Public services need another ?44bn by 2025 to cope with inflation, says IFS

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The government will need to spend an extra ?44bn over the next three years on public services to keep pace with rising inflation and avoid steep cuts, according to analysis by the Institute for Fiscal Studies.

In a review of the rising costs facing the public sector, the IFS said that without further funding, Whitehall budgets faced being overwhelmed by rising cost pressures that would force departments to cut staff and services.

The government said in its November spending review that it would increase departmental budgets by 3.3% on average above the then inflation rate. But with prices soaring since then, the tax and spending thinktank is forecasting the rise in budgets is now unlikely to be more than 1.9%.

“In other words, higher inflation is expected to wipe out more than 40% of the planned real terms increases,” it said.

Most of the increase in public spending budgets last year was targeted at the health service and social care sector and paid for with the ?39bn raised over three years by a 1.25% rise in national insurance contributions.

In other areas of government that were due to receive allocations above inflation, including education and defence, settlements that reversed large cuts made over several years preceding the pandemic would be less generous.

Education spending would “barely increase over the three-year spending review period”, the IFS said, while “the Ministry of Defence’s day-to-day budget would, on these estimates, be more than 8% lower in 2024-25 than in 2021-22”.

Inflation across the public sector was forecast to be 2.3% on average over three years at last year’s spending review. In March this year the figure was revised upwards to 2.8% and the real terms increase in spending dropped to 2.8%. The IFS has now increased the three-yearly inflation average to 3.7% and in response, the real terms spending increase shrank to 1.9%.

In what will be seen as a warning to the Tory candidates vying to be the next prime minister, the IFS said the Treasury will need to increase spending by more than ?8bn in the financial year to April 2023 and around ?18bn in each of the next two years to April 2025 to bring the average real terms increase back to 3.3%.

Ben Zaranko, a senior research economist at the IFS and author of the report, said the government’s spending plans were now less generous than they were originally intended to be when set out last autumn, “while public services – most notably the NHS – are under considerable, and visible, strain”.

He said: “Choosing not to compensate departments for unexpectedly high cost pressures would be one possible response to a cocktail of global economic shocks that leave us poorer as a nation, but would heighten the considerable pressures on public services heading into the winter.”

Both Conservative leadership challengers have committed funds from the ?30bn of financial headroom over the next four years calculated by the Office for Budget Responsibility in its March assessment to support their political and economic programmes.

However, the IFS review shows this headroom is likely to be absorbed by Whitehall departments if the government is to maintain public spending at current levels.

“It is notable that neither of the Conservative leadership contenders have said whether they intend to spend additional money to top up current spending plans or, if not, how they would manage the resulting pressures on public services,” said Zaranko.

The Bank of England has forecast that the consumer prices index (CPI) will rise to 13% before the end of the year and remain high during 2023. It is predicted to fall back during 2024 and by the end of that year settle below the central bank’s 2% target.

The next prime minister will have some flexibility because inflation boosts tax revenues, as the incomes and spending on which taxes are levied grow more quickly, the IFS said.

“But higher inflation also means a squeeze on public services, whose budgets are set in cash terms and therefore do not automatically increase in the face of higher-than-expected inflation.”

James Jamieson, chair of the Local Government Association, said inflation, energy costs and projected increases to the “National Living Wage” will add ?2.4bn in extra cost pressures to council budgets this year alone, rising to ?3.6bn in 2024/25.

“[These] pressures are putting council services at risk. Budgets are having to be reset with potential cuts to the essential services people rely on, in the middle of a cost-of-living crisis,” said the Conservative councillor and former leader of Central Bedfordshire council.

With inflation expected to remain high over the next year, he said the impact on our local services “could be disastrous”.

He added: “This will stifle our economic recovery, entrench disadvantage, and undermine government ambitions to level up the country.”