Policy Exchange Budget Digest

Mar 18, 2016

This was very much a transition Budget, the type you would normally expect in the middle years of a Parliament.

In the wake of growing economic uncertainty and attention increasingly focused on the upcoming referendum, the Chancellor largely stuck to his guns, sticking to his overall economic strategy and using a few tweaks on the margin to fill the OBR’s £13.4 billion forecast hole in his surplus target.  Rather than massively accelerate cuts, he allowed his second target for debt to fall as a share of GDP to be missed.  While he brought forward some investment spending, neither could this be described as the kind of short term stimulus Labour has been advocating. There was no “rabbit in the hat” on the scale of last year’s National Living Wage, with the biggest headline going to the new sugar levy.

Rather than announce one radical policy, the Chancellor instead used the Budget as an opportunity to move forward several long standing policy agendas, and lay the groundwork for bigger changes that might come in future.

The Treasury’s message largely centred around three themes:

•    Long Term Solutions to Long Term Problems

•    Putting the Next Generation First

•    A Devolution Revolution

How well did it do on each of those fronts?

Long Term Solutions to Long Term Problems

Economic Forecasts

The most important variable for our long term productivity is the underlying rate of productivity in the economy, and here, the news was not good. Last Autumn, the OBR believed that the economy was well on its way to being healed to something like normality, finally recovering back to the 2.2% average productivity improvements it has seen in the long term. New data for the fourth quarter, however, shows that instead of gradually improving productivity actually plummeted back down again. The return to normal seems as far away as ever.

No matter the sophistication of the OBR’s model, until we know better its cause of the slowdown, the OBR is unlikely to be able to forecast the future much better than any of the rest of us. While the UK has suffered a particularly acute “productivity puzzle”, slow productivity growth has been seen across many advanced economies. Offered explanations range from a series of bad luck, stumbling from crises in finance to the Eurozone to China, to more fundamental slowdowns in global demand or even innovation itself.

Public Spending

Perhaps appropriately, the Chancellor also hedged his bets in responding to the downgrade. While playing with the timing of various measures, he did not fundamentally change his economic strategy. The surplus is still to be achieved in 2019-20, but only by playing around with the timing of various measures, and extending austerity yet again with a further round of cuts of in 2020-21. On average, his new policy measures actually reduced tax revenues by £0.7 billion a year, while new spending commitments on schooling and flood defences cost an extra £1.9 billion This has partly been achieved by the target of an extra £3.5 billion “efficiency savings”, although the Government will not try to identify them until a 2018 review.

Another key saving comes from public sector employer pension contributions, which will increase by £2 Billion from 2019-20 onwards. From 2019/20 the discount rate will reduce to 2.8 per cent from 3 per cent. Public services are being given a few years notice of this impending cost but they will now have to readjust their expenditure plans. Given that long-term growth projections have been revised down in the four months between November 2015 and March 2016 it has to be asked if they are a reliable basis on which to make these calculations? The Dutch Pensions Federation has recommended that the discount rate be abolished due to the difficulty in predicting the cost of future pensions.

Overall, the Chancellor’s plans lead to a pattern of fiscal austerity – with the structural deficit falling at around 0.8% of GDP over the next three year, until a sharp jump up 1.5% in 2019-20.

Competitiveness

The Budget was light on measures to tackle productivity itself, partly because without betting understanding the underlying problem it is hard to know what to do. One area the Government did focus on was further improving the UK’s reputation for international competitiveness.

Building on the precedent of last Parliament’s corporate tax map, as advocated by Policy Exchange in our Economics Manifesto last year the Treasury published alongside the Budget a much broader roadmap setting out planned reforms and rates for business taxes over the next five years, with a headline announcement that corporation tax is to be cut yet again to 17% by 2020. Providing greater clarity and certainty on the tax system is a key part of the Chancellor’s strategy to improve the international competitiveness of the economy, with the hope that a simpler system and reduced uncertainty should encourage greater investment from the private sector.

It should also go some way to offset the pain of other tax changes he is making, such as the restriction on tax deductibility of interest and the ongoing costs of implementing the Apprenticeship Levy and the National Living Wage. The additional 1p cut will give the UK the lowest headline rate of corporation tax rate in the G20, lower than in Switzerland and equal to the current rate in Singapore.

Energy

One area where the tax simplification agenda was especially obvious was energy, with the Chancellor announcing a number of changes to simplify energy taxes, policies and regulations.

The Treasury announced that the Carbon Reduction Commitment – an energy efficiency scheme for large energy users – will be abolished. The move will be made fiscally neutral through an increase in Climate Change Levy rates. As highlighted in our 2011 report Boosting Energy IQ, businesses face a complex array of carbon and energy efficiency taxes and reporting schemes, while Governing Power highlighted the byzantine landscape of quangos and other bodies involved in the delivery of energy policies and regulations.  The changes announced yesterday are a sensible simplification, following our recommendations very closely. Interestingly, HM Treasury also suggested that the taxes on electricity and gas should be rebalanced to even out the effective carbon tax on these fuels, again following our recommendations.

Beyond this, the Budget has proposed some significant changes to oil and gas taxes in order to support the ailing sector. As set out in a recent blog, the North Sea industry has been hit hard by the significant drop in oil and gas prices over the last 18 months, leading to a loss of jobs and investment. The Chancellor has proposed to reduce oil and gas taxes, cutting the Supplementary Charge from 20% to 10%, and almost entirely removing the Petroleum Revenue Tax. This will no doubt provide welcome relief to the sector. However, OBR figures show that this means oil and gas revenues are likely to turn negative from 2016-17 onwards – with North Sea operators able to claw back previously paid taxes against current losses.

The Budget also provided some much needed clarity to the renewables sector, setting out proposals for a series of renewables auctions totalling £730 million per annum in support. DECC intends to focus the auctions on “less mature” technologies such as offshore wind. We support DECC’s proposal to auction renewables contracts and reduce subsidy levels over time. However it must be recognised that there are far cheaper ways of meeting carbon targets than offshore wind.

Finally, the Chancellor also accepted the recommendations from a recent report by the National Infrastructure Commission on how to create a Smart Power system. The NIC recommended that the UK should support an increase in power interconnection to other countries, deployment of energy storage, and active demand management.

Putting the Next Generation First

Sugar Levy

The Chancellor’s biggest headline came from a new levy on drinks with total sugar content above five grams per 100 millilitres, with the proceeds used to double dedicate spending on PE in primary schools. This was easily the biggest surprise in the Budget, with most not expecting any announcement till the publication of the Government’s long delayed child obesity strategy, and even then opinion equally divided on whether it would contain a sugar tax or not. This follows a recommendation made by James Cracknell CBE in a pamphlet for Policy Exchange – Britain Imbalanced.

Soft drinks account for two percent of our overall calorie intake, but they are disproportionately consumed by the young, with sugar sweetened drinks the largest source of sugar for children and teenagers. The new tax stands both as a symbolic gesture, and more importantly as a proof of concept. If this new “sin tax” works, the concept can easily be extended to other sources of Britain’s poor nutrition. Over the last five years, the Chancellor has followed a reasonably consistent strategy of cutting the taxes on things we want more of, raising the personal allowance for the income tax on work and slashing the corporation tax rate down from 28% to 17%. The other side of that has to be increased taxes on things we want less of, and taxes on poor diet look set to join environmental taxes as an increasingly important source of revenue in the future.

Education

Beyond its health announcements, the other way the Budget focussed on the next generation was the surprising emphasis on education, with the Department for Education (DfE) receiving an extra £1.185bn over the Spending Review period as a result of the Budget, of which £1.170bn is funded via the sugar levy and the remaining £715m from general HMT coffers.  Beneath the headlines of a commitment to full Academisation by 2020 and the possible introduction of compulsory maths to 18 (both advocated by Policy Exchange), there were some other intriguing policy announcements, although there were questions over the details of how the DfE had allocated its money.

Firstly, DfE have only allocated £140m over the Spending Review period for the costs of Academy conversion. That is nowhere near enough to pay the costs of around 16,000 conversions if the DfE stick with their existing funding of £25k grant per school. However, it is likely that DfE are assuming some big efficiency gains can be made in driving down the costs of conversion, if lots are done over a short period. Some education lawyers estimate the true costs for a straightforward conversion to be £6k-£10k. If DfE can construct a new procurement framework which offers a much lower price to bidding law firms, in exchange for the promise of high volume of work, the £140m starts to look sufficient (even accounting for the fact that some conversions of schools in particular circumstances – big debt, complex land ownership arrangements, large employment contractual issues – will cost considerably more).

Secondly, the £500m extra for the smoothing of the National Funding Formula is very welcome. What will likely happen in practice is that the “winning” schools (i.e. those currently funded at less than the formula would give them) will both get additional funds from the “losing” schools, and an additional tapered top up from this £500m. This will allow winning schools to move onto the formula more quickly, without risking destabilising the losing schools by dragging them down onto the formula at the same accelerated timetable. The Budget makes clear that around 90% of winning schools should be on the formula by 2019-2020, which would be a considerable achievement.

Thirdly, the generosity of the extra funds for various schemes is variable. On the generous side, funding of £285m a year to pay for around a quarter of secondary schools (850 schools) to extend their day by five hours a week means an average grant of £335,000 a school. The Education Endowment Foundation estimate an extra five hours a week will cost around £3,500 per child, so £335,000 seems if anything more than sufficient to fund that for an average sized school. By contrast, the £10m breakfast club funding is quite tight – spread across the 1,600 schools it is targeted at for a whole school year works out at £33 per school per day. Even on some bold assumptions about costs of breakfast, and assuming some strict targeting by schools, £33 does not feed too many more pupils.

Savings and Pensions

Despite the widely leaked news that the Government was backing away from radical reform of pensions, this Budget still contained two bits of eye catching policy on savings, with a focus on helping the young and the low paid. The first, the new Help to Save, targets adults on Universal Credit by providing a matching 50% government bonus on savings up to £50 a month.  It has been widely interpreted as a resurrection of Labour’s scrapped Saving Gateway scheme – which is not gigantically surprising given the main reason for its initial abandonment was cost at a time of tight finances.

The second policy, a new Lifetime ISA, is, if anything, even more intriguing. Adults under 40 are to receive a 25% government bonus on savings up to £4,000 a year, with funds able to be withdrawn cost free after twelve months to buy a house or at age 60 for retirement. While young adults can still run a pension alongside this – and the Government has to hope the new policy does not endanger the current success of auto enrolment – the big vision is that they will increasingly save in a simpler, more flexible system, one better suited to a world of faster job change, portfolio careers, the “gig economy” and all the rest of it.

The Lifetime ISA is clearly intended as a prototype for the larger, more radical changes the Chancellor had in mind for the whole savings and pension system and it would not be surprising if over the next years it continued to evolve and grow into a larger part of savings policy. The Government has already said that it will look at allowing penalty free withdrawals for other life events beyond buying a house – and an obvious extension would be to fund retraining and career transition, using it is a the kind of lifelong learning account that many have called for.

A Devolution Revolution

The Chancellor’s devolution revolution rolls on, with announcements on local government finance, devolution deals, transport investment, and housing.

Local Government

The direction of travel on local government finance has been set for this Parliament. In 2010, 80% of local government funding came from central government grants but by 2019-20 the Government expects 100% of local government funding to be raised locally. London and the Liverpool and Manchester City Regions will be the first to ‘pilot’ the full retention of local business rates. These decentralising moves jar slightly with other announcements on business rates, including the Chancellor’s decision to permanently double Small Business Rate Relief from 50-100% and increase the starting threshold, starting next year. A further rates cut will be introduced from 2020 by switching the annual uprating from RPI to CPI. All of this is welcome for small businesses, and the Government has agreed to compensate local areas for the loss of income from these changes. However given that business rates will be fully devolved by the end of the Parliament, there is a case to be made for allowing future rate reliefs and increases to be set locally, rather than from the centre.

Further devolution deals in East Anglia, the West of England, and Greater Lincolnshire have been agreed. Although none of these go any further than existing ones in terms of a transfer of powers,  they do cover some very large areas. The East Anglia deal, for example, involves 23 separate tiers of local government. It will be interesting to see how these fare. Economically, it might make sense to allocate money across the functional economic area of East Anglia or the West of England but politically combining city-level councils with rural ones will not be without its issues. A Metro Mayor more dependent on urban voters as opposed to rural ones might end up prioritising resources in a way that favours the former rather than the later. This might be a particular issue in the West of England where a popular and growing city like Bristol is keen to expand outwards.

The Chancellor also announced £20 million of new funding every year for a Northern Powerhouse Schools Strategy, given the attainment divide between schools in parts of the North and the rest of the country. This is the first big announcement the Government has made on education policy and the Northern Powerhouse. The Government’s educational reform programme has been about devolving power to parents, teachers and communities through Academies and Free Schools; the point has been to take power away from local government. More generally, it also reflects how difficult it will be for the Government to address the historical North South divide. While low levels of attainment are a cause for concern, and definitely need to be addressed, there is no guarantee that higher education will lead to higher levels of growth in the North. Mobility increases with education ,as explained in our paper On the Move, so higher attainment in future might simply mean more young people leaving for London and the South East

Transport

New investments in regional transport were trailed heavily in the days leading up to the Budget, particularly the announcement of Crossrail 2 in London and a high-speed connection between Leeds and Manchester (the start of High-Speed 3). Critics have noted that London again seems to be getting a disproportionate share of public funds in infrastructure – Crossrail 2 will cost £33 billion, whereas the first leg of HS3 is worth around £3bn. But when you consider that Transport for London believes it can fund over half the costs of Crossrail 2 through local property taxes, and given the expected larger gains for the Exchequer of increased economic activity, this criticism seems misplaced. By contrast there is not as many clear signs of pent up demand for mass commuting across the North as a whole, and by the Government’s own admission, transport is only one part of their plans for creating the Northern Powerhouse. It will need to be complemented by other policy interventions as well as private sector led investment.

Housing

In keeping with the localism mantra, the Government also announced that it will help local authorities that want to create new garden communities on garden city principles.  This is instead of just building around existing communities (the much maligned “bolt-on” housing estate) and building urban extensions, which is overwhelming the way we have built housing in recent decades. This is something we called for in our report Garden Villages.

To do this, Government will introduce legislation to make new settlements happen through the locally-led approach. The DCLG prospectus Locally-Led garden Villages, Towns and Cities, published alongside the Budget, invites expressions of interest from local authorities to build new settlements. It states “We are proposing to strengthen national planning policy to provide a more supportive approach for new settlements. We are committing to legislate to update the New Towns Act 1981 to ensure we have a statutory vehicle well-equipped to support the delivery of new garden cities, towns and villages for the 21st century.” Loosely interpreted, the Government intends the use of New Towns Act powers to designate new settlements when local authorities want them and take the lead, possibly by giving these powers to local authorities directly. Such powers, around cheap land acquisition and the establishment of the delivery body with master-planning functions, are crucial to successfully creating new settlements.

The Government also set out plans to speed up the planning process, including that for assessing local housing need. This assessment determines the number of homes a local authority must plan for – which in turn forms the basis of the local plan. Back in the summer, Government announced that all local authorities must ‘produce’ a local plan by 2017 or have one produced for them. Today we heard more on that in the Budget document: “Following the ongoing consultation on the delivery of Local Plans by 2017, the government will set out later this year details of measures to encourage the production of Local Plans.” This also has read-across to new settlements – Government sees these as an added option for local authorities to help them produce their local plan (and also for any plan produced for the local authority that doesn’t play ball).

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