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The Turning Point: 1992-93
Faced with the challenge of how to tackle a mounting budget deficit having cut income tax rates, and of delivering on electoral promises most of its ministers probably never expected to have to keep, the Major Government swiftly moved from pre-election tax-cutting largesse to post-election fiscal squeeze. Two months after the election, the cabinet adopted a new way of controlling public spending and a new medium-term spending plan which was redolent of the Medium Term Financial Strategies of the 1980s described in Chapter Eight.
The new arrangements, introduced by Norman Lamont based on work done by the Treasury's public spending team, were intended to avoid repeating the pattern of the later 1980s, in which (as noted earlier) the reduction of public spending relative to GDP during economic growth had been quickly reversed with the onset of recession. During the boom the government had accepted higher spending in constant price terms provided that the public spending/ GDP ratio was falling. According to Lamont (1999: 301-2), the new spending- control arrangements were intended to avoid repeating that pattern, and also to adapt to a changed political dynamic within the cabinet, from a position in which Prime Minister Margaret Thatcher had mostly sided with her Chancellor in efforts to impose restraint on spending ministers in cabinet battles to one in which John Major was more inclined to side with spending ministers against the Chancellor.
To deal with the first issue, Lamont reclassified public spending by dividing it into cyclical and non-cyclical public spending, with increases in the latter to be restricted to less than the long-term rate of growth in the UK economy as a whole, and the former intended to shrink in boom years to offset its growth during recessions (Lamont (1999): 300). According to Lamont, John Major refused to contemplate cuts in spending in constant-price terms, so Lamont pressed for a highly restrictive three year target for non-cyclical spending ('the New Control Total'), with a real-terms freeze over the following two years and growth limited to 1 per cent per year thereafter. The cabinet agreed in principle to this target in July 1993—but that left open all the subsequent autumn negotiations over individual spending settlements.
To deal with those negotiations, Lamont initiated a new cabinet committee procedure for handling departmental spending bids, that was a variant on the use of such committees in earlier eras and particularly of the so-called 'Star Chamber' system of adjudicating spending conflicts in a cabinet committee that had been adopted in 1982 but fell into disuse as spending control relaxed in the late 1980s (Thain (2010): 51-2). As with earlier spending control arrangements, the new system introduced in 1993 began with an overall total for spending agreed by cabinet in advance of later bilateral negotiations between the Treasury and spending departments. What was different was that that envelope now comprised the non-cyclical element of spending, the 'New Control Total'. The later political process consisted of departmental spending bids for funding from that total being considered by a special cabinet committee called 'EDX'. EDX included the Chief Secretary of the Treasury, some non-spending ministers and a few experienced cabinet heavyweights and was chaired by the Chancellor himself (in a departure from the system operating since the early 1960s when a second cabinet minister in the Treasury, the Chief Secretary, had dealt with the nitty-gritty of bilateral spending negotiations with departments each autumn). As with the 'Star Chamber' system of the 1980s, ministers could not join the Committee until they had agreed their own spending plans, meaning that 'holdouts' could expect to face a relatively unsympathetic committee of ministers who had already settled their budgets, and with a smaller pot of available cash left in the New Control Total (Thain and Wright (1995): 294-306).
A few months after the election, a severe currency crisis dramatically changed the political backdrop to fiscal policy. In September 1992, the pound, along with the Italian lira, suddenly crashed out of the European Exchange Rate Mechanism (ERM)—a system of fixed exchange rates that was a precursor of the euro, and which the UK had entered in 1989 under John Major's Chancellorship. That currency collapse took place in conditions of panic and recrimination, after the Treasury had spent some ?27bn of reserves in an unsuccessful attempt to keep the currency above its then agreed lower limit relative to the Deutschmark.
Many have commented on the economic effects of this currency collapse, with some arguing that the discipline imposed by ERM membership had benefits to the UK that outlasted the UK's membership of the ERM and others arguing that the cut in interest rates and currency devaluation that followed exit from the ERM boosted the UK economy (Budd 2004; Stephens 1997). But irrespective of any such economic effects, the episode had lasting and damaging political consequences for the Conservatives in general and more particularly for the prime minister and Chancellor. The Party's 1992 election manifesto had stated unequivocally that 'membership of the ERM is... central to our counter-inflation discipline', and pledged that, 'In due course, we will move to the narrow bands of the ERM'. The dramatic and ignominious collapse of a major plank of economic policy destroyed what had previously been a clear Conservative lead over Labour on economic competence in the opinion polls for more than a decade (Green and Jennings 2016), and in that sense can be seen as the equivalent for the Conservatives of what the 1976 IMF bailout had been for Labour.
Support for the Conservatives in Gallup polls plunged from 43 per cent in September to 29 per cent in October, opening up a strong Labour lead which persisted with only brief interludes for the next fourteen years. More particularly, the currency's exit from the ERM severely damaged the political career of the Chancellor, who, unlike James Callaghan after the devaluation of 1987, remained at the Treasury for a further six months despite widespread calls even in the Conservative press for his departure (Castle 1992). According to Lamont, the main reason for his continuance at the Treasury was to serve as a lightning rod to divert blame for the ERM fiasco away the prime minister, who as Chancellor had enthusiastically led the UK into the ERM. Lamont was finally sacked after a disastrous by-election defeat for the Conservatives the following May.
After the ERM debacle, the government tried to regain the political initiative by turning its 1992 autumn expenditure statement into a mini-budget. Following one four-hour cabinet meeting and two other shorter ones, that Autumn Statement was peppered with energetic rhetoric about stimulating investment and growth by protecting capital spending, but what the figures showed was a plan to keep overall expenditure virtually flat in real terms. That Statement marked the start of the 'soft' expenditure squeeze beginning in 1993 that we noted in Chapter Two. The squeeze involved holding down the non-cyclical part of public spending to less than the long-term rate of GDP growth as the economy recovered, and indeed adopting a standstill in such spending in real terms for 1993/94. Lamont failed to get cabinet support for big cuts in defence spending after the collapse of the USSR, but the cabinet agreed to a measure of non-fiscal austerity in the form of a 1.5 per cent cap on public sector pay rises, and cabinet ministers, senior civil servants, judges, and senior military officers received no pay increase at all.
Even then, the short-term effect of the spending plans, coupled with high cyclical spending resulting from the recession, meant a likely budget deficit of 7 to 8 per cent of GDP in 1993/94 (a number not revealed in the Autumn Statement, and not greatly different from what had occurred under the Labour Government of the 1970s (Lamont (1999): 333). And it was that expected deficit that seems to have triggered a squeeze on the revenue side as well for the following year's budget. So instead of the Labour 'tax bombshell' presaged by the Conservatives in the 1992 election campaign, the 1993 budget contained a Conservative 'tax bombshell'.
The 1993 budget reflected a strategy (probably reflecting the outcome of political negotiations over spending rather than a formula agreed in advance by cabinet) to reduce the deficit by two years of hard tax squeeze combined with a soft spending squeeze. That budget was also notable for the fact that it planned staged tax increases over three years rather than all at once—the revenue equivalent of the 'boiling frogs' approach discussed in Chapter One. The tax changes seem to have been intended to raise extra revenue approximating to that of Geoffrey Howe's 1981 budget discussed in the previous chapter, increasing revenue by 1 per cent of GDP as well as in constant prices (a 'hard' tax squeeze in our analytic terminology). Measures to take effect in 1993/94 included freezing income tax allowances and the threshold for inheritance tax (as had been applied in the 1981 budget, albeit at a much higher rate of inflation), reducing tax offsets for mortgage interest payments, and increasing taxes on alcohol, tobacco, gaming machines, and fuel. Also—taking a step which resembled Denis Healey's sale of BP shares in 1977 in that it opened up a precedent that would be seized upon and taken much further by the next government—tax credits which pension funds could claim from dividend payments on which tax had already been paid were reduced by five percentage points, intended to boost the tax take by some ?1bn a year.
For the later part of the multi-year 'tax wedge' plan for increasing revenue built into this budget, measures to take effect in FY 1994/95 included higher compulsory National Insurance contributions for employees (but not employers) and—most controversially—levying VAT on domestic energy bills for the first time, at 8 per cent. Further, the Finance Bill provided for a further major increase in VAT on domestic energy from 8 to 17.5 per cent in the following year (FY 1995/96), with accompanying but non-specific promises of compensation for those who would be particularly hard hit by this tax hike.
Reflecting on the political calculations that lay behind this 'tax wedge' strategy, Norman Lamont (1999: 336 and 345) writes that this tax squeeze was dictated by the limits of what the cabinet was prepared to accept in spending cuts, and that the scale of the revenue increases needed could only be realized from 'big-ticket' items such as National Insurance contributions, income tax, or VAT. Raising income tax rates was ruled out because it would run contrary to a central plank of Conservative policy since 1979, and when it came to possible VAT increases, the political judgement was that there were no obviously less unpopular alternatives to levying VAT on energy bills. Moreover, Lamont and his colleagues thought there was a greater risk of Conservative backbench revolts if VAT was applied to a range of other items that had previously been exempt rather than concentrated on domestic energy.
Lamont's memoirs also reflect on the blame risks that were run by the staged ('boiling frogs') approach to tax increases adopted in the 1993 budget. By comparison with the one-shot 'surgery without anaesthetics' approach (as in the 1981 budget), 'The stringing out of the tax increases meant that criticisms of the Conservatives "breaking their election promises" were regularly repeated throughout the rest of the Parliament and were still fresh in voters' minds at the subsequent (1997) general election' (Lamont 1999: 357). Further, phasing the imposition of VAT on energy bills ran the political risk that the second stage could be reversed at a later date by a backbench revolt. And that was exactly what did happen in 1994, in the form of an amendment to the Finance Act allowing a further vote on the second stage of the VAT increases, when the second proposed increase (to 17.5 per cent) was defeated by Conservative backbenchers. As a result, the eventual fiscal squeeze was much less severe than Lamont originally planned in 1993.