Why honesty is the best fiscal policy

By Martin Wolf

Abraham Lincoln famously said that “you can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time”. His successor, George W. Bush, is reported to have added: “You can fool some of the people all the time, and those are the ones you want to concentrate on.” Some British politicians wish to follow that advice in the debate on the public finances. Alistair Darling’s refusal to do that was, it appears, the reason Gordon Brown, the prime minister, wanted to drop him. But Mr Darling is to be praised, not dropped, for his probity.

As I have argued in two recent columns (“Tackling Britain’s fiscal debacle”, May 7, and “End Britain’s phoney fiscal war”, June 4), the fiscal position has become a huge medium-term challenge. It is also an obvious symptom of gross policy failure: structural public sector net borrowing is estimated by the Treasury at 9.8 per cent of gross domestic product this financial year.

This horrendous figure is the result of four mistakes: an overestimate of sustainable GDP; slippage in the fiscal position in the years up to the crisis; an exaggeration of sustainable revenue; and a surge in real spending, as a result of unexpectedly low inflation.

Next financial year, as a result, the British government is forecast to spend £4 for every £3 it receives. More precisely, spending is forecast at 48.1 per cent of GDP in 2010-11, up from 40.8 per cent in 2008-09, and current receipts are forecast at 36.2 per cent of GDP, down from 36.9 per cent in 2008-09. By 2013-14, spending is forecast to be down to 43.4 per cent of GDP, while receipts rise to 37.9 per cent. Thus, under Labour’s plans, three quarters of the improvement in the fiscal position would come from a fall in public spending, relative to GDP. Spending is to grow far more slowly than GDP over many years – indeed, under plausible assumptions, for a decade.

So what did my former colleague Ed Balls, now schools minister, mean when he insisted that Labour could afford real increases in spending on schools and hospitals after 2011? His political goal is to open “clear red water” between Labour and Tories. But does his claim also make sense? The answer is: “yes” and “no”.

My colleague, Chris Giles, has worked out what a “yes” answer might mean. Assume the overall spending figures put forward in the Budget, which includes a massive 17 per cent annualised real cut in net public investment between 2010-11 and 2013-14. After the now inevitable increases in debt service and social security spending, real current spending would fall at an annualised rate of 0.7 per cent over these three years. Suppose that spending on health and education were kept level in real terms. Then real current spending on everything else – again, apart from debt interest and social security – must fall at an annual rate of 3.1 per cent a year. Evidently, if spending on health and education were to be increased significantly in real terms, cuts in other areas would have to be savage.

This is why the answer must also be “no”. If re-elected, Labour could increase real spending on health and education but, under its forecasts, other spending would have to be cut fiercely unless it were to run even bigger fiscal deficits than now planned. So cuts in real spending are as inevitable under Labour as under the Conservatives. The only question is where those cuts might fall.

How might Labour escape this trap? One possibility is to campaign against the Treasury’s assumptions. It is certainly possible that Mr Darling is too pessimistic, as his predecessor, Mr Brown, was too optimistic. At this stage, we simply do not know. Yet it would be risky to hope for the best. It would also be embarrassing to reject the forecasts of Labour’s own chancellor.

Another possibility would be to argue for higher taxes. Here the difficulty is that the numbers are so large. Merely to eliminate the reduction in public spending as a share of GDP planned for the three years after 2010-11, receipts must rise by 5 per cent of GDP, or £60bn in current prices, to reach 41 per cent of GDP. This would be equivalent to raising the basic rate of income tax by as much as 12p in the pound.

The great American satirist H.L. Mencken once declared that “nobody ever went broke underestimating the taste of the great American public”. I am more worried by a political version of this cynical view: the idea has grown up among politicians that nobody ever lost an election by underestimating the electorate’s intelligence. But at the heart of the next general election will be hard choices, for whoever wins. A democracy should debate those alternatives openly and honestly.

Unless the economy recovers its lost output, the fiscal position will demand tough spending cuts or huge increases in taxation. Indeed, it will probably require some of both. Mr Darling has recognised that simple reality. So have the Conservatives. But does Mr Brown? He and his colleagues are surely entitled to campaign for higher real spending on health and education. But they also need to say how they plan to pay for it. Anything less is an insult to the electorate’s intelligence.