David Willetts is President of the Resolution Foundation and is a member of the House of Lords.
Budgets are moments when the big trends driving tax and public spending surface with visible, politically significant decisions.
During the forty years which followed the 1976 IMF crisis the big trends made it possible to hold down spending and tax: selling off public assets such as national industries and council houses; a favourable demographic backdrop as the post-War baby boomers entered work with fewer pensioners ahead of them and fewer children behind them; and the end of the cold war. We got used to tax cuts in Budgets – the basic rate of income tax fell from a peak of 35 per cent at the time of the IMF crisis to 20 per cent. In his 1979 Budget Geoffrey Howe set what we in the Treasury at the time thought was an extraordinarily bold target of bringing the basic rate down to 25 per cent.
Gordon Brown got it down to 20 per cent in 2008. That is also the year the backdrop shifted. The financial crisis, Covid, the ageing of the boomers, Brexit, Putin, Trump all push up public spending.
The tax rate meant for most political purposes the rate of income tax, leaving Chancellors considerable room for manoeuvre on everything else. Conservatives led a deliberate shift from direct to indirect taxation. Conservative manifestos never had bold commitments ruling out all tax increases as in Labour’s 2024 manifesto – Conservatives raised VAT from 8 per cent to 15 per cent on entering office in 1979 and from 17.5 per cent to 20 per cent on entering Government in the Coalition in 2010. Those income tax cuts which are lauded now were often funded by tax increases elsewhere.
Now the fiscal trends look very difficult.
The number of pensioners is surging, made even more expensive by the triple lock. There is also the urgent need to raise defence spending.
It is right to try to get a grip on welfare to help hold public spending down. The Resolution Foundation estimates that up to £5b could be saved on Personal Independence Payments. But these savings take a lot of time and hard work. An activist judiciary has been willing to rule welfare savings unlawful on the grounds that the decisions were improperly taken as there should have been more consultation: that is what they did when they struck down Rishi Sunak’s attempt to tighten work capability assessments. One reason why the new Labour Government rushed into primary legislation to deliver savings on welfare without time to prepare the political ground was that the judges were less likely to strike down primary legislation.
It is unlikely that cuts in spending on welfare benefits to people of working age are on themselves going to do enough to meet the powerful upward pressures on public spending. There is however one other option that could help- a radical agenda to harness technologies, notably AI, to improve the way the state works. That requires a deep programme of reform – a great example of where a party in opposition can do serious work to prepare the ground.
The Chancellor’s budget tomorrow will therefore be heavily constrained. He has successfully lowered expectations. He needs to continue to show effective control of public spending – not just because of the bond markets but because it is the right thing to do.
He does have some room for manoeuvre.
Our budgets are now shaped around the target of a balanced current budget in 2029-30. The IMF and other international observers do find it very odd that so much British economic policy debate is about adjustments to fiscal headroom, a figure three years out which is less than 1 per cent of the economy.
It stood at £24b in Rachel Reeves’ last budget but may now perhaps be down to around £12b, above all because the cost of borrowing has gone up. The Chancellor needs to do something about this. But as the key year gets closer this kind of contingency reserve can be allowed to shrink a bit, maybe to £18b or thereabouts.
He also has room for manoeuvre because of his new definition of national debt so it is net of financial assets. Hence the other key figure in Budgets nowadays is PSNFL, public sector net financial liabilities – pronounced persnuffle.
That means that public sector financial institutions – PuFins – which invest in financial assets such as loans to companies for infrastructure can spend money without adding to net national debt. So we may hear serious budget commentators sounding like David Attenborough as they observe that Persnuffle has enabled the Chancellor to put more into his Puffins. This is not actually an absurd financial device – it is plugging the gap left by Brexit as the European Investment Bank used to fund significant investment in Britain which did not show up on the Government’s balance sheet either.
Behind all this however are tricky issues which still need to be tackled. As the Chancellor resigned over defence spending it would be great if he could indicate how its growth is to be funded. Rising energy prices will hit low-income families hard and there needs to be some kind of package to help them, probably based on ingenious attempts to help the families facing the worst problems. Tackling NEETS is right and will save money in the long run but in the short run it costs money as we have to offer more education and training and active incentives to work to these young people. One reason why Alan Milburn’s report is delayed may be so its costs do not show in the budget arithmetic. And to find the money to do all this the Chancellor will be hoping that something might turn up – an improvement in the growth rate is by far the best way of making all these problems manageable.