The director of Britain's leading progressive think-tank sets out his vision for a transformation of social democracy that could renew its credibility and appeal for a new generation.

At the beginning of the 20th century, Britain spent just 12 per cent of its national output on public services and welfare support. By the onset of the financial crisis in 2008, it spent 40 per cent. In common with most other advanced economies, Britain underwent a huge expansion of public spending during the 20th century. It was a societal transformation to which labour movements and their political parties were midwives, defining the core of their political identities.

In his magisterial analysis of the growth of welfare states, the economic historian Peter Lindert identified three underlying drivers of this huge increase in state spending: the transition to full democracy which gave all citizens the political voice to claim welfare entitlements, increased longevity, which underpinned the spread of state pensions and health care for the elderly, and economic growth itself, which produced wealth that could be redistributed.

These drivers were present in all advanced societies but reached their fullest extent in western European countries that had strong labour movements, high levels of social solidarity between the working and middle classes, and limited ethnic heterogeneity. Parties of the left were at the heart of the changes, both as agents and beneficiaries, giving political voice to demands for the extension of pensions, public housing and unemployment benefits, while reaping the electoral rewards for standing at the leading edge of deep, long-term and popular economic and social change.

In Britain, this growth of the welfare state began life as a project of modernising society in the Edwardian era, and became a patriotic project of national reconstruction after the Second World War when the labour movement was the dominant political force in the country. Even when the Labour Party was subsequently out of power, the forces to which it gave political expression continued to drive forward expansion in the size and reach of the welfare state, up until the 1980s, when the increase in spending stopped before resuming its upward path at the turn of the 21st century.

The use of public spending to achieve broader political and social ambitions has therefore been hard-wired into the DNA of European social democracy for most of its history. Despite its protestations to the contrary, tax-and-spend strategies were as central to the New Labour Third Way as to the Croslandite social democracy of the revisionist postwar era. This is unsurprising: after democratic socialists had abandoned their belief in common ownership of the means of production, redistribution through public services and the welfare state formed the core of their political programmes.

Recognising this makes the challenge of reforming social democracy for an age of austerity a much bigger task than simply calculating plausible spending plans for the first half of the next parliament or the weighing up the efficacy of different electoral strategies. It goes to the core of the political identity of the left, in Europe and beyond. In Labour’s case, public perceptions of its profligacy in power and lack of trust in its ability to manage the public finances make this an existential challenge on which its long-term electoral fortunes hinge.

Focusing solely on the spending side of the equation would be a mistake, however. Under Labour, the UK entered the recession with a structural current deficit of only 0.6 per cent of GDP. With hindsight, it clearly would have been prudent to run a small surplus in the years leading up to the crash, and to that extent Labour can be criticised for its spending record. But Labour’s real fiscal mistake was consistently to overestimate the growth in tax revenues during this period. It mistook the buoyancy of revenues from the housing market and the City for a secure and sustainable tax base. When the accumulated asset and debt bubbles finally burst, revenues from these sectors collapsed. Fully a quarter of all corporation tax came from financial services before the crash, and this revenue fell from £10.3bn in 2007/2008 to £4.5bn in 2009/2010, while stamp and share duties fell from £14.1bn to £7.9bn. In contrast, consumption taxes and duties remained relatively stable, as did the Corporation Tax paid by manufacturing companies, which recovered quickly to its pre-recession level of around £4.5bn by 2009/2010.

The UK’s volatile tax base explains the size of its deficit relative to other countries that experienced a similar loss of economic output in the first phase of the financial crisis. In Germany, the general government deficit only reached 4.3 per cent of GDP, whereas in Britain it rose to 11 per cent at its peak, even though Germany’s fiscal stimulus was larger than the UK’s. A focus on government spending – while important in understanding long-term deficit bias in the UK economy and its cyclical vulnerability - cannot begin to explain differences in its fiscal position compared to the rest of the world (indeed, analysing the debt: GDP ratios or annual deficits of countries as they went into the recession is a poor guide to their subsequent fiscal trajectories; a far better place to start is with real housing market valuations, bank lending and current account balances).

Facing up to this record is a key task for social democrats. Without a proper, publicly articulated understanding of why the deficit increased as sharply as it did, future claims to fiscal credibility are unlikely to be persuasive. But even if that reckoning is made, it is only half the story, because after the UK emerges from the current period of austerity somewhere in the next Parliament it faces a double whammy of rising pressures on public spending from the ageing of society and falling tax receipts from fuel duties and other sources. The Office for Budget Responsibility estimates that increased costs to the NHS, state pensions and social care for the elderly will add 5.4 per cent to GDP by 2060, while tax revenues from North Sea oil, transport and others taxes will fall by 2 per cent of GDP. This is before any additional costs, such as the upfront investments needed to make the transition to a low carbon economy or spending to reduce child poverty, are factored in.

These are not unmanageable pressures, still less a justification for abandoning collective public services. Indeed, the superior cost-effectiveness of collectively funded health services over their private alternatives is a major reason why an ageing society provides long-term political opportunities for social democrats (what we might think of as “grey social democracy”). Nonetheless, the fiscal challenge posed by declining taxes and rising spending pressures is formidable. It exceeds the consolidation required to pay off the UK’s structural deficit. And it requires significant long-term changes in the structure of Britain’s political economy and the configuration of its state that Labour has not had to contemplate since the Attlee government came to power.

The first and hardest task is economic reform to achieve the kind of “responsible capitalism” Ed Miliband has made his central goal. Pre-tax inequalities in the UK are among the highest in the OECD. The top 20 per cent receives 15 times the income that goes to the bottom 20 per cent. After taxes and in-kind benefits like health and education, that ratio reduces to four to one. Services and income transfers therefore do most of the heavy lifting in reducing inequalities.

So-called “pre-distributive” economic reforms must therefore take more of the strain in the future. But it is important to be realistic about their potential. Trade unions compress wage dispersion but they are weak outside the public sector and stand no chance of providing the organised power that underpinned the left’s gains in the post-war period. High employment rates also require lower skilled jobs in the service sector, usually topped up by tax credits. The British left’s renewed enthusiasm for the Rhineland economic model often skates over the fact that Germany has greatly expanded its low skilled service sector jobs, to the degree that there are now widespread calls for the introduction of a National Minimum Wage. In advanced economies, consumer demand means that it is impossible to secure full employment without extensive, relatively low skilled service sector employment.

To believe that manufacturing will generate lots more well-paid jobs is also fanciful. In 1980, one in four workers were employed in manufacturing; by 2010 it was less than one in ten. One million manufacturing jobs have been lost in the last decade alone, largely in sectors most exposed to price competition in global markets, like textiles. Capital flows into the City have made the exchange rate less competitive for manufacturers, even after the devaluation of sterling that followed the economic crash, but the loss of manufacturing employment is largely an artefact of productivity gains and global competition. Manufacturing employment would have to increase at seven times the rate of private service sector job growth for more jobs to be created in manufacturing than services.

Yet a social-democratic agenda that cannot address indefensible market inequalities and offer the prospect of rising real wages to the bulk of the working population will always be weak. Elements of this agenda are to hand, even if they do not yet form a coherent programme. Constraints on top pay are now common currency among the political parties, at least rhetorically, and may bear fruit in the coming years. The Living Wage (a wage set high enough to live on and currently £8.30 an hour in London) could be expanded beyond its current bridgeheads in local government, city firms and universities. Employment could be better distributed between households, which would also reduce inequalities. A National Investment Bank would drive investment to critical infrastructure and leading sectors in which good middle-tier jobs can be created, while training policy could shift towards ensuring that workers’ skills are properly utilised by employers in order to increase productivity and real wages. Industrial strategies could foster competitive advantage in leading sectors and new forms or mutual and social ownership could be promoted to share wealth and power more widely. Although these measures do not add up to the kind of counter-blast to neo-liberalism many on the left yearn for, they begin to sketch a path to a more progressive political economy.

The second major task is to put together a credible and strategic account of the future of public spending. At its core, this must involve shifting spending out of services and transfers that do little work for social democrats, either electorally or substantively – such as winter fuel allowance and free bus passes for the elderly, road-building programmes and some elements of defence spending – towards those that increase the employment rate and reduce inequalities in life chances. The overriding priorities here are universal childcare and social care reform. Where care responsibilities fall to families or the market, inequalities grow, as women are drawn out of paid employment to perform caring functions, and children from low income homes get poorer care. If care services are provided universally at high quality standards, female employment rises and childhood inequalities are reduced. High-quality childcare is therefore a double win. It improves social mobility and pays for itself in higher tax receipts from working parents (and where both parents work, the risk of child poverty is minimal). This is why the Scandinavian welfare states have proved so successful: they absorbed the pioneering arguments of 1970s feminists and expanded universal childcare, while introducing parental leave and flexible working rights to promote gender equality at home and work.

If this sounds redolent of a big state social democracy that is in decline even in the Nordic countries, it should be remembered that childcare and parental leave entitlements have been expanded, not cut, in almost all European countries, and even in Canadian states like Quebec in the teeth of deficit-reduction programmes. Childcare services respond to irreversible changes in family structures, female employment patterns and demands for social equality between men and women, enabling families to make choices that the market would not otherwise provide. Moreover, Children’s Centres have become important institutions through which our common life is lived in the UK, valued by families and local communities alike. Unlike tax credits, such collective services are hard to cut once they put down roots in popular sentiment.

At the same time, spending on other areas that remain a priority – such as schooling – will have to remain constant as a share of the economy, rather than rising as they did in the Labour years. Improved outcomes will depend on a relentless search for greater effectiveness and efficiency in key services. Public-service reform will be defined by this objective long after the structural deficit has been paid off.

This will entail facing up to tough choices in a way that hasn’t been necessary for much of the left’s history. Some public services, such as routine operations, will have to become much more efficient and competitively tendered if resources are to be liberated for labour intensive services in which human relationships are most important, like home care of the elderly. Diversity of providers will become the norm, within a sharper accountability regime. New technologies will become more deeply embedded within services, leading to job losses and changes in working practices. Innovation and devolution of power will move centre-stage.

The third task is tax reform. The tax system must become more resilient without expanding beyond the electorate’s willingness to sustain it. Egalitarian concerns and popular outrage point to more taxes on banks, the wealthy and bankers’ bonuses, and such sentiment is perfectly reasonable given the cuts to the tax credits of low and middle income families. But over the long run this will simply exacerbate the structural weaknesses in the UK tax base. Tactical positioning from the Labour frontbench has got to give way to strategic rethinking on tax policy.

A suite of reforms is needed that broaden out the tax base, including an overhaul of VAT (which no future government is going to reduce), abolition of higher rate tax reliefs for pension contributions, and new wealth and property taxes that ensure the baby boomers pay for social care while dampening property speculation and asset bubbles. Road user charges and sensible carbon taxes must play a greater role in government revenues.

The key lesson for social democrats is that the quantity of the tax take and its resilience is more important than its progressivity per se, since the volume of tax, and the reliability of collection, is what enables governments to fund services that reduce inequality, while protecting revenue from exogenous shocks. This is another important ingredient of the success of the Nordic countries, which have the highest VAT rates in Europe, but make highly effective use of revenues to reduce inequalities. The point is not to stretch taxes beyond the electorate’s endurance but to ensure that the tax system is broader, more secure and doesn’t run behind core spending priorities.

All these considerations imply a very different kind of politics for the centre left, as Gavin Kelly of the Resolution Foundation has recently argued. Generational as well as class inequalities will have to be addressed: older people will have to lose some benefits and dip into their capital to pay for social care.

Even more politically challenging will be the reform of British capitalism itself. Thatcher achieved deep structural changes to the British economy by waging war on the Labour movement’s citadels of power, one by one. She gave large sections of British society a direct stake in the success of her project, placing her opponents on the wrong side of history defending crumbling bastions. Labour hasn’t achieved systemic reform of this kind since the Attlee government, which had an organised, patriotic working class pushing it forward. Today the sources of momentum and energy for progressive politics are far less strong, and the potential coalitions of support less clear.

Labour will therefore have to learn a new kind of statecraft, abandoning centralist micro-management and the targeting of stakeholders with spending offers, in favour of a more open, democratic and transparent politics that engages the public in wider social transformation. Political leadership that is capable of forging multiple coalitions, based on respect for different political traditions and a wider range of social actors, will become more important, replacing the machine politics in which constituencies of interest and support are manipulated. The pursuit of a fairer society will rest on the active engagement of those who stand to gain from its realisation, with a wider and deeper devolution of power than Labour has contemplated since its earliest years. Social democratic goals will also change in this process, broadening out from a preoccupation with social justice towards a new regard for the ambitions and concerns of wider, more diverse communities of interest.

Critically, identity politics will matter more than ever before. Britain is more socially liberal than it was in the early 1990s, but there has also been resilience in aspects of culturally conservative sentiment, often alienated by the language of modernity and progress. Too often the centre-left has ceded rather than contested values such as patriotism, family, responsibility, hard work, civility and local roots. These basic expressions of popular common sense not only contain political resources, but are consistent with any definition of social democracy.

Recapturing the conservative aspects of centre-left politics, without sacrificing personal freedoms, would allow issues like crime, defence, welfare and immigration to be addressed with greater intellectual confidence and authenticity. It would widen governing strategies beyond just the state, engaging citizens and associations as partners in a shared project. And it would reach into the right’s electoral strongholds, helping to forge alliances between those thought to be irrevocable divided.

Addressing these intellectual and political challenges is an immensely demanding task. But the prize is a fundamental revisionism of social democracy that can renew its credibility and political appeal for a new generation – a task which hitherto eluded every major social-democratic party.