Seeking to provoke serious debate on a credible social democratic agenda for the coming decade, Gavin Kelly and Nick Pearce set out the magnitude of the economic and fiscal challenges facing Britain in the next parliament and beyond, and offer ideas for rising to them.

British politics has entered a new period of flux. In a little over two years since the 2010 general election, the received political wisdom that the Labour party would suffer another defeat in 2015 has shifted to a belief that it has a realistic chance of electoral success. The failure of the government's economic strategy, a mishandled budget, and the fracturing of the Coalition parties over reform of the House of Lords, have all given Labour a new lease of life. While only a fool would read too much into mid-term polls - and any sensible reading of the political situation would suggest that all permutations for the result of the next general election remain wide open - it is clear that a significant shift in the British political landscape has occurred in 2012.

Less clear is whether a potential upswing in the electoral prospects of the centre-left will spark a more intense and far-reaching ideological debate about its fundamental ambitions, policies and governing strategies. Historically, prolonged economic crises have tended to manifest themselves in deep ideological transformations, on both left and right. But five years on from the start of the global financial meltdown, the debate on renewing social democracy has barely started. Is it still possible to reconstitute a 21st-century social democracy as an assertive, majoritarian political project, capable of constructing new popular alliances and addressing the fundamental challenges Britain faces? Or have those days long passed?

Without such a debate, there is a danger that Labour will retreat to a safety-first strategy of opposing the government and waiting for it to collapse, eschewing the difficult task of staking out new ground while masking its internal fissures. It is just about conceivable that such an approach could work electorally. But it would consign any incoming administration to a fraught period in its early years in office and increase the risk of rerunning the fragile, ideologically uncertain and ultimately politically weak Wilson-Callaghan government of the 1970s.

Twin challenges to social democracy

For the last half century or so, the twin central insights of the social democratic tradition have been, first, that greater equality is viable in a market economy if all citizens have access to the public services and social protections which are made possible by taxing the proceeds of economic growth and increasing government spending; and second, that market economies are both hugely dynamic and inherently unstable and therefore require active and continually evolving government intervention to make them resilient.

Today, the first argument is widely viewed to have run into the sand, given the UK's straitened fiscal position and the long-term pressures on public spending that an ageing society faces. The second, in contrast, remains significantly and curiously underdeveloped, particularly given the depth and extent of the recession. Both require urgent attention if Labour is to avoid a politically defensive stance in the run up to 2015.

One thing is certain: the outlook for public spending is unremittingly bleak between now and the end of the next parliament. Cuts to public services and welfare entitlements will continue until at least 2017, and quite possibly the end of the decade, at which point the demographic pressure for more health and social care spending will likely crowd out the demands of many other, less politically salient services. This challenge will dominate all others and cast a shadow across every political issue of the day.

Whatever the genesis of the problem, living in this era will affect all parties and in some respects push them together. Labour has correctly argued for a slowing down of spending cuts in order to help haul Britain out of recession, but as the election approaches and growth gradually returns, the distance between the parties will narrow. Each will commit to removing the structural deficit over roughly similar periods and each will embrace ongoing spending cuts. The politics of tax and spend will not disappear, however. Distributional issues will remain at the fore and fiscal constraint will render them more potent, not less. The balance between tax rises and spending cuts - even if at the margins - will continue to separate out the parties.

More fundamentally, the fiscal straitjacket will have politically asymmetrical effects. While conservatives can use the era of austerity to redefine the boundaries between the state and the market, the prospects for another instalment of Croslandite social democracy, in which progressive increases in public spending provide the basis for new attempts at a more equal society, will become vanishingly thin.

At the same time as the public finances are further squeezed, living standards for a typical low-to-middle income household are likely to be no higher in 2020 than they were before the recession in 2007 and quite plausibly will hover around their turn-of-the-millennium level. In contrast to the pre-recession period, however, we can no longer look to rising tax credits to mask the stagnation in real wages that is at the heart of the squeeze on household incomes. Real wage stagnation began in 2003 and has continued ever since.

These brute facts must not be an excuse for fatalism. Policy can make a huge difference, particularly over the long term. But now more than ever there must be a premium on realism, and that means facing up to the fact that there will be sharp limits as to how far it will be possible to raise living standards over the life of the next parliament. Again, this will profoundly affect and constrain all parties. Increasing the living standards of core voter groups has been the central plank of almost every post-war government's ambitions. But the challenge is perhaps posed most starkly for Labour, since it is has always been an existential raison d'etre of social democracy to improve the material circumstances of working people.

In what follows, we ask whether there are potential elements of a new social democratic agenda which could help to meet these twin challenges of reforming the British economy to secure shared prosperity and governing in conditions of extreme fiscal constraint. A strong opposition party needs to articulate public anxiety and anger, but it must also simultaneously demonstrate its own ability to govern. Our aim is to provide opening thoughts and to spark further discussion on that agenda for government, rather than to set out a policy blueprint. Nor do we address other, broader challenges for social democracy, such as its relationship to wider social movements, the alliances it must craft, and the components of any electoral coalition it might seek to forge. Our focus is squarely upon economic reform and the consequences of Britain's fiscal position.

From economics back to political economy

The primary task is to map out a new political economy. That might seem obvious, given the nature of the crisis and severity of the subsequent recession, but it is not universally accepted. Many currently believe that the only issue is how to secure growth and therefore focus primarily on determining which fiscal stance will generate it.

In this parliament, macroeconomics has roused itself from its 30-year doze to become once again the primary site of policy debate and political division. At some point this will subside. Fiscal and monetary policy will have to return to some type of normality, if not the stable equilibrium promised by orthodox economic textbooks. When this happens, those who think the fundamentals of the UK economy are sound are likely to be upbeat. Adherents of this view can point to key successes of the pre-crash era: rising GDP per capita, outstripping that of our competitors, as well as significant improvements in productivity in world-leading sectors and a strong labour market performance which has served us well in recession.

There is much in this view, and it helps to dispatch some of the more tiresome clich?s of both Britain-in-decline and anti-neoliberal narratives. British capitalism is characterised by real strengths: a resilient labour market that generates relatively high levels of employment, strong export performance in key service sectors that are increasingly critical to global economic growth, high levels of human capital in the top half of the occupational structure, and world-class business clusters supported by excellent institutions of higher education.

But this is an incomplete picture, to say the least. It skates over core weaknesses in the UK economy which were graphically exposed when the financial crisis struck, many of which are longstanding. A fuller structural account of British capitalism would begin by highlighting its long tail of pedestrian, low-skill sectors, in which millions of workers are employed on low wages with no prospect of career advancement. Over recent years the power of labour to lift wages and defend its share of GDP - typically the flipside of a tight labour market - has proved to be very weak in the UK, dampening the capacity of the economy to generate steadily rising and sustainable demand. An illustration of this was the significant deterioration in the relationship between wages and unemployment that occurred in the pre-crisis period, when increases in unemployment depressed wage growth more than was the case in the 1980s and '90s (see Gregg and Machin 2012 forthcoming, Resolution Foundation).

In the run up to the financial crisis, the weakness of labour manifested itself in a number of other ways. The quiet stagnation of living standards for working families - especially outside London - was cloaked by rising GDP, climbing property values, more generous tax credits and falling levels of poverty. We saw a major expansion in household debt, mostly driven by those straining to gain access to what turned out to be a housing bubble, and for some the use of credit to fund day-to-day consumption, resulting in the most highly leveraged households among the G7 economies. Though each property bubble feels different, we should hardly have been surprised to see another emerge. The UK has had four asset bubbles since the 1970s, of increasing strength and duration, each generating gross misallocations of capital followed by painful periods of deleveraging.

This increased volatility has taken place during a period in which the financial sector has grown substantially as a proportion of the economy, reaching a peak of 10 per cent of gross value added in 2009. While this reflects the comparative advantages of the City of London and the broader growth of financial intermediation in advanced economies, it also bears witness to well-attested imbalances in the British economy and the consequences of what has become known as 'financialisation' in the academic literature (see Dolphin 2012 forthcoming, IPPR). Britain has not run a current account surplus since 1983 and although its strong trade performance in services and high levels of foreign direct investment have helped to offset its weaknesses in exports of goods, flows into the City have undoubtedly kept sterling at levels that have made its manufacturing base less competitive while exacerbating regional economic disparities. The UK saw more precipitous falls in manufacturing employment after 1997, when sterling appreciated sharply, than did comparable countries. Employment in industry (excluding construction) fell by 3.8 per cent a year between 2001 and 2011 in the UK, compared to only 2.2 per cent in the US and 0.4 per cent in Germany. At the same time, debt financing skewed corporate priorities, excessive rewards in the City leeched across into other sectors, and investment levels in productive business activity remained relatively low.

These structural weaknesses are also reflected in the fragility of our tax base. Pre-crash, the UK became dangerously reliant on tax revenues from the housing market, City firms and wealthy individuals. Fully a quarter of all corporation tax came from financial services, but this revenue fell from £10.3 billion in 2007/08 to £4.5 billion in 2009/10, while stamp and share duties fell from £14.1 billion to £7.9 billion. As a result, with a similar loss of output to Germany and a proportionately smaller stimulus package, the UK registered a fiscal deficit of 11 per cent of GDP at the peak of the crisis, compared to only 4.3 per cent by its continental neighbour.

This analysis points to the need for a more fundamental rethinking of social democratic political economy than has yet been undertaken in the UK, and with it a new configuration of priorities. Our goal must be a more resilient and stable British capitalism, with more productive, regionally balanced investment, dynamic markets, and demand generated from higher productivity and rising real wages, rather than speculative bubbles, rent-seeking and debt-financed increases in living standards.

What this means in policy terms is to be debated but some key directions are clear. A macroeconomic regime is required that is premised on more than the narrow targeting of inflation, which has proven to be a highly inadequate guide to economic stability. Hard-edged macro-prudential regulation, including the imposition of constraints on risky lending and measures to pre-empt emergent speculative bubbles, needs to be brought to the fore. (It should not pass notice, for example, that Britain is currently in the throes of another buy-to-let boom, as rents rise sharply.) The Bank of England's new financial policy committee can take on much of that task, but the bank's core mandate should also be revised to embrace asset inflation as well as consumer price inflation.

Similarly, banking reform should not stop with the findings of the Vickers report. There is a strong case for considering breaking up the big banks and introducing greater competition to tackle rent-seeking, for which there is clear prima facie evidence. Business investment also needs to be stepped up, so in addition to incentivising patient capital and creating a new state investment bank, the deep cuts to public capital investment pencilled in by the Labour government and implemented by the Coalition should be substantially reversed. There is no prospect of expanding the sustainable productive capacity and employment potential of the British economy while the public investment rate plummets.

Nor is there any reason why low pay should remain so endemic in Britain. Over the medium term, there is considerable scope for increasing wages in a number of sectors at the bottom end of the labour market without increasing unemployment. This will require a more imaginative and aggressive national minimum wage policy and the introduction of so-called 'living wage' arrangements where they can be achieved. Better management and capital deployment in key business sectors are also necessary, alongside a new skills policy framework that focuses on the utilisation of workers' knowledge and qualifications by employers, rather than simply the supply of these into the labour market. We can no longer tell workers that if they gain skills then they will automatically get higher wages, nor invoke a move to a 'high-skill, high-productivity' economy for all. Low-skilled jobs simply aren't going to disappear. Instead, we need a policy agenda to push up real wages and to shift pedestrian companies out of low-cost, low-value-added business strategies.

Crucially, a key route to lifting household incomes will be increasing the employment rates of women and older workers, which in turn requires a strategic choice to expand and reform childcare and care of the elderly services. Our goal should be a high employment rate, preferably at 80 per cent or thereabouts, with employment levels of women and older people to match those found in the Nordic countries, where care services are affordable and universal. This is a wider ambition than reducing the rate of unemployment (crucial though that is), since most of the people who are inhibited from working by structural factors - such as poor skills, or a lack of childcare or elderly care - are economically inactive rather than unemployed.

Importantly, increased employment rates are the only plausible route to achieving improvements in household living standards in the medium term. Fiscal constraints mean that tax credits won't play the role they have in the past: if low-to-middle income families are to secure greater prosperity it will be because of a rise in employment income, not government transfers or higher household debt.

These realities place a premium on new strategies to shape the level and distribution of employment across the economy, of a kind that go beyond remedial, cyclical measures to keep the unemployed in touch with the labour market or welfare reforms aimed at particular groups of the economically inactive. If employment is to bear the weight of increasing household incomes, then dual-earner households should become more common and workless ones less prevalent. For instance, the impending universal credit should, at a minimum, reward dual-earner households, rather than penalising them, as the government's current proposals do. Youth unemployment must be tackled by offering much smoother, more inclusive transition from school to work, with a major expansion of apprenticeships and college-based vocational education.

It is important to be realistic about a new political economy, however. Dependency on one economic path is difficult to shift and it is not immediately apparent where the sources of momentum for progressive economic change will be found. There is, for instance, plenty of evidence to show the potential role of trade unions in raising real wages, but unions are weak outside the public sector in Britain, particularly in some of the lowest-paying parts of the private sector. There is little prospect of that changing, less still of unions providing the organised power of the kind that underpinned the left's gains in the post-war period. New coalitions for economic change will therefore have to be put together painstakingly. In the immediate future, social democratic economic thinking should be characterised by patience, humility and some incrementalism, even while it displays a willingness to break with established orthodoxies and the political strategies of yesteryear.

Embracing fiscal realism

In the long term, serious reform of the British economy will help to improve our underlying fiscal position. In the meantime, however, Labour must contemplate a sustained spell in government during which it will need to make tougher fiscal choices than it has previously experienced. Before embarking on this, then, it will need a clear vision of the state that it wants to shape - where it must be reined back, as well as expanded - rather than approaching this as an essentially technocratic question of fiscal adjustment. What currently passes for radical thinking on tough tax and spending choices in centre-left Westminster circles falls far short of grasping the scale of the challenge.

Two substantive debates are badly needed. The first concerns public spending in the next parliament. Given the scale of the hole to be filled, and the deterioration of the fiscal outlook over the last year, it is almost inconceivable that tax rises could do all or even most of the work of fiscal consolidation during this period. Even if the exact numbers move about, it's already beyond question that a future Labour government will oversee daunting cuts to public spending. Assuming no further tax rises, welfare cuts of £10 billion a year by 2016/17 will be needed just to hold the rate of cuts to departmental spending constant with those in the current spending review period - again, that is assuming that the fiscal position doesn't get worse.

Most difficult of all, perhaps, is how to handle the national health service (NHS). Continuing with a 'flat real' settlement will take the NHS into truly unchartered territory, given its history of long-run average real increases of 4 per cent a year. By 2017, the NHS is very likely to have had six years without a real spending increase. Yet to spend more in the short term would imply a scale of cuts to other public services that is completely untenable. Indeed, holding NHS and overseas aid spending constant in real terms to 2016/17 and cutting welfare spending by £10 billion still implies cuts of 3.7 per cent a year to all other departments. In education alone, that would mean a real terms cut of £4 billion between 2015/16 and 2016/17. Against such a backdrop, the NHS will require certainty and the permission to take some highly unpopular decisions. A 10-year settlement for the NHS and social care, in return for a reform plan along the lines proposed by former health under-secretary Lord Darzi, would give health professionals and managers the space and freedom from political interference they need to make far-reaching cost savings - involving many hospital closures - which politicians often impede.

More widely, the long-term trend for defence spending to fall as a proportion of GDP must continue, necessitating a further fundamental review of the UK's foreign and security posture. Public spending on education will need to remain constant as a share of the economy, rather than rising as it did between 1997 and 2010. Across the piece, efficiency and innovation must be built into social democratic reform models, not tacked on post-hoc in the vein of the efficiency reviews undertaken for the last Labour government by Sir Peter Gershon.

In some respects, however, this account underplays the public spending problem. Any incoming Labour government will inevitably want to increase resources for at least some key priorities, particularly where such measures could help to raise employment. Capital investment in the productive economy, childcare and social care stand out, but each will have to be funded by ring-fenced spending switches or specific taxes or charges.

Increases in capital spending are the top priority and can be amply justified by a more intelligent classification of investment spending, such as allowing local authorities more flexibility to borrow against their housing assets to finance new house building. A shift of resources towards infrastructure should also be accompanied by reform: a localised transfer of spending out of housing benefit and into building homes, and the more widespread take-up of road user charges to finance transport investment.

A second priority is the expansion of childcare. This could be paid for by freezing child benefit rates over a 10-year period or restricting higher-rate pension tax relief. Universal childcare would do far more to lift the employment rate than further increases to the personal tax allowance beyond £10,000. Efforts to reduce child poverty should focus on the under-fives and include an honest admission that the existing targets for 2020 cannot be met in their current form.

Next should be the introduction of a system of social care system along the lines of that recommended by last year's Dilnot report - assuming the Coalition has not already set aside resources to achieve this - for which there are a range of sources of funding, such as means testing winter fuel allowance and new charges on the housing wealth of baby boomers.

None of the above, however, responds to the need for further welfare savings to prevent acceleration in the rate of cuts to public services beyond 2015. This is perhaps Labour's most intractable problem. Some of the measures identified above, like cutting higher-rate pension tax relief, would save far more than is necessary for the earmarked spending. So there is scope to use these resources. Others, like building more houses and lifting low pay, would also reduce the pressure on major welfare budgets. So choices do exist for ameliorating implied welfare cuts but, as things stand - without a decisive, new revenue-raiser or major additional spending cut - it is hard to see how they could be circumvented altogether.

The crucial second debate we need to have is about tax reform over the medium to longer term. This will be at least as difficult and just as necessary as the debate on spending. In the post-war period, tax receipts have tended to fall below public spending by 3-4 per cent of GDP and revenues from some important measures like fuel duty are likely to fall in the future. Meanwhile, the pressures on spending will only mount. Demographic change will add some 5 per cent of GDP to NHS spending between now and 2060, while the basic state pension is guaranteed to rise with earnings or inflation, whichever is higher. These costs will have to be met, whether through public or private spending, unless we are prepared to see older people receive poorer services and a lower standard of living. Consequently, tough choices in this area confront all politicians, whatever their ideological predispositions. If Labour wants to protect the NHS and the state pension over the long term, without following the Conservatives down the path of steadily dismantling the welfare state for people of working age or conceding the gradual erosion of collective health services, it will have no choice but to face up to the structural weakness of the tax base.

To bridge this long-term fiscal gap will require major sources of revenue, particularly those that will remain buoyant over time. Some of these are relatively obvious, if still hard to pull off: for example, such measures could include charging national insurance beyond the state pension age, introducing a financial transactions tax, and reforming property housing taxes so they raise more revenue and are less regressive and distortive. Taken together, these would make a significant difference.

But they fall short of what is needed over the next generation. In the longer term, beyond the end of the next parliament, there is likely to be a need to raise more revenue from key taxes. If raising the basic rate of income tax is ruled out of bounds then this may necessitate a hard look at the reform and extension of VAT. It's noteworthy that despite the recent hike to 20 per cent, the UK's VAT rate falls short of those found in egalitarian Scandinavian countries, which suggests it could be extended without regressive consequences if offsetting transfers are put in place. Overall, the key political lesson from the Nordic countries is that the quantity of tax is as important as its progressivity, since larger revenues enable expenditure on key public services and transfers. Consumption taxes also have the advantage of being broadly based and hard to avoid.

Yet consumption taxes, like income taxes, fuel duties and other broad sources of revenue are also highly unpopular and potentially toxic politically. Electoral calculations weigh heavily against any of the main parties entering the next election with anything other than tax rises carefully targeted at unpopular targets, such as banks and bankers, and so a more open debate about tax is highly unlikely to take place for the next few years; indeed, it is inconceivable that ideas would be floated until living standards have been steadily rising for some years. But at some point over the long term, Britain's tax base will need to be widened if our services and welfare system are not to be greatly narrowed in scope. Being a fiscal realist in the decade ahead means not only being tough-minded about spending cuts, it means being prepared for new thinking on tax too.

In sum, these directions on spending and tax begin to frame a broadly progressive and least-bad response to the fiscal vice that will bear down on any future government. All are likely to be met with great opposition; all will be painful. Yet these choices are likely to be necessary, if other, undoubtedly more regressive options are not to prevail.


Fiscal constraint implies a very different kind of social democratic statecraft. The days of building political alliances on the back of sustained budget increases are over, and while the imperative for reform will not diminish, the architecture of governance through which it was previously secured cannot be reconstructed. Strategic choices about the size and scope of the state need to be accompanied by a wider reappraisal of the art of social democratic government.

This is an opportunity for rethinking how economic and social change can be achieved that should be relished, not feared. The combination of economic radicalism and fiscal realism that we have advocated demands that the centre-left opens up and faces outward to other social actors. It needs to build new alliances to sustain it through tough times, gathering support for the reform of British capitalism from a range of interests that can have a stake in its project, while localising power and endowing diverse institutions in the public sphere to secure support and commitment for difficult reform agendas. Neither political managerialism nor technocratic administration will be able to sustain it in these tasks.

This essay is published in Vol 19.2 of Juncture, IPPR's journal for rethinking the centre-left.