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Via @IWA_Wales

Eurfyl ap Gwilym and Gerry Holtham are trustees of the Institute of Welsh Affairs

The UK government’s policy of reducing public spending year by year, so-called austerity, has created acute problems for the public sector in Wales.  The policy is set to continue. Its duration and intensity may well be increased by Brexit. A hard Brexit by reducing GDP growth and foreign investment in the UK would reduce tax revenues and require longer spending restraint to achieve the balanced budget the government is targeting.

The imminent devolution of income tax to Wales in 2019 introduces a further risk to the Welsh public sector.  It will make the money available to the Welsh government depend for the first time on how the Welsh economy behaves.  Some 15 per cent of revenue in future will come from Wales’ own taxes, replacing part of the block grant it receives. There are reasons to think Wales could be hit harder by Brexit than the UK as a whole, which implies Welsh tax revenues could fall below the money it was receiving in block grant form.   There are moreover grounds for doubting whether the funds Wales receives from the EU, though guaranteed to 2020, will be replaced thereafter by the UK government. It all adds up to the prospect of a continuing squeeze on public spending.

The UK Context

Official UK data on the total identifiable public expenditure by country in real terms (i.e. after allowing for inflation) shows expenditure in Wales has been broadly flat over the last five years despite an increasing and ageing population. The strategy of the UK Government continues to be that of ‘balancing the budget’ in the near to medium term while not materially increasing taxation: this means that given weak economic growth there will continue to be pressure to cut or at least contain public spending. Expenditure as a proportion of GDP has fallen from a post-financial crisis high of 45 per cent in 2010-11 to 38 per cent in 2017-18 which was also the level immediately before the crisis.

Public Spending in Wales

Looking to the recent past and near-term future Table 1 shows the total Departmental Expenditure Limit (DEL) for Wales in real terms: DEL are firm plans for three years for specific parts of Wales’s expenditure and include health and education.  DEL approximates to the funding available to the Welsh Government from the UK’s block grant. By 2019-20 there will have been a real-terms cut of ~£1bn or 6 per cent over seven years.

Table 1: Total Departmental Expenditure Limit for Wales in real terms (£million).

2013-14
outturn
2014-15
outturn
2015-16
outturn
2016-17
outturn
2017-18
outturn
2018-19
plans
2019-20
plans
15,960 15,987 14,928 14,768 15,114 14,936 14,951

The further future

Austerity is not likely to end in 2019-20.  Paul Johnson, IFS director and an author of a report published in May said: “Leaving the EU would most likely increase (UK) borrowing by between £20 and £40 billion in 2019–20. Getting to budget balance from there, as the government desires, would require an additional year or two of austerity at current rates of spending cutsâ€�.

In any case from 2019-20 onwards the DEL will not tell the whole story.  Some 13 per cent of the spending is supposed to come from Wales’ own income tax revenues.  In the event of a hard Brexit, these will be affected and probably by more than tax revenues in England. Given the uncertainties it is very difficult to quantify the effect but let’s throw caution to the winds and try to establish a ball-park .  The National Institute of Economic and Social Research and HM Treasury estimate in the case of a hard Brexit that UK GDP could be over 7 per cent lower in 2030 than it would otherwise have been. The direct trade effects on UK GDP are estimated by NIESR at -3.2 per cent, with other effects like reduced inward investment and reduced migration accounting for the rest.  Yet whereas 48 per cent of UK exports went to the EU, for Wales that proportion has been 67 per cent in recent years. If the percentage fall in those exports were similar in Wales as for the UK, the direct trade effect on Welsh GDP would be greater – over 4 per cent. Moreover. that is just direct exports but much of Welsh production goes to England and is incorporated into exports from there.  This effect is likely to be of the same order of magnitude as direct exports, perhaps another 3 ½ per cent. It is impossible to quantify the indirect effects stemming from reduced inward investment but on a range of plausible assumptions about such things it is possible to generate an overall effect on GDP easily into double figures.

If such an outcome were to arrive (and it is a big if), Welsh income tax revenues would behave like GDP.  Instead of growing at 2 per cent a year as Welsh GDP averaged this century up to 2016, they would average growth of under 1 per cent in real terms.  Meanwhile the block grant, after stagnating to 2022 if the IFS is correct, would grow at just 1 ¼ per cent for the rest of the decade. Overall resources available to the Welsh government would grow at only 1 per cent on average through the 2020s.  Precise numbers are speculative but a picture of resources growing slowly is likely, given Brexit and very likely given a hard Brexit.

Furthermore, Wales gets some £650 million a year from the EU, mainly in regional development funds and agricultural support.  The latter goes directly to farmers but the former, some £375 million, supports capital spending by the Welsh public sector. The UK government has guaranteed these supports will continue until 2020 but has given no guarantees thereafter.  No doubt there will be British government schemes of regional and agricultural support but it is highly unlikely that Wales will get the same share of those as it does of EU funds coming to Britain, which are allocated according to assessed need.  David Phillips of the IFS has calculated what would happen if the UK government devoted similar money to agriculture and the regions but allocated it according to the Barnett formula. Even if the overall allocation rose by 2 per cent a year, the money coming to Wales would fall by 1 per cent a year through the 2020s and by 0.5 per cent through the 2030s.

All in all, there is a risk that the growth of government revenues in Wales could be very slow in the next decade, particularly in relation to the needs of an ageing population. Practically, four sorts of response are possible:

  • Withdraw government from some areas in order to concentrate spending on doing essential things as well as possible
  • Find ways to raise public services’ productivity so more can be done with less money
  • Increase revenue by charging for public services that have been free, raising rates on existing taxes or introducing new taxes
  • Find ways to accelerate economic growth over a reasonably short time period in order to increase the tax base.

The third option would be unpopular but may be inevitable if the electorate wants a good standard of health, education and social care provision.  There is a limit, however, to how far a small, highly open economy like Wales can raise tax rates above those of its neighbours without losing business and higher-rate taxpayers.  The fourth option is very difficult to achieve and impossible to do so in the short-to-medium run without taking risks. What about options one and two?

Scope for Savings

In looking for potential savings in expenditure a comparison between relative spending levels across the countries of the UK may suggest areas of potential savings. However, no broad category of public spending in Wales stands out like a ‘sore thumb’ when compared with the other countries of the UK. It follows that if economies are to be sought then the Welsh Government needs to look in greater detail at expenditure within the major spending programmes.  Spending on health has been rising and with social care now accounts for almost half the total Welsh budget.  Given the demands of an ageing population the risk is it will soon swallow more than half. It is within this area that efficiencies most urgently need to be sought.

One factor worth analysing in greater depth is the much higher proportion of people in Wales who are employed in the public sector. In March 2018, 22.3 per cent of employees (308,000 out of 1.381 million) worked in the public sector in Wales compared with 16.6 per cent in the UK. If the level in Wales was the same as that of the UK there would be 78,000 fewer people employed in the public sector. With greater needs for public expenditure in Wales than in wealthier parts of the UK it is natural there would be a greater need for public-sector employment. Still, the numbers raise the question: could better organisation allow a reduction of bureaucracy with more of the workforce being employed on front-line services?

All articles published on Click on Wales are subject to IWA’s disclaimer.

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