Government must reduce size of the state or raise taxes, IFS warns

The think tank has urged political parties to set out their plan
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The next government must cut down on public spending or raise taxes, the Institute for Fiscal Studies has warned in a report that says the size of the state is likely to remain “permanently bigger” than before Covid hit.

The size of the state – which the IFS defines as spending as a proportion of national income – has grown by significantly more in the last parliament than under any previous post-war Conservative parliament, the think tank has said. By 2028-29, it is on track to be larger than before the pandemic, the financial crisis or the post-Second World War average.

A large part of this increase “looks to be permanent”, according to its latest report, How have the size and shape of the UK state changed?, published yesterday.

The pre-election report, which was funded by the abrdn Financial Fairness Trust and the Nuffield Foundation, lays bare the choice facing political parties in the run-up to next month’s general election: cut the scope of what the state provides; raise taxes, for example to maintain real-terms levels of departmental funding; or borrow more, temporarily postponing tax rises or spending cuts.

“Both main parties should be clear on which of these three options they intend to take,” says the report, which comes soon after IFS director Paul Johnson said he was "frustrated" by a lack of transparency from the main political parties about where they would cut spending.

But the report warns that it would be difficult to cut the size of the state further because of the existing strain on public services, along with demographic pressures and geopolitical uncertainty.

“Indeed, there does not seem to be ambition from either main party to cut the scope of the state. In this parliament, new childcare and social care policies have added to what the state does,” it notes.

Protecting departmental spending – which is projected to fall in several areas to balance out budget increases in areas such as health and defence – would require a top-up of £30bn in cash terms, the IFS said.

As of 2019-20, the state had reached the same size as it was in 2007-08, just before the financial crisis, with spending representing around 40% of national income, the researchers found.

“In other words, almost a decade of ‘austerity’ simply returned the size of the state to where it had been after a decade of New Labour governments,” the report says.

Since the start of the 2019-20 parliament, spending has grown by 4.5% of national income, or £124bn in today’s terms – four-fifths of which was not anticipated before the pandemic, the report says.

A significant proportion of that increase is down to an unexpectedly high rise in spending on debt interest and social security. Debt interest spending was expected to fall as a share of national income but has instead risen by 1.5% of national income, or £41bn, over the course of this parliament, and social-security spending, which was expected to be stable, has increased by 1.2% of national income or £33bn.

Lower-than-expected economic growth has also contributed to public spending taking up a bigger portion of total output.

All of this means that “much of the rise in spending looks unlikely to be transient”, the IFS said.

Based on current spending plans – which the report describes as “unrealistically tight” – spending is forecast to hit 42.5% of national income by 2028-29 –  2.9% (£80bn in today’s terms) above pre-pandemic levels.

These forecasts are based on real-terms cuts to day-to-day spending for “unprotected” departments – which include those responsible for local government, higher education, courts and prisons – of between 1.9% and 3.5% each year.

“These areas are already under visible strain. The forecasts also imply real-terms cuts to investment spending,” the report says.

In March, after the Spring Budget, the IFS warned that chancellor Jeremy Hunt's decision to increase spending on public services by 1% a year left unprotected departments facing "dramatic real-terms cuts".

Adding the estimated £30bn top-up to protect all departments’ budgets would bring 2028-29 spending up to around 43.4% of national income – 3.8% (£107bn) higher than before the pandemic. This would mean a further increase in the size of the state, the report says.

The report also notes that the stability in public spending up to the start of the Covid pandemic masks a “substantial” change in the distribution of spending in that time, with the increase increase in health spending by around 1% of national income offset by an equivalent fall in spending on education. Spending on social-security benefits also fell in that time thanks to working-age welfare cuts.

Health spending is "likely to continue to rise", as is defence spending, which has been cut repeatedly in recent decades. The report notes that a "peace dividend" has enabled these cuts to defence spending, but that "even before the pandemic, it was clear that the declines in defence spending – and more recent declines in debt interest spending – could not continue".

“It seems unlikely – though not impossible – that we will return to the size of the state that we had been used to seeing pre-pandemic, at least without cutting the scope of what the state provides,” the report warns.

Bee Boileau, a research economist at IFS and an author of the report, said: "Whoever takes office after this election will have a choice. They can cut the scope of what the state provides, or accept further worsening of public services which already look under strain. Or they can raise taxes, or borrow more, in order to top up spending and maintain real-terms levels of departmental funding.

"Neither the Conservative Party nor the Labour Party has been clear about which of these options they would take. Neither has shown any ambition to cut the scope of the state. Both have ruled out increases in major taxes. Both have committed to a debt target that would prevent them from borrowing more. But, absent really significant improvements in growth forecasts, one of these options must be chosen. The trade-offs here cannot be solved by denying their existence."

Mubin Haq, chief executive of abrdn Financial Fairness Trust, said the report shows that "essential services are likely to face further cuts and pressures on them will intensify".

"There are difficult choices to be made by whoever forms the next government, whether that is raising taxes, increasing borrowing or cutting what we can get from public services," he said.

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