If they did a deal what might it look like: an end to austerity?

Five weeks to go to polling day and it’s clear that the media, and perhaps the public, aren’t getting the answers they’d like to some of the fiscal questions the next government will have to address. What we’ve termed the candour deficit is yet to be closed.

And with every projection for 7 May anticipating a hung parliament it looks likely that, as things stand, any future party of government is going to have to strike deals – whether formally or informally – in order to govern. What might be the nature of any such a deal on fiscal policy? Clearly neither of the parties will talk about this pre-election, so we thought we would engage in a bit of open speculation about how different combinations of parties might possibly work together. Here we look at Labour and the Liberal Democrats (we’ll look at the Conservatives and Lib Dems next).

Given that both Labour and the Lib Dems voted for the Charter for Budget Responsibility, that seems like a reasonable place to start, even if many commentators didn’t take the vote all that seriously. To fulfil the charter the government needs to set out a plan to reach current balance three years down the road. That is, tax revenues must cover day to day expenditure (i.e. excluding investment). So in any emergency budget in June, and again in Autumn Statement 2015, the government would have to set out a plan for achieving current balance in 2018-19 (a point also made by the FT’s Chris Giles).

Because it’s a rolling target, the date at which it applies moves forward as we enter the new financial year: anyone claiming the commitment is to get rid of the deficit by 2017-18 is wrong. Equally, if anyone claims (say in the ‘leader’s debate’ tonight) that those parties who voted for the charter have committed to ‘£30bn of cuts’ then they are making a (big) mistake. They haven’t. As the chart below shows, if restoring current balance in 2018-19 is the key fiscal goal guiding any Labour-Lib Dem deal, the two parties would be signing up to £6bn of consolidation by 2018-19 (the dark red line).

There are, however, some wrinkles. One of these is that the fiscal charter also has a supplementary element: the debt rule. This requires debt as a proportion of GDP to be falling in 2016-17. It’s worth saying that a one year goal for debt is pretty odd and many economists don’t think this is a sensible rule and would be happy for it to be replaced or dropped (unlike reaching current balance). But if Labour and the Lib Dems agreed as part of a deal that they needed to adhere to this bit of the charter too they’d have to have a plan for £10bn of tightening in 2016-17 (the green line) falling to £6bn by 2018-19.

Another caveat is that Labour’s usual formulation on fiscal matters is that they will reach balance ‘as soon as possible’ in the next Parliament which, at its loosest, means this might occur as late as 2019-20 (the red dotted line in the chart above) – that is, slower than the charter requires. Meanwhile, the Lib Dems have recently indicated (in Danny Alexander’s ‘yellow box’ statement) that they want to run a significant current surplus in 2017-18 (the yellow line in the chart) – that is, go faster and further than the fiscal charter requires them to. Given the gap between these party positions – one tighter and one looser than the fiscal charter – it seems sensible to assume that any deal is likely to stick to the position that both parties voted for: hitting current balance in 2018-19 and (perhaps) complying with the debt rule.

The path of fiscal consolidation this would require can, of course, be achieved in different ways. Many people will be as interested in the blend of spending cuts – and tax rises – as they are in the overall amount of tightening.

In order to try and put flesh on this tax/spend aspect of a potential Labour-Lib Dem agreement, let’s recall that the Lib Dems have already proposed raising £6bn via anti-avoidance measures, and another £6bn of extra taxes through a range of taxes which broadly fall on the affluent. Labour has said a bit less on tax rises: its mansion tax is earmarked for NHS spending so doesn’t help with consolidation; but its 50p top rate would help close the gap. And it’s pretty safe to assume it won’t want to be outbid by the Lib Dems and Conservatives on tax avoidance.

Given that none of the Lib Dems’ other tax proposals breach Labour’s new commitment not to raise VAT, the rate of income tax or NICs, let’s make the assumption that Chancellor Balls concedes to a number of these Lib Dem revenue raisers. Indeed, let’s assume that between the Lib Dem and Labour measures, the parties find agreement on £4bn of deficit-reducing revenue (i.e. £10bn including tax avoidance). Adding all this together, the following chart shows a highly indicative and simplified tax/spending profile for our (made-up) deal.

What would this deal achieve? Above all it means that the fiscal charter (that all three main parties voted for) would be met in full at the same time as there would be no further net spending cuts after the current year.

Spending would remain flat in real terms in 2016-17 and then grow very slightly in the following two years, before rising roughly in line with the economy in 2019-20. Clearly, taxes could go up further to enable a gentle upward spending path before 2019-20. But even with the approach we’ve indicated spending would rise by around £15bn over four years (and this will be an understatement as we don’t count some increases in expenditure that Labour have already said will be funded by specific tax rises).

To put this in political context, that’s about £7bn or so more than that implied by the SNP’s recent proposal to increase departmental spending by 0.5% a year. The higher spending under our hypothetical Labour-Lib Dem arrangement results from the tax rises we’ve assumed, the shift to reaching balance in 2018-19 (rather than 2017-18) and the small improvement in the underlying fiscal numbers at the Budget. (Prior to these changes we’d have expected the SNP stance to result in slightly higher spending than Labour as set out here.)

We don’t here look at what this package might mean for different departments but there would be scope to increase NHS spending to meeting Simon Stevens’ proposal (though this would gobble up much of the uplift that would occur at the end of the Parliament). And we’ve also factored in around £4bn to pay for the bulk of the Lib Dem’s flagship policy of raising the tax allowance to £12,500. Obviously, without that tax cut spending could be further boosted.

Finally some key caveats. Most obviously this is all complete speculation: the parties could come to an entirely different fiscal package. Second, the OBR’s fiscal projections which underpin all these figures could all be wrong: remember productivity is king. If it doesn’t start to rise (as the OBR assume) the true numbers will be dramatically bleaker. Lastly, even if the figures are right (unlikely), and the revenue increases achievable, no one should think that the ‘end of austerity’, as this would doubtless be billed, would be easy to live with. Sure, the parties would highlight that it’s far less scary than going down the cuts ‘rollercoaster’. But it still implies living with another three years of spending remaining (roughly) flat in real terms. And even that would be a very formidable task.