The positive case for balancing the books

“We all know what to do, but we don’t know how to get re-elected once we have done it.”― Jean-Claude Juncker

Zoso Davies, a credit strategist and Hartej Singh, a Credit Investor write a four-part series arguing that balancing the books should be the UK government’s number one priority. With living standards, immigration, climate change, and choppier geopolitical waters dominating national discourse, this may seem blinkered. We firmly disagree. In our view, the very ability to live well, invest in our future, and defend ourselves depends on the credibility of UK PLC. As stewards of long-term savings, we feel a personal responsibility to make this case.

These are our personal views and not the views of any institutions we are affiliated with.

The flow of our 4-part series

1. Why it matters now: Sound public finances underpin living standards Britain balancing its books part 1

2. What’s broken: More promises than productivity Britain balancing its books part 2

3. The moral case: Betraying our values? Britain balancing its books part 3

4. How to fix it: Efficiency, transparency, growth and credibility. Today’s blog.

When governments lose control of their finances, citizens pay the price: after Greece’s debt crisis, average incomes fell by around 25%. Lasting prosperity rests on sound public finances. Closing the fiscal gap must be priority number one.

A lack of willingness, not a lack of insight or ability

Across our series on UK finances, we have laid out our perspectives on the challenges that the UK faces. Our nation is blessed with an embarrassment of riches when it comes to sound, broadly-supported, economic and tax recommendations from institutions such as the Tax Policy Institute, Tax Reform for Growth, the Institute for Fiscal Studies, and so on. Therefore, our imperative is not to polish a list of possible policy interventions, but to make clear that the risks of not acting decisively vastly outweigh the danger of imperfect actions.

The challenge is every policy creates winners and losers and people who lose tend to be louder and more energised than beneficiaries – particularly if they are widely dispersed. In part 2 of the series, we highlighted the lack of willingness to tell current beneficiaries we need to change course, and in part 3 the lack of willingness within the electoral system to truly live up to our values.  

The key threads

Grasping the nettle is the way we get through this and come out the other side not just surviving but thriving. This will not be the first time an economy has faced overspending and sluggish growth, several Southern European economies have made progress on these exact same challenges in the last decade.

But we need to win the argument for acting immediately: democratically and through our elected officials, by demanding and voting for the change that is needed and that is right. Indeed, we have already seen movement on many of these issues from the current government in the time since we started writing, suggesting that our instincts are not far off the mark.

Our north star is economic prosperity, and this starts with closing the fiscal gap. It requires measures to reduce long term costs and to better direct spending, in ways that take into account the second order and long-term impacts. It requires aiming to make sure we are in a much better situation 20 years’ time, rather than trying to maximise each 1yr period.

The key principles we will follow are 1) the big cultural change needed – a national labour policy 2) deregulation, 3) cutting spending and inflation linkage 4) investing in the future 5) tax reforms that have low growth impacts, 6) Considering what might central bank co-ordination look like.

1.       Labour strategy – being productive

The proportion of workers in our society continues to decline. More of us are retiring or are unable to find full-time employment, perhaps because of disability. Some of this gap is being filled by foreign workers.

Critically, all parts of this equation are happening without any direction. There is no top-down mandate to get people into work, nor is there a flexible free-markets approach. When you add all the taxes, benefits, workers rights and relatively static pension age, we have a situation where it is both expensive to hire people and not that beneficial to take entry level jobs.

The UK needs a labour strategy. Our two pillars of the labour strategy are 1) building our homegrown working age population and skillset and 2) better pricing the benefits of migration.

Growing the productivity and size of our working age population

Something unusual is happening in the UK, the number of people claiming working age health-related benefits has increased in a way unlike any comparator countries.

When you drill down into the various drivers, most of the increase is coming from mental health-related issues, which  have increased significantly since 2020.

Like many big moves in statistics there are always many confident yet opposing answers. For some this is evidence of an underfunded mental health service, to others, this is about gaming the system. Either way, given the risks of long-term unemployment, leaving those with mental health challenges without a plan to get back to work, is an economic and social failing.

Institute for Fiscal Studies (Health-related-benefit-claims-post-pandemic_3_1.pdf)

Having British workers at home sick hits society on three fronts: public finances, skills, and health. On public finances it is estimated that working age sickness costs over £100billion per year (lost tax, higher welfare spending and extra health and social care costs). On the skills front 131 million working days lost annually with those out of work suffering measurable “scarring” effects, leading to reduced earning potential later - estimated at 10–15% of lifetime earnings. Unemployed individuals also have a 63% higher risk of death from all causes than those in work; and UK survey data show that unemployed adults are 50% more likely to report poor mental health, versus those in employment. The fact that so many young people are contained within these numbers makes it particularly worrying, putting their life’s potential at risk.

Given the strong personal and social benefits of people working, it would be rational for the tax and welfare system to be set-up in a way that “makes work pay”. However, our benefits and taxation system economically disincentivises recipients from taking entry level jobs.

The benefits system contains a cruel trap that is increasingly hard to escape. When people return to the workforce there are sharp withdrawals of certain cash benefits. Returning to work might result in people losing their PIP eligibility and similarly, Universal Credit is tapered such that returning workers can face a marginal rate of tax approaching 70%.

Focus 1: Remove the benefits trap. Remove the sharp taper such that working more pays well and ensure every person on health-related benefits has active support to get back into work.

Better align higher education with skill shortages

Whilst the debate on the “value” of higher education rages on, UK business has consistently argued that there are persistent skill gaps that either higher education or mid-career education could help with. Construction, adult social care, nursing, teaching, cybersecurity and laboratory technicians are areas that consistently need more skilled workers.

It seems both unwise and unfair that universities degrees require considerable resources in terms of cash out of the door and time (opportunity cost), but can still leave people with skills that are not likely to improve their earnings potential.

In our view, for many people it would be better to join the workforce through apprenticeships or mid-university placements. This accrues both specific skills/trades and also the meta-skills of working (be on time, follow through on tasks, operate as a part of a team, learn on the job). It needs to be more accessible for vocational learners to obtain qualifications during their career, when working towards a specific promotion or career shift. This is not about stymying ambition, but aligning skills with opportunities.

Focus 2: Train UK citizens to fill our persistent skill gaps, support industry-led apprenticeships and vocational training.

Making our pensions age sustainable

The workforce is not just limited by spiralling health related inactivity. The retirement and pensions age has decoupled from our lifespan. Curtailing our working lives with so many healthy years ahead, has significant public finance and societal impacts. To illustrate just how far retirement and longevity has decoupled, in 1948 when the pension was introduced, less than half of men would survive to the pension age of 65. Today over 85% of citizens survive to 67. For a country struggling with growth, having such a large population out of the workforce is unaffordable.

As a society, we will need to work a little (perhaps 2 years) longer and policy should support those who are still able to keep contributing their skills and knowledge in the workforce – particularly in roles that are not physically demanding. This would have multiple benefits for society. 1) It would increase the quality of life that can be enjoyed during retirement, due to higher pension savings 2) It would keep older people active for longer and connected to both the mental challenges and social connections at work 3) It would benefit the workplace with people who bring decades of cultural capital.

Focus 3: Increase the pension age by at least 2 years over time. Incentivise employers and support employees to make this happen.

Price immigration costs and benefits properly

What is the role of immigration? Each government over the last 15 years has pledged to curb it, but it has risen rather than fallen. Whilst illegal migration steals the headlines the bulk of immigration has been through legal channels – in particular the migration of families and dependents.

A robust economy needs to attract the most valuable global skills. But for this to be enjoyed and to maintain public services, an appropriate costing for building out public services needs to be allowed for. The UK has benefitted from immigration to fill the skill gaps identified above, but in our opinion not appropriately considered the costs to provide public services to them and as illustrated in the chart on the right, their dependents.

To use some heroic simplifications the UK government spent approximately £34,750 per worker in 2023/24. Given that around half of all government tax revenues come from NICs and Income tax, that suggests that “skilled worker” visas should be for jobs paying more than £70,000 per annum in order to reach the tax “break even” of £17,500 . This will be challenging for service employers, but we can see there is some slack in the system: we can get a cab in 1 minute, we can get our food delivered in 30mins. If additional people are coming to the country to fulfil those needs, their tax will not meet the threshold. We acknowledge that the NHS and teaching will find this challenging and that is where the harder decisions will need to be made.

Focus 4: Reshape migration, focusing on the most valuable skills – as evidenced by high wages.

2.       Deregulation: Unleashing progress

Regulation is an essential activity – it protects us from dangerous behaviours and poor-quality goods. It makes the economy more efficient, as consumers don’t have to inspect every apple that they buy to ensure it is safe to eat. Anyone who has tried to choose a builder will understand that transparency and standardisation lead to better outcomes!  

Regulation is not a free lunch though. It increases costs, reduces supply, and if complex, can require an army of specialists. The Building Safety Regulator has become such a bottle-neck that construction has almost halted in London, despite the desperate need (and market demand) for said housing. We think that in recent years the UK has, in many areas, passed the point at which the benefits of regulation are outweighed by the costs. Those costs are borne by society.

LSE research estimates that England’s planning policies have added around 35% to the cost of housing. Wordy applications, disconnected stages, inconsistent outcomes and delays increase construction costs and reduce the profit motive for people to build housing stock. The Institute for Government flagged that the UK’s housebuilding ambitions should be consistent with other policy objectives and it should prioritise national housing targets over local objections.

Housebuilding, housing regulation, natural conservation and local objections trade-off. The unwillingness of governments to pick a priority is leading to paralysis. This is where our north star, growth and fiscal stability, leads us to conclude that housebuilding should be the preference. Policy should signal the desired direction of travel. Examples that could get things moving again could be i) making local housing targets binding ii) make regulatory processes time-limited, iii) have a standardised set of conservation rules.

Likewise, we should fast-track nationally significant infrastructure projects (NSIPs): Time-limit examinations and fast track consents. Have specific time-limited objectives to build certain infrastructure in law. For critical energy infrastructure like offshore wind, establish off-the-shelf compensation methodologies to avoid individual negotiations.

Policy 5: Reduce the red tape on infrastructure, and homebuilding

3.       Cutting spending and reducing inflation linkages

A key part of financial anti-fragility is the ability to grow revenues somewhat independently of costs, creating the potential to close fiscal deficits. But 2022-24 demonstrated that the UK has high levels of effective indexation in the economy. This is problematic. It reinforces inflation and severely constrains the government in other spending. Mechanisms such as the pensions triple lock, minimum wage, public-sector wages and the index-linked gilt market not only track inflation – they drive it.

Because of these interlinkages, the UK has lost an important lever in cost control which is the ability to suppress real costs through inflation. Societally these indexation mechanisms create groups who are insulated from the health of the economy. But the sustainability of policy is driven by revenues (tax receipts) rather than prices (inflation). And with the minimum wage rising faster than inflation, but median wages not keeping up, there is wage compression occurring at the lower levels – further increasing the challenge of making entry-level jobs economically rewarding.

Focus 5: Halt non-contractual indexation for a few years e.g. 2, to reduce costs without a cliff edge.

Beyond simple indexation, there is a broader need to tackle the absolute level of spending. Each spending measure, we are sure, seemed sensible at the time, but 1000 sensible measures might not work together.

The measure that seems most obvious from a cost perspective is to make sure that only those who need it are getting benefits. The most controversial but ultimately the most yieldy in our opinion would be to means test all benefits including pensions, winter fuel allowance and TV licences. Nothing else comes close in terms of quantum.

Focus 6: Means test benefits

4.       Invest in the future

With our fiscal prudence hat on, the Chancellor’s instincts are correct in aiming for day-to-day spending be fully covered by tax receipts. Any debt taken on should, in our view, only be done to finance growth – i.e. it should be for public investment.

Spending control is not just about quantum but also direction. Our read is that too much government spending is in the form of subsidies, aiming to goad the private sector into doing things it otherwise would not – such as subsidies for renewables.

Subsidising uneconomic investment has a lower multiplier and a higher risk of failure – the UK’s energy policy is a stark example. With heavy subsidies, it might be assumed that UK power prices would be low at the point of consumption: instead the UK has one of the highest electricity bills in the whole world.

Instead of subsidies and tax breaks, the government should, in our view, be more like an accelerator for capital-constrained sectors of the economy – i.e. those things that the private sector wants to do, but that might be deemed risky or find hard to finance. A tried and tested model around the globe is investment banks such as KFW and EIB. The cost to the government is very low as they only contribute a small amount of paid in capital, alongside uncapitalised (often implicit) guarantees. As such we think the government’s goals with the National Wealth Fund is correct, but the proposed scale is too small. It should also be explicitly focused on boosting growth.

This could also open the door to sharing in the upside through equity investments – more like joint ventures.

Focus 7: Redirect energy and other policy to achieve overall better outcomes. Look to replicate successful investment bank models from around the world.

5.       Tax reform – be bold, not extreme

The genuinely cross-party tax reforms have consistent recommendations. People are converging on what they believe to be right, but the measures are politically challenging. We argue the role of politicians is to create good societal outcomes by making the hard decisions, however fanciful that might sound.

An obvious place to start is property taxation. Both Council Tax and Stamp Duty are badly misaligned with the distribution of house prices and therefore wealth. Reform would include restriking valuations, cutting moving costs (SDLT), and making property taxation more reflective of the value of property owned than the number of times you move house.

Source: IFS, Tax reliefs: look for the tax design behind the big numbers | Institute for Fiscal Studies 2017/18

Turning to reliefs, pensions tax relief encourages exactly the behaviour we want – long-term saving. However, as fiscal measures go, this is an expensive subsidy - allowing relief above the lowest band is now inefficient. We are effectively paying people (often to move capital offshore into foreign equities) in a tax-advantaged form, when fiscal space is scarce. If we are prioritising along a hierarchy of ideas, cutting higher-rate relief and standardising pension relief at 20% moves up the list. Another relief that costs a lot is the VAT on zero-rated items. If this were to move to 5% there would be significant money raised.

There also seems to be lots of well-paid tax “efficiency” advisors. Aggressive tax avoidance is profitable. We should be willing to reward firms that identify loopholes and help close them with a share of the additional tax take. Some tax avoidance occurs through complex loans which has the impact of reducing income and therefore tax. Capping the tax deductibility of interest costs to only a small portion of revenues will help avoid that.

With humility we realise that there might be many smaller measures that might also work, the key point here is that there is no shortage of technically sound options. The constraint is not policy imagination, but political will.If those measures are insufficient then a straightforward 1% increase in income-tax with extended freezes on the thresholds by 2 years would be easy to communicate, administer and would yield a material, broad-based tax take.

Focus 8: Fix property taxation, reliefs and tax avoidance. Use income tax to raise revenues in an open and honest way rather than burying tax raises in a number of cubby-holes.

6.       Unorthodox BOE policy – a tough choice

In a surprise policy announcement soon after Tony Blair was elected Prime Minister in 1997, the Blair government granted the Bank of England full operational independence. This thirty-year experiment has come to feel like a permanent and proper state of things. The challenge is, that when the government debt loads and government spending is such a large factor in the monetary workings of things, are they truly independent?

In one of the most surprising (for us, at least) recommendations from Ray Dalio’s book “How Countries Go Broke”, his recommendation was to reduce the effective Central Bank rate, even lower than the current independent body might set. This unorthodox move is brought about by a clash of two important but now opposing things: 1) can the government repay its debt and 2) is the monetary policy independent and effective. With 1) so clearly the highest priority we agree with Dalio’s arguments that it is less risky than it might first appear: Firstly, if there are spending cuts and tax rises, demand is likely to be softer. Secondly, a large government cost is servicing interest on the debt load and funding the QE balance. These two conditions both call for a loosening of interest policy but would risk weakening the currency. It is a balancing act, but would release some strain through this measure. Although it is a finely balanced argument, overall, it’s something worth considering in conjunction with broader policy adjustments.

A softer version of this would be to readdress the issue of the Bank of England’s Asset Purchase Facility and how that interacts with government finances. The Bank of England is the only central bank undertaking active QT (sales of government bonds) and this hurts the government, both by crystallising losses where bonds were purchased below par and by driving up the cost of new borrowing by putting a thumb on the scales of supply and demand.

Focus 9: Lower the BOE interest rate if and only if the hard yards have been done on the fiscal gap.

So what?

The UK enjoys deep and largely untapped resources in policy analysis and macro-economics. There is simply no shortage of strong, well-founded ideas on how to improve the vigour of the economy through realignment of tax and spending, a proper cost-benefit analysis of regulation, and government led investment that could add both economic and social value – including government led construction of social housing. What is lacking is the willingness to take our medicine.

We believe that is a strong argument to step away from the details and to prioritise the bigger picture. Any individual project for housing, or infrastructure, or tax changes will inevitably meet resistance from special-interest groups. These can ONLY be overcome by accounting for the larger benefits to society as a whole. Put simply, you can’t make an omelette without breaking eggs.

Likewise, when it comes to construction local objections should be subordinate to national priorities, they should not override them. The financial stability of the UK government, which threatens us all, must be held as a higher priority than the potential for individual hardships in edge cases – which in any case can often be mitigated.

In particular, we believe the UK needs a holistic labour policy – one that can properly trade off the pros and cons of workers’ rights versus employment, social safety net versus the benefits trap, immigration versus wage suppression, skills training versus skills shortages and so on. The current government calls itself the Labour party – we challenge them to step up and to build policies to support the people building Britain’s future, not just with pay rises for the public sector but with a cradle-to-grave vision of how citizens can be rewarded for their labour.

We also believe that the UK needs a holistic investment policy – for construction, infrastructure, and research and development. We believe that if the government itself were to become invested in investment, becoming a home builder or entering into joint ventures, then its incentives to balance the pros and cons of regulation would be better aligned than they are today where the government is positioned primarily as a champion for opposing corporate interests.

More than anything, we conclude our thoughts with our belief that the UK has the potential to overcome these challenges. We have the insights. We have the intellectual capital.

What we need is simply the will to do what we know is right, not for today, but for tomorrow and thereafter.

Thank you