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Keir Starmer has warned that things will get worse for the UK before they get better. The prime minister asked the country to accept short-term pain for the long-term good and warned of a tough budget to come in October, blaming the Conservatives for leaving a “black hole” in the public finances.
Labour is taking a leaf from the coalition playbook, when then-chancellor George Osborne blamed the previous Labour government for the dire state of the public finances after the global financial crisis, which was used to justify austerity.
But are things really so gloomy for the new government?
In some ways, Labour’s economic inheritance is less grim than it might have been. The economy is growing, albeit slowly, and real wages are beginning to rise. Inflation is back near its 2% target and the Bank of England is likely to continue to cut interest rates, easing pressure on mortgages. The jobs market is relatively healthy.
But the government does need to spend substantially more to revive the battered public sector. What the “black hole” revealed is that there is not just a long-term funding gap, but also a problem in the current financial year.
Almost half of the £22 billion funding gap revealed in July is the cost of the public sector pay awards to doctors, nurses and teachers. The other biggest unfunded item is £6.4 billion to house asylum seekers and migrants whose claims have not been processed.
Chancellor Rachel Reeves has already announced her plans to save £5.5 billion this year and £8 billion next year. Among other measures, all government departments will need to save a total of £3.2 billion this year to help fund the pay settlements. Controversially, she is saving £1.4 billion by means-testing the winter fuel payment.
It should come as no surprise that money is going to be tight ahead of the October budget. The Office for Budget Responsibility had already characterised the previous government’s future spending plans as a “work of fiction” that would lead to service cuts in unprotected departments like local government and prisons. After the summer riots, this could be seen as even more significant.
Now the task of reversing years of austerity will be even more difficult. And the pressures are greater, because the government has endorsed other ambitious but expensive and largely unfunded plans to increase childcare places and the numbers of doctors and nurses.
And that’s all before compensation for the infected blood scandal and potentially money to replace cladding on flats in the wake of the Grenfell Tower scandal. Long-term issues including child poverty, university funding and housing will not go away either.
The way forward – cuts or taxes?
In many ways, the prime minister’s speech was an attempt to lower expectations around what the government can deliver next year. But the speech also signalled that Labour will need to go beyond the modest tax plans promised in the election campaign. With the government committed to not increasing the rate of income tax, national insurance or VAT, the Treasury will struggle to find other means to close the remaining spending gap.
One target is bound to be taxes on wealth, especially capital gains tax and taxes on dividends, which are currently taxed much less than income. Another target could be pensions. Currently people who pay into their pension pot can deduct the amount from their taxable income, so that higher earners get a 40% rather than 25% tax break. But changing this could be complicated to administer.
Read more: If Rachel Reeves hikes capital gains tax, she’ll be more in line with Nigel Lawson than Gordon Brown
The government has no plans to change the continued freeze on income tax bands, which creates so-called fiscal drag and raises around £10 billion a year. It could also raise fuel duties.
These tough choices suggest the chancellor will also have to look at more cuts to spending. Half of government spending is made up of yearly outgoings on state pensions and welfare benefits for those of working age, and this could be a target. In particular, spending on disability and incapacity benefits has grown dramatically, from £28 billion 10 years ago to £43 billion today, and is projected to rise to £63 billion by the end of this parliament. This appears to be in the government’s sights already.
The need to reduce welfare spending in order to fix public services might explain why the chancellor is willing to risk her political capital by ending the universal winter fuel payment. The same might be said for her refusal to repeal the two-child limit on child benefit.
The government’s goal of economic growth is unlikely to provide enough additional revenue in the short term to alleviate the pressures on public services.
One way to boost growth would be to substantially increase public investment in infrastructure – which could be funded by borrowing. But the government has put itself in a straitjacket, as one of its key fiscal rules says that government borrowing cannot rise faster than economic growth in the long-term.
This puts the government in a bind. One way around it would be to tweak that fiscal rule – which is self-imposed – to make it easier to borrow over the long-term if it would increase economic growth.
Some of the cuts already announced, for example to the roads programme and new hospitals, suggest that the government may find it politically easier to cut long-term infrastructure plans than current spending.
But whichever method it chooses to reverse the effects of austerity – higher taxes, cuts to spending, or more borrowing – all have the potential to inflict pain.
This is above all a political choice with major implications both for the government’s own popularity and for the future of public services. While the government may have exaggerated the immediate spending dilemma it faces, there is no doubt that its long-term goal is challenging, and that economic growth is far from certain.
Keir Starmer has said it will take a decade to rebuild Britain. But will the government have the stamina to drive forward despite the political and economic headwinds?
Steve Schifferes does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
