Memorandum submitted by Professor Peter
Spencer, University of York
THE FISCAL ARITHMETIC AND THE ECONOMY
The Chancellor has had everything going his
way this year with the economy; asset markets and oil prices as
strong as or stronger than he expected. However, there has still
not been any improvement in the public sector finances—quite
the opposite. The public sector current deficit of £17.2
billion for the first seven months is actually worse than it was
last year (£15.6 billion). How does the Treasury expect to
meet the golden rule, when despite all the good news, the current
deficit is even higher than it was last year?
The answer is buried away in the appendixes
to the Report. In essence, it seems the recent data are misleading.
Tax revenues have lagged the strong economy and the high oil price
and have been held back by unforeseen problems like the accumulation
of past losses in the financial sector, which provide a temporary
tax shelter. The pattern of public spending across the year has
shifted forward, so the figures for the last few months of this
financial year will be more subdued. Going into next year, the
economy will continue to grow at an above trend 3-3½% rate,
promising another surge in tax revenue.
Once again we are faced with a forecast in which
the Chancellor meets his golden rule with a slim margin of error
(0.1% of GDP). Once again, this forecast is just possible, but
does not represent the most likely scenario. Indeed it shows exactly
what has to happen for the public finances to come right in the
end. Arithmetically, the growth in tax revenues necessary to meet
the golden rule after the recent slippage is now very challenging.
Economically, the PBR allows fully for the beneficial effects
of factors like high oil prices while playing down the adverse
effects. The odds are that tax revenue will continue to undershoot
the forecast and that the golden rule will be broken in this economic
cycle.
This note gives my assessment of the outlook
for the remainder of this financial year and 2005-06 and takes
a brief look at fiscal prospects over the next economic cycle.
GOVERNMENT REVENUES
IN 2004-05
Table B11 of the PBR shows tax receipts in the
first seven months of 2004-05 alongside the Treasury projection
for the rest of the year. This table shows acceleration in Inland
Revenue receipts from 8.6% to 10%. This is largely due to faster
growth in Petroleum revenue tax (PRT) and Corporation tax (CT).
The Treasury are expecting a windfall of £1.7 billions from
the North Sea this year. While this seems reasonable, high oil
prices reduce the profits of non-oil companies, especially when
they fmd it difficult to pass higher fuel costs on to their customers.
This is a reason for thinking that the strong growth rate in CT
projected for the rest of the year will not be achieved.
The PBR argues that the high oil price reflects
the strength of demand in the world economy, which is of clear
benefit to UK companies. However, much of this demand has come
from China, which takes just 1.2% of UK exports (with another
8% going to Japan and the Far East). Moreover, these benefits
have been offset by the weakness of the dollar, which (along with
the high oil price) is holding back our important European markets.
Reflecting this, UK exports have failed to benefit from the upturn
in the world economy this year (see below), helping to explain
the weakness of manufacturing and the shortfall in corporation
tax. Against this background, an increase of 21.5% in CT receipts
(over last five months compared with a year earlier) is optimistic.
On these PBR projections, tax receipts and national
insurance contributions will undershoot the Budget forecast by
£3.9 billions this financial year. Table B12 shows how this
figure is made up, with losses on onshore income and corporation
tax and elsewhere partially offset by the North Sea windfall.
This outcome would be very disappointing in view of the strength
of the economy and the oil price, but our estimates at ITEM point
to a larger shortfall, of about £6 billions. Our forecast
is summarised in Table 1 below. This table brings together ITEM's
revenue forecast and the government's expenditure projections
to give projection for the current deficit.
Table 1
THE FISCAL ARITHMETIC
| Current economic cycle
| | Next cycle |
| |
| 2003-04 | 2004-05
| 2005-06 | 2006-07
| 2007-08 | 2008-09
| 2009-10 |
A. £ billion
Current receipts
| 418.7 | 449.0 | 480.4
| 511.2 | 541.8 | 573.8
| 607.7 |
| Current spending | 425.5 |
448.6 | 478.0 | 503.0
| 531.0 | 555.0 | 581.0
|
| Depreciation | 14.3 | 14.9
| 16.0 | 17.0 | 18.0
| 19.0 | 20.0 |
| Current balance | -21.1 | -14.5
| -13.6 | -8.8 | -7.2
| -0.2 | 6.7 |
| Cycle cumulative | 14.538 |
0.0 | -13.5 | -8.8
| -16.0 | -16.2 | -9.5
|
| Net investment | 13.7 | 21.7
| 27.0 | 29.0 | 31.0
| 32.0 | 34.0 |
| Net borrowing | 34.8 | 36.2
| 40.6 | 37.8 | 38.2
| 32 | 32 |
B. As % of GDP
Current receipts
| 37.52 | 38.18 | 38.65
| 39.08 | 39.46 | 39.85
| 40.22 |
| Current spending | 38.13 |
38.15 | 38.46 | 38.46
| 38.67 | 38.54 | 38.45
|
| Depreciation | 1.28 | 1.27
| 1.29 | 1.30 | 1.31
| 1.32 | 1.32 |
| Current balance | -1.89 | -1.23
| -1.09 | -0.67 | -0.52
| -0.01 | 0.44 |
| Cycle cumulative | 1.95 | 0.72
| -0.37 | -0.67 | -1.20
| -1.21 | -0.77 |
| Net investment | 1.23 | 1.85
| 2.17 | 2.22 | 2.26
| 2.22 | 2.25 |
| Net borrowing | 3.12 | 3.08
| 3.26 | 2.89 | 2.78
| 2.22 | 2.12 |
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|
Source: Forecasts for current receipts from ITEM October
Economic Outlook, rest from PBR 2004.
PUBLIC EXPENDITURE
Turning to the spending side, the PBR argues that the excessive
increases seen so far this year are just a timing effect: 42%
of departmental spending is coming in the last five months as
against 43% last year. So these increases will tail off as the
year-end approaches, from the current 6.8% pa to just 4%. On this
forecast, public spending will be £1 billions below the Budget
forecast.
Chart 1
THE PRICE AND VOLUME OF PUBLIC CONSUMPTION
Despite the buoyancy of the recent figures, I am not expecting
a large overshoot in expenditure this year. The pressure on budgets
this year is much less than last year, when it was increased by
the Iraq war and the aftermath of the big pay restructuring agreements
seen in 2001 and 2002. This year public sector pay settlements
have been relatively restrained, reflecting an emphasis on performance
pay rather than reform or catch-up.
Reflecting this trend, the implicit deflator for government
consumption (which mainly reflects wages and salaries) increased
by just 3.1% in the year to the second quarter. The increase for
the financial year is likely to be close to 3.8%, compared with
5% in 2003-04 and 6.9% in 2002-03. As my first chart shows, this
has the effect of increasing the resources available for public
services represented by a given money budget. So the volume of
consumption is 3.8% this year, up from 2.8% in 2002-03 two years
earlier, despite a reduction in money spent from 9.7% to 7.6%.
This has helped to maintain the level of demand in the economy,
which is measured in real terms. Adding in capital expenditure,
PBR Table A4 shows government spending adding 1% to demand this
year, broadly in line with last year's contribution. However,
the rising cost of procurement in the second half of 2004-05 and
in 2005-06 will now bring down the growth of real consumption.
This squeeze is clearly shown by the chart which shows that next
year's money spend is less resource rich than this year.
THE ECONOMY
AND THE
PUBLIC FINANCES
IN 2005-06
The problem is that if the Treasury succeeds in slowing spending
in the second half of the year when prices are rising more quickly,
this will amount to a significant retrenchment in the public sector.
This will tend to slow the economy, making it harder for the Treasury
to hit the growth forecast. The massive infusion from the public
sector, which has kept the economy growing over the last few years,
will be reduced to a mere drip feed.
This is clear from the Treasury economic forecast, set out
in Annex A. Table A10 at the end shows the volume of the main
components of demand on a half (calendar) year basis. My table
2 shows the implied half-year growth rates for the four main components
of final expenditure. Comparing the first half of next year with
the second half of this year, the table shows the volume of public
sector current expenditure growing at an annualised rate of just
2.4%, after 3.6% and 4.3% respectively over the two previous half
year periods. There is also a deceleration in household consumption.
The Treasury assumes that the pace of output growth is maintained
by a rapid acceleration in investment and export growth. Investment
is boosted by a 30¾% increase in public sector investment
next year, shown separately in PBR Table A6. Adding this to current
expenditure, government spending adds 1¼% to output next
year, compared with a contribution of 1% for this year (Table
A4 again). However, there is clearly scope for public sector investment
to fall short of this figure, reducing the support for the economy.
The Treasury forecast a similar 30% increase for this year at
the time of the Budget, but their latest estimate is for a rise
of just 5¾%. Public sector investment managers have consistently
undershot their targets in recent years.
Table 2
THE TREASURY ECONOMIC FORECAST (annualised half-yearly
growth rates)
| Household
consumption
| Government
consumption | Fixed
Investment
|
Exports |
Imports
|
GDP |
| 2004 H1 | 3.5 | 4.3
| 7.7 | 1.2 | 4.9
| 3.3 |
| 2004 H2 | 2.3 | 3.6
| 5.7 | 7.0 | 5.9
| 2.8 |
| 2005 HI | 2.6 | 2.4
| 9.5 | 6.6 | 6.2
| 3.6 |
| 2005 H2 | 2.4 | 3.1
| 2.8 | 6.4 | 5.8
| 3.2 |
| 2006 H1 | 2.2 | 3.1
| 3.1 | 5.2 | 5.4
| 2.7 |
| 2006 H2 | 2.3 | 2.9
| 4.5 | 7.2 | 5.3
| 2.7 |
| | |
| | | |
Source: PBR 2004 Table A10.
Similarly, the Treasury forecast shows the volume of exports
growing at an annualised 7% in the second half of this year and
6.6% in the first half of next year, following rates of about
1% over the two previous half years. This is again ambitious,
particularly in view of the effects of the high oil price and
euro exchange rate on our European markets. Although I am relatively
optimistic about the prospects for the business investment and
export sectors it seems risky to assume that they will be able
to pick up the baton quite so deftly. Reflecting the risks inherent
in the prospective rebalancing of the economy, the ITEM October
forecast shown in table 3 is significantly below the Treasury,
although above consensus.
The optimistic Treasury economic forecast for 2005 is accompanied
by a revenue forecast for 2005-06 which is even more optimistic,
showing revenues growing much faster (8.0%) than money GDP (5.7%).
Table B13 shows the detail. Inland revenue receipts are very buoyant,
rising by 10.1%, with income tax up another 8.1%. Again, corporation
tax is the most striking—sporting another 25.5% gain. This
is very ambitious given the rising cost base; the lack of pricing
power in many business sectors and the need to increase (tax deductible)
contributions to pension funds. While it is possible that the
economy could just pick up again and give the Chancellor the extra
output he is expecting, it is unlikely that he will get this kind
of revenue growth.
PROSPECTS FOR
THE PUBLIC
FINANCES IN
THE NEXT
BUSINESS CYCLE
The PBR takes the fiscal arithmetic up to 2009-10, showing
a small margin of comfort on the golden rule and the debt to output
ratio on the central case. This long run projection is based on
a stylised assumption of a move back to trend as the output gap
is eliminated in 2006-07 followed by trend growth of 2¼%
from 2007-08 (Table B3). However, as chart 2.7 shows, the current
budget remains in cyclical deficit until 2009-10 on the cautious
case in which the trend level of output is 1% lower. This has
to be of concern given the uncertainty about the current level
of the output gap, which the Bank of England and the OECD believe
is close to zero at present. If the output gap is zero rather
than the 1% estimate of the PBR, then it is arguably more realistic
to look at the cautious case rather than the central one.
More of a concern in my view is the Treasury's continued
optimism about the tax multipliers, shown in Table B14. This shows
the share of tax in GDP increasing from 35.6% in 2003-04 to 38.4%
in 2009-10. This would be the highest ratio since 1984-85 when
North Sea revenues were at their peak, worth 3.6% of GDP. The
Treasury projection suggests that Non-North Sea taxation will
take up 38.0% of GDP in 2009-10, without any apparent increase
in tax rates. This compares with 35.3% in 1984-85, when the maximum
rate of income tax was 60%. Indeed, it would represent an all
time high in the Non-North Sea share. While the effect of fiscal
drag is likely to bring some rise in the share of personal taxes
in GDP, it is hard to see what could possibly justify such a large
rise in the tax ratio other than a rise in tax rates.
Chart 2
NET TAXES AND NICs AS SHARE OF GDP (Fiscal years)
The ITEM projections shown in my table 1 are based on tax-by-tax-
forecasts. These suggest that total receipts will grow about 1%
faster than money GDP between 2006-07 and the end of the forecast.
This projection suggests that the current balance will enter the
next economic cycle in the red. The cumulative balance will remain
in deficit until the end of the period despite the rising share
of GDP paid over in taxes.
CONCLUSION
The PBR provides a good illustration of what has to happen
if the Chancellor is to avoid breaking the golden rule next year.
The high oil price has to boost oil revenues without depressing
our overseas markets or the taxes paid by non-North Sea companies.
Exports (and business investment) have to revive despite the weakness
of the European market and the rise in the pound against the dollar.
Serious weakness in the housing market and the high street has
to be avoided. Public procurement managers have to slow current
budgets at a time of rising cost inflation, while simultaneously
boosting capital spending. This could all come to pass, but it
seems an unlikely combination of events.
Table 3
FORECAST COMPARISONS
| % change on previous year
| | | |
| | ITEM
| Consensus | HMT
|
| GDP | 2004 | 3.3
| 3.2 | 3¼ |
| 2005 | 2.8
| 2.5 | 3-3½ |
| 2006 | 2.5
| — | 2½-3 |
Household Spending | 2004
| 3.2 | 3.1 | 3¼
|
| 2005 | 2.6
| 2.2 | 2¼-2¾ |
| 2006 | 2.6
| — | 2-2½ |
Gov't consumption | 2004
| 4.4 | 4.3 | 4½
|
| 2005 | 3.0
| 2.9 | 3 |
| 2006 | 2.6
| — | 3 |
Investment | 2004
| 6.8 | 6.3 | 6½
|
| 2005 | 4.5
| 4.1 | 6¾-7¼ |
| 2006 | 4.0
| — | 3¼-3¾ |
Exports | 2004 |
2.2 | 2.1 | 2¼
|
| 2005 | 4.8
| 4.7 | 6½-7 |
| 2006 | 5.7
| — | 6¼-6¾ |
Imports | 2004 |
4.9 | 4.4 | 4¾
|
| 2005 | 6.3
| 4.8 | 6-6¼ |
| 2006 | 6.8
| — | 5¼-5¾ |
Sources: ITEM: October Economic Outlook;
Consensus: Forecasts for the UK Economy, HM Treasury, No 211.
Treasury: PBR 2004.
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