The £39bn black hole in the Chancellor's Budget

Institute for Fiscal Studies report reveals scale of the crisis in the public finances, concluding that their is little room to provide much-needed boost to economy

Economic Editor,Sean O'Grady
Tuesday 07 April 2009 00:00

The Chancellor, Alistair Darling, will be unable to deliver any meaningful boost to the economy in his Budget in a fortnight's time, and an almost unprecedented squeeze on public spending will be required over the next few years – whichever party wins the next general election – according to a pre-Budget analysis by the respected Institute for Fiscal Studies (IFS).

An annual "black hole" approaching £39bn will need to be plugged if the nation's finances are to be brought back into balance as the Government plans, warns the IFS, a looming problem that leaves the Chancellor with even less room for manoeuvre in his Budget, due on 22 April. The IFS said: "Because debt is going to be so much higher than had been previously expected, it has become more dangerous to add to it – even relatively modestly."

As public borrowing for this tax year, 2008-09, climbs to £95bn – some £17bn more than anticipated in the pre-Budget report last November – the IFS forecasts that it will hit around £150bn in each of the succeeding three years, again way beyond government estimates. Even without the additional cost of the various bank bailouts, that will take the national debt to more than £1 trillion (£1,000,000,000,000), or 73.5 per cent of GDP by 2015.

As a proportion of the size of the economy it has not been at those sorts of levels since the 1960s. Even so, in aggregate terms it is still likely to be lower than that of Germany and Japan, and about the same as the US.

Such sums, however alarming, exclude an additional £130bn, or almost 10 per cent of UK national income, that will eventually be required to pay for the banking bailout – the IMF's latest estimate. In other words, the credit boom and consequent banking crisis will cost each UK taxpayer approximately £4,000 – even before they address the current increase in levels of debt.

The IFS says that, having climbed to 82.4 per cent of GDP including the cost of bank bailouts, public debt is unlikely to return to pre-crisis levels until the 2030s. Without corrective action national debt will go on to reach more than 90 per cent of GDP by the 2050s – by that point a century-long high.

Only by radical cuts to public spending, tax rises or some combination of the two can the "structural" deficit be resolved, says the IFS. Public spending will already be severely curtailed through existing government spending plans, with growth down to a meagre 1.1 per cent per year after inflation. But the IFS cautions that deeper, real terms cuts may be needed in the NHS, schools and other "front line" services.

Indeed the rising burden of servicing the national debt, as interest rates return to more normal levels, will result in the sort of spending cuts not seen since the early 1980s: "Because of rising real spending on debt interest payments, tax credits and social security benefits, this would require real cuts in most areas of government spending, and even favoured areas such as health and education would undoubtedly see much lower spending growth than they have received in recent years."

High profile expenditure items such as public sector pensions also seem set to move closer to the centre of the political stage, as all the major parties review their fiscal programmes.

A good deal of the deterioration in the UK's once healthy public finances is a natural result of the economy going into recession, as tax revenues traditionally fall and unemployment and other social benefits rise at this point in the economic cycle. Allowing this to take its course is now economic orthodoxy, these "automatic stabilisers" helping to keep the economy on relatively even keel.

In the 1930s politicians made the error of trying to balance the Budget during the slump by raising taxes and cutting spending – with disastrous consequences.

Even so, much of the current additional public sector deficit – rising to £39bn a year by 2015 – is also due to the British economy entering this recession with relatively high levels of public spending and borrowing, as well as the £20bn of additional or "discretionary" spending announced in last November's pre-Budget report, designed to prevent the economy slipping from recession to deflation and slump.

On Sunday the Chancellor, who has called for more "humility" from the Government, admitted he had badly misread the prospects for the economy and, by implication, public borrowing. At the time of the pre-Budget report, Mr Darling predicted the UK economy would shrink some 1 per cent this year, returning to growth of 1.75 per cent in 2010. The IMF's latest prediction is for a 3.8 per cent drop, with a further contraction of 0.2 per cent the following year.

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