Hello, and welcome to the latest in our Negotiating Government podcasts, produced by Negotient, a negotiation consultancy specialising in public and private negotiations. This is David Gauke, Chair of Negotient, former Chief Secretary to the Treasury. I'm delighted to be joined by John Hall, who is a former Treasury and Department of Health official who knows all about spending reviews, having sat in a senior position on both sides of these discussions in the past, and we're going to be talking about the spending review that Rachel Reeves delivered on the 11th of June.

Spending review is that time where the government allocates resources across spending departments, allocates between day-to-day spending and capital spending, and between one department and another. On this occasion, the overall envelope was set out in the budget last year, but how that money was going to be spent, we only learned on the 11th of June. So we're going to talk through what the government has done, what they're trying to achieve, and what this may well mean for those businesses who are negotiating with government over the years ahead.

So, John, let's look at this at a high level to begin with. What was your impression of what the Chancellor set out? Thanks, David. I think I differentiate between the context in which Rachel Reeves made her spending review decisions and the decisions themselves.

It's not an easy time to be a Chancellor. That since the financial crisis of 2007-8, the British economy has grown at a fraction of the rate that it had fairly consistently for the previous two decades. That has meant the slowest growth in household incomes, the slowest economic growth and the slowest growth in the productivity of the economy that we've seen for many generations.

As a result of the pressures on public services from an ageing population, particularly on pensions and on the NHS, that means she had the unenviable position in that tax levels as a share of national income are back to the levels of the 1950s, that the national debt is back to the level of the 1950s, with us spending almost 4% of our national income each year just servicing it. And yet public services across the board are performing at a worse level than they were 15 years ago, including things like the Institute for Government Public Service Tracker. So it wasn't a great inheritance.

So looking forward, when Rachel Reeves set out her tax and spending plans last autumn, it was for a period of very rapid growth in public spending last year and this, and then three years in which public spending will increase far slower than it has in most previous spending reviews, albeit certainly not a period of austerity. So in a sense, this catch up and keep up approach meant that the good news on public spending got announced last autumn, where when she stood up on June the 11th, Rachel Reeves was allocating relatively small amounts of increases, so about 1.5% increase in public spending over inflation each year, with that heavily loaded towards capital. In terms of the big picture, in these very tight circumstances, I think Rachel Reeves made some very admirable choices.

First and perhaps most importantly, she's announced spending plans ahead for three years. Now, we haven't had that outside of a pandemic for a decade now, and that allows public services to plan and hopefully deliver far more efficiency in terms of public services. Secondly, she's heavily invested in capital infrastructure, and this is something that governments in tight fiscal situations tend to cut quite dramatically, with, in my view, a very detrimental impact on the British economy's growth potential.

So this spending review was heavily involved in infrastructure as opposed to day-to-day spending. She also spent the first two years effectively plugging holes in systems like local government and the asylum system, which were on the verge of keeling over. So, John, you talk there about not going into capital infrastructure.

There's, as you say, she has focused on capital investment. The big winner here, though, is defence, isn't it? That's where a lot of the money is going. There's also quite a lot, so something like £14 billion for defence at the end of this period.

There's a lot there for energy and net zero. I think that's another £9 billion or so. Quite a lot for the public services, I suppose, although not as much as in defence.

So there's a bit there for health and education, affordable housing and what have you. And then we have got a slug of money that is going to transport and science, innovation and technology, but perhaps not as much as one might have thought, I suspect not as much as she hoped for back in October, going into the economic infrastructure pieces. You know, transport, in fact, I think is down a little on where it was.

What do you make of that? I think that's right. I mean, big increase in capital spending. But once you go low for inflation, I think 90% of that is going into one service and that is defence. 

And it's all front loaded. So we will hit the 2.5% target of national income spent on defence by 2027. But after that, defence spending does not rise as a share of GDP, despite the fact the government's made a commitment, perhaps in the next parliament, to 3% of GDP, something we last achieved under the major government.

If Rachel Reeves had tried to achieve that by the end of parliament. We would have seen real terms cuts across other public spending programmes. And when you look underneath that detail, I think it's worth saying that all of the other areas of capital, while not getting big top ups in the next three years, had substantial increases in spending last year and this year.

So the overall level of public sector investment will be about 40% higher each year than it was in the years before the pandemic. And that's good for Britain. We'll be spending about 2.5% of our national income on public sector infrastructure.

The two winners, as you say, on the first hand are defence, on the second is the green energy transition. The Department of Energy, Security and Net Zero is seeing a five fold increase in spending compared to the average increase in capital spending across government. So that's making, you know, that is the big winner from that.

We obviously hope that investing in defence technologies and the green transition will have multiple economic spillovers for the rest of the economy and put Britain in a good position to export in these sectors to the rest of the world. But it must be said that in terms of our basic economic infrastructure, there's relatively small amounts of the increase in funding going towards that. And the transport budget, despite the blizzard of announcements, is going up relatively little.

Affordable housing, it's a roughly doubling of the budget over the next 10 years. We don't know what the trajectory is yet, so we'll have to see where that goes. But it's relatively small beer. 

We're only talking about an additional two billion of spending each year compared to the additional 14 billion, which will be going into defence. Just coming back to the spending on energy security and net zero, and an important part of this is size, we'll see. There's an interesting sort of wrinkle here, and this is one for the nerds, but that's presumably our audience for this podcast.

But when she announced her new fiscal rules last year, she introduced this idea of public sector net financial liabilities, which means that you can structure arrangements in such a way that essentially financial assets don't count against debt. And one might have thought, this is a point that Robert Peston of ITV picked up. One might have thought that the investment in Sizewell would constitute a financial asset and therefore not count towards debt.

And that isn't what's happened. There are some, within what the government has done, there are some financial assets. This has made a contribution.

This has helped them bring the debt number down compared to what it would otherwise have been. But they haven't managed for whatever reason to get the Sizewell investment into that definition of a financial asset. And it'll be fascinating to learn precisely what happened here, whether it just couldn't be structured that way for some reason, or whether they were a little bit surprised that the ONS didn't accept it as a financial asset.

I don't know, John, we don't really know what's happened here, but it's one that we're interested in, because this might be something to which some skilled negotiation might have addressed. Who knows? I mean, my suspicion is that this story is at its early chapters, and there's lots to run and run as the government explores exactly what the new fiscal flexibilities allow. I mean, if we remind ourselves that what came off the balance sheet with the new fiscal rules was illiquid financial assets.

So the government had always been able to count its own cash or gilts as an asset. What it hadn't been able to do was include things like the student loan book. So we had the slightly bizarre situation in which if a government had lost leave of its senses and decided to flog off the student loan book at a fraction of its market value, that would have counted as a positive thing for the public finances, while obviously it was a negative thing for the public sector balance sheet overall.

So those financial assets, illiquid ones, like debt, like equity, are now not included within the rule. And that has allowed some flexibility. I mean, I think commentators at the time said it might allow up to 200 billion of extra capital investment over time, you know, perhaps up to 50 billion a year by the end of the decade.

Some people said, in practice, it looks like the government's penciling in about 8 or 9 billion a year, largely within the green transition area and affordable housing areas where there's a clear debt which needs to be repaid to government, which the government can marketise. What the rules didn't allow was the government to count investment in physical assets. And I think there's good reasons for that.

And I would say this as a treasury official, but I'm conscious that a lot of the government's assets are the value of roads, bridges, infrastructure, which are notoriously difficult to value. And every five years when they're revalued, you have shifts of billions worth the value of the government estate. And we wouldn't want to be planning public spending on that basis.

And when you look at the government liabilities, like on medical negligence claims, nuclear decommissioning costs, again, you can have huge swings worth billions just because an accountant has assessed risk or discount rates differently. That would have, I think, undermined completely the government's fiscal credibility. What I think is interesting to pay for going forward is what is that balance when a physical asset is being created by a private sector firm, the extent to which it can be securitised or turned into a financial asset, which the government could legitimately claim was an illiquid financial asset.

My suspicion, and this is early days for all of us trying to work out how these new fiscal flexibilities can be used in practice, is that simply not enough is known about the structure of the deal by which size we'll see will be created and supply energy to the great in order for financial assets to be created. But we'll see how that plays out. Yeah, I think it's certainly going to be an issue for future negotiations with the government trying to structure this so that it is helpful in terms of the government's definition of debt.

And I'd also just want to come back to health. And health was the winner when it comes to day-to-day spending, not on capital spending. But interesting comments coming from Jim Mackey, who is the acting head of NHS England, as it's being wound up, essentially suggesting the return of PFI.

Now, this is very much your area, John. What do you make of that? As you say, David, health was the big winner from the announcements that Rachel Reeves made on June the 11th. The NHS got effectively about 90% of the additional spending over and above inflation that went to other public services.

Now, that looks very generous compared to everybody else. It's not particularly generous when it comes to the NHS. It's well below its historic average of 3.6% over and above inflation every year since 1948, when I've ever created it, although it is more generous than the NHS has seen over the last 15 years.

I think the big issue for me is that the government has set itself quite challenging targets to reduce waiting times. There's targets of 92% of people, for example, to be fully treated if they're referred by their GP within 18 weeks. That target hasn't been hit.

None of the waiting times targets have been hit for 10 years now. And performance has been flatlining. So about 6 in 10 people are effectively being treated at 18 weeks at the moment.

Now, the last time a government made a step change in how long people were waiting for treatment under the Blair Brown years, we saw spending increases of the order of 5% or 6% over inflation year after year for the best part of half a decade. So I don't think 3%, whether generous compared to other services or not, will be enough to turn the dial in terms of the government's objectives. So bizarrely, the biggest risks to the government's achievement of its objectives might actually be on the two services, health and defence, which have got the bulk of the cash from the spending review.

But as you said, the revenue increases weren't matched by capital increases. There's evidence that the NHS has underspent other health systems for decades. And if you look over the last 15 years, you can almost pick your number, but estimates vary between 27 and 37 billion less capital spend than compared to countries.

And by the range, it depends who you compare yourself to. Is it the European Union? Is it Western Europe? Is it the Nordic countries or whatever? Whichever of those things we look at, we know that we have fewer scanners behind the population of other countries. We have less hospital beds.

So the NHS has got a huge capacity constraint. And while it did relatively generously this year and last, we had about four billion increase in capital investment. That's not really going up very much at all over the next three years.

I don't think that will be enough to sort out the backlog of investment, which is about 12 billion at the moment, let alone prepare the NHS for the needs of the future. So I think it's natural that Jim Mackey and others look at, is there a way of getting private sector investment into our health infrastructure? But there's some challenges there. The government sets fiscal rules to get credibility with the markets, that it's not going to take an ever growing share of the national cake in terms of future taxes.

And there's a big price to be paid there. If we could get the rates that we pay on our guilds down to German levels, we'd release over one and a half percent of GDP every year in terms of public spending. We pay a price for not having a credible fiscal policy.

So what Rachel Reeves can't do, is set up a set of fiscal rules to get credibility with the market, and then actively conspire to set up schemes which get around them. So I think two things are going to matter there. From the Treasury's point of view, it's VFM.

If schemes are designed simply to get around fiscal rules, and as a result, private sector is borrowing at a higher rate than government could, then that's just a bad deal for the taxpayer. And there's very little merit. If there's a genuine transfer of risk, and we can benefit from the private sector managing that risk better, and there's some evidence from PFI that that happens, certainly in terms of construction times and construction overruns, then that is a good deal for the taxpayer.

But the ultimate arbitrator on this is not Treasury, it's ONS. And if ONS thinks that risk hasn't been transferred, or the public sector is really still controlling the asset, it will classify it on balance sheet. Just like it did with Foundation Trusts, which were designed to be off balance sheet.

Just like it did with PFI, designed to be off balance sheet. Just like it did with a lot of the operational leases which the NHS has entered into in the last few years, which have all been brought back on balance sheet. So this is one to look out for. 

Presumably, if you are negotiating with the NHS, as you say, this is a tricky area, and there's lots of issues that the government needs to appreciate. We may be seeing something like a return to what we've had in the past. Is that fair? I think the NHS is going to be short of revenue, it's going to be short of capital. 

So different bits of the NHS are going to be interested in the private sector being able to supply either infrastructure which can be used where modernisation funds aren't available, or services which we contracted out as long as they provide value for money. So I think the key thing for the private sector is to be agile in its response, so can put together that package of either equipment, construction, or full services, which the local NHS requires, and think carefully how it structures through its deals so that it genuinely can manage its risk itself. And this other point I wanted to discuss, which is about perhaps a sort of change of approach on regional spending, by which I mean infrastructure projects and what goes where. 

And there's long been a debate about the Treasury Green Book, and the criticism that the Green Book says, essentially invest your, let's say, transport infrastructure project, if you're going to spend some money on that, spend it where the return is going to be greatest, which tends to be in productive and densely populated areas. In other words, London gets a lot of it, and there are a lot of complaints about that. Now, I would suggest a good economic argument for doing that, because that is where it will make the biggest impact economically.

But it's quite an unfashionable view, and we do seem to have a change of approach coming out of the government, suggesting that they want to do more in other parts of the country. There's also an interesting point that Paul Johnson of the IFS picked up, which is a line in the Treasury, in the spending review, saying that just because the benefit cost ratio is below one doesn't mean that it's a bad project. And certainly my time as Chief Secretary, I can remember lots of projects where the benefit cost ratio was well above one, but we had to turn it down because you can't do everything.

Are we seeing a move away from an economically rational approach to allocating resources here towards a much more political approach that is perhaps more focused on those parts of the country, I'm being cynical here, where reform opposing a risk to the Labour Party, and they want to sort of shore up their heartlands? What do you make of that, John? I think the government cares both about the overall growth and size of the economy, but also its distribution, both between people by income group, age group and geography. So there's always a balancing act for all chancellors between investment in the areas which are the key to future growth, where returns can be very high, and investment in those areas which are at risk of being left behind. If you think about can you justify the fifth lane on a section of the M25 before you've got the dual carriage of the main road between Newcastle and Edinburgh? As you say, the Green Book, that's the sort of government voluminous bible, which governs these decisions, is actually very flexible.

It's not just it produces a list of projects by cost benefit ratio, it takes account of loads of things, environmental issues, distributional issues, and so forth. And it would be, I think, crazy if the government was investing in projects which delivered less benefits than that costs, when, as you say, there's many projects which we can't invest in where the benefits are many times that. What I perhaps would say, which is very interesting in how the guidance has been rewritten, is if you're looking at complex redevelopments, and this applies to high growth areas, as well as those areas that have been left behind, where the success of one project depends on the success of many other projects.

I mean, you can think of Docklands in London 30 years ago as being a classic example of that, or the Battersea Power Station development more recently. Then it allows in the appraisal of one investment project to take account of the spillovers with each other. And that, I think, could be quite interesting in unlocking quite complex redevelopment deals across the country.

Very good. Now, let's look forward. John, you sort of set out the difficulties the government had in terms of its inheritance.

We have also got some economic headwinds that perhaps weren't there at the time of the autumn budget last year. So that was before President Trump returned to the Oval Office, and certainly before the announcement of his various tariff policies. So they have moved around a bit, it would be fair to say.

And obviously, even her spending review was before events in the Middle East became more uncertain. And we've seen a spike in oil prices and so on that could have significant economic effects. There's got to be a pretty good chance that come the autumn and her autumn budget, the OBR is going to say, without some kind of action, she's going to be in breach of her fiscal rules.

She's already loosened those fiscal rules. As you've said, John, we pay a lot in terms of the interest rates that we have in the UK, significantly higher than many other countries because of concerns over fiscal policies. So it's hard to see that she can step away from those already loose fiscal rules.

She's just set out spending plans and made a virtue of the fact that this provides departments with some certainty as to what they're going to do. Doesn't all this mean that taxes are going up in the autumn? Well, let's just say that the current set of fiscal rules, which Rachel Reeves is, even on the forecast done in March, is going to make by a tiny margin. I mean, 10 billion sounds like a big number.

It's not a big number when it comes to public finances five years ago. And yet it's hard to say how she could make the rules any laxer. There is pretty much as lax as they could be without losing complete credibility.

So it's always going to be tight. This was the first multi-year spending review we've had outside of a pandemic, which didn't have a budget attached, I think since 2000. This allowed Rachel Reeves to credibly say to our colleagues, I'm not reopening the spending envelope, which has in almost all previous cases, and therefore has probably given her a bit of negotiating leverage in terms of keeping public spending increases down.

However, in terms of your question, they're premised on taxes going up, if only because they pencil in increases in council tax of about 5% a year for each of the next three years. Without that, police funding is falling. Without that, local government finance is falling.

As you see, the margin is so tight. The last set of forecasts by the OBR did not include the impact on the world economy of the chaos and uncertainty coming out of the Trump administration. It doesn't include any impact on oil prices or world growth coming out of what's currently happening in the Middle East.

It doesn't take account of the increase in guilt yields, which are tipping up at the moment. And the one that everybody's focused on, which is probably the least important, is it doesn't include the cost of restoring the winter fuel allowance. I think Rachel Reeves will be in a terrible political position.

So open spending decisions, which had just been set a few months earlier and hadn't actually kicked in yet, would undermine a lot of those long-term spending plans. I think it's an absolute no-go area to relax the fiscal rules, but that does mean she would need to have an honest conversation with the public about what it meant for tax. Yeah, and that's a tough one because if you start talking about tax now, if you start rolling the pitch, then you might see a repeat of what happened last summer, which is a sort of sense of consumer confidence potentially being hit because the government's being a bit gloomy and people start to say, well, if I'm going to be paying more tax next year, I better spend less money this year. 

And that can have a short-term detrimental effect. So thank you, John. Thanks for your words of wisdom today and understanding what's going on in the Treasury and indeed on occasions also the Department of Health.

Thank you very much to our listeners for joining us today in our Negotiating Government podcast. We'll be back again in the near future to discuss future developments in this world. It just leaves me to thank John and thank the listeners and tune in again.

Thank you.