The UK Public Finances: A Lengthy but Necessary Repair

November 27, 2016

Phillip Hammond’s Autumn Statement has established his political authority as Chancellor of the Exchequer. A chancellor’s authority arises from a mixture of style of presentation and the substance of the measures presented in a financial statement. Mr Hammond, in manner, was careful and thoughtful, and he displayed a natural lightness of touch. The measures themselves were sensible caution writ large. The discretionary spending and tax measures will amount to £9.5 billion in 2020-21, with most of this going on an increase in public spending on science and capital investment. The caution is illustrated when those figures are looked at in the context of the forecast for Total Managed Expenditure of £886.4 billion, and money GDP of £2,346 billion in 2021-22. The UK is roughly halfway through a fiscal repair, which will take half a generation. Its centre piece is a reduction in proportion of national income absorbed by the public sector. It started with the Emergency Budget in 2010. The ratio of government spending to GDP will continue to fall. In 2009-10, it peaked at 47.7 per cent. In the present financial year 2016-17, this ratio will be just below 40 per cent, and it is projected to fall to 37.8 per cent in 2021-22. This will align public spending more closely with a realistic assessment of the taxable capacity of the UK economy of around 36 to 37 per cent, and will reduce annual borrowing to manageable levels.

A unified budget statement

The one coup de theatre that the Chancellor effected was the announcement that he would end the practice of having an Autumn Statement and a Spring Budget, and move to a single fiscal event in the autumn. Mr Hammond made the sensible observation that this would reduce the temptation for needless policy meddling, and would help to shape a better and more consistent tax policy. There is no doubt that this will be welcomed by most economic analysts with specialist interests in fiscal policy and taxation, such as the Institute for Fiscal Studies and the Chartered Institute for Taxation. A similar welcome greeted the previous announcement of the unified budgets delivered by Kenneth Clarke in the 1990s. This was a practice abandoned by Gordon Brown, with barely a whimper of dissent.

Budgets are political events

Budgets and financial statements are not just about economic policy and technical financial schedules — they are inherently political events. There is a certain kind of economic and financial commentator who abhors the intrusion of overt partisan politics or political ideology when the Chancellor of Exchequer makes a financial statement. The truth is that all economic policy is inherently political, and, however technically presented it may be, it is the product of an implied intellectual framework, which is given political expression in government policy. A budget should be a political vision with numbers attached to it.

The UK budget has a distinct place in British politics, and is a focus of much greater attention than in most other countries. Satirists lampooning Sir Robert Walpole’s bag of financial papers containing a proposed increased in excise duties, appear to have given the word ‘budget’ to the English language. Like much else in the British constitution, the modern budget is a Victorian political innovation. It emerged out of the political, or — to be more accurate — the personal animosity between Benjamin Disraeli and William Gladstone.

Don’t worry, they give you the figures

In 1852, Lord Derby persuaded Disraeli to become Chancellor of the Exchequer. Disraeli was hesitant about taking the office. He told Derby that he knew nothing about the details of finance and the supply estimates, which elicited the assurance from Derby that such ignorance would not present an obstacle, because the Treasury give you the figures. Of course, following George Osborne’s decision to establish an independent Office of Budget Responsibility in 2010, that is exactly what now happens. Disraeli’s first budget was a disaster. Gladstone, who considered Disraeli to be the grand corrupter of public life in England, made a three-hour speech, which resulted in the House of Commons defeating the budget, and the collapse of Derby’s administration.

Gladstone’s invention of the budget

Gladstone became chancellor, and used his budgets to politicise the chancellorship, and developed a highly stylised form of political economy. Gladstone forged a fiscal policy that was central to his political objectives. Its purpose was to balance the competing political interests operating on and shaping the Victorian constitution. Gladstone developed a conception of the functions of the state that he expressed in tax policy. In the twelve budgets he delivered — and principally in the budgets in 1852 and 1860 — the balance between revenue raised from indirect expenditure taxes was shifted towards direct tax — mainly income tax — that fell on higher-income households. This shift in revenue made the tax system more progressive, although Gladstone remained resolute in his ambition to abolish income tax.

Gladstonian fiscal orthodoxy

Gladstone’s financial orthodoxy offers a guide for any finance minister. His starting point was that finance should determine expenditure. Taxes should not simply be raised to accommodate spending, and budgets should be balanced. Money was better left in the hands of private individuals and business to ‘fructify’, than being taken in taxes and spent through a political process. The first job of a chancellor is to control expenditure. As Gladstone put it, ‘the chancellor of the exchequer should boldly uphold economy in detail’. A chancellor who will not risk being ‘ridiculed, no doubt, for what is called candle ends and cheese parings ….is not worth his salt’

Gladstone’s support of free trade, the abolition of duties and tariffs, and the free trade treaty with France in 1860, have a direct pertinence to the contemporary British Brexit debate. While his scepticism of growth, and determination that government should spend less, made Gladstone a distinctly unmodern figure during much of the twentieth century, that form of realism appears to have greater resonance today. The stationary states that occupied the great classical economists in the nineteenth century, are a pertinent intellectual backdrop to the economic performance of Japan, Italy, much of the Eurozone, and the evolution of productivity and real earning in the UK and USA.

The Keynesian Palace Revolution and the modern budget

If Gladstone, in effect, invented the modern political budget, and bequeathed a legacy of probity and prudence that serves as a kind of continuing rebuke to modern finance ministers, it was the budget of Sir Kingsley Wood that established the modern practice in which the budget is a macro-economic regulator. In the 1941 budget, Wood introduced the Keynesian conception — Lord Keynes was a Treasury official at the time — that the budget was not just about financing the government, but stabilising demand in the economy. It was the first budget that used national income statistics. An indication of the significance of the 1941 budget is provided by Sir Leo Pliatzky — the second permanent secretary at the Treasury responsible for public expenditure during the fiscal crisis in 1976, the year Britain ‘went bust’. Writing many years later, he described Wood’s changes as ‘the Keynesian palace revolution which captured the Treasury during the war’, and ‘would have seemed unthinkable’ only a few years earlier.

Harold Macmillan’s talent to amuse and the difficulty of economic forecasting

The next seventy-five years have generally been distinguished by financial statements and forecasts that have been too optimistic about the economy’s trend rate of growth, tax receipts, and borrowing. Chancellors benefit when they speak with authority, and combine it with a talent to amuse. Harold Macmillan’s single budget in 1956 sets the benchmark for entertainment. Macmillan’s main purpose at the Treasury appears to have been to subvert every piece of sensible Treasury orthodoxy. He wrote a paper for the Prime Minister on the economy, Dizzy with Success, which warned of the dangers of an expansion of demand and over full employment, but did nothing about it. His budget is best remembered for describing the Treasury’s forecast as, ‘We are always, as it were, looking up a train in last year’s Bradshaw’. Complaints about the forecast have been a staple of UK budgets ever since. The data is inaccurate, and the forecasts are unreliable.

The merits of a Treasury that is cautious and realistic

As well as the forecasts being misleading and overly optimistic, the impact of policy measures to regulate the economy operate with a delay. Macmillan liked to compare managing the economy with driving a car alternating between the accelerator and the break. The metaphor breaks down because of the lags involved in getting the information to act, and the time lag in measures affecting the economy. The result is that active demand management tends to operate in a pro-cyclical manner, and amplifies the economic cycle, while public expenditure has been planned on a central forecast that is too optimistic about the potential performance of the economy and tax receipts.

In the context of the experience of the last seventy-five years, Phillip Hammond’s caution is merited. As he thinks about the future presentation of the budget statement, he will have time to consider the repeated legacy of optimism punctured by disappointment.

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