Memorandum submitted by Mr Carl Emmerson,
Institute for Fiscal Studies
This note draws on the analysis presented by
Tom Clark, Christine Frayne and Julian McCrae at the IFS post-Budget
briefing on Thursday 18 April 2002. Copies of the slides from
these presentations are available at www.ifs.org.uk/budgetindex.shtml.
1. The effect of the Budget measures is
to increase taxes by £8 billion a year by 2005-06, even if
the full cost of the new tax credits for families with and without
children are counted as reductions in tax rather than increases
in spending. Many of the measures introduced had been pre-announced.
The Chancellor's intention to introduce a research and development
tax credit for larger firms, reform the taxation of intangible
assets and an exemption for gains arising on the sale of substantial
shareholdings were confirmed in a press release on 26 March. The
proposals for the Child Tax Credit and the Working Tax Credit
were originally mooted in the late 1990s. The effect of the measures
that were previously announced will cost the Chancellor around
£3.5 billion by 2005-06. The measures that were announced
in the Budget which had not previously been consulted on were
to increase taxes by around £11.5 billion by 2005-06.
2. The net increase in taxes from the Budget
measures is not being used to reduce public borrowing. Instead
it is being used to increase public spending. This is in contrast
to the large tax raising Budgets of Summer 1997 and Spring 1993
which had the stated aim of reducing borrowing. By 2005-06 public
spending will be £17 billion a year higher as a result of
3. The net effect of the Budget is to loosen
the fiscal stance by £9 billion by 2005-06 relative to what
it would have been had the Chancellor not introduced any of the
measures contained in the FSBR. This arises from a £8 billion
increase in taxes (net of new tax credits) and a £17 billion
increase in spending. The Budget has a negligible impact on the
fiscal stance in 2003-04 and 2004-05.
4. It might seem surprising that this fiscal
loosening is possible given the Chancellor's desire to meet his
fiscal rules with a particular degree of caution. In part this
has been made possible by an increase in projected tax revenues
flowing from more optimistic assumptions about economic growth.
5. The Budget forecast is that borrowing
in 2005-06 will be £5 billion higher than that forecast in
the Pre-Budget Report. This is the £9 billion fiscal loosening
outlined above, less £5 billion strengthening due to changes
in the forecasts for tax revenues and public spending (numbers
do not sum perfectly due to rounding). The outstanding increase
in borrowing in 2005-06 is consistent with the Chancellor's golden
rules since it is being used to pay for an increase in investment
spending in that year.
6. Of the £5 billion fall in borrowing
from changes to the underlying forecasts, £4 billion comes
from the fact that the public finances forecasts now assume that
the economy will exhibit real economic growth of 2½ per cent
a year, rather than the 2¼ per cent previously assumed. At
the time of the Pre-Budget Report the Treasury assumed that the
economy would grow at 2½ per cent a year but used 2¼
per cent a year for the purposes of its fiscal projections. It
now believes there is sufficient evidence that the economy will
grow at 2¾ per cent a year but is using a more cautious 2½
per cent a year for its fiscal projections. This means that while
the fiscal projections contained in the Budget are based on cautious
rather than central assumptions, there has been a reduction in
caution in what the Treasury judges as "cautious" and
"central" scenarios. Even if the Chancellor had assumed
2¼ per cent trend growth the Treasury forecasts would still
suggest that the fiscal rules were going to be met, but that they
would be hit far less comfortably on the central case.
7. Figure 1 contrasts the projections for
Government receipts and spending with that seen since 1991-92.
The difference between the two lines is public sector net borrowing.
Both taxes and spending are set to rise as a share of national
income between 2002-03 and 2005-06. If the forecasts turn-out
to be correct then in 2005-06 taxes will be at their highest level
since 1988-89 while spending will be at its highest level since
1995-96. Public Sector Net Borrowing will remain historically
low, as is required given the planned levels of investment and
the Chancellor's stated aim to meet his "golden rule".
Source: HM Treasury (2002), Financial
Statement and Budget Report, April 2002; HM Treasury (2002), Public
Finances Databank, February 2002.
8. Looking internationally, OECD data for
2000 shows that the UK spent 37.0 per cent of GDP publicly compared
to United States 29.9 per cent, Japan 36.6 per cent, Canada 37.7
per cent, Germany 43.3 per cent, Italy 44.4 per cent and France
51 per cent. The unweighted EU average was 43.9 per cent. The
increase in public spending between 1999-2000 and 2005-06 is set
to be 4 percentage points of GDP. This will leave UK public spending
still lower than the 2000 EU unweighted average, and below that
spent publicly by France, Germany or Italy.
2002 SPENDING REVIEW
1. As mentioned above the increases in tax
announced in the Budget are being used to increase public spending.
In particular NHS spending is set to receive real increases in
spending averaging 7.4 per cent a year for the next five years.
Taken together with the increases seen since April 1999 this will
represent the largest sustained period of growth in spending that
the NHS has received since its inception.
2. Over the next three years total managed
expenditure is set to grow by an average 4.3 per cent a year in
real terms (6.0 per cent in 2003-04, 3.2 per cent in 2004-05 and
3.6 per cent in 2005-06). This comprises real average annual growth
in current spending of 3.8 per cent a year and 15.7 per cent real
growth in capital spending. These large increases in capital spending
are from a relatively low base and will result in net investment
spending in 2005-06 reaching 2.0 per cent of national income.
This is the level of investment spending seen in 1992-93, but
is higher than all of the rest of the 1980s and 1990s.
3. The increase in public spending, excluding
the NHS, over the next three years is set to be 3.7 per cent a
year on average (5.7 per cent in 2003-04, 2.5 per cent in 2004-05
and 2.9 per cent in 2005-06). This implies that public spending
on areas other than the NHS will increase as a share of national
income. This overall increase in non-NHS expenditure would allow
the Chancellor, if he wanted, to continue increasing education
and social security spending at the rate seen since April 1999
and still allow the rest of Government spending to grow at 3.1
per cent a year in real terms over the next three years. This
is faster than expected real growth in the economy. The fact that
the increase in overall spending in 2003-04 is larger than the
increase forecast for 2004-05 and 2005-06 will mean that some
departments will find that their settlements will imply greater
real growth in spending next year than in the following two years.
While the Chancellor may continue to assert that the spending
plans are fixed in practice he has tended to add to them in Budgets
and Pre-Budget Reports. If this pattern continues then some departments
may subsequently receive additional funds in 2004-05 and 2005-06.
In any case spending in the latter year may be re-assessed by
the 2004 Spending Review. Of course the fact that the Chancellor
has previously added to his spending plans may, in part, have
been a result of consistently more favourable outcome for receipts
than expecteda trend which may not persist into the future.
4. The Chancellor has also pledged to continue
increasing NHS spending in 2006-07 and 2007-08. These increases
will cost an additional 0.7 per cent of GDP, which in current
terms is approximately £7 billion. Spending more on any area
of public spending will always require either less public spending
elsewhere, higher borrowing or higher taxes. This does not mean
that the Chancellor will necessarily have to announce future increases
in, for example, National Insurance rates, to pay for these NHS
increases since it is possible that the existing tax system might
simply deliver sufficient funds. For example as long as the economy
grows there may be sufficient fiscal drag, and it is quite plausible
that some areas of public spending will fall as a share of national
income. In any case the errors on planning government revenues
and expenditures over such long periods are extremely large.
1. The main measures announced by the Budget
having a direct effect on personal finances are: increases in
national insurance rates, freezing of the personal allowance and
the national insurance primary earnings threshold, introduction
of the Working Tax Credit and the Child Tax Credit, Increases
in the pension tax allowance and a freezing of petrol and alcohol
2. The increase in the employees and self-employed
national insurance rates by one percentage point is for somebody
whose sole source of income is from paid employment exactly like
increasing the starting, basic and higher rates of income tax
by 1 percentage point. The Chancellor also decided to increase
the rate of employer national insurance by 1 percentage point.
Given that income tax, employee national insurance and employer
national insurance are all taxes on wages, economic theory suggests
that in the long run their effect will be the same. This means
that the long run effect of the overall increases in national
insurance are, for someone whose sole source of income is from
paid employment, like increasing the starting, basic and higher
rates of income tax by 2 percentage points.
3. The Budget also confirmed the structure
of the new tax credits. The new tax credits for families with
children will cost £2.5 billion from April 2003 and will
be indexed in line with earnings. They represent a further extension
of means-testing. As a result of these changes the majority of
couples with kids will face joint assessment. The Working Tax
Credit for childless families costs just £¼ billion
since it is a relatively tightly focussed benefit. Many low earners
will not be eligible since they either have a more highly paid
partner (which applies to many married women), they work part-time
(you need to work at least 30 hours a week to qualify), or they
are aged under 25. A single person working 30 hours a week on
the minimum wage will receive a maximum £29.50 a week, while
a single person working 40 hours a week on £5 per hour will
have exhausted their entitlement.
4. Figure 2 shows the proportional gains
and losses from these reforms across the income distribution.
The lighter bars assume that the changes to income tax and employees
national insurance result in lower take home pay, but that employers
national insurance has no effect. The darker bars assume that
employers national insurance is fully incident on wages. Both
bars show that the effect of the measures is redistribution from
the top half of the income distribution to the bottom half of
the income distribution. Lower-income individuals gain from the
new tax credits and either do not lose, or lose a smaller proportion
of their income, from the national insurance changes.
5. The bars in figure 2 are shown as a percentage
of income. This means that bars at the lower end of the income
distribution represent a smaller cash change than those towards
the top end of the income distribution. In cash terms, losses
outstrip gains since the Budget raised money to pay for increases
in public spending.
1. The Budget contained several measures
which had already been confirmed in the statement on 26 March:
a research and development tax credit for large firms; reform
the taxation of intangible assets; and an exemption from corporation
tax on gains arising from the sale of substantial shareholdings.
These measures reduced taxes on businesses by £¾ billion
a year by 2004-05.
2. The Budget also contained a number of
measures that had not been mentioned in any previous consultation
document or Pre-Budget Statement. These measures raised taxes
on businesses by more than £2 billion a year by 2004-05.
3. Several of these measures are related
to the introduction of new anti-avoidance measures. It is often
sensible for the Government not to consult on these types of measures.
4. However, many of the measures were not
anti-avoidance measures, for example the £600 million raised
by increasing taxes on north-sea oil. Consultation on policies
such as the research and development tax credit has allowed the
Government to consider the views of various groups. As a result
the policy changed substantially between the initial consultation
and the final policy design. It is possible that the policies
implemented in the Budget could have been improved with a full
5. The Government has decided to cut the
corporation tax rate on companies with profits of less than £10,000
from 10 per cent to 0 per cent. This dramatically increases the
incentive that self-employed individuals have to start up their
own business with themselves as the sole employee. There is no
economic rationale for the tax system to provide such an incentive.
The clear risks to the income tax base do not appear to be reflected
in the Governments costings.
6. The new surcharge on north-sea profits
is based on economic theory for taxing a highly profitable sector
of the economy. It does however add another layer to an already
complex system that includes oil royalties and petroleum revenue
duty. This system creates many problems including an odd distinction
in the tax treatment of oil fields opened prior to 1982, those
opened between 1982 and 1993 and those opened after 1993. The
Government should use its consultation on the abolition of royalties
to examine more widely the taxation of north sea profits.