The UK economy is under the cosh. According to the latest forecasts from the Bank of England, we are going to experience both a recession and a prolonged period of high inflation. This poses serious challenges for households, businesses and policymakers, including the next prime minister.
It also poses challenges for utilities, whose budgets are set in terms of cash and therefore do not automatically increase in the face of higher-than-expected inflation. Higher inflation means that hospitals, schools, prisons and councils are able to buy fewer goods and services: their budgets become smaller in real terms. In other words, surprisingly high inflation is imposing an unintended dose of austerity as government spending plans become less generous. This is one of the reasons why high inflation can be “good” for public finances, at least in the short term: tax revenues are higher, because incomes and the expenses on which they are levied increase more rapidly. , but government spending plans adjust upward much more slowly (if at all).
Measuring the pressure on public services
How less generous have government plans become? And how much would it cost to compensate departments and bring their budgets back to the level of generosity the government had originally planned to achieve when the plans were drawn up last year?
The answers to these questions depend on how you measure inflation. The measure of inflation generally used to make such assessments is called the GDP deflator, a measure of general inflation in the national economy (unlike the consumer price index, CPI, which is a measure the rate of inflation faced by households and which will naturally include variations in the price of imported goods and services). The GDP deflator underpins the UK Treasury’s calculations of the generosity in real terms of its spending plans. It is not a perfect measure of the cost pressures faced by departments. In fact, for a number of obscure technical reasons, this likely underestimates the “real” cost pressures facing departments today. But it is perhaps the best generalist measure we have and, whatever its shortcomings, it will be used by the Treasury in its decision-making.
According to spending plans published in the government’s October 2021 spending review, day-to-day funding for public services (ministry spending limit resources, excluding depreciation, in tax jargon) was to grow by 3.3% per year, on average, between 2021 −22 and 2024−25. This was based on the Office for Budget Responsibility (OBR) forecast at the time, which stated that GDP deflator inflation was set at 2.3% on average over this three-year period. In March 2022, the OBR forecast an average inflation of 2.8% (measured by the GDP deflator) over the three years (i.e. an increase of 0.5% per year). Average funding growth in real terms over the spending review period thus fell from 3.3% to 2.8% (ie a decline of 0.5% per year).
A lot has changed since March. On the one hand, the Lionesses are now European champions. On the other hand, inflation is now expected to be considerably higher. While the Bank of England and many other institutions produce regular forecasts for the CPI, the same is not true for the GDP deflator. The OBR’s March forecast for the GDP deflator is still the most recent we have. The CPI is not a good measure of the cost pressures facing public services (a hospital does not have the same consumption basket as a typical household, for example – households typically spend a fraction much more significant portion of their energy and food budget, and a much smaller fraction). fraction on prescription drugs and midwives). More generally, personnel costs represent a significant share of expenditure for most public services, but public sector salaries do not, for obvious reasons, fall into the CPI basket. But there is good reason to think that just as the CPI inflation forecast has risen, so too has the GDP deflator forecast. Indeed, the GDP deflator growth data is already well above the OBR’s March forecast (2.8% year-on-year growth in the first quarter of 2022, compared to -0.1% in the forecast).
Here we adjust the OBR’s March forecast for the GDP deflator based on: 1) the change in the CPI forecast between the OBR’s March 2022 forecast and the August 2022 forecast form the bank ; and 2) the past relationship between the CPI and the GDP deflator. Specifically, we assume that the degree of “pass-through” from the CPI to the GDP deflator between March and August 2022 is the same as that observed between October 2021 and March 2022. Under this assumption, GDP deflator inflation should average 3.7% over the three years from 2021-22 to 2024-25 (compared to 2.8% according to the OBR March forecast and 7.1% for the CPI according to the August forecast form the bank).
This is only an approximation and may well turn out to be an underestimate. In any case, for the reasons discussed above, there is no reason to expect the GDP deflator to perfectly capture the cost pressures facing departments (although, reassuringly , it is broadly comparable to the IFS school-specific cost index). Nonetheless, with these caveats in mind, it allows us to produce an illustrative estimate of what departmental spending plans might look like in real terms.
How less generous have the plans become?
Using this rough estimate of the GDP deflator, we can examine how less generous departmental spending plans have become in real terms. This is illustrated in Figure 1. The average growth rate in real terms of the day-to-day financing of the civil service falls from 3.3% in the initial plans to 1.9% per year. In other words, the rise in inflation should wipe out more than 40% of the projected increases in real terms.
For the Department of Health and Social Action (DHSC), the expected growth rate drops from 4.3% to 2.9%; for the Department of Education (DfE), it falls from 2.2% to 0.7%. Since the increases for these departments were anticipated (with large increases in the current year followed by much smaller increases in subsequent years), both departments would face a budget reduction in real terms between 2022-23 and 2023-24. The Ministry of Defense was already facing average reductions in real terms of 1.4% per year under initial plans; which can now increase to 2.8% per year, according to these estimates. That would eerily fit with Mr. Sunak’s and Ms. Truss’ stated plans to increase defense spending to 2.5% and 3.0% of GDP, respectively, by the end of the decade.
These numbers are by no means accurate. If this continued period of economic turmoil tells us anything, it’s that things can change very quickly. But the general conclusion of the exercise is clear: the financing plans for the civil service have become considerably less generous than initially envisaged.
Figure 1. Projected average growth in real terms of selected day-to-day budgets over the spending review period under different inflation forecasts
Note: October 2021 plans refer to the real growth rate associated with the final cash spending settlements, based on the GDP deflator forecast in October 2021. The estimated GDP deflator forecast for August 2022 is calculated on the basis for the evolution of CPI forecasts between March and August. 2022, and previous rates of “pass-through” from the CPI to the GDP deflator.
Source: Author’s calculations using HM Treasury PESA 2022, Spring Statement 2022 and Spending Review 2021; OBR Economic and Fiscal Outlook, March 2022; and Bank of England Monetary Policy Report August 2022.
To compensate or not to compensate?
The new Prime Minister and the new Chancellor are faced with the choice of whether or not to compensate departments for higher than expected inflation and, in particular, for higher public sector pay than originally budgeted.
Figure 2 provides an estimate of the magnitude of the additional spending that might be needed to ensure departments are no worse off, in real terms, than they projected in the October spending review. According to our estimated trajectory for the GDP deflator, this would require over £8bn this year (2022-23) and around £18bn in each of the next two years (2023-24 and 2024-25) . Even according to the OBR’s outdated March forecast, departments would need a further £4bn this year (followed by £5.5bn in each of the following two years) to be fully compensated.
Figure 2. Estimated amount of incremental spending needed to bring departmental spending plans back to the originally projected real growth rate (October 2021)
Note: Figures refer to the amount of incremental (nominal) spending needed to achieve the real growth rate of the LED resource, excluding the depreciation originally planned for the October 2021 spending review. The GDP deflator forecast estimate for August 2022 is calculated based on the change in CPI forecasts between March and August 2022, and previous CPI “pass-through” rates to the GDP deflator.
Source: Author’s calculations using HM Treasury PESA 2022, Spring Statement 2022 and Spending Review 2021; OBR Economic and Fiscal Outlook, March 2022; and Bank of England Monetary Policy Report, August 2022.
Choosing not to compensate departments for unexpectedly high cost pressures would be a deliberate move to cut spending in real terms, at a time when many utilities are showing signs of strain. The NHS, for example, is already experiencing an unprecedented busy summer, with its busiest June on record for 999 A&E calls and attendances, and a worrying increase in average ambulance response times.
An unfortunate series of global shocks has left us impoverished as an energy and food importing nation. Dividing this economic pain between households, businesses and public services is the inevitable and unpleasant task that awaits the next government. Choosing to accept a reduced range and quality of public services is a possible response to the impoverishment of the nation. But if the next prime minister chooses to cut corporation tax, national insurance or income tax rates, and chooses to make public services worse before a tough winter, he must be honest and transparent about the choice he made.