How the chancellor used his new-found luck: Easing the squeeze on public services

 
Bill Robinson
GEORGE Osborne has not, up to now, been a very lucky chancellor. He inherited a huge fiscal deficit and has presided over a recovery that, in the early years, repeatedly disappointed. Initial plans to eliminate the deficit over the life of the last Parliament morphed, year by year, into plans to halve the deficit over the same period.

In March, there were signs that his luck was changing. Tax revenues came in a bit higher than expected. The government debt peaked as a share of GDP. Real disposable incomes started to rise. Helpful developments just ahead of an election.

The Summer Budget shows further change in the same direction. According to the OBR, the fiscal watchdog, the underlying state of the public finances has improved. Output will be significantly higher this year – mainly thanks to faster growth in 2014. Wage growth has risen to 3 per cent, while price inflation is in negative territory. Real incomes, and consumption, are growing at their fastest rate since recession struck, generating more tax revenue across the board. Meanwhile, lower inflation is holding down the costs of public procurement, while, as so often happens in upswings, public sector wages are not rising as fast as in the private sector – a fiscally helpful development that the chancellor will prolong by limiting public sector wage growth to 1 per cent per annum.

The tax windfall presented the chancellor with choices: to eliminate the deficit faster: to cut back on public spending more slowly; or to cut tax rates. He has chosen to cut the deficit faster this year. He then eases up in the following years, before achieving his target surplus in 2019-20. This change of deficit reduction profile, together with the expected sharp cuts in welfare spending and a net rise in taxation, allows him to free up a significant increase (averaging nearly £20bn per annum) in the Departmental spending limits.

You would never have guessed this from his speech, but he has “used his first Budget to loosen significantly the impending squeeze on public services spending that had been pencilled in by the coalition in March.” That is official, from the opening sentence of the OBR report, published alongside the Budget.

Osborne is a political craftsman. He found the room for his tax cuts by raising taxes on the insurance companies and the (still unpopular) banks, increasing the climate change levy (a green tax), and raising Vehicle Excise Duty (now re-branded as a new source of dedicated revenue to pay for better roads).

How would he spend it? His Budget objective – a low tax, low welfare, high wage economy – was well trailed. We expected the increase in the income tax personal allowance and in the 40 per cent tax threshold. We wondered if he would cut inheritance tax, and he did, to the delight of the Tory faithful. And we knew he was going to cut welfare.

The rabbit from the hat was to raise the minimum wage to the Living Wage, for which he had previously evinced little enthusiasm. The measure could, it is hoped, boost productivity (as some early adopters have found). However, it won’t be popular with the catering trade or the (struggling) food retailers. But who cares about the economics. It was a political masterstroke.

Bill Robinson is chief economist at KPMG.