No short-term fix for UK public spending

Rachel Reeves has not had a good start as our new chancellor. The £22 billion “black hole” identified by Treasury officials has been shown to be greatly inflated by her own decisions to increase public sector pay. Meanwhile, her changes to the pensioner winter fuel allowance, which will yield only £1.4 billion of savings, about 0.1 per cent of total public expenditure, have caused a massive public and political backlash.
The new chancellor is right to focus on controlling public spending. It is one of the most important of her roles and one of the most challenging and complex. But she has got off on the wrong foot, focusing on the short-term spending situation and using her “black hole” analysis to blame the previous government.
Instead, the chancellor needs to take a long-term perspective, focusing on the future and putting party political point-scoring aside.
The long-term picture is that successive governments have faced pressure for increased public spending since the 1990s. These pressures have come from three main sources. The first is the NHS. In 1997, when Tony Blair came to power, the UK spent less than 5 per cent of GDP on publicly funded health services. The total in the last financial year was above 8 per cent, an increase of 3.4 percentage points since the late 1990s, adding £95 billion to NHS financing at present values.
A second source of upward pressure on public spending is the need to repair, replace and renew our national infrastructure. From the late 1970s, through the 1980s and into the 1990s, successive governments used cuts to capital investment as a convenient way of reducing public spending. But eventually new schools and hospitals must be built and better road and rail infrastructure is needed to support a growing economy.
Recognising these pressures, both Labour and Conservative governments have increased public investment, which has risen from 2.7 per cent to 5 per cent of GDP since the mid-1990s, an additional infrastructure spend of £65 billion at today’s values.
A third factor driving up public spending since the 1990s has been pensions and other benefit payments. In this financial year the total bill for these “social protection” payments will be about £380 billion, 13.5 per cent of GDP. Again, this is significantly higher than in the early years of Blair’s government, when these pension and other benefit payments were around 11.5 percent of GDP. In the latest values, this adds a further £55 billion to public spending.
For this financial year, the Office for Budget Responsibility estimates that the government will spend 44 per cent of GDP, eight percentage points higher than in 1997 when the last Labour government came to power. These three upward pressures — the NHS, infrastructure spending and pension/benefit payments — largely account for this rise in the public spending share of GDP. Eight per cent of GDP is close to £220 billion at today’s values, ten times the size of Reeves’ much-discussed “black hole”.
These increases in public spending have clearly benefited our economy and society, but the overall total is still too high. If Reeves is to avoid further significant tax rises or excessive public borrowing, she will need a plan to reduce the public spending share of GDP.
From 1979 to 2019, before the pandemic, public expenditure averaged 39.6 per cent of GDP, or slightly less than 40 per cent. If that seems an unachievable goal, it is worth noting that public spending was below 40 per cent of GDP in 2018-19 and 2019-20, only five to six years ago.
A public spending share of 40 per cent of GDP is a good target for Reeves in framing her public spending plans for the future, but that should be a longer-term goal. Over the lifetime of this parliament, a reduction in the government expenditure share of GDP to about 42 per cent is likely to be more credible and achievable.
On two previous occasions, we have seen big reductions in the UK public spending share of GDP: from the mid-1970s to the mid-1980s under both Labour and Conservative governments; and from 2010 to 2016 under David Cameron and George Osborne. In these previous episodes, the public spending share was reduced from over 46 per cent to its historic norm of 40 per cent or so. But this was not achieved quickly. In the late 1970s and 1980s the process took about ten years and after the global financial crisis in the 2010s it took six to seven years.
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On both these occasions, the backdrop was a growing economy, accompanied by measures that held down public spending increases in real terms. That suggests that the chancellor should avoid significant tax rises in her budget next month. She will be relying on the private sector to underpin economic growth and significant tax rises are likely to hold back business investment and add to consumer caution.
What should be the key elements of the chancellor’s plan gradually to reduce the public spending share of GDP closer to 40 per cent? Government spending is used mainly to support public services, invest in infrastructure and pay benefits to pensioners and others needing income support.
Cutting public sector capital investment is not a good idea. The two main pillars of the chancellor’s long-term spending plan therefore need to be productivity improvements in the delivery of public services and welfare reforms that target benefits more effectively. On the productivity front, better use of information technology and artificial intelligence systems could yield significant cost-saving benefits in the public sector, including the NHS.
The chancellor hopefully will have learnt from her experience with the winter fuel allowance that piecemeal short-term measures announced at short notice will not work. So there is a limited amount that can be achieved in next month’s budget, which will plan only one year ahead for public finances. That budget needs to focus on boosting economic growth and investment, as the chancellor promised in the general election campaign.
The more significant event for public spending in the early years of this parliament will be the three-year spending review that will be concluded next spring. That will be Reeves’ big opportunity to show that the new Labour government has a convincing plan for public expenditure, not merely for one or two years but for the remainder of the 2020s.
Andrew Sentance is an independent business economist and former MPC member