Chancellor Rachel Reeves’ first budget in October 2024, with its increases in public expenditure, borrowing and taxation, was presented as a one-off ‘reset’ of fiscal policy, not to be repeated in the current parliament. This is too optimistic.
The planned growth in public expenditure after the 2025-26 financial year is, as with the previous government’s plans, unrealistically low. Either public spending will be higher, involving more borrowing or further increases in taxation, or there will have to be painful cuts in public services. This will come to a head when the government sets spending plans for departments for the years after 2025-26 in the spending round it is committed to carrying out in ‘late spring’ 2025.
Given the immense pressures for more spending – notably on health, defence, local authority services, the justice system and many investment projects – the 2025 spending round will reopen all the issues on spending, borrowing and taxation that the October budget was meant to settle.
Fiscal policy in the UK is better managed and on a more predictable path than in some other large economies. President-elect Donald Trump’s tax-cutting aspirations could increase further the historically high rate of public borrowing in the US. The German and French governments cannot get their legislatures to agree budgets for 2025, let alone the medium term.
Such uncertainties abroad at a time when most governments are financing their activities through high recourse to the bond markets does not mean that the UK can be assured of financing future deficits comfortably. There will be high levels of gilt redemptions to finance, and it is likely that the Bank of England will continue quantitative tightening, which will involve selling gilts in the market.
Against this background, the government should urgently consider further ways to ease its fiscal pressures beyond simply raising taxes or squeezing services. It should reverse the large fall in public sector productivity during the pandemic and finance increased infrastructure investment other than relying on gilt sales. This would necessitate a thorough revamp of the Private Finance Initiative. The last Labour government’s PFI was regarded as poor value for money and there were many complaints about aspects of the contracts. The initiative was eventually ended and not replaced. Instead, investment in infrastructure, such as in hospitals and schools, fell away – the worst possible outcome.
Restoring productivity levels
Focus on these reforms will be crucial as there will be strong resistance to tax increases for individuals and companies following the recent budget. There is mounting evidence that public sector efficiency and productivity in the UK fell sharply during the pandemic and have not fully recovered. According to the Office for National Statistics, at the beginning of 2024, public service productivity was over 6% lower than its pre-pandemic peak at the end of 2019.
Measuring the output and productivity of public services is notoriously difficult. The ONS stresses that its work in this area is still under development. Yet there is enough evidence to suggest that the fall in efficiency is a serious problem. Reversing it will take far more than setting modest annual efficiency targets of around 2% for government departments. It will require some drastic changes that would be difficult to achieve and uncomfortable for the workforce. But as the alternative is cuts in public services or further increases in taxes, it is the least bad option.
Much of the pre-budget discussion focused on changing the government’s fiscal rules to allow more borrowing for investment. The post-budget projections from the Debt Management Office show gross financing requirements (new borrowing plus refinancing of redemptions) in the range of £250bn to £300bn in each of the four financial years to 2028-29. The bulk of these will be met by gilt sales. At the same time, the Bank will be running off its stock of gilts (currently at a rate of £100bn per annum). This scenario may be feasible, particularly if the UK’s fiscal policy is perceived as relatively responsible by international standards. However, there are risks. Everything should be done to prevent a loss of confidence in the gilt market that could make a policy correction necessary.
Adapting to new investment models
It is ironic that governments, including the UK since 1694, invariably seek to finance even their legitimate financing requirements primarily through bond issuance. Yet despite the importance of the international bond market, recent decades have seen huge developments in other financial products and institutions. Many of these institutions are interested in infrastructure but have little or no appetite for UK government bonds. In financing their own activities, governments have not kept up with the changes in the international financial system.
Recent UK governments have tried to diversify from exclusive bond financing by tapping sovereign funds, insurance companies, pension funds, private equity and others to help fund infrastructure projects. The challenge is not so much to attract these investors as to find acceptable structures with adequate returns into which they might invest. Outright privatisation has been severely criticised, especially in the case of the water companies and train operators.
Since there will be future constraints on gilt-financed public sector investment, it would be preferable to design structures for private finance that reduce or minimise the previous problems with private finance. As with the need to improve public sector productivity, designing acceptable structures for private finance is primarily a task for government. An ambitious public sector efficiency programme and a reformed PFI need to be in place before next year’s spending round if service cuts and tax increases are to be avoided.
Peter Sedgwick was a senior UK Treasury official, Vice President of the European Investment Bank from 2000-06, Chair of 3i Infrastructure PLC from 2007-15 and Chair of the Guernsey Financial Stability Committee 2016-19.
Image credit: HM Treasury
