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May 10, 2010

UK Election Special

by Richard Hughes

Last Thursday’s general election in the UK took place against the background of the UK’s largest fiscal deficit since the Second World War. The result was a “hung Parliament” in which none of the country’s three major political parties won a majority of seats in the House of Commons. The weekend has seen marathon meetings between the David Cameron’s Conservatives (or “Tories”) , Nick Clegg’s Liberal Democrats (or “Lib Dems”), and Gordon Brown’s Labour Party, but there are no decisions as yet about who will be forming a government. So what do the various political combinations and permutations mean for how the UK will go about reducing what is forecast to be largest fiscal deficit in the EU this year?

Timing and pace of fiscal consolidation: While this was a major theme and “dividing line” in the campaign, there is actually relatively little difference between the parties. Over the medium-term, the Liberal Democrats have promised to halve the deficit by 2013 while Labour say they will do the same by 2014. For their part, the Conservatives promise to eliminate “the bulk” of the deficit by 2015. If there is any real difference between the parties it is about when to start the consolidation process.  Labour have committed to stick to the three year spending plans they set out in 2007 while the Tories want to cut 5bn from public spending starting in 2010.  The Lib Dems fall somewhere in the middle with a promise to introduce a fiscally neutral “emergency budget” in June which pays for an increase in the personal tax allowances with cuts to middle class tax credits and welfare benefits.

Where the ax will fall: None of the parties have provided many details of how they plan to deliver the promised reduction in the deficit. The Lib Dems have gone the furthest in setting out a costed program of tax rises and spending cuts. Labour has focused more on the areas they plan to protect by promising to grow hospital, schools, childcare, and policing at least in line with inflation and paying for those through a cap on public sector pay and pensions and unspecified “efficiency savings.” The Tories have focused instead on the areas where they are prepared to cut which includes the more generous elements of the child benefit system and the Regional Development Agencies set up by Labour.

Wither the UK’s fiscal rules: The Labour Government had already abandoned their much celebrated Golden Rule and Sustainable Investment Rule shortly after the onset of the crisis in 2008. They were replaced in early 2010 by a new Fiscal Responsibility Act which gave legal force the government’s commitment to halve the deficit over the next four years. The other two parties have expressed little enthusiasm for introducing their own fiscal rules but nor have their vowed to repeal the new Act.

A new fiscal council for Britain?: The Conservatives and Liberal Democrats have looked instead to new institutions to restore the UK’s fiscal credibility. The Tory manifesto calls for the creation of an independent Office of Budget Responsibility charged with conducting a comprehensive audit of the government’s liabilities and producing an the macroeconomic and fiscal forecasts that underpin future budgets. The Lib Dems favor a new Council on Financial Stability comprised of all political parties, the Governor of the Bank of England and the Chairman of the Financial Services Authority to agree on the scale and timetable for fiscal consolidation.

Electoral arthmetic vs. fiscal arithmetic: What does the lack of a decisive victory for any parties mean for any new government’s ability to deliver the largest fiscal consolidation in a generation? The conventional wisdom says that hung parliaments are less able to consolidate because the governing party is forced to “buy” support from other parties by protecting them from the pain of adjustment. However, as discussed in a recent blog by Joachim Wehner at the London School of Economics, the resulting form of government seems to make all the difference. While minority government are associated with higher fiscal deficits, coalitions appear to just as effective as majority governments in delivering successful fiscal consolidations. The explanation for latter may be that the process of negotiating a coalition agreement forces the various partners to confront and commitment to painful decisions about priorities at the outset and raises the political costs of any of them defecting from the agreed plan once it begins to bite.

Note: The posts on the IMF PFM Blog should not be reported as representing the views of the IMF. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy.

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