Page last updated at 16:01 GMT, Sunday, 6 December 2009

Tough choices for UK's public finances

By Stephen Coulter
BBC economics analyst

Alistair Darling
The state of the public finances is a major issue for the chancellor

The party - or coalition of parties - forming the next government will face some tough decisions on public spending and tax.

With the economy still mired in the longest recession since the 1950s, and the public finances in their worst state since World War Two, there will be little scope for the expansive promises and grand visions which are the normal currency of general election campaigns.

The next two financial statements from the Treasury, the pre-Budget report (PBR) on Wednesday, and the 2010 Budget in the spring, will lay out the grim financial terrain on which the main parties will battle for power.

In the coming PBR Chancellor Alistair Darling should be able to forecast the UK economy's imminent return to positive growth after six successive quarters of decline.

However, the lagged impact of recession on the public finances will place tight constraints on fiscal policy (tax and public spending) for the bulk of the coming decade.

Tough talk

The fallout from recession and high cost of bailing out the banking system are set to swell government borrowing this year to £175bn, or 12.4% of GDP.

Public sector borrowing

Annual borrowing is not forecast to dip below £100bn until 2013/14 at the earliest.

The cumulative effect of this will be to push government net debt towards 80% of GDP by then, compared with a previous maximum of 40% of GDP under the Treasury's long-forgotten fiscal rules.

Moreover, the interest on this debt needs to be serviced.

The cost of doing so will be affected by the views of international investors on the viability of the next government's plans for bringing the UK's wayward finances under control.

It was for this reason that the public were treated to the unusual spectacle of political parties vying with each other at their recent conferences to sound toughest on spending and tax.

Political challenges

The government's deficit reduction plan consists of a fiscal tightening (spending cuts and tax rises) beginning gradually and building over eight years to 6.4% of GDP.

Shadow chancellor George Osborne
The opposition parties are also having to rethink their election pledges

This will amount to around £90bn (£2,840 per family) a year in today's terms from 2017-19 onwards, according to the Institute for Fiscal Studies, a respected think tank.

It is the biggest squeeze since the 1970s, when the UK was being bailed out by the International Monetary Fund.

And if implemented in full it will effectively obliterate new Labour's investment in public services since 1997.

Yet opposition parties say the government is deliberately under-stating the scale of the tightening needed, so as to underplay its impact on public services and take-home pay in advance of the election.

The Conservatives and Liberal Democrats are also having to rip up their carefully-costed election sweeteners and are not about to let Labour off the hook on its own promises.

Gone, for instance, is the Conservatives' earlier pledge to match Labour's planned spending increases on the NHS.

Government: 6.4% of GDP by 2017/18
Lib Dems: 8% of GDP by 2014/15
NIESR: 6% of GDP by 2017/18
PWC: 3% of GDP by 2015/16

The party's current program for slashing the deficit starts earlier and goes further than the government's. It now emphasises deep cuts in public spending rather than recovery-stifling tax increases, although these may be necessary as well.

Also in limbo are Liberal Democrat pledges to abolish university tuition fees and restore the link between pensions and earnings.

Vince Cable, the party's Treasury spokesman, says the fiscal tightening should be more like 8% of GDP annually (about £112bn) after only five years.

Mr Cable has set out a much more detailed slate of spending cuts than the other parties.

Unreliable forecasts

There are lots of unknown factors in trying to determine which is the right way forward.

Whatever happens, expect a lot of talk in future about cutting your coat according to your cloth

One is the impact of the fiscal tightening itself on the pace and vitality of the economic recovery.

Tighten too fast, warn some economists, such as former Bank of England Monetary Policy Committee member David Blanchflower, and you risk strangling recovery at birth.

The quickest and surest route to balancing the government's books, Mr Blanchflower argues, is a fast-growing economy producing low unemployment and buoyant tax revenues.

Economic and budgetary forecasts are also notoriously unreliable.

If GDP growth was to pick up sharply over the next few years - not impossible, given the current slack in the economy - the deficit may quickly sort itself out.

This happened after the early 1990s recession, when borrowing swung from a deficit of 7.7% of GDP in 1993/94 back to surplus in just six years.

This time is probably different, economists warn, as the recession's severity has occasioned the permanent destruction of a significant portion of the country's revenue-generating capacity.

The size of this "structural deficit" is, again, a moot point.

But it could be as much as 6% of GDP, says Ray Barrell of the National Institute of Economic and Social Research (NIESR).

That represents a lot less tax income for politicians to conjure with.

NIESR has drawn up its own list of revenue raising schemes that is sure to make voters' eyes water. It includes seven pence on income tax or a public sector wage freeze for five years.

Whatever happens, expect a lot of talk in future about cutting your coat according to your cloth.

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