Roughly half of all the money spent is in the public sector, and half in the private sector. Around one fifth of all the public money spent is borrowed. The other fourth fifths comes from taxing the private sector.
Most people now agree we cannot carry on borrowing at the rate we are to pay for all that extra public spending. There are two choices on how to stop the borrowing. The first would be to cut spending. The second is to take more tax from the private sector.
The Coalition government has ruled out cutting the amount we actually spend on the public sector – indeed, they want it to go up a little over the next five years. This is presented as cuts, because it entails cutting previous plans to increase spending. In a few areas it entails actual cash cuts, and in more areas cuts after allowing for general inflation. Bad management or politically inspired management will ensure there are some unpopular cuts in some areas. In other preferred programmes like overseas aid, EU contributions, health and pensions it entails real increases. In an area like Health because the increases will be much smaller than the service is used to, there could well be tensions.
That means that all the reduction of the deficit is planned to come from increased tax revenue. Some is going to come from increased tax rates. The government has put in place or confirmed higher rates of Income Tax, VAT, fuel duty and others, and has lowered Income Tax thresholds for higher rate tax. The bulk of the required increased tax revenue is forecast to come from the proceeds of growth.
This simple arithmetic will dictate the politics of the next few years. The squeeze will be most intense on the private sector, as it struggles to find all that extra tax revenue and faces those higher tax bills. Nonetheless the public sector will feel hard done by, as the contrast with the spend and borrow more years will be sharp.
All rests on growth. If the economy starts growing at above its trend rate of growth and sustains that until 2015 the strategy will succeed. If growth continues to disappoint, and it turns out the government has not done enough even to recreate the old trend rate of growth that was so damaged by the experiences of the last few years, the deficit will stay obstinately high. Getting to an above average rate of growth with badly regulated banks and with a rising tax burden is not going to be easy.
The sad truth is we all have to take a hit as the country stops living 10% beyond its means. The current plan is the private sector takes more of the hit. That’s why the Governor of the Bank of England made such a gloomy speech about real incomes last week. If the private sector hit is too big the recovery will be weakened.