Departments could face funding cuts of 15%, IFS warns

Inflation could mean “hidden” austerity if spending settlements remain unchanged, as think tank predicts £62bn of “fiscal tightening” needed

By Jim Dunton

11 Oct 2022

Funding cuts to public services in the region of 15% could be required to get the nation’s finances back on track over the medium term, according to a financial analysis by the Institute for Fiscal Studies.

The think tank said the measures would be one way to contribute towards £62bn of “fiscal tightening” projected to be necessary if chancellor Kwasi Kwarteng sets a target of getting debt falling as a proportion of national income by 2026-27.

Following the economic fallout from last month’s mini-budget, which has today seen a new bond-market intervention from the Bank of England, Kwarteng has brought forward the statement date when he will set out his medium-term fiscal plan to 31 October. He is widely expected to push the envelope for reining in debt growth from its current three-year target to five years.

In an analysis forming part of its just-published “Green Budget”, the IFS used data from global bank Citi – which is projecting UK annual economic growth to be 0.8% over the next five years – to examine how the nation’s financial outlook has changed in recent months.

Since last year’s Spending Review, inflation has soared and Citi is now projecting it will peak at 12%, significantly outstripping the increases offered to departments in their three-year settlements. The government’s aid packages to help consumers and businesses deal with rising energy prices, meanwhile, have also added £68bn to government spending plans since the Spending Review was set out.

Although they were badged as growth-promoting, Kwarteng’s mini-budget tax cuts will reduce revenue by £43bn a year by 2026-27, down from £45bn following his U-turn over scrapping the 45p rate of income tax.

The IFS said it did not expect the chancellor and prime minister Liz Truss to reopen departmental spending settlements to take account for inflationary pressures over the remaining two-and-a-half years of the Spending Review period, meaning  a “hidden form of austerity” was being imposed.

It said restoring the original “generosity” of the plans to account for inflation would require an additional £14bn of spending in 2023-24 and a further £23bn in 2024-25.

However, the think tank said ministers could look at redistributing allocations within the overall Spending Review envelope to reflect the way that rising prices are affecting different departments.

Further down the line, the IFS said the government of the day would need to find £62bn of savings by 2026-27 to get borrowing down to acceptable levels, and that reversing last month’s package of tax cuts would not be enough on its own – even if the will was there.

The Green Budget said one way of achieving the magnitude of savings required would be looking to save £35bn a year from public services, with the exception of the NHS and defence; linking working-age benefit increases to wage inflation rather than cost-of-living inflation, to save £13bn over the next two years; and reducing investment spending plans to 2% of national income, which would save £14bn.

It said the cuts to spending on public services would be “far from easy” because they would come on top of deep cuts delivered between 2010 and 2019. However the IFS said such cuts would be possible.

The IFS said it was assuming that plans to return to the legislated target of spending 0.7% of national income on overseas aid would not be returned to in 2024–25 and would remain at 0.5%.

IFS director Paul Johnson said uncertainty about the UK’s economic fortunes in the coming years meant projections about borrowing could be “wrong by tens of billions” in either direction, and that Kwarteng would have to recognise that uncertainty in his fiscal plan.

“It is just about possible to see how Mr Kwarteng could get debt on a stable, or ever-so-slightly falling, path in the final year of his forecast,” Johnson said.

“He could, for example, announce some combination of cuts to working-age benefits and capital investment, plus some unspecified cuts to public services pencilled in for the years after 2025.

“That might work on paper and spare him having to row back on any more of his mini-budget tax cuts.

“But the specifics of the UK government’s fiscal strategy are under more scrutiny by financial markets than at any point in the recent past.

“The chancellor should not rely on over-optimistic growth forecasts or promises of unspecified spending cuts. To do so would risk his plans lacking the credibility which recent events have shown to be so important.”

“Strong case” for public-sector pensions reform

Elsewhere in its Green Budget, the IFS suggested there is “a strong case” for rebalancing public-sector remuneration away from pensions and towards pay.

It said that while pay rises in the public sector – such as the sub-inflationary 2%-3% being offered to civil servants this year – lagged private-sector pay levels, the figures were skewed by more generous pensions packages offered to public-sector workers.

“A far greater share of overall public sector remuneration is deferred, in the form of both employer and employee pension contributions, compared with the private sector (20.1% versus 7.6% on average in 2021),” the think-tank said.

“This difference has been increasing over time. That means for a given level of remuneration, take-home pay is lower in the public sector.

“One option, as a starting point, would be to reduce employee pension contributions in the public sector, alongside a commensurate decrease in pension generosity. That would increase take-home pay for public-sector employees with no change to the costs for their employers.”

The IFS said it estimated that public-sector workers were paid around 6% more than private-sector counterparts when “total remuneration” including pensions was accounted for.

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