Monetary policy under the Coalition

In this piece David Cobham assesses the contribution of monetary policy to the economic recovery. He argues that once the basic choice of fiscal austerity had been made the authorities searched, largely in vain, for ways to make monetary policy boost demand in compensation. No doubt the recession would have been even worse without the monetary expansion that was implemented, but there is no sense in which normal operations have been restored.

Cobham’s paper on monetary policy under the last Labour government is free to view until the election, via the Labour government page. See also this short piece on common misconceptions about the crisis:

The role of monetary policy over this period was determined from the start by the government’s basic choice of ‘austerity’ in the sense of fiscal consolidation: with the economy in a deep recession (though it had been recovering before the election) and fiscal policy affecting aggregate demand negatively, monetary policy needed to be made more expansionary even though the policy interest rate was already (since March 2009) at its effective lower bound of 0.5%.

The government therefore sought a significant increase in ‘monetary policy activism’. In the short term the Bank of England embarked on further rounds of quantitative easing, while the Treasury offered credit subsidies in the form of Funding for Lending and Help to Buy, and the government appointed a new governor from June 2013 who was known to support ‘forward guidance’ and duly introduced it in the UK.

1.  Quantitative easing (QE) and monetary growth

When interest rates cannot be reduced further, monetary expansion can be delivered most obviously by expanding the money supply through the process called quantitative easing. In the first round of QE before the election, between March 2009 and January 2010, the Bank of England had bought £200 bn of financial assets (mostly UK government bonds). Two further rounds of QE, referred to as QE2 and QE3, involved another £175 bn of asset purchases between October 2011 and November 2012.

Such purchases lead to increases in the bank deposits of the non-bank private sector (initially the deposits of the non-bank financial institutions that sell their gilts to the Bank of England, mainly pension funds and life assurance companies). These deposits are part of the broad money supply. At the same time the asset purchases bring about increases in the deposits of the banks at the Bank of England.

Figure 1 shows the four-quarter growth of the Bank of England’s preferred measure of broad money, M4ex, and its two principal ‘credit counterparts’, bank lending to the non-bank private sector and the public sector’s contribution to monetary growth (the budget deficit minus borrowing from the non-bank private sector), in each case as a percentage of the outstanding stock of M4ex.

Three things stand out from this graph. First, in the period before the crisis the growth of M4ex closely reflected the growth of M4ex lending (bank lending to non-banks), but that collapsed in the crisis. Second, the public sector’s contribution, which had been minimal before the crisis, became very large in 2009-10 and large again in 2012 (as the result of QE), offsetting the negative or very low levels of bank lending and ensuring that the money supply did not fall. And third, bank lending has still not returned to anywhere near the level it maintained throughout the pre-crisis ‘Great Moderation’ period.

There is considerable agreement that QE1 had a positive effect on GDP growth. Initial studies from within the Bank identified significant effects of QE on long-term bond yields, but the Bank’s later studies of the wider macro effects estimated that QE raised GDP, relative to what it would otherwise have been, by 1½ to 2% and inflation by ¾ to 1½% (Joyce et al., 2011). Some other studies found larger effects: Cobham and Kang (2012) estimated that in the absence of QE nominal GDP in 2010 Q1 might have been between 3% and 11% lower, while Baumeister and Benati (2013) thought that without QE inflation could have fallen to minus 4% and real GDP growth to minus 12% at an annual rate.

However, non-Bank of England observers were less convinced of the effectiveness of the asset purchases in QE2 and QE3 (Goodhart and Ashworth, 2012; Martin and Milas, 2012): yields seemed less affected, the rise in corporate issuance of equity and bonds during QE1 was not repeated, and the international climate (the eurozone crisis) made it harder to isolate the effects of UK QE. In addition, while the large depreciation of sterling in 2007-8 may have contributed to the higher growth ascribed to QE1, it did not recur in a way that would have affected the outcome for QE2 and QE3.

At intervals from late 2012 there was speculation about a further round of QE, and three of the nine members of the MPC voted for (smallish) additional asset purchases in each of the meetings between February and June 2013. But there was never a majority for this, and after June 2013 the issue was dropped. On the other hand, there has been little discussion so far of unwinding the asset purchases, that is, selling off the gilts the Bank had acquired. It is generally understood that interest rates would be raised first, and assets resold only later, in a controlled and orderly process.

2. Funding for Lending and Help to Buy

In July 2012 the Bank of England and the Treasury launched the new Funding for Lending Scheme (FLS) which provides banks with a source of funds other than that obtained from retail deposits or wholesale markets. These funds would be made available more cheaply, and in larger amounts, to banks which increased their lending to households for mortgages, to companies and to buy-to-let landlords: banks were given an incentive to lend more. The scheme was extended in 2013 and again in 2014.

The Help to Buy (HB) scheme was started in April 2013 (in England but later schemes covered the rest of the UK too). At that time it offered equity loans of up to 20% to first-time buyers and people buying new-build homes, but the scheme was extended to provide mortgage guarantees of up to 15% to lenders where buyers put down deposits of 5%, so that lenders could offer better terms.

Both these schemes are essentially subsidies to particular types of credit, and their likely effect on house prices – if borrowers can borrow more easily, then they can bid more for the properties they seek to buy – was widely criticised. While it is not possible to be sure of the causes, house prices began to rise more strongly in 2013 and especially 2014, with a peak in 12-month growth of 12.1% in September 2014 (UK, all dwellings, ONS data).

House price growth was higher in London, the East and the South East of England, but much lower in Wales and the North West, with other regions in between. Concerns about a fresh house price bubble led to mortgage lending being made no longer eligible under the FLS in the autumn of 2014.

Bank lending, on the other hand, remained (in total) well below the period before the crisis, as is clear from Figure 1: as a percentage of M4ex, bank lending to the non-bank private sector (four quarter change), which had fluctuated around 15% between 2000 and 2007 and collapsed in 2009-10, became positive again in late 2011 and 2012 (with a peak of only 1.7%), but went negative again in 2013 before returning to the positive in the second half of 2014. While we cannot be sure how much banks would have lent in the absence of FLS and HB, it is clear that there has not been a significant revival of lending.

Figure 1: Growth of money supply and its main credit counterparts (growth since four quarters earlier, %)

cobhamfig1Source: Bank of England statistics

3. Forward Guidance

Mervyn (now Lord) King’s second term of office as governor of the Bank of England came to an end in June 2013, and he was succeeded by Mark Carney, who was appointed in November 2012 while he was still governor of the Bank of Canada. Carney was known for pioneering ‘forward guidance’ at the Bank of Canada and for his position as chair of the international Financial Stability Board, and from his appointment it was expected that he would introduce some forward guidance in the UK. The MPC unveiled its forward guidance policy in August 2013.

The MPC said that interest rates would not be raised until the unemployment rate came down to 7%, unless (a) its inflation forecast for 18-24 months ahead was 0.5 or more above its 2% target, and/or (b) inflation expectations were no longer ‘well anchored’, and/or (c) the Financial Policy Committee decided that the current interest rate level was posing a threat to financial stability which could not be dealt with by other (macroprudential) means.

Technically this is a ‘state-contingent’ rather than open-ended or time-contingent type of forward guidance, that is one where a rise in interest rates would depend on the state of the economy. The policy was justified by the MPC in three ways: (1) it would give greater clarity about the trade-off between the speed at which inflation should be returned to target and the speed with which economic growth recovered, (ii) it would reduce uncertainty about the future path of monetary policy, and (iii) it would allow the MPC to explore the scope for expansion without jeopardising price and financial stability.

However, it should be noted that the 7% was a threshold not an automatic trigger, that inflation expectations would be monitored via a range of indicators (survey data, extrapolations from financial market data), and that MPC members would make up their own minds as to whether the ‘knockout clauses’ had been breached. Thus the information conveyed in the guidance was hardly clear-cut or precise, in which case its contributions to controlling inflation expectations and reducing uncertainty could be expected to be limited. [I have suggested elsewhere that the initial guidance was so opaque because it emerged from a policy disagreement between a Treasury pushing for the Bank to introduce the policy and MPC members trying to formulate an intellectually respectable version of it. See Cobham (2013).]

In the event the unemployment rate fell more quickly than expected, going below the 7% threshold in the period December 2013-February 2014, but by then the MPC had issued fresh guidance which emphasised the continuing spare capacity in the economy, to be assessed by a range of indicators including the growth of wages. As of March 2015, the unemployment rate was well below 6% and expectations were for interest rates to rise only some time in 2016. However, the initial confusion over the meaning of the guidance and the subsequent changes to that guidance make it difficult to regard the policy as coherent or, given the speed and quality of the recovery, successful.

4. Alternatives and debates

The crisis and the difficulties of the recovery period have stimulated debate on possible alternative frameworks for monetary policy, other than the inflation targeting which the UK has pursued since the 1990s. There has been discussion of price-level targeting and nominal income targeting (growth and level), but these alternatives each have their disadvantages (Goodhart et al., 2013) and no consensus has developed.

A general problem with each of these is that a higher rate of monetary expansion might be required in order to attain the new targets, but – with the effects of QE waning, credit subsidies having failed to revive bank lending and forward guidance largely incoherent – the monetary authorities lack adequate instruments to bring that about. There have also been calls for modifications of current arrangements in the form of a rise in the inflation target (Ball, 2014), the continued use of the central bank balance sheet as an extra instrument (Friedman, 2015) and the formal adoption by the Bank of England of a secondary concern with asset prices (e.g. Cobham, 2015).

The only area on which the Bank of England has concurred and progress has been made is in the introduction of new ‘macroprudential’ instruments by which the new Financial Policy Committee of the Bank of England might try to head off various possible sources of financial instability. These instruments include the ability to vary the amounts of own capital the banks are required to have relative to their outstanding loans, and the ability to limit loan to value and debt to income ratios in the mortgage market.

While such measures seem eminently desirable, there are open questions about how the Financial Policy Committee will interact with the Monetary Policy Committee (Shakir and Tong, 2014), and since the effects of these instruments are likely to vary with the state of the economy (Harlmohan and Nelson, 2014) it is arguable that monetary policy will need to be kept as a backstop policy for financial stability (in addition to its role as principal instrument for price stability).

5. Outcomes

Figures 2 and 3 show the outcomes for the level of GDP and the rate of inflation in the UK, the Eurozone and the US. Figure 2 makes clear that the UK had a much deeper fall in GDP from the crisis than the Eurozone (as a whole – individual countries had different trajectories) or the US, which moved remarkably closely together until the end of 2011 when the US began to recover strongly while the Eurozone stagnated. The UK recovered somewhat in 2010 but between late 2010 and late 2012 its recovery was meagre, and it was only in 2013 that a more substantial recovery got under way.

This pattern is consistent with the view that the Coalition’s choice of austerity in the early years reduced UK growth in 2010-11 and 2011-12 (see Simon Wren-Lewis’s piece in this collection), while the resumption of growth from 2013 is consistent with the view that austerity had been quietly put on hold from 2012, together with the slow and partial bounce-back that can be expected of squeezed market economies.

Figure 2: GDP levels, UK, US and Eurozone


Source: International Financial Statistics (IMF)

Figure 3 shows that the UK experienced much the worst inflation over these years of the three currency areas shown, with a sharp peak in late 2008 and a more long-lasting rise in late 2011, which may have reflected the sterling depreciation of late 2007 and 2008 as well as fluctuations in world commodity prices (and the January 2011 rise in VAT). The recent further sharp fall in UK inflation, which has enabled a limited recovery in living standards after years of decline, is also heavily international in origin.

Figure 3: Consumer price inflation UK, US and Eurozone


Source: International Financial Statistics (IMF)

6. Conclusions

The monetary history of this period is a history of a search for ways to make monetary policy more expansionary, to overcome the drag on growth due to fiscal austerity measures which, as Wren-Lewis points out, were not required by the Coalition government’s new fiscal rules and are hard to explain. The search included further quantitative easing, the credit subsidies of FLS and HB, and forward guidance (facilitated by the appointment of a new governor), but there remains a shortage of effective monetary instruments.

The overall framework for monetary and financial policy was changed by the establishment of the Financial Policy Committee at the Bank, whose new macroprudential focus had its first test in trying to head off a nascent house price bubble caused, at least in part, by the credit subsidies. The monetary policy developments were mostly responses to short term problems, and not very successful ones at that, but the changes to the framework are likely to outlast the Coalition.



  • Ball, L. (2014), ‘The Case for a Long-Run Inflation Target of Four Percent’, IMF Working Papers 14/92
  • Baumeister, C., and Benati, L. (2013), ‘Unconventional Monetary Policy and the Great Recession: Estimating the Macroeconomic Effects of a Spread Compression at the Zero Lower Bound’, International Journal of Central Banking, 9(2), 165-212
  • Cobham, D. (2013), ‘Forward guidance in the UK: holding rates down till something happens’, in W. Den Haan (ed.), Forward Guidance, VoxEU ebook
  • Cobham, D. (2015), ‘Multiple objectives in monetary policy: a de facto analysis for ‘advanced’ countries’, forthcoming in Manchester School
  • Cobham, D., and Kang, Y. (2012), ‘Financial crisis and quantitative easing: can broad money tell us anything?’  Manchester School, 80 (s1), 54-76
  • Friedman, B. (2015), ‘Has the financial crisis permanently changed the practice of monetary policy? Has it changed the theory of monetary policy?’, forthcoming, Manchester School
  • Goodhart, C., and Ashworth, J. (2012), ‘QE: a successful start may be running into diminishing returns’, Oxford Review of Economic Policy, 28(4), 640-70
  • Goodhart, C., Baker, M., and Ashworth, J. (2013), ‘Monetary targetry: possible changes under Carney’, Morgan Stanley Research Europe
  • Harlmohan, R., and Nelson, B. (2014), ‘How might macroprudential capital policy affect credit conditions?’, Bank of England Quarterly Bulletin, Q3, 287-303
  • Martin, C., and Milas, C. (2012), ‘Quantitative easing: a sceptical survey’, Oxford Review of Economic Policy,28(4), 750-64
  • Shakir, T., and Tong, M. (2014), ‘The interaction of the FPC and the MPC’, Bank of England Quarterly Bulletin, Q4, 396-408

Aggregate fiscal policy under the Coalition

In this article Simon Wren-Lewis considers the fiscal policy innovations under the Coalition before discussing the choice of austerity. He argues that that choice was a policy mistake which is difficult to explain and has had significant costs for the UK. [A link to Wren-Lewis’s earlier paper on the fiscal policy of the last Labour government, free to view until the election, can be found on the Labour government page .]

When the Labour government came to power in 1997, it made the Bank of England independent, and introduced a new framework for aggregate fiscal policy. Most academic macroeconomists would view both changes as progressive, and in Wren-Lewis (2013) I argue that Labour’s fiscal rules and the transparency that went with them came close to best practice at the time. When the Coalition government came to power in 2010, it also introduced an important institutional reform: creating the Office of Budget Responsibility (OBR). It too introduced a new framework for aggregate fiscal policy: their primary and secondary ‘fiscal mandates’. I would argue that, as with Labour, both changes can be seen as largely progressive.

There is a third similarity between 1997 and 2010. Both governments started with a tight fiscal policy. Labour promised to be more prudent than its predecessor, and the Coalition promised to reduce the deficit faster than Labour. However there was a key difference in the environment in which these pledges were made. In 1997 the economy was growing reasonably well, and interest rates were above 6%. In 2010 the recovery from the largest recession since WWII had only just begun, and interest rates were at their ‘Zero Lower Bound’ (ZLB): 0.5%.

This difference was crucial. The Coalition government’s policy of sharp fiscal consolidation reduced demand at a time when monetary policy could not reliably counteract this deflationary force, and as a result the recovery was delayed. Although fiscal austerity was to some extent put on hold in 2012, the damage had been done. A conservative estimate is that around 5% of GDP was lost forever as a result of this mistake, and it produced the slowest UK recovery on record. It is difficult to understand why this mistake was made and even more perplexing why the major party in the coalition is planning to make the same mistake again after 2015.

  1. The Office of Budget Responsibility

In my study of the Labour government’s fiscal policy record (Wren-Lewis, 2013), I noted that the years before the recession were characterised by over-optimistic fiscal forecasts. This, combined with fiscal rules that with hindsight were not ambitious enough, led to fiscal policy being a little too lax before the recession, although the impact on the deficit was dwarfed by the consequences of the subsequent recession . This over-optimism was an important motivation behind the Conservative plan to create a fiscal council for the UK: the OBR. Under the Coalition, fiscal forecasts were contracted out to the OBR, which would be independent of any political pressure to be over-optimistic.

Fiscal councils have become increasingly popular over the last ten years, but their role and form differ substantially from country to country (Calmfors and Wren-Lewis, 2011). A key question in setting up the OBR was whether it could be independent of government, even though it relied to a considerable extent on government departments for parts of its forecast. The OBR has inevitably made forecasting errors – all macro forecasters do – but there is no evidence that these errors have resulted from manipulation or pressure by government. In that sense the OBR has provided proof of concept.

In political terms the OBR also appears to have been a success, as both parties are talking about the possibility of extending its role. The opposition Labour Party wanted it to cost its post-election plans, and although the government has refused this particular request it has not ruled out this possibility for the future. George Osborne’s long term plans for fiscal policy also hint at a stronger role for the OBR. 

  1. Fiscal rules

The Coalition government introduced two fiscal rules to govern its decisions about aggregate fiscal policy. The primary fiscal mandate aimed to achieve cyclically adjusted current balance within five years, but where that target was rolling (i.e. the next year the target was still 5 years ahead). The secondary mandate was to have debt to GDP falling in 2015. This secondary mandate makes little sense in either theoretical or practical terms, and was abandoned. The primary mandate is more interesting.

Portes and Wren-Lewis (2014) argue that for a country like the UK where deficit bias is not endemic, and where there is an independent fiscal institution like the OBR, a rolling target for some measure of the deficit represents a good compromise between flexibility and effectiveness. It is flexible because it allows fiscal policy to respond gradually to shocks, but it is effective in achieving longer term goals for the debt to GDP ratio and allowing scrutiny by independent organisations. So the principles behind the Coalition’s primary fiscal mandate would have been sound if it had been implemented in normal times. The tragedy for the Coalition, and the UK economy, was that it was applied at the one time it should not have been: when interest rates were stuck at their ZLB.

Before discussing that point, we should make two additional points about the Coalition’s primary fiscal mandate. First, it targeted the current balance rather than the deficit, so it excluded public investment. (This may have been one of the reasons for the addition of a secondary mandate.) This gave the Coalition the option of keeping public investment high to support the recovery, an option which they did not take up: instead public investment was cut quite sharply. Second, the target was for the cyclically adjusted current balance 5 years ahead. While the 5 year period makes sense, it would be normal over such a long time horizon to assume that monetary policy would have returned the output gap to zero, making cyclical adjustment unnecessary.

  1. Austerity

In a speech delivered to the RSA in April 2009, George Osborne gave a short account of some history of macroeconomic thought, in which he said that the New Keynesian (NK) model underpinned his whole macroeconomic policy framework. In the basic NK model, monetary policy loses effectiveness when nominal interest rates hit zero, because nominal rates cannot fall further. In the UK they hit the ZLB at about the time he made that speech. In addition the same model says that if interest rates have hit their ZLB, a decrease in government spending will reduce demand and output with a multiplier greater than one.

Thus according to the model that underpinned George Osborne’s policy, fiscal austerity when interest rates are at their ZLB will substantially reduce output. So the Coalition, by introducing a more ambitious fiscal retrenchment than had been planned, was knowingly taking a large risk with the recovery. If the forecast outlined by the OBR in June 2010 proved too optimistic (and all macro forecasts are always subject to wide margins of error), then monetary policy would have to rely on the unconventional and untested tool of Quantitative Easing (QE) to put the recovery back on track.

As we now know, those downside risks came to pass. The OBR estimate that fiscal austerity reduced GDP growth by 1% in both 2010-11 and 2011-12. That means that by 2012 GDP was 2% lower than it could have been. Even if we make the extremely optimistic assumption that all of that lost growth was recovered in 2013, this means that during the first three years of the Coalition government 5% of GDP, or nearly £1,500 for each adult and child, was lost forever as a result of the austerity programme.

A counterargument sometimes made is that without austerity, any positive impact on GDP would have been offset by the MPC raising interest rates, because inflation rose sharply in 2011. This point does not excuse the policy mistake – high inflation was not anticipated in 2010 – but it could influence estimates of the cost of that mistake. I argue in Wren-Lewis (2015) that interest rates were unlikely to have been raised in 2010-11, and in addition that the OBR numbers already incorporate some monetary policy offset.

A cumulated GDP loss of 5% is probably a lower bound for the amount of resources wasted as a result of austerity. The OBR estimates assume multipliers that are based on past evidence, which includes periods where monetary policy was able to offset the impact of any fiscal change. Over this period interest rates were stuck at their lower bound, so monetary policy had to rely on the much more uncertain tool of QE. In this situation, multipliers are likely to be higher than any historic average, and for changes in public consumption and investment could easily exceed one.

If we apply a multiplier of 1.5 to the deviation from longer term trends in public consumption and investment over the first two years of the Coalition, the impact on GDP by the beginning of 2012 could be nearer 4% rather than the 2% estimated by the OBR. If we make the further assumption that this output loss has not been recouped subsequently (which at the ZLB also makes sense), then the cumulated output cost of austerity by the beginning of 2014 could be closer to 14% rather than 5% of GDP (Wren-Lewis, 2015b).

It is tempting to ascribe this policy mistake to a misreading of the Eurozone crisis of 2010, and the view of some at the time that austerity was required to avoid suffering the fate of the Eurozone periphery. (Subsequent events, and particularly the end of the crisis following the ECB’s introduction of OMT in September 2012, suggest the source of the crisis was the failure of the ECB to act as a sovereign lender of last resort.) A recent IMF evaluation (IMF, 2014) reaches exactly that conclusion about its own policy recommendations. However this view appears not to apply to George Osborne for three reasons.

First, unlike the IMF in 2009, he opposed fiscal stimulus when it was undertaken under the previous government. Second, public investment was cut back sharply in the first two years of the Coalition government, even though there was no requirement to do so coming from the Coalition’s own fiscal rules. Third, the Chancellor is proposing a further period of fiscal austerity after 2015, even though interest rates are still at the ZLB.

While it is difficult to find any economic rationale for why the fiscal austerity mistake was made, the consequences for the UK economy are not difficult to discern. In the 13 years of the Labour administration, GDP per head grew at an average rate of over 1.6%: the red line in the chart below. This was below the longer term average growth rate of 2.25% simply because this period includes the Great Recession. In the four years under the Coalition, growth in GDP per head has averaged just less than 1%. As the earlier calculations suggest, this exceptionally slow recovery is at least in part a result of fiscal austerity.

Chart 1 Growth in GDP per head (quarter on previous year’s quarter)

wrenlewiscoal1The original fiscal plan outlined in 2010 was to achieve cyclically adjusted current balance by 2015. No doubt as a response to the faltering recovery, this plan was abandoned in 2012, when the pace of deficit reduction slowed substantially. That the Chancellor was able to do this while still observing his primary mandate illustrates the flexibility of that mandate. 2012 and 2013 also saw the introduction of two schemes designed to stimulate the economy which are at the interface between monetary and fiscal policy: the Funding for Lending scheme, and the Help to Buy scheme. These may have contributed to a sustained recovery in GDP that began in 2013, such that GDP per head in 2014 probably grew at a rate close to its historic average.

  1. Conclusion

The Coalition government introduced two important fiscal policy innovations in 2010 that should be viewed as progressive: establishing the OBR, and adopting a primary fiscal mandate which would have been a good framework in normal times.

The tragedy for the Coalition, and the UK economy, was that the mandate was applied to implement a sharp fiscal contraction at the one time it should not have been, when interest rates were stuck at their ZLB. This was a decision that appeared to fly in the face of mainstream macroeconomic analysis, and – for the majority party in the Coalition at least – does not seem to be explained by unwarranted panic following the Eurozone crisis.

Unfortunately the impact of this mistake on the UK economy has been quite predictable, and helped create an unprecedentedly slow recovery from the Great Recession.


Calmfors, L and Wren‐Lewis, S (2011) ‘What should fiscal councils do?’, Economic Policy, CEPR;CES;MSH, vol. 26(68), pages 649-695, October.

IMF (2014) ‘IMF response to the financial and economic crisis’, Independent Evaluation Office, International Monetary Fund, Washington DC.

Portes, J and Wren-Lewis, S (2014)Issues in the Design of Fiscal Policy Rules’, Economics Series Working Papers 704, University of Oxford, Department of Economics.

Wren-Lewis (2013) ‘Aggregate fiscal policy under the Labour government, 1997–2010’, Oxford Review of Economic Policy, Oxford University Press, vol. 29(1), pages 25-46, SPRING.

Wren-Lewis (2015) ‘The Macroeconomic Record of the Coalition Government’, National Institute Economic Review, National Institute of Economic and Social Research, vol. 231(1), pages R5-R16, February.

Wren-Lewis (2015b) ‘The size of the recent macro policy failure’, Mainly macro blog post , 15th February:

Productivity under the Coalition

In this piece Ken Mayhew (Oxford) considers the low level and low growth of productivity in the UK, especially in the ‘disastrous’ period since the crisis. He argues the UK needs not just more human capital but a higher ratio of investment to GDP, and a labour market which offers better and higher paying jobs. An article on UK productivity in the Labour government period can be found on the Labour government 1997-2010 page, free to download.

The IFS reported that real take home pay was 1 per cent lower in the third quarter of 2014 than in the third quarter of 2001. Though real wages have started to rise slowly in recent months, there has been a real threat to standards of living in the UK. This is closely associated with a disastrous performance on productivity since the beginning of the recession.

Defining productivity

Productivity can be defined in a number of ways: output per head of the population, output per worker, output per worker hour. Which is the appropriate measure to use depends upon precisely what one is attempting to analyse. Commentators have voiced concern about the UK’s performance on all three measures since the onset of the 2008 recession. Not only has it been linked with the very slow recovery in the standard of living but it is also an important indicator of an economy’s productive efficiency and of the quality of jobs on offer.

Output per head of the population will be influenced not just by the productivity of workers but also by the employment rate. Output per worker is affected not just by the number of workers employed but by the hours they work; for example, it used to be said in the 1960s and 1970s that higher Japanese manufacturing productivity per worker was largely explained by the fact that the Japanese worked much longer hours than people in other developed economies. This note concentrates on efficiency and jobs and therefore highlights output per worker hour.

Productivity under Labour

First, however, it gives some historical background. In his article for OXREP’s issue on the Labour Government’s Economic Record, John van Reenen discussed this background. He split GDP per capita into two components: output per worker and the employment rate. He argued that the growth of UK GDP per capita “outstripped” the US, France and Germany under the 1997 – 2010 Labour Government. The growth of output per worker was better than in Europe but worse than in the US. Conversely the growth of the employment rate was better than in the US but slightly lower than in Europe. He went on to remind us that GDP per capita also grew healthily under the previous Conservative Governments (1979 – 1997) when the country did well in terms of output per worker.

Rehearsing the various reasons advanced by researchers for Thatcher’s and Major’s success, van Reenen considered the argument that Labour might simply have continued to reap the rewards for their policies. However, he argued, it is important to distinguish between levels and growth and that it was implausible to believe that growth could have continued without some further stimuli.

He suggests that Labour’s specific contribution was in three areas.   The first was Labour’s product market competition policies. Noting the increase in higher education participation rates and in staying on rates at school, he tentatively suggested that improvements in human capital might also have had a role to play – though he does acknowledge that there may have been quality problems in what our education and training system was producing. The third explanation he advances is innovation, which he believes may have been stimulated by tax policies to encourage R & D and by science spending via the research councils.

All of this is against a background of long-standing governmental concern about the country’s poor productivity performance when compared with other OECD countries.

And indeed there have been several, at least partially, false dawns. The so-called productivity miracle of the 1980s still left us lagging. Indeed once it was realized that that there had been significant over-recording of capital stock at the beginning of the 1980s and that therefore its growth through the decade was greater than had originally been thought, a significant part of the miracle disappeared. Output growth had been attributed to productivity gains when in fact it was attributable to an increase in capital stock.

In any event it was a strange miracle that took us back to more or less the productivity growth of the 1960s. What in effect we saw was a recovery from the disastrous performance of the 1970s, at a time when most other OECD countries had not experienced such a recovery.

Productivity since the crisis

Whilst it was reasonable for the last Labour government to claim some further catch-up, on output per worker hour we were still behind some of our traditional comparator countries. By just before the onset of the recession, though the gap with rest of the G7 as a whole had been closed, we still lagged the US, France and Germany. Since the beginning of the recession, the UK’s productivity has flat lined whilst other countries have experienced slow growth in output per hour. So, on Office for National Statistics (ONS) numbers for 2013 (Figure 1), we are 31 per cent behind the US, 28 percent behind Germany, 27 per cent behind France, 9 per cent behind Italy and 1 per cent behind Canada. Only Japan performs worse.

Figure 1: Output per hour, 2013


Source: Reproduced from ONS, “International Comparisons of Productivity”, 20 February 2015

According to the ONS (Figure 2) output per hour is probably just about at the level it was in 2007, just before the onset of the recession, and the ONS suggests that the gap with the average for the rest of the G7 is at its widest since 1992. In fact output per hour actually fell slightly in 2013 despite the signs of economic recovery and the ONS calculates that it is 15-16 points “below a counterfactual level had the UK’s strong productivity growth prior to the downturn continued”. The ONS continues, “ the productivity gap on the same basis for the rest of the G7 is around 6 percentage points”.

Figure 2: Productivity gaps, 1997-2013


Source: Reproduced from ONS, “International Comparisons of Productivity”, 20 February 2015

So this raises two questions.

  • First, why could we not catch up with the likes of France, Germany and the US before the recession?
  • Second, why did we fare so relatively badly during the recession?

Why the limited UK productivity catch-up?

Productivity growth can be enhanced by improvements in dynamic efficiency and static efficiency. Dynamic efficiency is all about obtaining productivity improvement via investment – through technical progress embodied in new physical plant and equipment, in knowledge generated by R & D and in increasing human capital through education and training. Static efficiency is about improving the efficiency with which existing productive assets are deployed.

It is conventionally thought that the productivity gains under Thatcher were largely achieved by enhancing static efficiency. Whatever else motivated them, Thatcherite policies towards the labour market had this as a central aim. This was one explicit justification for the measures taken to reduce the power of unions and increase managerial prerogative, as it was for the removal of various forms of low pay protection and for reducing the extent of employment protection.

Similarly privatization and the introduction of quasi-markets into public sector activities, notably health and education, were justified partly on efficiency grounds. It was also argued that private business pursuing the profit motive in competitive and/or suitably regulated product markets would operate more efficiently than state-owned enterprises run by civil servants.

Reform of the tax and social security systems had similar intent. The reduction of higher rates of income taxation was meant to increase the incentive to work; so were attempts to reduce replacement ratios – the ratio of incomes from social security whilst out of work to income in work.

The Labour and Coalition governments maintained and probably increased static efficiency. However the UK’s long-standing failure was in dynamic efficiency. Investment/GDP ratios have been stubbornly low compared to many of our competitors, as has investment in R & D. The component of investment on which all governments from Thatcher onwards have placed massive emphasis has been on increasing human capital both via the formal education system and via work-based training.  Even the Thatcher government devoted significant subsidies to private sector training.

Under Blair and Brown the emphasis on human capital became even greater and this emphasis has continued under the Coalition. Originally this emphasis was part of the high skills vision which had initially been popularized in the US by economists such as Thurow and Reich. They asked how a rich country like the US could compete in an increasingly competitive world as more and more “developing” countries became serious players in international trade.

They argued that, for any well- defined product, US producers could not compete at the low end. Imagine a range of specification for that product – it becomes more highly specified the more characteristics it possesses, the more its producer is willing to customize the offer for different segments of the market and the more frequently it changes its specification. Any emerging economy could produce the low spec version of that product and the only factor which could give competitive advantage was price or unit labour cost. US producers would be beaten on price and therefore should move up-market where price was not such a constraining factor.

All OECD governments espoused this vision – the high value-added vision. Accompanying it was the belief that as a country moved up-market, production processes would become more skill intensive. Thus the high value-added vision became the high skills vision. Improving human capital was a necessary condition for successfully implementing such a national strategy. However it was not a sufficient condition.

If firms did not change their product and production strategies the human capital investment could be wasted. As noted above, van Reenen voiced some justifiable doubts about the quality of some of the human capital that was produced. The content of some of the lower vocational qualifications has been dubious, whilst exactly what our universities are producing bears some scrutiny.

But, even if there were no quality problems, there are certainly underutilization problems. Cedefop, studying the 2001-2011 period, estimates that between 10 and 15 per cent of UK workers reported that they did not need their highest qualification to get their job. We were not alone in this.

More revealing, in 2010, again according to Cedefop, about 60 per cent of UK workers reported that they believed themselves to be over-skilled for their jobs. This was a higher percentage than for all but four of the EU 27 countries. These four were Slovenia, Cyprus, Greece and Romania.

So the UK’s experience before the recession suggests that our failure to fully catch up with our comparator countries may well have been down to investment, and not even the stress on human capital investment had the leverage that governments had hoped for.

At the time some commentators were widening the discussion of investment deficiencies and arguing that inadequate infrastructure investment together with over-restrictive planning regulations were adding to our problems. They were also starting to suggest that officialdom often seemed to be slipping from regarding improvements in human capital as a necessary condition for achieving the high skills vision to thinking of it as a sufficient condition.

Why such poor progress under the Coalition?

So why have the last few years proved so disastrous? Investment and R & D performance have remained poor, whilst there is absolutely no evidence to suggest that the underutilization of skill has diminished. The ‘success’ story of the post-recession period has been the rapid growth of employment. Unemployment rose by less than in the major continental economies and fell fairly quickly. Unemployment rates are lower and employment rates are higher.

But the big doubt is about the quality of this employment growth.

Long before the recession struck Goos and Manning had introduced us to the notion of the hourglass labour market. They argued that over a couple of decades there had been growth in “top-end” jobs and in “bottom-end” jobs but that those in the middle had been squeezed – hence the hourglass shape.   Much of the employment growth during the recovery has been in lousy, low-end jobs where productivity is naturally low.

Late last year the TUC claimed that only one in 40 of the jobs created was full time and that the vast majority of employment created was either part time and/or self-employment. Of course neither part time work nor self employed work is necessarily less productive than full time work, but these figures are probably an indicator of this employment being created towards the bottom of the labour market.

A Joseph Rowntree Foundation Report found that in 2011-12 more households with members in work were in poverty than those with only workless members. The report attributes this to part time work and low pay. Thirteen million were classified as being in poverty. Even in better jobs, the fact that all power has been with management and that wage growth has been slow reduces the incentives for employers to increase the efficiency with which they deploy their workers.

Our recent productivity experience is historically unique for the UK and this adds to the worry is that it is not just a temporary blip on the route to a more productive and higher paying labour market. Investment in its many forms remains the key but so does trying to encourage a labour market with better and higher paying jobs.



Guardian, coverage of IFS report, 30.01.15

M. Goos and A Manning, ‘Lousy and Lovely Jobs – The Rising Polarization of Work in Britain’, Review of Economics and Statistics, February 2007.

The Coalition’s record on health care, 2010-2015: The NHS in austere times

In this piece John Appleby (King’s Fund) argues that the NHS has done reasonably well in the face of a financial squeeze and distracting reforms, thanks to the efforts of its staff, but the shortage of resources is now becoming very serious. A paper on health in the 1997-2010 Labour government (written by other economists for the Oxford Review of Economic Policy) is available, free to download, on the Labour government 1997-2010 page.

Looking back at the thirty bullet-pointed promises on the NHS listed in the coalition agreement thrashed out in the days after the 2010 general election, the second pledge sticks out: ‘We will stop the top-down reorganisations of the NHS that have got in the way of patient care..’ (HM Government, 2010). But plans for the extensive organisational reform of the NHS in fact pervade the coalition’s programme for government and trace their origins to Andrew Lansley’s work when in opposition (Lansley, 2005; The Conservative Party, 2007).

But between Lansley’s 2007 ‘white paper’ and the 2010 general election, there was the small matter of a global financial crisis and the start of what turned out to be the longest recession on record. Aside from the huge amounts of public money used to support the banking sector, the consequences of these events for public spending were somewhat more parsimonious. The coalition’s austerity programme has seen substantial real cuts in budgets across the board. However, as the first commitment in the coalition’s programme for government made clear, the NHS would be guaranteed real increases in funding in every year of the parliament.

For the NHS in England[1] then, two issues have dominated its life over the last five years: organisational reform and funding. Teasing out the coalition’s reform and funding commitments as they affected the NHS, its work, its outputs and its eventual impact on its core business of improving the nation’s health is not an easy task. As other attempts to assess the performance of health systems has shown, this can be a controversial and inexact science (cf WHO, 2000; Davis et al, 2014; Austin et al, 2015). Tracing the cause and effect of policy is hampered by lags between the two, difficulties in attributing changes in health to changes in health care and often poor and patchy data. Population health measures – such as life expectancy – are the product not only of people’s lifetime consumption of health care, but also of their lifetime’s economic experience, their personal lifestyle choices and so on. And while the NHS has traditionally been good at collecting data on work activity in secondary care, for example, in other areas – notably community health services such as district nursing and health visiting, and in general practice – even basic activity data is sparse or non-existent.

With these limitations in mind, any assessment of the coalition’s record on health needs to ask what happened to funding for the NHS (and its consequences, in particular, productivity), and the outcomes of the programme of organisational reform.


  1. Funding

While the coalition’s programme for government gave a qualitative commitment to increasing NHS spending in real terms, the recognition of the relatively high value the public placed on the NHS was quantified in the coalition’s first spending review (SR) in 2010. SR 2010 set out a plan to allocate to the NHS in England an extra £10.6 billion between 2010/11 (the baseline year) and 2014/15. At the prevailing forecast inflation (GDP deflator) at the time, this was equivalent to a real rise of just under 0.4% over the four years. Real average annual increases of just under 0.1% (equivalent to around £100 million – or the amount of money the NHS spends every 11 hours) met the coalition’s promise, if only just (HM Treasury, 2010).

Nevertheless, even such a small rise compared to deep cuts for other spending departments. On the other hand, it would mean the smallest increase in NHS funding over a four year period since 1948. Compared to the long run average annual increase of around 4% up to 2009, it was clear that while the NHS was ‘protected’ this did not mean business as usual.

But while the plan was parsimonious, the outturn has in some ways been better (and in some ways worse) than expected. One silver lining to the longest recessionary period on record has been lower than expected inflation. The planned 0.1% per annum real increase has turned out to be closer to 0.8%.

On the other hand, SR 2010 also planned for a transfer of around £3.8 billion from the NHS budget over the four years to 2014/15 (close to 1% of its budget each year) to local government to bolster social care spending. While this recognised the financial pressures local government were going to be under and the intimate links between health and social care, nevertheless this represented a not insubstantial opportunity cost to the NHS.

One final complication is the choice of baseline year. Conventionally, 2010/11 can be used as the base year for calculating percentage changes etc. However, this does imply that the coalition had no influence over the NHS budget in its first – nearly full – year in power. Using 2009/10 as the base year instead suggests a smaller average annual rise over the five years to 2014/15 and indeed, a real cut in 2010/11.

Despite these details the larger funding picture essentially remains the same: while the coalition has, more by accident perhaps than design, met the spirit of its real funding promise, however the figures are cut, the sums remain very small.


  1. Productivity

Importantly, they significantly undershot estimates of how much money the NHS required to meet growing demands. As the global financial crisis unfolded in 2008 and 2009, and the impact on the economy and public finances became clear, a number of estimates were made of future funding needs set against various, fairly bleak (but as it turned out, reasonably realistic) prospects for NHS funding (cf Appleby et al, 2009; McKinsey & Company, 2009). The unavoidable policy option in the face of growing demand but near stagnant budget growth, was for the NHS to fill the funding-needs gap with improved productivity – in other words, extra activity and improved quality of care that could have been bought if funding had increased in line with demand.

The monetary value of the funding-needs gap to be filled over the four years to 2014/15 was calculated to be £20 billion. A suspiciously round figure perhaps, but in fact reflecting the inherent uncertainty of such projections. For the NHS, the ‘Nicholson Challenge’ as it was dubbed by Stephen Dorrell, past chair of the Health Select Committee, after the then NHS chief executive, Sir David Nicholson, translated into a need to generate productivity improvements of between 4 percent and 5 percent a year. To put this in perspective, the average productivity gain between 1995 and 2009 for the UK NHS was an order of magnitude less – just 0.5% per year (ONS, 2015). And to add another twist, the challenge in practice was even tougher as not every NHS pound of spending would be available to be squeezed. In the short term at least, a proportion of NHS spending each year is fixed – in long term contracts (such as private finance initiative deals), for example – which meant a higher percentage productivity gain would be required each year than the 4% or so implied by dividing the annual productivity challenge of around £5 billion by the total NHS budget of around £100 billion.

The Department of Health’s productivity plan was mostly a top-down strategy: reducing pay costs, cutting central budgets, cutting management costs mainly through the abolition of regional tiers of management and local commissioning costs and cutting in real terms the prices providers were able to charge under the national tariff system, Payment by Results.

Did it work? Unfortunately there is little direct evidence to answer this question. Restricting pay growth and cutting staff numbers probably reduced costs by around £800 million a year – though this is a very approximate figure (Appleby, Galea, Murray, 2014). Cutting tariff prices implied a productivity gain of just over £2 billion a year – but whether the price cut actually translated into such a gain is moot; little is known as to how hospitals and other providers actually reacted to the price cut they faced. Aggregate productivity estimates from ONS for the whole of the UK (not just the English NHS) suggest that productivity rose by an average per year of 1.6% over the three years from 2010 to 2012 (ONS, 2015).

In the secondary care sector, there’s no doubt that activity – from outpatient and A&E attendances to day cases and emergency admissions – continued rising more or less on trend between 2010 and 2014 (Appleby et al 2015). On the other hand, it is likely that some aspects of quality have suffered. Waiting times, for example, have been increasing since 2012 with some targets, such as the minimum four hour wait in A&E, now unmet by major A&E departments for the last 84 weeks.

There are creaking signs too on finances. The NHS in England could well end the 2014/15 financial year in overall deficit for the first time in a decade as reserves nationally and locally run out, and increasing numbers of trusts choose to blow the budget in an attempt to maintain services, while facing increasing difficulties in making ends meet through their traditional cost improvement programmes (Appleby et al 2015).


  1. Organisational reform

Just sixty days after the 2010 general election, the government published its White Paper, Equity and excellence: liberating the NHS (Department of Health, 2010). This built on previous Labour and Conservative administration reforms, putting into legislation structures needed to embed a provider market in the NHS. Patient choice and competition were to be enhanced with more direct commissioning control passed to groups of GPs in new commissioning groups, with existing purchasing organisations (primary care trusts) and a layer of strategic health authority management to be abolished. Monitor – then the body responsible for seeing the conversion of trusts to foundation trusts – was to take on an economic regulator role, with a part in setting the existing menu of tariff prices and licensing foundation trusts. The NHS public health function was to be transferred to local authorities (from whence it had come many decades ago). And last but not least, the Department of Health and ministers were to take an arm’s length role, with a new body, NHS England, running the NHS (via the new commissioning groups) under a mandate from the Department setting out broad goals to improve the nation’s health.

At one level these are deeply dull administrative changes. And while they affected every organisation at every level in the NHS, the story or narrative reason for such changes remained murky at best. More fundamentally, it was hard then, and harder now, to see how this organisational shake up connected either with the financial situation facing the NHS or with patients in terms of the volume and quality of care they received.

After some turbulent public debate and considerable opposition, and with a degree of amendment, the white paper was translated into legislation in 2012.

One immediate quantifiable impact of the white paper and the associated public debate was evident in 2011 when the British Social Attitudes survey reported the largest fall in satisfaction with the NHS since the survey began in 1983 (Appleby and Robertson, 2015). Less quantifiable has been the impact of (a greater degree) of competition. In part this is because it is questionable whether this has actually happened, and in part because, with just over two years since the Health and Social Care Act, we would probably not expect much change.

Although the NHS has not been privatised as some had feared, the changes have created a more complex system with confusion about accountability. Ultimately, the government’s organisational changes have proved a distraction – and as such damaging at a time when the really big policy issue to grapple with has been funding (Ham et al 2015).

  1. A verdict?

The NHS has done pretty well in the first half to two thirds of this parliament given the financial squeeze coupled with a distracting set of reforms. It’s a big enterprise, spending over £300 million a day. Turn off the money and mess around with the deckchairs and, with a dedicated workforce, it’s perhaps no surprise that it copes with the pressures. But in the last year or so there are increasing signs – financially and on headline performance measures such as waiting times – that the service is reaching its limits. Nevertheless, the NHS will reach May 7th, somewhat scathed and overspent, but still a tax-funded service functioning reasonably well for most people most of the time – a tribute to the NHS and its staff.



[1] Scotland, Northern Ireland and Wales have their own devolved powers of spending and policy making for health. Here, geographically, the record of the coalition government on health means England.



Education under the Coalition

In this article Anthony Heath and Anna Mountford-Zimdars summarise the evidence on the effects of Coalition policies on education. They find that, while the government implemented its core policies – the pupil premium and the promotion of academies and free schools – it is not clear whether its reforms have had any effect in raising educational standards and reducing class inequalities. Their earlier assessment of education under the Labour government, 1997-2010, is included in the special journal edition which is free to download until the election.

  1. Introduction

In their 2010 manifesto the Conservatives had emphasized raising school standards and closing the attainment gap between pupils from the richest and poorest backgrounds, two themes which had also been present in the previous Labour manifestos. Their partner in the coalition, the Liberal Democrats, had rather different emphases, focussing on cutting class sizes in schools and famously promising to scrap ‘unfair university tuition fees’. In the coalition agreement, the key elements became:

  • To fund a significant premium for disadvantaged pupils from outside the schools budget by reductions in spending elsewhere.
  • To promote the reform of schools in order to ensure that new providers can enter the state school system in response to parental demand.

There followed a major programme of reform, not all of which had actually figured in the coalition agreement. The most eye-catching reforms which the coalition undertook in office were to encourage private providers to establish Free Schools and to extend the Academies programme . There were also, later in the life of the coalition, major reforms to GCSEs intended to strengthen standards and make them ‘more challenging’, notably by ending the modular system and moving to assessment at the end of the course, changing subject content, and restricting the number of ‘equivalent’ qualifications which count towards school performance tables.

In some respects these were continuations of Labour policy, particularly the emphasis on school choice and extending Labour’s Academies programme, although the GCSE reforms diverged from previous Labour policy. It is also worth emphasizing that these reforms applied to England, since education is a devolved responsibility.

In the case of further and higher education, the Coalition’s principal reforms were:

  • Abolition of Labour’s Education Maintenance Allowance and replacement by a 16-19 Bursary Fund (with a much lower level of funding)
  • Implementation of Labour’s policy of Raising the Participation Age (RPA) to 17 (from 2013) and 18 (from 2015)
  • Extension and reform of apprenticeships
  • Increasing the fee cap in higher education to £9000 for full-time students

A detailed analysis of both inputs and outcomes for schools has been carried out by Ruth Lupton and Stephanie Thomson (2015), and for further and higher education by Ruth Lupton, Lorna Urwin and Stephanie Thomson (2015). We summarize some of their key findings below.

  1. Inputs

The Coalition protected school spending in real terms. Current spending on schools in England increased from £39.5bn in 2009/10 to £43.8bn in 2013/14, although capital spending decreased from £6.5bn to £2.8bn. The pupil premium directed more money to schools with ‘poor’ intakes (judged by Free School Meal eligibility). Among primary schools the least deprived schools saw a small (real) increase in grant funding of around 1.1%, while the most deprived saw a larger increase of around 7%. Among secondary schools, the least deprived saw a loss of around 2.5%, while more deprived schools had increases of about 4.3%.

There was also a major expansion of the Academies programme. In January 2010, just over half of state-funded secondary schools were community schools overseen by local authorities with only 6% being academies independent of LAs. By January 2014 the proportion of secondary schools overseen by LAs had fallen to around one fifth, and over half were now academies (in which Free Schools are technically included). Among primary schools, changes were less dramatic. The percentage of Academies increased from 0% to 11%, almost wholly at the expense of community schools rather than of voluntary-aided or voluntary-controlled primary schools.

Despite the protection of school spending in real terms, and the use of the pupil premium to help primary schools, class sizes in primary schools began to increase (largely due to demographic pressures).   After declining considerably under the Labour governments between 1997 and 2009, class sizes increased from an average of 26.2 pupils per class in 2009 to 26.9 in 2014 (Neve, 2015). The average hides differences between classes for different age groups; the average class size for 5-7 year-olds grew by 7% from 2007 to 2014 (from 25.6 to 27.4), while average class sizes for 7-11 year-olds remained constant throughout the period. Meanwhile, average secondary school class sizes fell steadily from 21.7 in 1998 to 20.6 in 2009 and to 20.1 in 2014.

  1. Outcomes

Changes in assessment procedures make it difficult to evaluate changes over time in school attainment. However Lupton and Thomson (2015) report that KS2 reading and mathematics attainment both improved. At KS4 (GCSE) the DfE released two sets of headline data in 2014, the official results using the new qualification rules and an adjusted set following the old qualification rules (intended to enable comparison on a like for like basis over time). The trends over time also differ according to whether one uses the criterion of 5 or more GCSEs at grades A* to C, or the more challenging criterion which requires passes at both English and Maths among the 5 subjects (5 A*-CEM).   The most positive story from the Coalition’s point of view was that the percentage obtaining 5 A*-CEM was slightly higher in 2014 than it had been in 2010.

There remain considerable doubts, however, whatever rules or criterion one takes, whether percentages obtaining GCSEs (or expected standards at KS2) actually give valid measures of changes over time in the skills and competencies of school children. Independent measures conducted as part of cross-national programmes, such as that of OECD, suggest that changes over time have been much smaller than the changes shown by government data on attainment at KS2 or KS4. Between 2009 and 2012 (the latest year available), scores on the OECD’s PISA tests (taken around age 15), for example, showed only small improvements for reading, small declines for maths, and stability in science (Wiertz 2015).

In addition it is not clear yet whether Academies actually do improve educational standards. The House of Commons Education Committee concluded in January 2015 that “it is too early to judge whether academies raise standards overall or for disadvantaged children”.   There have also been concerns expressed about the governance and financial control of Academies. In October 2014 the National Audit Office concluded that the DfE and other oversight bodies had not demonstrated the effectiveness of their interventions. “The NAO finds that the DfE and others, such as the Education Funding Agency and local authorities, have not tackled underperformance consistently. The spending watchdog, therefore, cannot conclude that the oversight system for maintained schools and academies is achieving value for money.”

Lupton and Thomson also examine trends in socio-economic inequalities, using so-called Eligibility for Free School Meals as the proxy for socio-economic background (a criterion which also appears to be the main one currently used by government). (Eligibility is in fact a misnomer, since families have to apply in order for their eligibility to be approved by the local authority. Possibly many ‘eligible’ families do not apply in the first place.) Lupton and Thomson found that socio-economic inequalities at GCSE declined up until 2013 but then widened sharply in 2014 when the new qualification rules were introduced.

Academic research (Mills 2015) using the standard ONS socio-economic classification (NS-SEC) has also shown a slight narrowing of the inequalities up until 2013 at GCSE (based on data from the Labour Force Survey) but data for 2014 are not yet available. The narrowing of class inequalities, however, had begun before 2010 and may well not be due to reforms undertaken by the Coalition (which might in any event take a longer time to bear fruit).

In the case of 16-19 education there were modest increases in proportions of 16, 17 and 18 year olds in full-time education or training, although it is clear that not all 16 year olds are as yet participating despite the RPA. There has also been a decline in the proportion not in education, employment or training (NEET) which had declined to its lowest level since 1997 by the end of 2013. Lupton et al (2015), however, show that the increase in participation is a continuation of longer-term trends and is unlikely to be explained solely by the Coalition’s reforms.

With respect to higher education, applications fell sharply in 2012 with the introduction of the new fee regime. This was almost certainly because many students had decided to apply in the previous year, rather than taking a gap year, in order to avoid the increase in fees.  Applications recovered by 2014.   The application rate for students domiciled in England rose from 31.3% in 2010 to 33.2% in 2014, again a continuation of longer-term trends.

However, there was a dramatic drop in mature students’ participation in higher education. The number of mature undergraduate entrants to universities fell by 40% between 2007-8 and 2012-13. Universities UK have attributed this to increased fees and the switch to loans in 2012, although as Lupton et al (2015) point out, the economic downturn and reductions in employer funding may also have been contributory factors.

  1. Conclusions

The coalition clearly did implement the two central planks of the coalition agreement on the pupil premium and new providers. However, it is not as yet clear whether these reforms have had any effect either on educational standards or on reducing class inequalities. Class inequalities at GCSE (although not perhaps at higher levels of education) have been slowly declining, but it is far from clear that this has been due to the coalition’s reforms.

The absence of independent and up-to-date evidence on students’ skills continues to be a major obstacle to monitoring the effectiveness of government policy in raising standards, just as we reported in our previous article on education under New Labour (Heath et al 2013). The whole area is bedevilled by the paucity of authoritative, independent assessment and is largely reliant on administrative statistics, with all the pitfalls to which they have long been known to be prey.

At present, the most that can be said is that the jury is still out on the question of whether the Coalition’s reforms actually made any difference to either standards or socio-economic inequalities.



The Coalition’s record on poverty and inequality

In this fourth article on Coalition Economics, Robert Joyce and Luke Sibieta (Institute of Fiscal Studies) consider the effects of the Coalition’s policies on inequality and poverty. They discuss the impact of the recession, which tended to reduce inequality, and then of government tax and benefits policies, which have tended to increase it, and the rising incidence of child poverty. Sibieta and Joyce’s earlier assessment of income inequallity under the Labour government, 1997-2010, is included in the special journal edition which is free to download until the election.

The coalition government came to power just after the Great Recession and during the associated fall in real earnings. One cannot properly understand the coalition’s record on inequality and poverty without considering that context. The Great Recession led to large falls in workers’ real pay between 2009 and 2011, which led to bigger falls in incomes further up the income distribution. However, the coalition government also had to implement a large fiscal consolidation in response to a hole in the public finances that had opened up or revealed itself due to the recession.

Decisions on how to implement this consolidation have had further important implications for inequality, with cuts to working-age benefits leading to reductions in income primarily towards the bottom of the income distribution and some net tax rises primarily hitting a smaller group towards the top.

Hence, falling real pay meant that incomes initially fell more towards the top of the distribution – partly at the end of Labour’s reign and partly at the start of the coalition’s – but the fiscal consolidation probably means that incomes are falling at the bottom of the distribution towards the end of the current parliament.

  1. Changes in household income during the Great Recession

The coalition came to power right in the middle of a period of large falls in workers’ pay. Between 2009 and 2011 – a period which neatly sandwiched the May 2010 election – median weekly earnings fell by 7% in real terms ( Because earnings are a larger source of household income, on average, further up the income distribution, this acted to reduce income inequality. This came on the back of a reduction in inequality during the recession itself, as the real value of benefits and tax credits had been boosted by falling inflation and some discretionary increases, meaning that the bottom had been catching up with the middle. These patterns are shown in Figure 1.

The precise timing of this fall in real earnings was not entirely independent of policy choices. The Labour government’s temporary VAT reduction between 1 December 2008 and 31 December 2009, as a fiscal stimulus measure, had kept inflation very low and hence real earnings did not fall during this period. But ultimately the fall in earnings was an inevitable, if somewhat delayed, impact of the severe economic contraction.

Had the election happened a year earlier this would all have happened under the coalition; had it taken place a year later it would have been largely on Labour’s watch. In truth it would be economically arbitrary to attribute trends in the income distribution since May 2010 to the coalition and anything before that to the previous government. The large fall in income inequality between 2009 and 2011 was driven by the large scale of the recession and the historically unusual nature of the labour market shock that came with it – namely widespread falls in workers’ pay, rather than sharp rises in unemployment.

Figure 1. Real changes in real household income from 2007–08 to 2012­–13, by percentile point sibjoyfig1 Notes: Percentiles 1-4 and 96 to 99 are excluded due to high levels of statistical and modelling uncertainty. Incomes are deflated using the RPIJ index.

Source: Cribb et al (2015);

  1. Role of tax and benefit policy

It is more instructive to think about the coalition’s record on inequality and poverty by looking at what it has done since coming to power in response to the hole in the public finances. One obvious thing to look at, which affects inequality via direct policy levers, is tax and benefit policy. Considering all tax and benefit changes between January 2010 and May 2015 together, this group of measures have had the largest impact on a small group at the very top of the income distribution. This is mainly due to the implementation of tax measures pre-announced by the previous Labour government (such as the introduction of a 50% income tax rate, subsequently reduced by the coalition to 45%), which had their biggest effects just before or early in the coalition’s period in government.

The coalition government has chosen to implement a package of cuts to benefits and tax credits totalling £16.7 billion per year by 2015–16, and a net tax rise of £16.3 billion (all in 2015–16 prices). Figure 2 below (taken from Browne and Elming, 2015) shows the net impact of these changes on the incomes of different groups. Households are divided into ten equally sized deciles depending on their household income, but also different demographic groups within each decile (pensioners, working-age adults without children and working-age adults with children).

These measures (such as the increase in VAT and cuts to benefits and tax credits) have had the largest impact on approximately the bottom third of the income distribution but have been focused on those of working age. Low-income pensioners seem to have been largely protected from these cuts. Individuals in the middle and upper-middle parts of the income distribution have actually gained on average from tax and benefit changes under the coalition (such as increases in the personal allowance), though they had been more affected by cuts in earnings during and immediately after the Great Recession. In sum this probably means that inequality has risen in the latter half of the parliament, at least across much of the distribution.

Figure 2. Impact of tax and benefit reforms introduced between May 2010 and May 2015 by income decile and household type

sibjoyfig2Source: Browne and Elming (2015),

  1. Overall changes in inequality during recession and recovery

Figure 3 brings these stories together by showing expected changes in income across the income distribution between 2007-08 and 2014-15 (using simulation techniques beyond 2012–13 – the latest household income data – accounting for changes to taxes and benefits and trends in employment and earnings), covering the whole period of recession and coalition government. Perhaps contrary to popular perception, inequality will in fact still be lower in 2014–15 than in 2007–08. This is due in no small part to the nature of the labour market shock, which caused widespread falls in real pay rather than the kinds of rises in unemployment – concentrated on the low skilled – seen in previous recessions. Cuts to social security as part of the post-recession fiscal tightening have so far unwound only some of that sharp prior fall in inequality. This highlights the important point that, whilst the fiscal consolidation measures – which increase inequality across much of the income distribution – are the result of direct choices made by the coalition, these choices were of course made in a context where inequality had just fallen substantially and earnings levels had fallen relative to benefits.

There is a twist to this story though. Inflation has been hitting the poor harder over this period (primarily between 2007–08 and 2009–10), because they are less likely to have benefitted from plummeting mortgage interest rates and more likely to spend large shares of their budgets on food and energy, which have risen in relative price. The black line on Figure 3 shows that accounting for this does make an important difference. Nevertheless, even having done so there is no rise in inequality between 2007–08 and 2014–15.

Figure 3. Change in real household income from 2007–08 to 2014­–15, by percentile point sibjoyfig3Notes: Percentiles 1-4 and 96 to 99 are excluded due to high levels of statistical and modelling uncertainty. Incomes are deflated using the RPIJ index.

Source: Cribb et al (2015);

  1. Poverty

When it comes to poverty, trends and policy have been somewhat more confusing. Measures of relative poverty – such as the proportion of individuals with incomes below 60% of the contemporary median – have fallen significantly since the start of the Great Recession and over the period of coalition government (from 18% in 2007-08 to 16% in 2010-11 and 15% in 2012-13). However, this is mostly because falls in median income have reduced the poverty line, rather than because of rises in the living standards of low-income households. Absolute poverty (defined as household incomes less than the 2010­-11 median) has risen since household incomes began to fall (rising from 15% in 2009-10 to 17% in 2012-13) and is likely to have increased further as a result of cuts to benefits and tax credits taking effect from 2013-14 onwards.

However, there has been a distinct lack of clarity over what the coalition government goals really are with respect to poverty. There is currently a legally-binding target to ‘abolish’ child poverty by 2020, defined as reducing relative child poverty to below 10% as well as targets across a number of other domains. The coalition government initially announced rises in the Child Tax Credit alongside other benefit cuts in order to ensure no net impact on child poverty; but swiftly abandoned this practice (and cancelled the second planned CTC rise). Child poverty stood at 17% in 2012-13 and is expected to increase to 21% by 2020 ( ), clearly way off the legally-binding target. The coalition government has expressed some dissatisfaction with the current measure of child poverty and has consulted on a new measure of child poverty (, though this has led to nothing as of yet. We are therefore left in an odd situation whereby there is a legally-binding target to reduce child poverty by 2020 and no credible plan to meet that target.

The coalition government has outlined a number of strategies to reduce child poverty in the long-run ( For instance, it has emphasised improving work incentives, which have indeed been strengthened for most groups over the past five years ( Improving work incentives and reducing complexity have been important motivations for the introduction of Universal Credit. However, the implementation of this has been fraught with delays and is unlikely to be fully implemented until at least 2020 on current plans (

The coalition has also emphasised improvements in education outcomes, which are likely to be crucial determinants of later-life earnings capacity. The introduction of the disadvantaged pupil premium was a major plank of policy to improve the educational performance of disadvantaged children. However, there were already very significant amounts of funding targeted at poorer pupils before the coalition came to power ( and there is no evidence to suggest that this led to a larger reduction in the attainment gap. Moreover, any such improvements in educational outcomes are likely to feed through into the labour market in the long-run.

Looking to the future, an important challenge for the next government will be to set out a clear set of objectives in the area of child poverty alongside measures to meet those objectives, whatever they may be. For instance, are they still committed to the 2020 target and, if so, how are they going to meet it?

Financial regulation under the coalition government

In this, the third article on Coalition Economics, Arup Daripa and Sandeep Kapur (Birkbeck, University of London) examine the changes to financial regulation made since 2010. They argue the Coalition has improved the overall regulatory architecture with respect to systemic risk, but made little progress on either the regulation of shadow banking activities or the introduction of methods of resolving (winding down) large banks that get into trouble. Daripa and Kapur’s earlier assessment of financial regulation under the Labour government, 1997-2010, is included in the special journal edition which is free to download until the election.

  1. Introduction

The Coalition government came to power in 2010 in the wake of a financial crisis that had exposed significant weaknesses in the UK’s financial regulatory structure. The new government’s early attempts to repair these weaknesses had two elements: to the extent the financial crisis was seen as a banking crisis, it set up an Independent Commission for Banking (ICB) to identify the fault-lines. But it also launched an overhaul of the institutional architecture of financial regulation in the UK, leading to the Financial Services Act 2012. This note assesses the Coalition’s record and achievements in the area of financial regulation.

While the financial crisis focused attention on the failures and near-failures of some of the UK’s largest retail banks, to a large extent the underlying problems had emerged from the so-called shadow banking sector. This sector comprises a variety of non-deposit-taking financial institutions which engage in maturity transformation like retail banks but lack any protection for their creditors. Without protection, this sector is particularly vulnerable to wholesale ‘runs’, if short-term lenders decide en masse not to roll over their debt or demand large ‘haircuts’ to do so. In the recent crisis, problems arose initially in markets for securities backed by subprime mortgages, but metastasised into a broader crisis of illiquidity, and eventually came to stress the balance sheets of retail banks.

Once market turmoil sets in, any fragility of financial intermediaries is vulnerable to endogenous amplification mechanisms. A bank that wants to repair its stressed balance sheet may choose to deleverage by selling some of its assets. While optimal from the standpoint of a single bank, when many financial institutions make similar adjustments simultaneously, asset prices fall; this triggers further adjustment of leverage by additional sale of assets. This ‘fire-sale externality’ may be exacerbated by a ‘haircut spiral’ as lenders in repo markets demand larger discounts to lend against collateral. In the recent crisis, the combination of falling asset prices and large haircuts created a downward spiral that threatened systemic stability.

The principal lessons from the crisis are clear. One, in order to manage systemic risk, we must regulate all institutions deemed systemic, whether they are conventional banks, investment banks or shadow banks. Two, microprudential regulation of individual institutions does not per se guarantee systemic safety, and additional tools must be employed for macroprudential regulation. Three, when a crisis sets in, some form of liquidity provision facility is essential to guard against a sudden loss of investor confidence. Finally, large, complex, systemically-important financial institutions should have relatively transparent resolution mechanisms in place. Let us consider the structure and content of regulation proposed by the Coalition government against this background.

  1. The Independent Commission on Banking

As the crisis revealed many UK banks to be quite fragile, the new government established an Independent Commission on Banking in 2010 to explore structural reforms of the UK banking sector to promote its systemic stability. It sought to assess UK banks’ traditional model of ‘universal banking’ which combines both retail and investment banking. It also examined the relatively concentrated structure that had emerged, with a handful of large banks dominating the industry.

The Commission’s report, released in 2011, put forward a proposal to limit the interaction between the retail and investment banking functions in UK banks. It called for the assets and liabilities of the retail and investment banking functions to be separated, and the retail arm to be ‘ring fenced’. The retail arm must carry capital in excess of Basel III regulatory requirements, and only capital above this enhanced level can be transferred to the investment banking part. The purpose of this restriction is to limit the risk that an investment arm that runs into trouble might drain capital from the retail operation. The Coalition government agreed to implement this proposal, but under pressure from the City decided that the restriction would be imposed only after 2019.

In our opinion, the ring-fencing policy addresses the wrong problem. The crisis arose not within the traditional banking sector, but largely from the shadow banking sector. Unlike banks that had some depositor protection, this sector was particularly vulnerable to runs once doubts emerged about certain classes of securities. Ring-fencing, had it been in place, could hardly have prevented such runs in repo markets. More generally, systemic stability requires that all systemically important financial institutions be subject to macroprudential capital requirements. Subjecting only banks, or only retail parts of banks, to capital restrictions simply creates distortions without much gain in systemic stability. Indeed such ring-fencing can even increase systemic risk. If the investment banking part is in trouble, a universal bank may have an incentive to shrink its retail balance sheet so that excess capital can be released to support its investment banking arm. Such asset sales can trigger fire-sale externalities.

Further, the ring-fencing proposal seems to implicitly assume that the main problem in a crisis is that of solvency. In the recent crisis many financial intermediaries who required central bank support were solvent but illiquid. A ring-fence would, once again, have made this problem worse. The liquidity from depositor funds is typically unaffected in a crisis because such funds are backed by depositor insurance (which, when designed properly, eliminates depositor runs). If the crisis is primarily one of liquidity, access to depositor funds can help investment banking activities in a crisis. Overall, in our opinion, the implementation of the ring-fencing proposal would be a step in the wrong direction.

  1. A new structure for prudential regulation

In the tripartite regulatory structure created by the Labour government, the Bank of England, the Treasury and the Financial Services Authority (FSA) were collectively responsible for financial regulation. This arrangement had transferred microprudential regulation of banks, and also regulation of their conduct, to the FSA, while financial stability and lender-of-last resort functions remained a responsibility of the Bank of England. This tripartite structure was seriously tested by the crisis: with insufficient communication between the various parties as events unfolded, and poorly assigned responsibilities, this arrangement was found to have a ‘regulatory underlap’.

The Coalition government remedied this by reforming the institutional structure of financial regulation, specifically to improve macroprudential oversight. A new Financial Services Act 2012, which came into force in April 2013, abolished the FSA and divided its tasks across different bodies. Conduct regulation was transferred to a new body, called the Financial Conduct Authority (FCA). A Prudential Regulation Authority (PRA) was set up under the Bank of England to return microprudential regulation to the Bank of England, while a Financial Policy Committee (FPC) was established in the Bank to maintain systemic oversight. The FPC is tasked with monitoring overall levels of leverage and credit growth in the financial system and makes policy recommendations to the PRA and FCA as well as to the Treasury. Along with the existing Monetary Policy Committee, the FPC and PRA together puts the Bank of England in charge of monetary policy, prudential bank solvency as well as systemic financial stability, making it one of the most powerful central banks in the world.

The new arrangement enables better macroprudential oversight and, as such, is a move in the right direction. However, the arrangements fall short when it comes to regulating shadow banks. In the US, the Dodd-Frank act of 2010 includes a number of measures to achieve precisely such control. The lack of any comparable attempt at gaining control over the shadow sector remains a significant weakness of the current UK regime.

  1. Regulation of conduct and practice

The Financial Services Act 2012 hived off the regulation of financial services to a new Financial Conduct Authority (FCA). Consumer protection is its key remit, but the FCA is also responsible for some broader regulatory functions, notably preventing market abuse (such as insider dealing or market manipulation) and for promoting competition and innovation. Its mandate covers all firms providing retail or wholesale financial services (for instance, banks, building societies, insurance companies); its enforcement powers come from its ability to exclude individuals and firms from financial markets, to investigate financial crime and to seek criminal penalties through the legal system.

Pre-crisis conduct regulation in the UK had been celebrated as ‘light touch’. Given the extent of corporate excess and malfeasance revealed in the wake of the financial crisis, some regulatory tightening was inevitable. Indeed regulatory tightening had commenced while the FSA was still in charge, and the FCA has largely continued that task using institutional assets and personnel it inherited from the FSA. In recent years, the FCA has led the investigations into the manipulation of LIBOR and foreign exchange markets by UK banks. The value of financial penalties has risen from about £34 million in 2009-10 to £425 million in 2013-14, and the FCA has also resorted to issuing public warning notices as a deterrent.

However the choice of regulatory intensity presents a familiar dilemma for the Coalition. The financial services industry continues to be a very substantial part of the UK economy and continues to lobby against ‘excessive regulation’ that might damage London’s position as a leading global financial centre. But stronger enforcement may be critical for restoring public trust in financial institutions tainted by scandals. The on-going debate over excessive personal remuneration in the financial sector offers a case in point: despite the public hostility to a culture of large bonuses, the UK government has lobbied aggressively against EU attempts to restrain high performance-related pay in banks, and even sought legal challenges against European directives that aim to do so. Given the Coalition’s reflexive preference for laissez faire policy wherever feasible, there is the risk that choice of regulatory intensity may be distorted by ideological considerations.

  1. Private debt restructuring

Recent research has thrown light on the importance of private-sector debt, especially housing debt, in determining the severity of crises as well as the duration of the recessions that follow. Jorda et al. (2014), drawing on data from banks’ balance sheets for 17 advanced economies since 1870, show that mortgage lending by banks has been the driving force behind the rise of the financial sector. Mortgage credit accounts for the bulk of the episodes of credit expansion and these episodes tend to be followed by deeper recessions and slower recoveries. This research programme puts housing finance at the centre of the economy, with significant responsibility for financial instability.

A related research programme by Mian and Sufi has examined disaggregated data on credit and spending from the US. Using a rich variety of sources, they establish that, after the collapse of the housing bubble destroyed the net worth of indebted individuals, the withdrawal of their private demand, more than any credit crunch, has prolonged the recent recession. If so, restructuring of housing debt must form a crucial element of any financial policy reform to enable faster recovery. The ‘Help to Buy’ programme in the UK, which involves provision of public equity to support investment in housing (the government puts up 20% of the purchase price thus absorbing 20% of any subsequent capital gains or losses), is a step in this direction.

  1. Conclusion

Financial regulation is not easy. Regulated entities tend to devote far more resources to avoiding any regulatory burden than those available to the regulator in enforcing regulation. This reduces the information content of the measures that the regulator depends on. Further, regulation gives rise to a boundary problem: regulated entities have the incentive to try to locate economic activity just outside the purview of the regulatory authorities, as evident from the rise of shadow banking. It follows that any regulatory regime is bound to be imperfect and future crises cannot be ruled out. Casting the regulatory net as widely as possible to contain systemic risk, and planning for a soft landing should therefore form crucial parts of any regime of financial regulation.

Since 2010, the Coalition government has improved the regulatory architecture to better manage systemic risk, but the lack of any progress towards regulating shadow activities remains a significant weakness in the UK regime. The ICB proposal adds little in this regard. As for containing future crises, there remains the crucial task of designing transparent resolution mechanisms for large financial intermediaries, so that debt holders are prevented from free-riding on the public purse. A debt-restructuring regime for distressed mortgage holders would help in the event of any collapse in real estate prices. However, very little progress has been made on either front so far.



  • Adrian, Tobias and Hyun Song Shin (2010) “Liquidity and Leverage,” Journal of Financial Intermediation, Volume 19 (3), 418-437.
  • Afonso, Gara, Anna Kovner, and Antoinette Schoar (2011) “Stressed, Not Frozen: The Federal Funds Market in the Financial Crisis,” Journal of Finance, 66 (4), 1109–1139.
  • Brunnermeier, Markus K and Lasse H. Pedersen (2009) “Market Liquidity and Funding Liquidity,” Review of Financial Studies 22, 2201–2238.
  • Daripa, Arup, Sandeep Kapur and Stephen Wright (2013) “Labour’s record on financial regulation,” Oxford Review of Economic Policy, Volume 29 (1), 71–94.
  • Jordà, Òscar, Moritz Schularick, and Alan M Taylor (2013) “When Credit Bites Back,” Journal of Money, Credit and Banking, 45(s2): 3–28.
  • Jordà, Òscar, Moritz Schularick, and Alan M Taylor (2014) “The Great Mortgaging: Housing Finance, Crises, and Business Cycles,” NBER Working Paper 20501.
  • Mian, Atif, and Amir Sufi (2009) “The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis,” Quarterly Journal of Economics, Vol. 124 (4)
  • Mian, Atif, and Amir Sufi (2011) “House Prices, Home Equity-Based Borrowing, and the U.S. Household Leverage Crisis,” American Economic Review, Vol. 101 (5)
  • Mian, Atif, and Amir Sufi (2014) “What Explains the 2007-2009 Drop in Employment?” Econometrica, Vol. 82 (6): 2197-2223.
  • Mian, Atif, and Amir Sufi (2014) House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again, Chicago: University of Chicago Press.
  • Shleifer, Andrei and Robert Vishny (2011) “Fire Sales in Finance and Macroeconomics,” Journal of Economic Perspectives, 2011, 25 (1), 29–48.

Corporate taxation under the coalition government

In this second article on Coalition Economics, Giorgia Maffini (Said Business School, Oxford University) analyses the changes in corporate taxation over the period. She argues that the UK’s international competitive position has been improved, but at considerable cost, while little has been done to assist the UK manufacturing sector and promote the rebalancing of the economy. Maffini’s earlier assessment of the Labour government, 1997-2010, is included in the special journal edition which is free to download until the election.

  1. Introduction

Over the last 30 years and until the global financial crisis, governments across the OECD have gradually cut statutory rates of corporation tax to attract mobile activities and profits (see figure 1). This trend had slowed by 2010. At the height of the global financial crisis, governments were struggling to reduce their budget deficits. There was little room for tax cuts and most OECD countries decided to avoid large tax reductions. The Coalition had a very different plan:

“Our aim is to create the most competitive corporate tax regime in the G20, while protecting manufacturing industries”

- The Coalition agreement, May 2010.

Over five years the government unrolled an intense reform programme which would substantially reduce the tax burden on business and make the UK business tax regime substantially more attractive.

  1. Changes to the statutory corporate tax rate and to capital allowances

As of 2015, the main statutory corporation tax rate has been cut from 28 to 20%. This is the (equal)[1] lowest corporation tax rate in the G20 and the lowest in UK history. The small profits rate applicable to profits below £300,000 was cut from 21 to 20% in 2011.[2]

In terms of tax revenue, rate cuts have been partially compensated for by enlarging the tax base. In 2012, writing-down allowances for the main pool of plant and machinery were cut from 20 to 18%.[3] Additionally, the government did not repeal Labour’s decision to phase out allowances for industrial buildings by 2011.

The value of allowances for small and medium sized enterprises (SMEs) differs markedly, due primarily to the Annual Investment Allowance (AIA). Introduced by the Labour government in 2008, the AIA gives a 100% deduction for expenditure in plant and machinery with a threshold of investment initially of £50,000 and then of £100,000. The Coalition announced temporary changes to the AIA threshold several times (mainly increases). If the government’s announcement were credible, a temporarily higher threshold could provide an incentive for business to bring investment forward.[4]

  1. Effects of rates cuts on the competitiveness of the UK tax system

Three measures are used to assess the tax costs associated with corporation tax: the main statutory rate and two summary measures that account for both the statutory rate and the tax base: the effective average tax rate (EATR) and the effective marginal tax rate (EMTR).

The statutory tax rate affects profit-shifting as the marginal incentive to shift an additional unit of corporate profits after all deductions depends on the corporate statutory tax rate. Figure 1 shows that the UK rate was substantially lower than the OECD average until 2004 when cuts in other OECD countries meant that the UK 30% rate was higher than the OECD average for the first time in 20 years.

Figure 1. Statutory corporate tax rates (1994-2015)

maff4fig1Source: OUCBT tax database

In 2012 the UK rate dropped again below the OECD average and by 2015, it is about 7.5 percentage points lower.[5] Although the UK rate is consistently lower than the French and German rates, smaller, low-tax OECD jurisdictions (e.g. Ireland) have had very attractive rates for profit shifting activities. Such small jurisdictions have now become less appealing if compared to the UK corporate tax rate of 20% or to the 10% rate available with the Patent Box, a scheme granting a reduced rate to income generated by patents held in the UK.

Figure 2 shows the evolution of the EATR which depends on the statutory rate and on capital allowances. It is the proportion of pre-tax profit of a typical investment project that would be taken in tax. It affects the location of investment in the UK, i.e. it affects inward foreign direct investment (FDI). Until 2013, the UK EATR was not particularly competitive compared to the OECD average, although the OECD average includes smaller countries which would not necessarily be competitors of the UK. Starting in 2011, the UK EATR began declining and by 2015, it is well below the OECD average. Historically, the UK EATR is lower than the French and German rates, with the gap widening substantially since 2011.

Figure 2. Effective average tax rates (1994-2015)


Source: OUCBT tax database

If the UK has improved its competitive position substantially in terms of attracting profits and FDI, the EMTR which affects the size of investment remains relatively high. The EMTR measures the proportionate increase in the cost of capital due to the tax. It accounts for both the statutory rate and for capital allowances. It affects the size of investment, given the decision to locate in the UK. The EMTR focuses on the margin, i.e. it focuses on a project that just breaks even by earning a return equal to the cost of capital.

The tax base and hence capital allowances are very important for the marginal investment project and that is why the UK ranks low on this measure: the UK capital allowances regime is one of the least generous in the OECD (OUCBT, 2015). Historically, the UK EMTR has been higher than the OECD average (figure 3). It declined after 2011 but in 2015 it remains well above the OECD average.

Figure 3. Effective marginal tax rates (1994-2015)

maff4fig3Source: OUCBT tax database

  1. Effects of rates cuts on investment and FDI

At the beginning of the Coalition term in 2010, investment and FDI were considerably lower than their pre-crisis peak. There was little doubt about the need to stimulate investment at that time. To calculate the effect that the tax reform could have had, we use estimates in the economic literature (Feld and Heckemeyer, 2011).

The cut in the EATR from 26 to 18% could have increased inbound FDI by 12.5% and the reduction in the EMTR from 22 to 17% could have increased the capital stock by about 2%.This does not necessarily mean that FDI and the capital stock have increased. It could also be that they have decreased but less than they would have done without the reform. As explained in OUCBT (2015), although there is uncertainty in these estimates, economic evidence points to large effects of tax cuts on FDI and capital stock.

The assessment of the effect of the AIA is different. The AIA only affects the cost of capital of companies with investment below the AIA threshold[6] and these are likely to be smaller companies. The AIA threshold only covers investment of smaller firms, generally with less than 100 employees (OUCBT, 2015). These companies only account for about 20% of aggregate investment. Hence, the AIA is unlikely to have had a large effect on aggregate investment.

  1. Additional changes and impact on competitiveness

There are some very important elements of the UK tax system such as the controlled foreign corporation (CFC) regime, the Patent Box (PB) and the R&D tax incentives which are not reflected in the statutory rate, the EATR or the EMTR.[7]

CFC rules are anti-avoidance provisions whereby under certain conditions profits of CFCs located in low-tax jurisdictions are taxed upon accrual at the domestic corporation tax rate. The old UK CFC rules had been deemed very stringent and not in line with business practices. The Coalition continued Labour’s plan to reform the CFC rules and delivered the final regime[8] which is considered more business friendly.[9] Despite being controversial, some of its provisions create a competitive advantage to locating a headquarters company in the UK and certainly lower the cost of capital for multinationals, for example, by facilitating financing of the group through low-tax subsidiaries.[10]

The PB entered into force on 1 April 2013.[11] It provides that corporate profits derived from patents held by a UK-resident company are taxed at a reduced rate of 10%.[12] The scheme was welcomed by business but some countries, particularly Germany, raised concerns that the PB could be used as a tool to shift profits out of their high-tax jurisdictions.

Under the initial version, patents created elsewhere and possibly awarded tax incentives by other countries could have been easily shifted to a UK company and their income (i.e. royalties) would have enjoyed the reduced rate of corporation tax available under the PB.[13] In November 2014, after an agreement with Germany, the UK accepted to reform its PB regime with the aim of introducing a closer link between the jurisdiction where the patents have been developed and the jurisdiction where the income from such patents enjoys the benefits of a lower corporate statutory rate.[14]

Although the initial version was probably more competitive, the existence of a PB encourages companies to hold intellectual property rights in the UK, rather than shifting them to a low-tax jurisdiction. There are concerns that such schemes could provide a further incentive to profit-shifting[15] by multinational companies (Griffith et al., 2014). Legislation regulating the new PB regime will be implemented by the next government and its role in increasing the attractiveness of the UK for mobile, intangible assets and profits will depend on the details of the law.

The Coalition has also expanded the generosity of R&D tax incentive schemes for both SMEs and larger companies. It has simplified the system and made it more salient for larger companies by transforming R&D deductions into a credit (the so-called “above the line credit”).[16]

  1. Costs of the reform

Such a comprehensive reform of business taxation implies large costs. In terms of foregone revenues, the reform will cost £7.5 billion a year by 2015/16 (or 21% of average annual corporate income revenues). Adding the initial version of the PB brings annual costs to £8.2 billion (or 23% of annual corporate income tax revenues). By any standards, these are large costs which will translate into a higher deficit or lower public spending and/or they will need to be financed by other taxes, such as VAT.[17] Figure 4 shows that VAT revenues (as a share of total tax revenues) have increased under the Coalition, after the standard rate of VAT was raised from 17.5 to 20% in 2011. Revenues from other taxes remained stable or declined.

Figure 4. Own revenues, share of total tax revenues (%).

maff4fig4Source: OECD Revenue Statistics, series 1110 (personal income tax), 1210 (corporate income tax), 2000 (social security contributions), 4120 (Business rates), 5111 (VAT).

The Coalition has also introduced new taxes, in particular on the banking sector. The 2010 Budget introduced a Bank Levy applied to banks’ total liabilities.[18] Before the crisis, the financial industry contributed between 21 and 26% of net corporate tax receipts. From 2008/09 onwards, its contribution declined to between 11 and 16%. Figure 5 shows that even accounting for the Bank Levy receipts, the contribution of the financial sector remains well below its pre-crisis level.

Figure 5. Financial sector corporation tax revenues (% total corporation tax revenues)

maff4fig5Source: HMRC Corporation Tax Statistics, table 11.1A, 2014.

  1. Avoidance

The government has been very active on tax-avoidance.[19] It was one of the key priorities of its tax reform programme and overall the Coalition has not allowed a lax anti-avoidance strategy to affect its competitiveness agenda.[20] The fight against avoidance was considered as a way to finance rate cuts and other business tax reforms. The Coalition introduced significant measures such as the General Anti-Abuse Rule (GAAR), probably the most significant domestic development in the fight against avoidance over the past five years. The UK has also actively participated in the OECD/G20 Base Erosion and Profit Shifting (BEPS) project.

Nonetheless, some anti-avoidance measures have been controversial.[21] Very recently, in its 2014 Autumn Statement, the government introduced the Diverted Profits Tax (DPT) which applies a rate of 25% (instead of the standard 20% corporation tax rate) to profits “diverted” from the UK.[22] The DPT seems to target a small number of companies[23] but, in fact, some of its provisions could draw in companies not intentionally targeted. This creates uncertainty for business and some observers have wondered whether the DPT signals a change of course in the Coalition’s competitiveness agenda.

  1. Conclusion

The competitive position of the UK with respect to the OECD has improved substantially since 2011, and by 2015, the main corporate statutory tax rate and the EATR are well beneath the OECD average. This suggests that for the location of profits and of FDI, the UK has become very attractive.

The government has failed to make the tax component of the user cost of capital (EMTR) particularly competitive, though. The UK EMTR has historically been higher than the OECD average and this has not changed under the Coalition. For large companies, the UK capital allowances regime remains one of the least generous in the OECD. This affects firms’ cost of capital negatively and hence reduces their incentive to expand the size of their investment in physical assets such as plant and machinery and buildings. It is difficult to reconcile a regime of low capital allowances with the Coalition’s ambition of protecting the manufacturing sector.

Although relatively less attractive for industries with large investment in physical assets, overall, today’s UK tax system is very attractive for the location of company headquarters and more generally for the location of activities of multinational companies. There are seven main reasons.

  • First, the exemption system of taxation of foreign profits[24] allows parent companies located in the UK to receive dividends exempt from UK corporate income tax. Because of the substantial shareholding exemption introduced in 2002, foreign capital gains are also exempt.
  • Second, the rate of corporate income tax is low with respect to other OECD countries, reaching 20% in 2015.
  • Third, the presence of a PB regime with a rate of 10% lowers the tax burden on very mobile factors such as intangibles and together with a relatively simple R&D tax incentives regime makes it more attractive to research and own UK-developed patents in the UK, rather than locate them in a low-tax entity.
  • Fourth, the new CFC regime allows important exemptions which essentially lower the tax burden on CFCs located in low-tax jurisdictions. In particular, the finance company exemption allows financing of high-tax subsidiaries via a low-tax CFC.
  • Fifth, historically the UK system does not charge withholding taxes on dividends paid from UK companies to their foreign shareholders. And the UK has signed a large number of tax treaties reducing outbound withholding taxes on interest payments and on royalties.
  • Sixth, the UK is part of the European Union: the EU Parent-Subsidiary Directive provides that intra-EU dividends paid by EU subsidiaries to an EU parent are exempt from withholding taxes, and the Interest and Royalties Directive provides that withholding taxes on intra-EU royalty and interest payments are set to zero.
  • Finally, the UK has generous rules for the deduction of interest payments. Although a worldwide debt cap for large companies was introduced in 2009 under the Labour government,[25] current interest rules remain relatively generous by international standards.

In this competitive context, at the end of the Coalition’s term, some questions remain. Primarily, was the increase in competitiveness worth £7.5 billion (or more)? The economic literature points to large effects of tax cuts on FDI and on investment. The Government and a large part of the business community seem to agree that the gain in competitiveness was worth forsaking some revenues. Some of the specific reform proposals originated with the Labour government and the Coalition’s business tax reforms have not generally been strongly contested politically.

If the gain in competitiveness outweighs the loss in revenues, why not cut even further and, indeed, what’s the optimal corporate tax rate for the UK?

The Coalition and business seem satisfied with where the statutory tax rate is now. If elected, the Labour Party has pledged not to cut the statutory corporate tax rate to 20% in 2015 but to keep it at 21%. The difference between 20 and 21% is minimal and hence, there seems to be a broad consensus on the fact that, for now, the appropriate UK corporate statutory tax rate is around 20%.

The political debate has not yet addressed some of the weaknesses of the UK business tax regime considered in this paper. In particular, the relatively ungenerosity of the capital allowances regime has been subject to very little discussion. According to the latest data, business investment fell in quarter 3 of 2014, leaving the annual pace of growth at 6.3%.

The UK is today one of the fastest growing developed economies but its productivity has historically been lower than that of other comparable countries such as Germany and France. For productivity to increase, investment has to hold up. Capital allowances are a key policy tool for stimulating investment. The issue then becomes which capital assets should be incentivised.

With new business models heavily relying on information and communications technology and the growing importance of the services sector, the tax system should not only target traditional capital such as machinery, equipment and buildings but also intangible assets which have a high potential to increase productivity.



  1. In 2015, three other G20 countries have a statutory corporate tax rate of 20%: Russia, Saudi Arabia and Turkey.
  2. In fiscal year 2015/16, if after the election the new government confirms the changes introduced by the Coalition, the UK will have a single statutory corporation tax rate of 20%.
  3. The main pool attracts the majority of standard plant and equipment, including computers and software. The rate of capital allowances was reduced from 10 to 8% for the special pool. The main items in the special pool are long-life assets or cars with higher CO2 emissions.
  4. Frequent and close announcements of temporary increases reduce the credibility of each further announcement. In its first emergency Budget in June 2010, the Coalition announced a cut in the AIA threshold to £25,000 to be implemented almost two years after the announcement, for expenditures incurred on or after 1 April 2012. However, subsequently, the AIA threshold was kept at £25,000 only for eight months (between 1 April and the 31 December 2012). It was then raised tenfold, again on a temporary basis, to £250,000 for expenditures incurred on or after 1 January 2013 and then doubled – yet again on a temporary basis – to £500,000 for expenditures incurred on or after 1 April 2014. Although the AIA is available for all companies, it narrows the tax base for SMEs substantially as it covers all or most of their investment in plant and machinery.
  5. In 2015, the OECD average is about 25.7% against the 20% corporate statutory rate for the UK.
  6. The tax burden on the marginal unit of investment affects the incentive to invest and hence, the size of investment.
  7. Such elements will only affect some firms whilst changes in the statutory rate and in general capital allowances affect all corporations.
  8. The new regime is applicable to financial years starting on or after 1 January 2013. A reform of the CFC regime was first launched by the Labour government and in part motivated by a ruling of the Court of Justice of the European Union (CJEU). In September 2006 in the Cadbury Schweppes plc case, the CJEU held that the old UK CFC rules restricted the freedom of establishment within the EU.
  9. The new regime is now based on an estimate of the amount of profit diverted from the UK whilst the previous regime had an entity-based approach: all or none of the profit of a CFC was subject to the CFC rules. The new regime targets the “artificial” diversion of profits and passive income when there is no economic substance in the low-tax location of the profits whereas in the previous regime all passive income and profits located in a low-tax jurisdiction may have been subject to the CFC rules. The principles underlying the new regime are reflected in the introduction of specific exemptions. For example, the new regime provides for a 12 months’ exemption for foreign subsidiaries which come under UK control, after the restructuring of a group. This facilitates reorganizations involving UK companies.
  10. In particular, the finance company exemption provides that only one quarter of profits earned by a CFC from loans to overseas companies is taxable at the main UK corporate income tax rate. This implies that the effective tax rate for such companies in 2015 is 5%.
  11. The PB was first proposed by the Labour government in its 2009 Pre-Budget Report.
  12. The PB benefits are phased in gradually so that companies need to apply an appropriate percentage to the company earnings from patented inventions, i.e. 1 April 2013 to 31 March 2014: 60%; 1 April 2014 to 31 March 2015: 70%; 1 April 2015 to 31 March 2016: 80%; 1 April 2016 to 31 March 2017: 90%; and from 1 April 2017: 100%.
  13. In this form, the UK regime seemed to be in contrast with the principles emerging from the OECD Base Erosion and Profit Shifting (BEPS) Action Plan (in particular, Action 5). At the same time, the Council of the European Union and the European Commission started investigating the UK Patent Box (OUCBT, 2015, sec 2.3).
  14. This is the so-called modified nexus approach. The existing regime needs to be closed to new entrants by 30 June 2016 and should be abolished by 30 June 2021. A new regime incorporating the modified nexus approach will co-exist in parallel with the old one until 2021. After this date, all countries have to maintain “nexus-compliant” regimes (OUCBT, 2015). For a more detailed description of the challenges for the new PB regime, see OUCBT (2015), section 2.3 and Englisch and Yevgenyeva (2013).
  15. A multinational company would locate patents in low-tax jurisdictions or in jurisdictions where a lower corporate tax rate is available through a PB regime. Royalties for the exploitation of the patents will then be paid from the operational subsidiaries located in high-tax jurisdictions to the owner of the patents located in a low-tax jurisdiction. This mechanism reduces taxable income in high-tax jurisdictions to shift it to low-tax countries.
  16. This implies that such credit could be added to the corporate pre-tax profit and hence be more easily incorporated into the decisions of the research and operative departments. For a more detailed description of the British R&D regime, see OUCBT (2015), section 2.4 and 3.2.
  17. For an analysis of the UK public finances, see Crawford et al. (2015) and Emmerson et al. (2015).
  18. The Bank Levy is not applied to tier 1 capital, insured retail deposits, repos secured on sovereign debt, and policyholder liabilities of retail insurance businesses within banking groups. It only applies to financial institutions with aggregate liabilities of £20 billion or more from 1 January 2011. For more details, see OUCBT (2015), section 2.7.
  19. For a more detailed description of the anti-avoidance measures introduced under the Coalition government, see OUCBT (2015), section 4. For an evaluation of the principles which should guide anti-avoidance tax policy, see Vella et al. (2012).
  20. To get some order of magnitude of the revenues involved in the fight against avoidance, OUCBT (2015) estimates that revenues raised from specific measures implemented between 2010 and 2015 amount to about £7.5 billion a year. Although these estimates are uncertain, these are large numbers which could partially offset the cost of the reform to the business tax system.
  21. There are other examples of controversial anti-avoidance measures. For example, the Chancellor has asked banks to sign up to the Code of Conduct for Banks detailing that financial institutions should respect not only the letter but also the spirit of the law. The Code has also been used to introduce retrospective legislation. All this clearly raises serious concerns about the rule of law (OUCTB, 2015).
  22. These are profits generated but not taxed in the UK because the company involved does not have a taxable presence in the UK or because of other arrangements lacking economic substance.
  23. The government’s own costings also seem to confirm that the DPT is narrowly targeted (£270m in 2016/17).
  24. The system was introduced under the Labour government in 2009.
  25. The worldwide debt cap was introduced with the Finance Bill 2009 under the Labour government and applies to financial accounts beginning on or after 1 January 2010. The objective of the regime is to restrict deductions for interest payments and other finance expenses claimed by members of a large group. A group is defined as large if at least one of its members has at least 250 employees, an annual turnover of at least EUR50 million, and/or a balance sheet total of at least EUR43 million. The cap will only apply if the UK net debt of the worldwide group exceeds 75% of the group’s worldwide debt. Once the cap applies, complex rules provide that the excess deductions for interest payments will be disallowed.


  • Crawford, R., Emmerson, C., Keynes, S. and Tetlow, G. (2015) “Fiscal aims and austerity: the parties’ plans compared”, IFS briefing note BN158, election briefing note 2015, no. 1.
  • Emmerson, C., Johnson, P. and Joyce, R. (2015) “IFS Green Budget”, January.
  • Englisch, J., and Yevgenyeva A. (2013) “The ‘Upgraded’ Strategy against Harmful Tax Practices under the BEPS Action Plan”, British Tax Review, 5, 620-637.
  • Feld, L. P. and Heckemeyer, J. H. (2011) “FDI and taxation: a meta-study”, Journal of Economic Surveys, 25(2), 233-272.
  • Griffith R, Miller H, O’Connell M. “Ownership of Intellectual Property and Corporate Taxation”, Journal of Public Economics 111(2014): 12-23.
  • Oxford University Centre for Business Taxation (OUCBT), (2015) “Business Taxation under the Coalition Government”, OUCBT Report. Available at:
  • Vella, J., Devereux M. and Freedman, J, (2012) “Tax Avoidance”, Report commissioned by the UK National Audit Office. Available at:

Public-Private Partnerships under the Coalition

In this first article on Coalition Economics, Paul Hare (Heriot-Watt University) addresses the UK government’s approach to public-private partnerships. His findings reflect changes in the approach taken since 2010; the scale of investment resulting; and the range of ongoing criticisms.

  1. Introduction

This short paper is an update of Hare (2013), sketching how both the policy and practice relating to public-private partnerships (PPP) and the private finance initiative (PFI) have evolved since the end of the last Labour Government in May 2010.

As soon as it assumed power, the Conservative/Liberal Democrat coalition government (referred to below as the Coalition, for short) was quick to declare that Labour’s form of PPP would no longer be pursued, and that a new model to support public infrastructure would be developed. How this new model evolved, and how well (or otherwise) it has worked, are examined below.

In Hare (2013) it was found that a good deal of much needed public infrastructure spending – on schools, hospitals, and other public facilities – had taken place under the PPP banner, including some spending that might not otherwise have gone forward. While ostensibly, the reason for funding infrastructure through the PPP route was to achieve more efficient construction (lower cost, on budget, on time), and to share risks with the private funders, an underlying justification (often not acknowledged) was the desire to build more schools, hospitals, etc., without the associated capital costs appearing  in the public accounts. In other words, accounting rules in effect at the time allowed what was for all practical purposes public capital spending to be carried out without adding to the public debt.

Towards the end of the period of Labour government, the accounting rules changed, and most PPP-type spending is accounted for correctly at departmental level, but at National Accounts level, much still does not add either to the deficit (current account) or to the debt (capital account) of the public sector.

How effective were the investments carried out under the PPP and PFI headings? The evidence is quite mixed, though with some indication that capital costs and project completion times were often better managed than under the alternative of conventional public sector projects (as was confirmed in a National Audit Office report, NAO, 2009; though the data needed to make these judgements properly was not always available, see NAO, 2011, p.6).

It was far from clear whether much project risk was ever effectively shifted, however. And the principal legacy of these numerous projects is a stream of capital charges (to give the private investors a return on their capital) and service costs (PPP projects usually bundled in some service provision) extending for as long as 30 years or so. These have already proved to be a difficult burden on school and hospital budgets, among others.

Has the Coalition managed to do any better in this important area? We review that next.

  1. Developments in PFI and PPP

Having declared that the Labour Government’s approach to PPP, notably the PFI, was not fit for purpose, the Coalition worked to develop a new/amended model.  It started by announcing, in October 2010, an Infrastructure Plan for the nation (HM Treasury, 2010; subsequently updated several times), under which it was envisaged that £200 billion would be spent on infrastructure capital projects over the ensuing five years (see Helm, 2013). Much of this was expected to come from private sources, and it was never wholly clear how much of this spending would be ‘new money’ (i.e. public spending not already committed under some other heading).

The House of Commons Treasury Committee reviewed PFI as it had operated under the old model, publishing its findings in 2011 (see HoC, 2011). It found that PFI projects faced a cost of capital exceeding 8%, as compared to the Government’s ability then to borrow long term at 4% or less. The Committee were sceptical whether other purported benefits of the PFI approach were often sufficient to justify this higher capital cost.

Despite changes in official accounting rules, they found that far too much PFI remained ‘off budget’ and was therefore still not counted as part of public deficits or debt (see Heald and Georgiou, 2011); Departmental public spending rules also still allowed PFI projects to be treated as ‘additional investment’, not part of the allotted capital budget. The Committee urged the Government not to allow much PFI spending without a very clear focus on the Value for Money (VfM) criterion.


The new version of PFI, quickly dubbed PF2, was announced in December 2012 via the publication of a Treasury paper, HMT (2012a), with an accompanying guide to new PFI contracts (HMT, 2012b; running to 400 pages), and a much shorter user-guide issued by Infrastructure UK (Infrastructure, 2012). According to Buisson (2013), the basic PFI model remains essentially intact, with a few changes to address perceived weaknesses. The changes are summed up briefly in Table 1, above (click for full-size version).

Only a small number of new projects has been approved under PF2.  According to HM Treasury data, at March 2013 (more recent data appears not to be available) just 23 new PF2 projects were in procurement with a total expected funding requirement of £3,547.3 million. Treasury data also show that in the financial year 2012-13, 15 PF2 projects were signed, with a funding requirement of £1,539.3 million. The same data source also identified each project’s equity holders and their respective shares; most holders being private, contrary to the intention expressed in the first row of Table 1.

Most projects were funded through a special purpose vehicle (SPV) set up for the purpose, and these too were listed. These modest recent numbers contrast with the total PFI commitment reported a year earlier, March 2012. At that time there were 717 projects in the Treasury database, involving a total capital spend of £54.7 billion; total expected repayments on these projects (covering both return on capital, and the unitary charges), over a period of up to 30 years, came to £301.3 billion.

Not a great deal of time has elapsed since the above changes were brought in as part of PF2, but the House of Commons Treasury Committee has already attempted to review the new model (HoC, 2014). Their report raises some interesting questions about how PF2 is supposed to work, and its likely effectiveness.

The Committee particularly questioned accounting and budgetary issues; value for money; and securing private investment. On the first question, the Committee repeated earlier concerns about much PF2 spending remain  off budget in the National Accounts, and doubted whether the innovation of a ‘control total’ would greatly change the incentives to seek private finance for a proposed project (see Table 1).

On VfM, there was concern about the likely cost of capital under PF2, with its expected higher equity contribution. In addition, while projects are all to be evaluated using the guidance in the Treasury Green Book (HMT, 2011), a VfM quantitative assessment tool was withdrawn by HMT in December 2012, and an alternative tool has not been provided. Hence projects could be approved without undergoing a full quantitative assessment. There was also a risk that splitting out ‘soft services’ from PF2 projects could increase contractual complexity by requiring multiple contracts. Last, attracting private investors in sufficient numbers for competition to keep down the required returns on equity involves a significant flow of PF2 projects coming forward, and this had not yet materialised.

Recent press reports illustrate some of the problems that PFI projects have encountered, notably in the health sector. Thus FT (2014) reports on the first NHS Trust to buy out its PFI contract, replacing private funding with a loan from the local council, and enabling the Trust to cut its charges by £3.5 million per year over the next 19 years. And Telegraph (2011) claims that 22 NHS Trusts were struggling to balance their books due to the high payments expected under PFI contracts, while also noting some examples of waste, including an empty school (no longer needed) for which the local authority would be paying the private investor until 2027. This highlights a drawback of the PFI model, and the new PF2 variant, namely the lack of flexibility in resource use.

In Scotland, while the overall PFI/PF2 framework remains available, and has been extensively used, the Scottish Government has opted to develop its own new model for public-private partnerships, under the heading of Non-Profit Distributing PPPs (or NPDs) (see Scottish Government website, Scottish Futures Trust website).

An NPD project has three features:

  • there is enhanced stakeholder involvement in project management (though I confess to being unsure what this can mean);
  • there is no dividend bearing equity; and
  • private sector returns are capped.

Thus the model does not prevent private sector partners from making a reasonable profit, it merely seeks to limit that profit.  The Scottish Futures Trust is currently delivering through the NPD model a £3.5 billion pipeline of major infrastructure projects, which includes some major motorway improvements as well as projects in health and education.

  1. Conclusions

Finally, then, has the Coalition advanced matters much as regards PPP investments? A few points suffice to sum up the current situation.

  • PF2, the new model, has brought in some modest changes to the original PFI model, but the changes appear less substantial than has been claimed.
  • The flow of activity under the PF2 banner – both numbers of projects and funds committed – has slowed down considerably since the Labour years.
  • Scotland has been experimenting with an interesting alternative model, the NPD model, which is already funding a good deal of infrastructure spending.
  • Many of the shortcomings of PFI, reported by the National Audit Office and other bodies in the later years of the Labour Government, are still being reported today – both as legacy issues from PFI projects, and as issues affecting PF2 projects.

It seems that despite much well intentioned effort, the UK has not yet found a model for PPP that delivers solid net benefits without the accompanying drawbacks. It is a difficult area to get right.



  • Buisson, Andrew (2013), ‘From PFI to PF2: The reform of the public private partnership model in the UK’, London: Norton Rose Fulbright LLP.
  • FT (2014), ‘NHS trust becomes first to buy out its PFI contract’, Gill Plimmer and Sarah Neville, London: Financial Times (read online)
  • Hare, Paul (2013),’PPP and PFI: The political economy of building public infrastructure and delivering services’, Oxford Review of Economic Policy, vol.29(1), pp.95-112
  • Heald, David and Georgiou, George (2011), ‘The substance of accounting for public-private partnerships’, Financial Accountability & Management, vol.27(2), pp.217-247
  • Helm, Dieter (2013), ‘British infrastructure policy and the gradual return of the state’, Oxford Review of Economic Policy, vol.29(2), pp.287-306
  • HMT (2012a), A new approach to public private partnerships, London: HM Treasury
  • HMT (2012b), Standardisation of PF2 Contracts, London: HM Treasury
  • HMT (2011), The Green Book: Appraisal and Evaluation in Central Government, London: HM Treasury, 2003 edition updated to 2011
  • HMT (2010), National Infrastructure Plan 2010, London: HM Treasury/Infrastructure UK
  • HoC (2014), Private Finance 2, Tenth Report of Session 2013-14, Treasury Committee, HC97, 2 volumes, London: House of Commons
  • HoC (2011), Private Finance Initiative, Seventeenth Report of Session 2010-12, Treasury Committee, HC1146, 2 volumes, London: House of Commons
  • Infrastructure (2012), PF2: A User Guide, London: Infrastructure UK (part of HM Treasury)
  • NAO (2011), Lessons from PFI and other projects, London: National Audit Office
  • NAO (2009), Performance of PFI Construction, London: National Audit Office
  • Telegraph (2011), ‘Private Finance Initiative: Where did it all go wrong?’, London: The Telegraph

Welcome to Coalition Economics

The performance of the economy and the economic credibility of the parties are central issues in the UK general election of May 2015. Most of the underlying policy questions are the subject of substantial academic research; and yet all too often, the findings of researchers do not make it into the public debate.

Over the coming weeks, Coalition Economics will host a collection of contributions from leading economic experts. These are intended to provide critical but fair assessments of the economic policies pursued by the coalition government in the UK since May 2010. They are in nearly all cases written by the people who contributed to a detailed assessment of the economic record of the previous Labour government, published in the spring 2013 edition of the Oxford Review of Economic Policy, and who are now writing on the coalition’s record in the same areas.

These contributions will include:

  • Paul Hare, Heriot-Watt University, on private public partnerships
  • Giorgia Maffini, Oxford University, on corporate taxation
  • Darup Aripa and Sandeep Kapur, Birkbeck, University of London, on financial regulation
  • Robert Joyce and Luke Sibieta, IFS, on income inequality and poverty
  • Anthony Heath, Oxford University, on education
  • Stephen Machin, UCL and LSE, on wage inequality
  • John Appleby, King’s Fund, on health
  • Ken Mayhew, Oxford University, on productivity
  • Simon Wren-Lewis, Oxford University, on fiscal policy
  • David Cobham, Heriot-Watt University, on monetary policy