Select Committee on Treasury Minutes of Evidence

Memorandum submitted by Mr David Walton, Chief European Economist, Goldman Sachs (13 July 2004)


    —  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 2003Q2—GDP 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 Budget.

  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 ending April.

  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 error—averaging 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.

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