Memorandum submitted by Mr David Walton,
Chief European Economist, Goldman Sachs (13 July 2004)
UK FISCAL ARITHMETIC
Though there was little new in the
UK government's Spending Review about the path for public spending,
two developments since the Budget have reduced the likelihood
that the government will meet its golden rule in future without
tax increases. First, it is likely that the economy will be back
to trend a year earlier than the Treasury assumes. Second, tax
receipts have continued to disappoint.
In macroeconomic terms, there was little new
in the 2004 Spending Review. The public spending totals were set
in the Budget, though Total Managed Expenditure appears to have
been revised up by £0.4 billion in 2005-06 and by £1
billion in both 2006-07 and 2007-08. However, two developments
since the Budget have reduced the likelihood that the government
will meet its golden rule (financing current public spending out
of taxation over the economic cycle) in the next economic cycle
without future tax increases.
In the national accounts release on 30 June,
GDP growth was revised up in most recent years. Of the 0.7% cumulative
revision to GDP since 1996, 0.5% was attributable to the new methodology
for measuring government healthcare output.
These revisions have little bearing on our estimate
of the output gap since it seems safe to assume that any revisions
to GDP prior to 2001 have already fed through fully to inflation.
Thus to the extent that actual GDP has been revised up prior to
the past couple of years, potential GDP was higher too, leaving
the estimate of the output gap broadly unchanged.
However, upward revisions to more recent data
could have a bearing on the outlook for inflation. The economy
is now shown to have been growing at an above-trend rate since
2003Q2GDP was up by 3.4% in the year to 2004Q1. This is
about 1% faster than trend, particularly allowing for probable
future upward revisions.
Near-term growth prospects remain favourable.
After declining by 0.5% between 2003Q4 and 2004Q1, industrial
production in April and May was 1.0% higher than the Q1 average.
Other things equal, this would add 0.3% to the quarterly growth
rate of GDP, consistent with our forecast that GDP will rise 1.0%
between Q1 and Q2, up from 0.7% in Q1. We now expect GDP to grow
by 3½% in 2004-05, ½% stronger than forecast in the
With growth running considerably faster than
trend, the available slack in the economy is being taken up quickly.
This is also suggested by evidence from the labour market. After
a period of broad stability during the global downturn, UK unemployment
has been on a gradually declining trend over the past year. On
both the ILO and claimant count measures, the unemployment rate
is now the lowest for at least 25 years. Wage growth has also
picked up. Excluding bonuses, average earnings growth has picked
up from 3.4% in 2003Q2 to 4.1% in the year to the three months
The salaries index in the monthly Report on
Jobs has been rising strongly in recent months, suggesting a further
pick-up in wage inflation is in the pipeline.
Our central estimate is that the output gap
will be eliminated by the late summer. It would be prudent for
the Treasury to assume that the economy is back to trend in 2004-05,
a year earlier than assumed in the Budget.
Despite faster than expected growth, tax receipts
continue to undershoot. On the latest data, the current budget
(-£23.4 billion) was £2.1 billion (0.2% of GDP) worse
than expected at the time of the Budget. The ONS has noted that
some of this will be revised away, when it publishes updated (lower)
estimates of depreciation.
Of concern, however, is that current receipts
were £1.6 billion lower than expected. Other things equal,
this will carry forward to future years. Though we assume some
clawback, the current budget improves only to ¸£11.6
billion in 2004-05, £1.1 billion worse than the Treasury's
Budget forecast. This is despite the fact that we expect the economy
to grow Ö% faster than the Budget projection.
Taking the period from 1999-2000 to 2004-05,
the government's "golden rule" will be met; the surplus
on current budget will average 0.1% of GDP over this period.
However, if the economy is back to trend in
2004-05, it will be much harder for the government to meet the
golden rule in future. On the Budget projections, the government
expected the current budget to average ¸0.1% of GDP between
2004-05 and 2008-09. On our latest projections, the shortfall
may be as much as ¸0.5% of GDP. On these projections, taxes
will need to increase by around £8 billion a year from 2005-06
onwards to meet the golden rule.
There are lots of uncertainties attached to
these projections and we would not expect the Chancellor to admit
any time soon that taxes need to rise. In particular:
The Treasury may still believe that
the output gap won't close until 2005-06 despite upward revisions
to recent GDP data and the prospect of faster than anticipated
economic growth in the coming year. It will be hard to tell with
any degree of certainty when the economy was back to trend until
some considerable time afterwards.
Forecasts of public borrowing have
huge margins of erroraveraging around 1% of GDP just one
year ahead. Tax receipts could easily surprise on the upside,
particularly if the economy grows rapidly this year. Nevertheless,
the Budget forecast assumed an ambitious rise in receipts from
37.8% of GDP to 38.7% of GDP between 2003-04 and 2004-05; last
year's outturn is already known to be lower at 37.6% of GDP.