The Institute for Fiscal Studies (IFS) has launched its annual Green Budget report, setting out its views on the prospects for the economy and the public finances ahead of the Spending Review and Autumn Budget scheduled for 27 October 2021.

Produced in conjunction with Citi and the Nuffield Foundation, the 427-page report contains detailed chapters on the global and UK economy, the economic and fiscal outlook, the Spending Review, fiscal rules, NHS spending, local government funding in England, tax policies to achieve net zero, and employment and the end of the furlough scheme.

A summary of the key findings in each chapter is set out below, but the key headlines are that COVID has damaged the economy, the fiscal outlook is better than predicted in March but still much worse than pre-pandemic forecasts, and the Chancellor has some very difficult spending choices to make in the Spending Review. 

The IFS cautions that the new health and social care levy will not be sufficient to meet medium-term cost pressures and that ‘unprotected budgets’ continue to be under severe strain, with cuts possible if the Chancellor wants to meet his proposed new fiscal rules.

More detailed analysis goes into spending by the NHS and local government and the implications of net zero for tax policy. A final chapter highlights the mismatch between those losing their jobs and vacancies in a very different employment market following the end of the furlough scheme.

Alison Ring, Director for Public Sector and Taxation at ICAEW, commented: “As ever, the IFS have produced one of the most authoritative analyses of the state of the UK public finances, setting out many of the difficult choices facing the Chancellor in the Spending Review and Autumn Budget.

“The challenge for the Chancellor will be how to address severe spending pressures across central and local government and deliver on ‘levelling up’ and ‘net zero’, at the same time as repairing the public balance sheet and charting a path towards sustainable public finances.”

IFS Green Budget 2021: key points

Citi says the global economy is recovering:

• Pandemic is not over, but economies are resilient and rebound can become a recovery
• Supply constraints will restrict growth and higher inflation is likely for some time
• Risk of fiscal tightening is low and central banks likely to be cautious in exiting monetary support

Citi expects UK economy to be 2.5% smaller in 2024-25 than pre-pandemic forecasts:

• UK in an imbalanced recovery with fading growth in the winter
• Profound economic adjustment looms (e.g. less hospitality, more transport and storage). 
• Brexit leading to supply disruptions and a drop in exports
• Labour market in process of adjustment, but despite shortage sectors, real-terms pay settlements overall remain broadly in line with pre-pandemic range 
• Inflation increasing sharply – should be temporary, but there is risk of a wage price spiral
• Monetary policy constrained, so fiscal capacity needed to stabilise the economy.

IFS says economic and fiscal outlook is better than predicted in March, but still much worse than pre-pandemic forecasts:

• Deficit in 2021-22 to be £180bn, over £50bn below OBR Spring Budget forecast
• At 7.7% of GDP deficit remains extraordinarily high – the third highest deficit since WWII
• Recovery should see current budget be in surplus by 2023-24
• Upside scenario would see overall deficit eliminated
• But further lockdowns could see borrowing more than double pre-pandemic forecasts in 2024-25
• Central scenario would see public debt start to fall, but only gradually
• Higher interest rates and inflation have increased debt interest costs to around £15bn a year more than expected in March
• Health and social care levy will need to increase from 1.25% to 3.15% by end of the decade to meet expected health and social care pressures

Fiscal rules are needed, but:

• Well-designed fiscal rules can help make it harder to borrow for ‘bad reasons’
• UK has had poorly designed fiscal targets, with 11 new rules in the last seven years - most of which have been missed before being dropped
• Both Conservatives and Labour appear to favour a current budget fiscal rule
• Strong case for gilt-issuance to be tilted towards more long-dated index-linked gilts to lock in the current low real cost of more debt
• Reducing debt should be a long-term target to create more fiscal space for potential future adverse shocks
• Health, social care and state pensions likely to add 6.1% of national income to costs by 2050
• Net zero costs likely to peak in 2026-27 at 2.2% of national income
• IMF says UK has lowest general government net worth of 24 advanced economies
• A broader focus on wider public balance sheet by government and opposition is welcome
• Fiscal rules should be seen as rules of thumb and no fiscal target is sacrosanct

Spending Review 2021:

• Chancellor faces unpalatable set of spending choices, despite manifesto-breaking tax rise
• Spending envelope is £3bn a year smaller than pre-pandemic plans, which is a problem when 64% of departmental spending is already protected or otherwise committed
• Potential cuts in unprotected budgets such as local government, prisons, further education and courts of £2bn in 2022-23
• More spending room in 2024-25, so potential for Chancellor to re-profile spend to avoid cuts next year with spending more overall
• NHS and other demands likely to eat into amounts available for unprotected budgets.
• COVID-19 reserve needed to cover non-NHS virus-related spending
• Now is time to return to certainty of multi-year budgeting
• Extending public sector pay freeze risks damaging recruitment, retention and motivation

Pressures on the NHS:

• NHS already showing signs of strain before pandemic began, with last decade seeing lowest level of spending growth in NHS history
• NHS entered pandemic with 39,000 nursing vacancies and many fewer doctors, hospital beds and CT scanners per person than in many similar countries
• NHS funding plans blown out of water by pandemic, with extra £63bn spent in 2020-21 and £34bn in 2021-22
• Extra funding needed in the next three years of £9bn, £6bn and £5bn – substantial, but manageable, sums. Covered by new health and social levy initial for first two years
• New funding unlikely to be sufficient in the medium term, with extra money needed from 2024-25 onwards
• Missed treatments, bringing down waiting lists, demand for mental health services and higher pay all likely to add to spending pressures
• Some savings from moving to remote outpatient appointments and potential for more from other innovations in the pandemic

Local government funding in England:

• English councils’ non-education spending almost a quarter lower than 2009-10. 
• This contrasts with Welsh councils, where spending has fallen by only a tenth
• £10.4bn in additional funding in 2020-21 covered most in-year COVID-19 pressures
• But mismatches mean some councils are ‘over-compensated’ while district councils are ‘under-compensated’
• COVID-19 funding in 2021-22 of £3.8bn expected to be £0.7bn short of what is needed
• Central government funding currently implies council tax rises of 3.6% a year assuming no further impact on budgets from COVID beyond next April
• Uncertainties mean that setting firm plans for council funding for the next three years is an impossible task without guarantees from central government
• Social care funding still allocated based on local populations in 2013 and the delayed ‘Fair Funding Review’ needs to be completed
• For example, Tower Hamlets’ population is up 21%, Blackpool’s is down 2%.
• Transition to new system of funding may need extra money to avoid potentially large cuts in some areas
• Council tax needs reform!
• More devolution on the agenda – government should develop ‘devolution packages’ rather than have bespoke arrangements for each area
• Additional £5bn of health and social care levy funding for adult social care is unlikely to be sufficient – an extra £5bn a year could be needed by the second half of the 2020s

Tax policies to achieve net zero:

• Greenhouse gas emissions fell 38% between 1990 and 2018, the fastest in the G7
• Emission reductions will have to accelerate from 1.4% a year to 3.1% a year to meet net zero in 2050
• Many low-cost opportunities to reduce emissions already done, so further reductions will be more difficult
• Tax rates on emissions vary wildly, so incentives to reduce emissions are highly uneven
• Renewables attract subsidies paid for by higher electricity prices – may pay-off in long-term but there are risks
• Carbon footprint higher for higher-income households, but costs take up a bigger share of poorer household budgets
• Weak incentives to improve energy efficiency
• International collaboration needed, eg on taxing international aviation

Employment and the end of the furlough scheme:

• Furlough scheme ended in September at gross cost of £70bn
• Huge success, but significant challenges remain in the labour market
• Significant concerns about the employment prospects for the 1.6m on furlough in July
• Vacancies exceed 1.0m, but mismatch between regions and industries
• London appears hard-hit on multiple fronts
• Young people leaving full-time education last year were less likely to get jobs, but employment rates have since fallen back into line with pre-pandemic cohorts

Visit the IFS website to find out more about the IFS Green Budget and to download a copy.