Memorandum submitted by Mr David Walton,
Chief European Economist, Goldman Sachs
From a macroeconomic perspective, the Pre-Budget
Report (PBR) raises several issues, most of which relate to whether
the Government's fiscal rules will be met.
1. ARE THE
TREASURY'S
ECONOMIC GROWTH
PROJECTIONS TOO
OPTIMISTIC?
The Treasury's main economic projections are
unchanged from Budget 2004. GDP is forecast to grow by 3-3½%
in 2005 and 2½-3% in 2006. These forecasts are based on a
consideration of trend growth in the economy and the size of the
output gap.
Trend GDP Growth: Table A2 of the PBR
(p 169) gives the Treasury's estimate of trend GDP growth. Between
2001 Q4 and 2006 Q4, it is put at 2¾% a year—down from
just over 3% a year between 1997 H1 and 2001 Q3. Thereafter the
economy is projected to grow by 2½% a year due to slower
growth in the working age population.
These estimates are very similar to those made
by Kevin Daly of Goldman Sachs. Trend growth appears to have risen
in recent years from 2½% to around 2¾% (see Chart 1).
This is due partly to faster growth in the labour force but also
to a better productivity performance. The level of productivity
in the UK remains comfortably below that in the US and Euroland
but the gap has been closing over the past decade (see Chart 2).
Given the likely trends in employment and productivity
from now on, trend GDP growth is likely to be maintained at around
2¾% over the next few years. Unfavourable demographics will
then reduce growth after 2008. Table 1 gives Goldman Sachs' estimates
of the contributions to GDP growth.
Table 1
GDP GROWTH PROJECTION OVER THE NEXT 10 YEARS
| Average Annual Growth Rates1
| 1993-2003 | 2003-08
| 2008-03 |
| GDP Growth equals changes in | 2.7
| 2.8 | 2.5 |
| Population | 0.3 | 0.4
| 0.4 |
| plus Productivity (GDP/Hour) | 2.1
| 2.2 | 2.2 |
| plus Labour Utilisation | 0.3
| 0.2 | -0.1 |
| Of which Average Hours Worked | -0.2
| -0.2 | -0.2 |
| Employment Rate | 0.4 | 0.2
| 0.4 |
| Working Age Population | 0.1
| 0.2 | -0.3 |
1 Data are smoothed and may not sum to totals due to rounding.
| | | |
Output Gap: The Treasury believes that GDP is currently
below potential by around 1%. The Treasury bases its view on three
judgements: (i) average hours worked "remain below their
projected trend levels"; the employment rate has also "grown
at a little less than its projected trend"; "the lack
of apparent inflationary pressure in the economy lends strong
support to the current assessment of a negative output gap".
Each of these judgements can be questioned.
— Average hours, which have been declining since
the Industrial Revolution, are only slightly below a simple trend
estimate (see Chart 3). According to the Labour Force Survey,
the number of people who say they are in part-time work only because
they cannot find full-time work is at a record low of 7½%.
It is hard to argue, after two years of above-trend GDP growth,
that the continuing decline in average hours is cyclical.
— On the employment rate, any difference with the
"projected trend" can only be very small. In the year
to 2004 Q3, employment rose by 0.16% of the workforce; the average
rise over the previous five years was 0.21% a year.
— On inflation, a negative output gap would mean
not just "a lack of apparent inflationary pressure"
but its opposite—an increase in deflationary pressure. This
is certainly not what is suggested by the sharp acceleration in
core producer output prices and the gradual rise in non-bonus
pay growth.
Assessment: The Treasury's growth forecasts are reasonable
if output is below trend. Given its view of the output gap, there
would be a serious risk that inflation will continue to undershoot
its target unless growth is as strong as the Treasury expects.
We believe that the output gap is close to zero but the difference
should not be exaggerated. On our view of the output gap and trend
growth, GDP growth could average 2¾% a year over the next
two years to be consistent with the inflation target—a cumulative
increase in GDP of 5.5%. This is at the lower end of the Treasury's
expected growth rate of 5.5-6.5%.
2. ARE THE
TREASURY'S
PUBLIC BORROWING
ESTIMATES TOO
OPTIMISTIC?
For 2004-05, the Treasury revised its estimate of the current
budget from -£10.5 billion to -£12.5 billion. Of this
£2 billion revision, £0.7 billion is due to discretionary
changes announced in the PBR (mainly the £520 million added
to the special reserve for the Iraq war). Central government receipts
are forecast to grow by 7.2%, compared with growth of 6.3% in
the first seven months of the financial year. Some pick-up in
the growth rate of receipts is likely reflecting stronger corporation
tax and petroleum revenue tax receipts, though we expect an undershoot
of around £1 billion. Central government current spending
is forecast to grow by 5.4% vs 6.6% so far this year—most
of the slowdown in spending expected by the Treasury is within
DEL, and quite likely to be seen. Thus we expect the deficit on
the current budget to be around £1 billion larger than the
Treasury expects. As in previous years, there is a good chance
that investment spending will undershoot, leaving public sector
net borrowing close to the £34.2 billion PBR forecast.
For 2005-06, we are considerably more cautious about receipts.
The Treasury is projecting a 0.9% rise in the share of tax receipts
in GDP. Some rise is likely in response to the lagged effects
of above trend growth and higher oil prices but the Treasury seems
to be placing a lot of faith in the effectiveness of measures
announced in the Budget to tackle tax avoidance. We expect an
£8 billion shortfall in receipts and a similar shortfall
in the current budget relative to the Treasury's expectations.
Thereafter, we project a gradual clawing back in this receipts
gap, mainly because the Treasury adopts a more cautious estimate
of GDP growth in its public finance projections than Goldman Sachs.
3. WILL THE
FISCAL RULES
BE MET?
On the Treasury's definition of the economic cycle from 1999-2000
to 2005-06, we expect the golden rule to be missed by 0.05% of
GDP a year on average. In the period from 2005-06 to 2009-10,
we expect the golden rule to be missed by 0.12% of GDP a year
on average. In both periods, the sustainable investment rule is
met comfortably—net public sector debt peaks at 37.4% of
GDP in 2007-08 and then begins to decline, below the 40% ceiling
set by the Government (see Chart 4).
4. DOES IT
MATTER IF
THE GOLDEN
RULE IS
BREACHED?
If the golden rule is missed by a small margin in the current
cycle, it would be of little economic consequence. Importantly,
the UK would still have the soundest fiscal position of any country
in the G7. As required by the Code for Fiscal Stability, the Chancellor
would be required to explain the reason for the deviation. He
could do this easily. He might, for instance, decide to treat
the £5 billion or so of expenditure on the Iraq war as of
a one-off nature, best dealt with outside the fiscal rules.
Looking forward, there is a great deal of uncertainty about
the path of tax receipts. One approach would be to raise taxes
in Budget 2005, or reduce the growth of public spending, to be
absolutely certain of hitting the golden rule over the next cycle.
Another approach would be to see how things develop: fiscal drag
could be sufficient to push the tax share up over the next cycle
to hit the golden rule as the Treasury expects. A third approach
would be to change the fiscal rules.
There are strong arguments in favour of the wait-and-see
approach. Net debt remains below 40% of GDP. The deficit on the
current budget is narrowing. It peaked last year at 1.9% of GDP
and is set to fall to 1.1% of GDP this year. A move back to balance
is likely in coming years without government intervention. An
analogy can be made with the actions of the Monetary Policy Committee.
When inflation undershoots the target, the MPC does not cut interest
rates aggressively to get inflation back to target as soon as
possible. This would be too disruptive for the real economy. Instead
it aims to get inflation back to target on a two year view. There
are merits to a similar gradualist approach to eliminating current
budget imbalances.
5. ARE THE
FISCAL RULES
SACRED?
The Code for Fiscal Stability is a lot more relaxed about
the fiscal rules than many analysts are. It merely requires fiscal
policy to be conducted in accordance with five principles:
(i) transparency (setting of objectives, implementation
of policy, publication of accounts);
(ii) stability (process, impact on economy);
(iii) responsibility (management of public finances);
(iv) fairness (including between generations); and
(v) efficiency (policy design, managing public sector
balance sheet).
The Code allows the Government to change its fiscal objectives
and operating rules provided that they abide with these five principles
and the Government states the reasons for departing from the previous
objectives and operating rules. This means that no new Government
or new Chancellor is tied to the previous fiscal framework.
In this regard, it is somewhat surprising—with a general
election in sight—that all of the debate about the public
finances, by Government and opposition alike, is conducted within
the framework of the current fiscal rules. As the Treasury notes
(on p 140 of its book "Reforming Britain's Economic and Financial
Policy"), "it is for the elected Government of the day
to choose and announce its fiscal policy objectives and rules,
provided these are consistent with the fiscal principles set out
in the Code."
Once the election is out of the way, one of the first tasks
for the Chancellor will be to set the fiscal framework for the
new Parliament. This will involve a consideration of the appropriate
levels of spending, taxation and borrowing in the next Parliament.
There is nothing in the Code that requires the fiscal framework
to be the same as in the last two Parliaments.
7 December 2004
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