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The First Thatcher Squeeze

The 1979 election produced an overall majority of forty-four for the Conservatives, who had promised the voters 'substantial economies' in public spending, to be achieved among other things by scrapping 'expensive socialist programmes' like land nationalization and outsourcing the work done by heavily-unionized direct labour organizations in local government.[1] [2] The

Conservatives also promised a switch from taxes on earnings to taxes on spending, with cuts in income tax at all levels, including the topmost rates and the tax surcharge on income from savings and investment. (The Liberals also campaigned for income tax cuts in the 1979 election, proposing a basic rate of 20 per cent and top rate of 50 per cent.)

The Conservative manifesto also reflected a commitment to 'monetarism' in the form of targets for limiting the growth of the money supply by restricting public and private debt. Such targets had been adopted in effect under the previous Labour Government, and indeed that approach is traced by some scholars back to the late 1960s, contrary to the view that monetarism only appeared in the Thatcher era (Davies 2012). But the process of setting and applying those targets was now formalized, elaborated in new arcane jargon and reflected acceptance of monetarist doctrine by some leading Conservatives, including Sir Keith Joseph and Margaret Thatcher.

Monetarist concerns to limit government borrowing (Miller (1981)) meant more pressure to apply fiscal squeeze, albeit through a justification different at least in detail from the pre-World War II ideas about balanced budgets that were discussed in Chapters Three and Four (Neild (2012)). And the higher interest rates that were another part of the monetarist medicine in the early years of the Thatcher Government also pushed up public spending by increasing the costs of debt servicing, as well as constituting an element of non-fiscal austerity.

Those 1979 election promises to cut spending and taxes had some resemblance to the 'set the people free' platform on which the Conservatives campaigned in 1951, as described in Chapter Six. And there were other parallels with the early 1950s. Like its Conservative predecessor of 1951, the Thatcher Government comprised many ministers who had been in the 1970-74 Heath Government only five years earlier and who could draw on what they had learned from that experience in a way not open to those governments with little previous ministerial experience, for example in 1924, 1997, or 2010. Also comparable with the early 1950s was the fact that the new government's fiscal stance was affected by several 'post-dated cheques' left by the previous Labour Government in the form of catch-up public sector pay settlements (which the Conservatives had promised to honour in their 1979 manifesto, and which sharply pushed up the public sector pay bill between 1979/80 and 1980/81). Moreover, as with the early 1950s, the Labour opposition was divided, partly in consequence of ongoing conflicts associated with the 1976 fiscal squeeze.

But there were also differences between 1979 and 1951. At forty-four, the Conservative Government's parliamentary majority was much larger than in 1951 and the Labour opposition was arguably more divided. As mentioned in Chapter Seven, whereas the split between the Bevanites and the Gaitskellites originating in the battles over spending cuts in 1950/51 had been contained within the Party, the 1980s were more like the 1930s for Labour in that the divisions led to the formation of a breakaway Social Democratic Party, set up in 1981 by four ex-Labour ministers disaffected with what they saw as excessive domination of the Labour Party by the far left. Twenty-eight Labour MPs (and one Conservative) eventually defected to the new party, which scored dramatic victories in two by-elections in 1981-82, formed an electoral alliance with the Liberals, and deeply split the left-of-centre vote.

Further, the economic background after the 1979 election differed greatly from that of the 1950s. As already mentioned, the North Sea oilfields came into full production in the 1980s, giving the Conservatives a huge new revenue source not available to their 1950s predecessors (a revenue squeeze can still be identified for 1980/81 even when oil revenues are excluded, but the squeeze is much less deep when calculated that way). But oil also provided a major exogenous shock, in that a large spike in world oil prices only weeks after the Conservatives won government triggered recession across the developed world, increasing UK unemployment by a million and a half, particularly in manufacturing. That unemployment, together with the Thatcher Government's emphasis on the contested doctrine of monetarism ('sado-monetarism', as its opponents dubbed it), produced political conflict and criticism over the government's efforts to contain public spending in the early 1980s recession that seems to have gone much deeper than in the early 1950s. Perhaps the high point of such criticism was a statement in The Times newspaper in March 1981[3] signed by 364 academic economists (including most of the officeholders of the Royal Economic Society, and five of the postWorld War II Chief Economic Advisers to the Government) highly critical of the government's 1981 budget and of Margaret Thatcher's often-repeated claim that there was no real alternative to the government's policies.[4] The degree of opposition within the economics profession to the 1981 revenue squeeze seems to have gone much deeper than in the squeezes of the 1950s, 1960s, and even 1970s, and is arguably more comparable to the disputes over the ideas of 'expansionary fiscal contraction' associated with fiscal squeeze across the eurozone in the 2010s (Needham and Hotson (2014)).

As the Conservatives had done in 1951, the new government began trying to squeeze public spending as soon as it took office. One of its early tactics (reminiscent of that adopted by the 1954 Swinton Committee described in

Chapter Six) was to ask all departmental ministers to say what would be needed to reduce their 1979/80 staff costs by 10 per cent, 15 per cent, or 20 per cent by the end of 1981/82. That led to a plan developed at the start of the government's life imposing ambitious targets for cuts in civil service headcount from over 730,000 in 1979 to 630,000 by 1984.

Similarly, following an idea originally floated by Nigel Lawson and others in the 1970s, the government developed a four-year plan (the Medium Term Financial Strategy) for public spending to 1983/84. Intended as a commitment mechanism, the Strategy was described by the Chancellor as 'a logical development of the "letters of intent" which our Labour predecessors had been obliged to send to the IMF' (Howe (1994): 169). Championed by Nigel Lawson, then Financial Secretary of the Treasury, and eventually published alongside the 1980 budget, the MTFS aimed not just to reduce the previous Labour Government's plans for spending increases but also to squeeze spending in constant-price terms, cutting it by some 4 per cent between 1980/81 and 1983/84.

Within that total, the plan was to increase defence and law and order spending, raise spending on health by an amount similar to that planned by the previous Labour Government (that is, about 2 per cent a year, offset by higher prescription charges and other charges, including on overseas health 'tourists' using the NHS and on insurance companies for NHS treatment of road traffic accident victims). Overall education spending was to be cut but school rolls were falling at that time, such that spending per pupil would still increase. Civil service staffing and overseas aid were among the areas selected for big cuts.

Related to those plans, two politically important spending changes were introduced in the post-election 1979 budget.[5] One was a reduction of the real value of sickness, unemployment, and other social security benefits (first by raising them by five percentage points less than the rise in the price index and later, in 1982, subjecting them to income tax). The other was the breaking of what had been a double lock on pension payments introduced by the previous Labour Government. That 'double lock', meaning that state retirement pensions were to be increased according to the rate of price or earnings increase, whichever was the higher, was broken in the post-election budget, which changed the system to uprating on the basis of price indexation alone. But, important as these changes may have been in the long term, neither served to reduce overall spending immediately. Rising unemployment in the government's early years drove up expenditure on benefit payments and special employment measures. And high inflation in the early years of the Thatcher

Government (in 1980 inflation was running at about 22 per cent on the measures used at that time) meant that breaking the double lock on pensions only began to bring down spending relative to GDP when price rises started to fall behind earnings growth during the economic recovery a few years later.

For these and other reasons, those 'substantial economies' in public spending promised by the Conservatives failed to materialize in the first few years after 1979 and the targets of Lawson's 1980 Medium Term Financial Strategy were dramatically missed. A key political turning point in that process seems to have come in 1982, in the form of a cabinet revolt over a review for options for significant cuts in public spending relative to GDP in a low-growth environment that was leaked to the media and provoked major political attack from opposition parties claiming the government was contemplating a wholesale demolition of the welfare state (Lawson (1992): 189). But the government did deliver on its promise to switch the relative tax burden from earnings to consumption, albeit in the context of an overall tax squeeze that had certainly not been trailed in the 1979 Conservative manifesto and which produced high political conflict, not only between government and opposition but also within the Party and the cabinet.

The Treasury's 1979 post-election briefing (with two separate versions to cover the eventuality of a Conservative or Labour victory) pointed out that there had been a notable shift from indirect to direct taxes as a result of 'inertia policies' that had raised direct tax levels from a quarter to a fifth of average earnings in the 1970s Labour squeeze, while reducing the relative share of indirect taxes based on nominal rates for the same reason.[6] The Treasury expected the Conservatives if elected to go for a higher unified VAT rate (unifying the 'standard' rate and the 'luxury' 25 per cent rate mentioned in Chapter Seven) of about 12.5 per cent, and Labour to opt for a unified VAT of about 10 per cent.

But the new Chancellor, Geoffrey Howe, opted for a rate of some 15 per cent.[7] According to his memoirs, Howe (1994: 130) argued that the government's first budget presented the only political chance for such a big tax hike, although Margaret Thatcher was reluctant to agree to raise VAT above 12.5 per cent. The post-election 1979 budget duly enacted a dramatic shift from direct to indirect taxation by all but doubling the (standard) VAT rate at a stroke while cutting the standard rate of income tax from 33 to 30 per cent and the top rate of tax (on earned income) from 83 to 60 per cent.

While that post-election move substantially altered the tax structure (and created its own winners and losers) it does not show up as a revenue squeeze for 1979/80 in Chapter Two, because the 1979 budget intended the extra yield from increased VAT (plus increases in fuel duty and Petroleum Revenue Tax) to be more than offset by reduced yield from lower income tax rates and higher thresholds.[8] Outside the formal realm of taxation, NHS prescription charges were more than doubled (and were doubled again the following year) and the Chancellor's budget speech announced a plan for asset sales amounting to approximately ?1bn in 1979, pointedly declaring, '...we shall follow the example of the previous administration'. Neither of the latter two measures had been foreshadowed in the 1979 Conservative manifesto, which did not feature the word 'privatization' or mention the asset sales for which the Thatcher Government later became internationally famous.

As well as the 'headwinds' already mentioned that pushed up public spending in the Thatcher Government's early years (high welfare spending as a result of the recession, high debt servicing costs, and the manifesto commitment to honour catch-up public sector pay settlements agreed by the previous government), there were other forms of resistance within the Party and the cabinet. Some of the government's early ideas for increasing charges to offset spending proved impractical or hit a political brick wall, and the Chancellor was defeated by Margaret Thatcher and others in an attempt to resist a NATO target of increasing defence spending by more than the rate of inflation (Howe 1994: 144). The Financial Secretary to the Treasury, Nigel Lawson, recalled in his memoirs that though the Chancellor secured cabinet agreement to a reduction in total planned public expenditure for 1981/82 in July 1980, the autumn bilateral discussions between the Treasury and spending ministers failed to produce agreement on ways to realize such cutbacks, and one of the major savings proposed, namely to abandon annual uprating of retirement pensions for inflation, was of the 'political boomerang' nature that was predictably later overturned in cabinet as electorally toxic (Lawson (1992): 59-60).

Perhaps the most public and dramatic political reversal over spending restraint in the government's first few years was a proposal to charge parents for school transport (a measure the Treasury had frequently floated to ministers in the 1950s), estimated to save about ?50m a year.[9] The plan was defeated in the House of Lords in 1980 by opponents from across the political spectrum including such Conservative grandees as the Duke of Norfolk and Lord 'RAB' Butler, who as Chancellor had presided over the mid-1950s fiscal squeeze (James (1997): 195-7). A plan for charging insurance companies for NHS treatment of road traffic victims also came to nothing.

In the run-up to the 1981 budget the Treasury detected doubts or resistance among Conservative backbenchers to other spending cuts, including criticism of a perceived tendency to target capital spending for cutbacks, resistance to cuts in defence spending, pressure for increases in child benefit payments, and resistance to proposals to trim the next uprating of retirement pensions by 1 per cent.[10] And as already mentioned, there was a major cabinet row over a review of options for public spending cuts in 1982 which forced the government to retreat and deny that it was considering radical options for reducing welfare state expenditure.

At the same time, efforts to limit the budget deficit (which had risen from the cap of 3.75 per cent of GDP agreed in the 1976 IMF loan agreement discussed in the previous chapter to 5.5 per cent in 1978/79 and about 6 per cent in 1980/81) led to continuing efforts to increase tax revenue. Those efforts included successive hikes in indirect taxes on fuel, alcohol, tobacco, and vehicles at about twice the rate of inflation, higher rates of compulsory National Insurance contributions for three years in succession, and new taxes on North Sea oil production in 1980, in just the sort of revenue-raising minibudget the Conservatives had condemned during the Labour years and resolved to eschew (Lawson (1992): 60; Howe (1994): 190).

The high point of the revenue squeeze arguably came in the controversial 1981 budget, in the form of complete non-indexation of personal income tax thresholds and allowances for that year—partly to create room for more tax breaks for companies aimed at helping employers at a time when the government was facing severe political criticism over the rise in unemployment. There had been debates within government over whether to increase the basic rate of income tax or freeze tax thresholds, with the prime minister and Chancellor opting for the latter as the least electorally damaging (Howe (1994): 204). But freezing tax thresholds and allowances effectively increased income tax rates (and raised tax revenue by some ?2bn) through 'fiscal drag' at a time when annual inflation was about 20 per cent. There was even a one-off 2.5 per cent windfall tax on bank deposits in the same year, a measure that a left-wing Labour Chancellor might have adopted with enthusiasm (it resulted in the resignation of one PPS, Tim Renton) and which reflected the 'desperate circumstances' (in Lawson's (1992: 62) words) the cabinet felt itself to be in.

The degree of political effort that went into this much-discussed revenue squeeze went far beyond the 'inertia' level discussed in Chapter One and indeed must rank alongside episodes such as 1931 and 1976, in that manifesto promises had to be set aside and significant political capital expended to pass the necessary legislation. The tax increases in the 1981 budget flew in the face of the Conservatives' 1979 election pledges to cut taxation and pressures from parts of the Party to abolish domestic rates, the local property tax. It went against established Keynesian economic doctrine and the views of many respected economists that fiscal squeeze together with a tight money policy would exacerbate the recession as well as pressures for a fiscal expansionism by business groups and trade unions. It provoked fierce and continuing political attack from the Opposition11 and many other critics as unemployment soared and communities were blighted by industrial closures.

The non-indexation of income tax allowances also reflected high political effort in that it went against an explicit statutory requirement to index such allowances, the so-called 'Rooker-Wise amendment', which had been written into the 1977 Finance Act as a result of a backbench revolt, mentioned in Chapter Seven, against the previous Labour Government's practice of revenue squeeze through 'fiscal drag' (raising tax allowances by less than the inflation rate). The Thatcher Government therefore had to legislate to set aside that indexation requirement in its 1981 Finance Bill (Lawson (1992), Chapter 9). Threats of a Conservative backbench revolt against an increase in tax on diesel in the Finance Bill also forced the government to cut the proposed increase in diesel taxation by half and make up the revenue foregone by higher taxes on betting and tobacco.

Although the 1981 budget did not involve the long-drawn-out cabinet wrangling over spending cuts packages that took place under Labour Governments in 1931 and 1976 (indeed there was no detailed prior consideration of the budget prior to the cabinet meeting on the morning of the budget itself), the prime minister was said to have been aghast at the political prospect of the steep tax increases proposed,[11] [12] and the cabinet was divided over the plans (Lawson (1992): 64) says they were 'roundly attacked' by 'the usual wets'). It is not hard to understand those political anxieties. By March 1981 the government was extraordinarily unpopular in opinion polls, with only 16 per cent of IPSOS-Mori poll respondents expressing satisfaction over the way it was running the country. Other indications of the government's political unpopularity were the loss of over 1000 Conservative seats in 1981 local government elections and the fact that the Conservatives sank to third place in the opinion polls for a time after the formation of the Social Democratic Party in 1981. Even the rioting that broke out in several deprived urban areas in England between April and July of that year (including Brixton, Hands- worth, Southall, Toxteth, Hyson Green, and Moss Side) seems to have been sparked in part by discontent over government fiscal policies in the face of recession and unemployment.

The combination of the revenue squeeze that reached its peak in the 1981 budget and the effects of mass unemployment on public spending meant that both revenue and overall government spending in fact rose as a proportion of GDP over the first term of the Thatcher Government, despite the government's efforts, manifesto promises, and ambitions—a fact that was not lost on its critics in the run-up to the 1983 general election.[13] However, in the general election of 1983 the Thatcher Government managed to avoid the electoral punishment that (as of 1981) might have been and was predicted for a government that had raised taxes and presided over steeply rising unemployment.

Several reasons have been given for the lack of electoral punishment in this case. One factor stressed by observers such as Peter Riddell (1987: 4), is that the political opposition was more divided than at any time since the 1920s. The breakaway centrist party, the Social Democrats, came within 700,000 of Labour's total vote in the 1983 general election, deeply splitting the anti-Conservative vote, even though the SDP only won six seats. The defection of many Labour 'centrists' to the SDP left the Labour Party itself dominated by the left and campaigning on a far from 'centrist' manifesto that included unilateral nuclear disarmament and Britain's departure from the European Union.

Another factor stressed by commentators such as Andrew Marr (2007) is a form of 'heresthetic', as mentioned in Chapter One, in this case taking the form of the diversionary effect of an extraneous crisis over the invasion of the Falkland Islands (Malvinas)—remote and sparsely populated islands in the South Atlantic which were a British Crown dependency but claimed by Argentina in a long-running territorial dispute—by General Galtieri's military government in Argentina in April 1982. Argentina's invasion followed reductions in UK defence expenditure in the South Atlantic, and thus was partly prompted by the Thatcher Government's efforts to cut spending. The invasion triggered high-risk military operations by the UK to recapture the islands with a combined-operations task force. Some claim the unexpected war provided a powerful diversion from the 'blame game' over the government's handling of tax, unemployment, and recession, suddenly boosting its popularity as a result of support from most of the tabloid press that dramatically changed Margaret Thatcher's fortunes as a political leader. But this view is contested by those observers (notably Sanders etal. (1987)) who note that, from the low point of March 1981, the Conservatives had recovered their lead in the opinion polls and their support was accelerating before the Argentine invasion, such that the so-called 'Falklands factor' was worth only a few points at most in the polls.

A third view, advanced by David Sanders and others (Sanders etal. (1991); Dunleavy (1991: 123)), is that the distributive effects of the Conservatives' economic policies (such as income tax cuts, council house sales, trade union reforms) on median or swing voters over this period account for the absence of severe electoral punishment in 1983, though some (such as Kempley (2010)) have objected that those policies created large numbers of losers as well as winners, such that the split on the left and the division of the Opposition is a more convincing explanation of the electoral outcome. In addition, as noted earlier, about half the extra taxation raised in the 1981 budget comprised a one-off windfall tax and new taxes on oil production, meaning that any losses they imposed on key or median voters were far less visible than changes in income tax, National Insurance, and the major indirect taxes. Further, it can also be noted that the revenue squeeze was accompanied by increasing expenditure and also by tacit abandonment of the tight money policy associated with the government's initial enthusiasm for monetarism, to the point that observers such as Robert Neild[14] have argued that the net effect of the 1981 budget was expansionary.

For those or other reasons, March 1981 proved to be the low point of the Conservatives' popularity and their opinion poll ratings subsequently began to climb. It is true that unemployment went on rising (albeit at a declining rate from 1982), remained very high by historical standards, and indeed did not fall until 1986. But just as the 364 economists signed their famous letter, the recession was bottoming out. By 1982/83 GDP had begun to rise, while (partly due to a fall in world oil prices) inflation fell to half the rate it had been in 1980. Those developments eased the upward pressure on public spending and thereby cut the budget deficit. So the 1982 and 1983 budgets relaxed the earlier revenue squeeze (even though they did not wholly reverse it) and eased restrictions on consumer credit as well.

Accordingly, while most of the tax reduction in the 1982 budget was directed to creating more tax breaks for business (for example by reducing a surcharge on National Insurance contributions by employers, an easy-to-col- lect payroll tax that had been introduced by the previous Labour Government), that budget raised personal income tax thresholds and allowances by slightly more than the inflation rate while leaving the standard tax rate unchanged at 30 per cent and raising most excise taxes only in line with inflation. The next budget, before the 1983 general election, was not a preelection giveaway on the same scale as the Conservative budgets of 1955 and 1959 and contained no eye-catching cuts in income tax rates, but it raised tax thresholds and allowances by well above the inflation rate. It also added other pre-election sweeteners, such as raising pensions to a level that allowed the Party to claim it had delivered on a 1979 manifesto pledge to protect the real value of pensions, as well as raising child benefit and extending tax relief on mortgage payments for first-time home-buyers.

Whatever accounts for the 1983 electoral outcome, this major revenue squeeze episode (as well as the rise in unemployment to levels previously thought to be politically unsustainable in the government's first term) is notable for the absence of severe retrospective punishment from the voters. Instead of sharing the electoral fate of the previous Labour Government, the Conservatives only saw their overall vote share fall by 1 per cent or so, and under the first-past-the-post electoral system the split on the left between Labour and the SDP had the effect of increasing the Conservatives' parliamentary majority by some sixty seats. Any electoral punishment for revenue squeeze was muted and indeed the outcome in this case amounted to de facto electoral reward.

  • [1] (Neil Kinnock), HC Deb 17 March 1987, c.833.
  • [2] Conservative Manifesto 1979, http://www.politicsresources.net/area/uk/man/con79.htm.
  • [3] 'Monetarism Attacked by Top Economists', The Times, 30 March 1981, p. 1 (continued p. 15).
  • [4] The letter was immediately used by the Labour opposition as political ammunition against thegovernment. Unusually, it provoked a formal rebuttal from the Treasury, arguing that, 'althoughthe 364 economists assert that there are alternative policies, they are unable to specifyany... agreed alternatives'. ('Treasury Denies Economy Damaged by Policies', The Times,31 March 1981, p. 3).
  • [5] T366/456, Approach to the Second 1979 Budget, Treasury note, 4 April 1979.
  • [6] T366/525, Treasury Post-Election Briefing for the Labour Party, April 1979.
  • [7] Note of a meeting between the Chancellor and Treasury officials to discuss the budget,9 May 1979, T366/456.
  • [8] Budget statement, HC Debs 12 June 1979, c.251 and 261.
  • [9] Paper circulated by the Chief Secretary of the Treasury (John Biffen) as background for thecabinet's discussion of the 1980 Public Expenditure Survey, July 1980, CAB 129/204/14.
  • [10] T414/374 Spring Budget 1981, Budget briefs, 20 February 1981, comment on 'outsiderepresentations—political groups'.
  • [11] For instance, the Labour leader, James Callaghan, described the 1980 budget as, '... threeyears of austerity and industrial decline on the basis of a stagnating economy combined withshifting the burden from the healthy to the sick and from the rich to the poor'. (HC Deb 26 March1980, c.1492). The Labour MP Jack Straw described the budget as 'vicious and wicked' (HC Deb26 March 1980, c.1508).
  • [12] Stephanie Flanders (2006) 'Were 364 Economists All Wrong?', http://news.bbc.co.uk/1/hi/programmes/newsnight/4803858.stm, accessed July 2015.
  • [13] (Austen Mitchell) HC Deb 15 March 1983, c.181.
  • [14] Quoted by F. Williams, 'The Economic Mirage—by "Rebel" Professors,' The Time, 30 March1984.
 
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