1. Fixing the public finances: eight years of pain?
Carl Emmerson
Presentation at IFS public economics lecture, London
17 December 2012
© Institute for Fiscal Studies
IFS hosts two ESRC Research Centres

2. What are the objectives of fiscal policy?
Resource allocation
public goods
externalities
Distributional objectives
between individuals
between generations
Smooth output fluctuations
automatic stabilisers
discretionary stabilisers
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3. What are the constraints on fiscal policy?
Intertemporal budget constraint
Should be consistent with macro stability and sustained economic growth
internal vs. external borrowing
taxes are distortionary
Should consider intergenerational equity
avoid excess debt and borrowing
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4. Why is fiscal discipline hard to achieve?
Temptation to spend more / cut taxes leads to deficit bias
Political business cycles play a role
risk of losing the next election means policymakers place too little weight on the future cost of current borrowing
Imperfect information
often unclear where in the economic cycle we are, therefore how much spending/revenue is structural (permanent) or cyclical (temporary)
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5. How can fiscal discipline be improved?
Make explicit what the government views as desirable policy
Make sure policymakers’ incentives are better aligned with the optimal outcome
change payoff structure to increase the cost to the government of deviating from desirable policy
Trade-off between delegation and discretion
delegation: increases credibility and reduces political risk
discretion: enables policy makers to respond to shocks
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6. The Chancellor’s fiscal framework
Rule 1: balanced structural current budget by end of forecast horizon
advantage: forward-looking not inappropriately constrained by past borrowing performance
disadvantage: easy continually to add an extra year of fiscal squeeze in last year of forecast horizon
Rule 2: debt as a share of GDP falling in 2015–16
not a sufficiently constraining fiscal target in the longer term
sensibly, Chancellor plans to announce a debt target “once the exceptional rise in debt has been addressed”
Independent “Office for Budget Responsibility” to produce official macro and fiscal forecasts
increased transparency, intended to eliminate any suspicion that forecasts politically motivated
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7. The problem? 7 Sources: OBR; Author’s calculations.
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Sources: OBR; Author’s calculations. 7

8. The problem? 8 Sources: OBR; Author’s calculations.
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Sources: OBR; Author’s calculations. 8

9. The cure (December 2012): 9.2% national income consolidation over 8 years (£143bn)
Dec 2012: 8.2% national income (£129bn) hole in public finances
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Sources: HM Treasury; OBR; Author’s calculations.

10. The cure (December 2012): 9.2% national income consolidation over 8 years (£143bn)
Dec 2012: 8.2% national income (£129bn) hole in public finances
85%
15%
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Sources: HM Treasury; OBR; Author’s calculations.

11. The cure (December 2012): 9.2% national income consolidation over 8 years (£143bn)
Dec 2012: 8.2% national income (£129bn) hole in public finances
85%
81%
19%
15%
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Sources: HM Treasury; OBR; Author’s calculations.

12. Tax and spend forecast to return to pre-crisis levels
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Sources: OBR; Author’s calculations. 12

13. Tax and spend forecast to return to pre-crisis levels
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Sources: OBR; Author’s calculations. 13

14. Dealing with the problem in 2017–18 and meeting the fiscal mandate
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Note: PSNB excludes impact of transfer of Royal Mail Pension Fund assets.
Sources: OBR; Author’s calculations.

15. Dealing with the problem in 2017–18 and meeting the fiscal mandate
Fiscal mandate: “cyclically adjusted current budget balance by the end of the rolling, five year forecast period”
© Institute for Fiscal Studies
Note: PSNB excludes impact of transfer of Royal Mail Pension Fund assets.
Sources: OBR; Author’s calculations.

16. Dealing with the problem in 2017–18 and meeting the fiscal mandate
Fiscal mandate: “cyclically adjusted current budget balance by the end of the rolling, five year forecast period”
© Institute for Fiscal Studies
Note: PSNB excludes impact of transfer of Royal Mail Pension Fund assets.
Sources: OBR; Author’s calculations.

17. Dealing with the problem in 2017–18 and meeting the fiscal mandate
Fiscal mandate: “cyclically adjusted current budget balance by the end of the rolling, five year forecast period”
© Institute for Fiscal Studies
Note: PSNB excludes impact of transfer of Royal Mail Pension Fund assets.
Sources: OBR; Author’s calculations.

18. Dealing with the problem in 2017–18 and meeting the fiscal mandate
Fiscal mandate: “cyclically adjusted current budget balance by the end of the rolling, five year forecast period”
© Institute for Fiscal Studies
Note: PSNB excludes impact of transfer of Royal Mail Pension Fund assets.
Sources: OBR; Author’s calculations.

19. On course to miss the debt target
Supplementary target: “public sector net debt as a percentage of GDP to be falling at a fixed date of 2015–16 ”
Source: OBR.
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20. 6–year squeeze on public service spending
17.0% cut over 8 years
9.0% cut over 2 years
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Note: Figure shows total public spending less spending on welfare benefits and debt interest.

21. Real change in resource DEL
–9.3%
–10.8%
–16.9%
–1.6%
–6.9%
Note: Figure shows resource Departmental Expenditure Limits (DELs) including depreciation under current policies, assuming no further changes to welfare policies or total government spending.
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22. Spending Review to come early next year
Total DEL
Of which:
NHS
Schools
Aid
Other DEL
Real percentage change in resource spending between 2010–11 and...
–15
–9.3
–16
–10.8
–18
–16.9
Source: Crawford (2012).
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23. Spending Review to come early next year
Total DEL
Of which:
NHS
Schools
Aid
Other DEL
Real percentage change in resource spending between 2010–11 and...
–15
–9.3
2.9
0.6
31.0
–18.3
–16
–10.8
–18
–16.9
Source: Crawford (2012).
© Institute for Fiscal Studies

24. Spending Review to come early next year
Total DEL
Of which:
NHS
Schools
Aid
Other DEL
Real percentage change in resource spending between 2010–11 and...
–15
–9.3
2.9
0.6
31.0
–18.3
–16
–10.8
34.0
–20.9
–18
–16.9
Source: Crawford (2012).
© Institute for Fiscal Studies

25. Spending Review to come early next year
Total DEL
Of which:
NHS
Schools
Aid
Other DEL
Real percentage change in resource spending between 2010–11 and...
–15
–9.3
2.9
0.6
31.0
–18.3
–16
–10.8
34.0
–20.9
–18
–16.9
2.9?
0.6?
41.7?
–31.5?
Source: Crawford (2012).
© Institute for Fiscal Studies

26. Summary Considerable uncertainty remains
Permanent hit to public finances from financial crisis estimated at £129 billion a year (in today’s terms)
Response is a planned £143 billion fiscal tightening by 2017–18
Eight years from April 2010 imply the tightest eight-year squeeze on ‘public service’ spending since at least end of Second World War
Spending Review in early 2013 to set departmental budgets for 2015–16
total real cut to ‘unprotected’ resource DEL since 2010–11 of 20.9%
Further real cuts to departmental spending to come in 2016–17 and 2017–18
without tax increases or welfare cuts then if NHS, schools and aid still protected, ‘unprotected’ resource DELs would face cumulative cut of 31.5% since 2010–11
cutting resource DELs at the same rate as over the SR2010 period (7% real cut over the two years) would require £4 billion of tax increases/welfare cuts and would still leave ‘unprotected’ resource DELs facing a cut of 29.7% since 2010–11
Considerable uncertainty remains
© Institute for Fiscal Studies

27. Fixing the public finances: eight years of pain?
Carl Emmerson
Presentation at IFS public economics lecture, London
17 December 2012
© Institute for Fiscal Studies
IFS hosts two ESRC Research Centres