office for National Statistics revised the reported deficit for the year ended 31 March 2020 down by £1.5bn from £299.2bn to £297.7bn, still a peacetime record. The final total is still expected to exceed £300bn as the ONS has yet to include in the order of £27bn of bad debts on COVID-related lending in this number. Estimates will be refined further over the next few months.

Alison Ring, ICAEW Public Sector Director, said: “Public sector net debt has risen by £420bn since the first lockdown in March 2020, making the public finances more vulnerable to changes in interest rates and reducing the fiscal headroom available to the Chancellor as he seeks to navigate the economy out of the pandemic.

“Rumours that Rishi Sunak is considering cutting investment plans and delaying the Budget and departmental Spending Reviews are concerning. It is important that the baby of borrowing sensibly to fund much-needed investment in infrastructure is not thrown out with the bathwater of post-pandemic spending restraint.

“Central and local government desperately need budget certainty so they can plan, even if there are some adjustments next year when we all hope the pandemic will have run its course. The last full Spending Review was in 2015; it’s important that we end the cycle of deferral and delay and restore financial discipline to the government’s budgeting.”

Public sector finances 2021-22: three months to 30 June 2021

3 months to
June 2021
Variance vs
prior year
Variance vs
two years ago
£bn£bn%£bn%
Receipts201.629.5+17%6.4+3%
Expenditure(243.4)26.0-10%(51.6)+27%
Interest(18.1)(6.0)+50%0.4-2%
Net investment(9.6)0.3-3%(1.7)+22%
Deficit(69.5)49.8-42%(46.5)+202%
Other borrowing(11.3)44.4-80%(19.7)-235%
Change in net debt(80.8)94.2-54%(66.2)+453%
Public sector net debt2,218.2245.5+12%438.2+25%
Public sector net debt / GDP99.7%6.3%+7%19.4%+24%
Public sector finances 2021-22: three months to 30 June 2021

Public sector finances 2021-22: fiscal deficit by month


Receipts
Expend-
iture

Interest
Net
investment

Deficit
£bn£bn£bn£bn£bn
April 202166.2(82.3)(4.8)(5.2)(26.1)
May 202166.3(80.8)(4.5)(1.6)(20.6)
June 202169.1(80.3)(8.8)(2.8)(22.7)
Cumulative to June 2021201.6(243.4)(18.1)(9.6)(69.5)
Public sector finances 2021-22: fiscal deficit by month

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 reducing the reported fiscal deficit for April 2021 from £29.1bn to £26.1bn, for May 2021 from £24.3bn to £20.6bn and for the twelve months ended 31 March 2021 from £299.2bn to £297.7bn.

For further information, read the public sector finances release for June 2021.

This article was originally published by ICAEW.

ICAEW chart of the week: personal taxation by legal form

ICAEW’s chart this week compares the differences in the tax payable depending on legal form – an area ripe for reform in theory, but much more difficult in practice.

Chart showing tax payable on £80,000 of business earnings:

Employee - income tax: 20.0%, employee NI 6.6%, employer NI 10.7% - take home pay 62.7%.

Self-employed - income tax: 24.3%, employee NI 5.5% - take home pay 70.2%.

Company owner - income tax 9.9%, corporation tax 16.9% - take home pay 73.2%.

Comments by the Chancellor last year suggested he might tackle one of the thorniest challenges in the UK tax system – the differences in tax paid by individuals depending on the legal form through which they conduct their business activities. However, as the controversy over IR35 has demonstrated, a significant amount of political capital is likely to be needed if changes are to be made.

The #icaewchartoftheweek provides an illustrative example of just how significant the differences can be, with £80,000 in business earnings attracting an effective tax rate of 37.3% if paid to an employee on a salary of £71,460, 29.8% if paid to an individual who is self-employed or in a partnership, or 26.8% if earned through a company and distributed as dividends. 

(It is important to note that this is a theoretical illustrative example for a single person with no other earnings and not paying any pension contributions, with the company owner in the example paying a salary equivalent to the secondary threshold for national insurance before paying the rest as dividends. Actual amounts of tax paid will of course depend on both business and individual circumstances, which can vary significantly.)

The last decade or so has seen a significant increase in the numbers of people becoming self-employed or conducting business through their own companies, and the tax authorities have been concerned about the loss in tax that has followed. One way they have sought to tackle this is by removing the tax benefits of being self-employed or operating through a company from some people, which is the approach adopted by IR35. Coming into force this month, IR35 in effect creates a new legal status of ‘deemed employee’ for tax purposes, reclassifying individuals back into the scope of employment taxes. This has proved highly controversial, accompanied as it is by extensive compliance requirements and general unhappiness by those determined to be subject to it.

Another potential approach would be to change the taxes and tax rates applying to three different forms – either by reducing the taxes on employees or by increasing them on the self-employed or those operating through companies. The former seems unlikely given the state of the public finances, but the challenge in increasing rates can be extremely politically difficult, as former Chancellor Philip Hammond found a few years ago when he proposed a relatively modest increase in the amount of national insurance to be paid by the self-employed.

Whether current Chancellor of the Exchequer Rishi Sunak will take forward a suggestion he made last year when he announced the self-employed income support scheme last year that taxes on the self-employed might rise is yet to be seen. However, what is likely is that this and future Chancellors will continue to look at this particular aspect of the tax system and wonder how they might collect a little more from the ranks of the self-employed and company owners. 

This chart was originally published by ICAEW.