House of Commons - Treasury

Select Committee on Treasury Second Report

3 THE PUBLIC FINANCES

The fiscal policy framework and the fiscal position

37. Since 1997 the Government has put in place and sought to adhere to a new fiscal policy framework based on the five key principles of transparency, stability, responsibility, fairness and efficiency set out in the Code for fiscal stability. The Code requires the Government to state the rules through which fiscal policy be operated.[95] In the words of the Government, "rules, by their very nature, are intended to impose restrictions on behaviour. Fiscal rules must ensure that the public finances are managed prudently and maintained within sensible boundaries so that Government meets its spending commitments without jeopardising economic stability or running up an unfair bill for future generations."[96] If a government states explicit fiscal rules and households and firms believe that the government will adhere to its own rules, the credibility of the fiscal framework is enhanced.[97] There are currently two fiscal rules stated as part of the fiscal policy framework, which are:

The golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending; and
The sustainable investment rule: public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level. Other things being equal, net debt will be maintained below 40 per cent of GDP over the economic cycle.[98]

38. Mr Robert Chote of the Institute for Fiscal Studies cautioned that "the golden rule at best was only ever a reasonable rule of thumb … The idea that over a period of seven or twelve years if you beat it by one billion that is terrific and you miss it by one billion that is a disaster just is not sustainable on any analytical grounds."[99] Mr Broadbent also thought that "whether or not the Government borrows an extra five or ten billion relative to its forecast or even relative to its rule is neither here nor there in terms of the overall economy".[100] Furthermore, the OECD has said that "Given the margin by which [the golden rule] will, or will not, be met during the current cycle is likely to be small, using this criterion to judge whether fiscal policy has been a success or failure is inappropriate. Clearly, the new fiscal framework has been helpful in restoring credibility to fiscal policy and the economic consequences of slightly missing the golden rule over the current cycle should be regarded as negligible, particularly in the context of low net government debt."[101]

39. Scepticism has also been evinced about the economic value of the sustainable investment rule as currently formulated. Mr Chote said that "there is nothing written in stone about 40 per cent; there is nothing in the economic textbooks that says 40 per cent is right and that 20 per cent or 60 per cent is not … At the end of the day it is a question of whether you are more interested in meeting the letter of the rule or more interested in delivering the broader objectives, and that is a political judgment as much as an economic one".[102] However, the International Monetary Fund recently stated that they "strongly endorse" the objective of stabilising net debt at about 40 percent of GDP.[103]

MEETING THE GOLDEN RULE IN THE CURRENT ECONOMIC CYCLE

40. The golden rule is evaluated using the current account balance, which measures the difference between current receipts and current expenditure, including depreciation, and therefore measures the degree to which current taxpayers meet the cost of paying for the public services that they use. Progress against this rule over an economic cycle is measured by the average annual surplus on the current budget as a percentage of GDP.[104]

41. Following the 2004 Pre-Budget Report, our predecessors noted that the margin for meeting the golden rule in the current cycle had fallen since the Budget so that it stood at 0.1 per cent of GDP. The Committee concluded that "on current Treasury forecasts, the golden rule will be met—by a narrow margin".[105] Since our predecessors reported a year ago, the prospects for meeting the golden rule in the current cycle have been significantly affected by three developments: the change to the Treasury's view on the start of the current cycle, the revision of forecast fiscal outturns for the current and forthcoming financial years and the change to the Treasury's forecast for the end of the current cycle.

42. During the last Parliament, our predecessors noted the difficulties associated with the measurement of compliance with the golden rule. The Committee noted criticisms of this approach, including the fact that assessment was retrospective and that identifying the start and end dates of cycles is a subjective process. The Committee observed that "there is a danger that decisions by the Treasury on the determination of the economic cycle could be seen to be taken simply in order to comply with the golden rule".[106] Our predecessors received evidence on two particular problems of measuring compliance with the golden rule in the current cycle: the first was uncertainty within the Treasury and amongst outside observers as to whether the current cycle began in 1999-2000 (the Government's provisional view in 2002) or in 1997-98;[107] the second was uncertainty as to when the current cycle would be declared closed.[108]

43. In July 2005, on the occasion of his first evidence to this Committee in the new Parliament, the Chancellor of the Exchequer announced that, following "the significant historical updating by the Office of National Statistics … all the evidence now points to the conclusion that the economic cycle started in 1997-98".[109] That announcement was accompanied by a publication which explained the Treasury's thinking on the economic cycle in more detail and which in part responded to calls by our predecessors for timely analysis of the economic cycle.[110] In Budget 2000, HM Treasury had provisionally judged mid-1999 to have been an on-trend point, implying a very short full cycle between the first half of 1997 and mid-1999 of just over two years. Data revisions for growth around 1999 between Budget 2000 and Budget 2005 reduced the magnitude of the dip below trend during this period. Further data revisions announced in July 2005 further reduced the size of any dip and HM Treasury noted that there "is now no evidence of a clear dip below [trend] in 1999".[111] The effect of the Treasury's revision of the start date of the current economic cycle is to bring within the current cycle two additional financial years, including 1998-99 during which the public sector current balance was in surplus by 1.2 per cent of GDP. In other words, all other things being equal, it becomes easier to meet the golden rule during the current economic cycle as a result of the change to the start of the current cycle.

44. The second change affecting the golden rule relates to the fiscal position itself. At the time of the 2004 Pre-Budget Report, the Treasury was forecasting deficits on the current budget of £12.5 billion in 2004-05 and £7 billion in 2005-06, with a small current budget surplus expected in 2006-07. The 2005 Pre-Budget Report indicates that the outturn for 2004-05 was a deficit of £19.9 billion; the Treasury is now expecting a current budget deficit of £10.6 billion in 2005-06 and a deficit of £4 billion in 2006-07, with the current budget returning to balance in 2007-08 with a £7 billion surplus in 2008-09.[112] These revisions are linked to the downward revision of growth forecasts discussed earlier.[113] They result largely from downward revisions to the forecasts of revenue receipts, an issue considered later in this Report.[114]

45. The third change affecting the golden rule relates to the projected ending of the current economic cycle. In the 2005 Pre-Budget Report, the Treasury announced a further revision of its view of the economic cycle, this time relating to the end of the current cycle. In the 2004 Pre-Budget Report the Treasury forecast that the current cycle would come to an end in early 2006.[115] In view of the downward revision of growth forecasts for 2005 and 2006, the Treasury now expects the economy to return to its trend level, ending the current cycle, in 2008-09. This more recent change to the end of the cycle further increases the forecast flexibility in relation to meeting the golden rule, in that a significant surplus on the current budget is projected for 2008-09.[116]

46. The 2005 Pre-Budget Report states:

117

In July 2005 the Chancellor of the Exchequer told us that he considered that the Government would meet the golden rule over the present cycle even without the revision to the start date of the current cycle announced at that time.[118] The Institute for Fiscal Studies estimated that, using the latest forecasts contained in the 2005 Pre-Budget Report, the golden rule would not be met during a cycle beginning in 1999-2000 and ending in 2005-06.[119] However, Mr Chote of the Institute for Fiscal Studies acknowledged that "the Government is a bit of a victim of its own success" in that, by reducing the extent to which the economy went through recession and expansion, the Treasury was faced with a situation in which the business cycle was less easily identifiable.[120]

47. The actual or forecast surplus or deficit on the current account for each year of the current economic cycle is set out in the table below, together with the average surplus or deficit since 1997-98 and 1999-2000, being the start dates for the current economic cycle as estimated at PBR 2005 and Budget 2005 respectively.

Table 3: Current account balances over most recent economic cycle

	Public sector current budget of % of GDP	Average since 1999/2000 (estimation of the start date of the current economic cycle as at Budget 2005)	Average since 1997/98 (estimation of the start date of the current economic cycle as at PBR 2005)
1997/8 outturn	-0.2%	n/a	-0.15%
1998/9 outturn	1.2%	n/a	0.52%
1999/00 outturn	2.2%	2.21%	1.08%
2000/01 outturn	2.2%	2.23%	1.37%
2001/02 outturn	1.0%	1.83%	1.30%
2002/03 outturn	-1.2%	1.07%	0.88%
2003/04 outturn	-1.9%	0.48%	0.49%
2004/05 outturn	-1.7%	0.12%	0.22%
2005/06 estimate (estimated end date of current cycle as at Budget 2005)	-0.9%	-0.02%	0.10%
2006/07 estimate	-0.3%	-0.06%	0.06%
2007/08 estimate	0.0%	-0.05%	0.05%
2008/09 estimate (estimated end date of current cycle as at PBR 2005)	0.5%	0.00%	0.09%
2009/10 estimate	0.7%	0.07%	0.14%
2010/11 estimate	0.8%	0.13%	0.18%

Data sources: public sector current budgets from 1997/98 to 2004/05 taken from Public sector finances, National Statistics, November 2005; and public sector current budgets from 2005/06 to 2010/11 taken from Pre-Budget Report 2005, Table B1

We estimate that the impact of excluding 1997-98 and 1998-99 from the golden rule calculation for the current cycle would reduce the average surplus on the current account to an approximately balanced budget over the current economic cycle. The calculations indicate that, based on the Treasury's fiscal forecasts set out in the Pre-Budget Report, were the current cycle still to be viewed as having begun in 1999-2000, the golden rule would still be met if the current cycle were judged to end in 2008-09, but would not be met if the current cycle were judged to end in 2005-06, 2006-07 or 2007-08. On the basis of the Treasury's revised assumptions about the timing of the cycle and about the fiscal position in coming years, it appears likely that the golden rule will be met during the current cycle. The International Monetary Fund concluded in December 2005: "The fiscal rules are playing an important role in disciplining fiscal policy, although at times this role is overshadowed by peripheral controversies. We strongly endorse the objectives of the golden rule … However, the current form of the golden rule requires a precise dating of the cycle. Not only is this difficult, but the adjustments in the definition of the cycle have proved an unhelpful distraction from the more important considerations of what a sustainable fiscal policy is and how it should be achieved."[121]

MEETING THE SUSTAINABLE INVESTMENT RULE IN THE CURRENT ECONOMIC CYCLE

48. The golden rule operates alongside a second fiscal rule known as the sustainable investment rule under which "Other things being equal, net debt will be maintained below 40 per cent of GDP over the economic cycle".[122] In the last Parliament, our predecessors referred to an ambiguity in this formulation, in that it is not immediately clear whether net debt is to remain below 40 per cent of GDP in each year of a cycle or using an average for the cycle as a whole.[123] The Treasury has made it clear that, as far as the current cycle is concerned, net debt will be maintained below 40 per cent of GDP in each and every year of the current economic cycle.[124]

49. The 2005 Pre-Budget Report stated that "public sector net debt is expected to stabilise at around 38 percent of GDP from 2007-08. Therefore the Government continues to meet its sustainable investment rule while continuing to borrow to fund increased long-term capital investment in public services."[125] This is shown in the table below, which also shows the current "headroom" between the forecast level of net debt and the maximum level of net debt permitted under the sustainable investment rule. The headroom falls to a minimum of £26.4 billion during 2008-09. The headroom would decrease if GDP growth were to be lower than currently forecast, and could also be affected by differences between forecasts and outcomes relating to revenue receipts and expenditure.

Table 4: Public sector net debt and headroom under sustainable investment rule

	Public sector net debt (% of GDP)	Public sector net debt (£ billions)	Headroom under sustainable investment rule (£ billions)
1997/8 outturn	41.5%	352.1	0.0
1998/9 outturn	39.0%	348.9	8.9
1999/00 outturn	36.2%	341.3	35.8
2000/01 outturn	31.2%	307.2	86.6
2001/02 outturn	30.1%	311.7	102.5
2002/03 outturn	31.4%	342.4	93.8
2003/04 outturn	32.8%	377.3	82.8
2004/05 outturn	34.7%	416.7	63.6
2005/06 estimate	36.5%	456.6	43.8
2006/07 estimate	37.4%	493.0	34.3
2007/08 estimate	37.9%	529.0	29.3
2008/09 estimate	38.2%	560.0	26.4
2009/10 estimate	38.2%	589.0	27.8
2010/11 estimate	38.2%	617.0	29.1

Data source: public sector net debt from 1997/98 to 2004/05 taken from Public sector finances, National Statistics, November 2005 and Pre-Budget Report 2005, Tables B30; and public sector net debt from 2005/06 to 2010/11 taken from Pre-Budget Report 2005, Tables B9 and B10

The sustainable investment rule complements the golden rule in that, at least as far as the current cycle is concerned, it is subject to annual measurement rather than measurement over an economic cycle.

THE FISCAL RULES: AUDIT, SCRUTINY AND REVIEW

50. Since 1997, the Treasury has invited the National Audit Office (NAO) to audit key assumptions and conventions underpinning the fiscal projections. According to the Treasury, "the involvement of the NAO has been an important factor helping to build confidence in the basis for government fiscal projections".[126] Following the decision in July 2005 to revise the start date for the current cycle, the Chancellor of the Exchequer asked the Comptroller and Auditor General to audit "whether on the basis of existing data it is a reasonable and cautious view that the previous economic cycle as defined by the Treasury ended in 1997".[127]

51. The Treasury uses a "growth cycle" approach to define the business cycle, a method which provides a measure of the output gap—the difference between actual output for an economy and output at full capacity—which is relevant to assessing and setting fiscal policy. This approach is widely used amongst expert organisations such as the IMF, OECD and the European Commission.[128] For completed business cycles, the growth cycle approach involves identifying the points in the cycle when the economy is judged to be "on-trend" and factors of production are employed at normal rates of utilisation. Having identified comparable on-trend points in the economic cycle, the permanent component of output is assumed to follow a linear trend between these two points. However, estimating the trend rate of growth for a current, incomplete cycle requires a different approach because the "next" point at which the economy will be on trend is unknown. While there are several methods of estimating trend growth and therefore the date at which the economy will return to trend, the Treasury's approach in 2005 has been to use cyclical indicators, such as the percentage of manufacturing or service firms operating at or below full capacity. The Treasury's current estimate of the end date of the previous economic cycle is based on 22 indicators.[129]

52. The Comptroller and Auditor General's report on assumptions in the Pre-Budget Report notes that "the general view amongst those I consulted was that the Treasury's approach based on cyclical indicators was not unreasonable".[130] He concludes that, "though there are many uncertainties, there are reasonable grounds to date the end of the previous economic cycle to 1997 … Dating the end of the previous economic cycle to 1997 would therefore not reduce the extent of caution in making the fiscal projections."[131] The Comptroller and Auditor General goes on to remark: "Some reduction in uncertainty in the timing of economic cycles could result from the consistent use of more than one method of estimating the output gap. Thus I recommend for the future that the Treasury considers more systematically than previously what estimates of the output gap would be if other techniques were used in addition to its cyclical indicator based approach."[132] The Chancellor of the Exchequer told us that he was prepared to look at recommendations by the Comptroller and Auditor General, but was not yet in a position to come to a judgment.[133]

53. The recommendations of the Comptroller and Auditor General represent only one part of the continuing dialogue between the Treasury and the NAO on the fiscal projections. The Treasury intends to invite the NAO to complete its next rolling review of the trend growth assumption at Budget 2006.[134] The NAO will also be asked to audit the end date of the current and future cycles once the Treasury has made a firm judgment.[135] The IMF recently concluded that the NAO's role represents a strength of the fiscal framework and stated that "reliance on independent audit puts the United Kingdom, along with some other countries, on the frontier of institutional development. That frontier is moving, however, and we urge the government to further expand the role of the NAO in auditing the assumptions and methodologies underlying the preparation of the fiscal projections."[136]

54. Some evidence questioned whether retrospective audit was sufficient to maintain the credibility of the fiscal rules and the fiscal policy framework more generally. Mr Chote did not believe that the changes to the estimated start date and the expected end of the current cycle had "done anything to help the credibility of the framework".[137] Our predecessors noted calls for an "independent scrutineer" of the fiscal rules.[138] Treasury officials and the Chancellor of the Exchequer did not think it was appropriate to seek to separate the fiscal forecasting function from the wider fiscal decision-making process of a Government accountable to the House of Commons.[139] We welcome the decision of the Treasury to invite the NAO to examine the reasonableness and caution of the Treasury's view on the end-date of the last cycle and the Treasury's intention to ask the NAO to conduct a similar exercise when the Treasury has made a firm judgment about the close of the current cycle, but this should be conducted and published alongside the Treasury's announcement of that judgment. We note the view of the IMF that the NAO's involvement puts the United Kingdom "on the frontier of institutional development". However, the limitations of the NAO's involvement must also be recognised in that the scope of the NAO's activities is determined by invitations from the Treasury.

55. Our predecessors, in reviewing the 2004 Pre-Budget Report, noted that the current fiscal rules "have generally worked well since their introduction, but are likely to be capable of further improvement and refinement in the light of the practical experience accumulated over recent years". The Committee considered that the start of a new cycle provided an appropriate opportunity to review the fiscal rules, so that any changes could take effect in a new cycle.[140] The Governor of the Bank of England told our predecessors in March 2005 that "looking back [over the economic cycle] is not entirely helpful". He thought that "what is significant is the need to look forward, and that is to look at the rules in terms of whether it is plausible in a forward-looking sense that the rules will be met".[141] The start of the new cycle now seems less imminent than when our predecessors last considered the matter, but a review of the fiscal rules in the near future would be timely. There is strong evidence to suggest that clearly stated and measurable rules assist in the conduct of fiscal policy and help to enhance transparency. Although the golden rule has proved of considerable value to date, there is a risk that, as the final years of the current economic cycle are approached, too much emphasis is placed on immaterial or technical matters rather than the rule being used to assess whether Government policy has been broadly appropriate and fair over the medium term. The golden rule's focus should be on ensuring that fiscal policy is sustainable on a forward-looking basis, rather than encouraging changes to tax levels or spending now as a consequence of data revisions relating to levels of growth several years ago. There may be merit in seeking to supplement the golden rule with a rule or statement of policy that governs fiscal policy during the period when it seems likely that the economy is passing from one cycle to another.

56. A review might also provide an opportunity to consider the application and interpretation of the sustainable investment rule. In his submission to the Committee, Professor Miles noted that the revisions to the net debt projections bring the government closer to the limit under the sustainable investment rule and argued that "the sustainable debt rule rather than the golden rule has perhaps the greater potential to become a binding constraint on government expenditures".[142] In oral evidence to the Committee, Professor Miles noted that his "worry is that [the sustainable investment rule] could curtail investment in infrastructure".[143] Some evidence we received reflected concern that the sustainable investment rule did not capture the full range of public sector liabilities.[144] The Treasury is hoping that the first Whole of Government Accounts (WGA) balance sheet information can be made available for the year ending 31 March 2007.[145] This may prove a timely opportunity to consider if an alternative measure to public sector net debt should be used in the sustainable investment rule. It will also be important for the Treasury to indicate before the start of the next cycle whether the sustainable investment rule will be subject to the same stricter interpretation during the next cycle as during the current cycle. While criticisms of the arbitrary level of the limit imposed by the sustainable investment rule as interpreted during the current cycle have some merit, these do not outweigh the essential role that the rule plays in ensuring that Government expenditure and investment today do not lead to an unfair or unsustainable burden on future generations. Before the current economic cycle is declared closed, we recommend that the Treasury state whether, during the subsequent economic cycle, it proposes to interpret the sustainable investment rule as requiring that net debt be maintained below 40 per cent of GDP in each and every year of the next economic cycle.

Revenues

OVERALL TAX RECEIPTS

57. Tax receipts (net taxes and national insurance contributions) in 2005-06 are now projected to be £458 billion compared with £461.9 billion projected at the time of Budget 2005.[146] The main shortfalls[147] in tax receipts occurred for:

non-North Sea corporation tax (£3.2 billion) with the bulk of the shortfall reflecting "weaker than expected receipts from industrial and commercial companies, particularly from firms in the retail and manufacturing sectors". The Treasury considers that "there is likely to have been an impact on input costs and hence on profitability from higher oil prices in oil-intensive sectors"[148]
income tax and tax credits (combined £2.9 billion), the Treasury noting that "overall growth in average earnings has slowed from nearly 4½ per cent at the end of 2004 to just under 4 per cent in recent months. However, earnings increases remain high in particular sectors of the economy such as the financial sector which has a higher proportion of tax payers who pay tax at the higher rate than other sectors of the economy";[149]
value added tax (£2 billion), with the Treasury commenting that "growth in VAT receipts has been affected by slower than expected growth in consumer spending, which represents around two-thirds of the total VAT tax base, a decline in the proportion of consumer spending subject to VAT and increasing losses from fraudulent attacks on the system";[150] and
excise duties (£1 billion), a shortfall which reflects the continuation of frozen fuel duties and the impact of higher pump prices on the demand for fuel.[151]

The Treasury is now expecting improved tax receipts in the areas of:

North Sea revenues (£2 billion): "oil prices are forecast to average around $55.5 a barrel in 2005, compared with $40.6 a barrel assumed in the Budget. The revenue gain … is tempered by the drop in North Sea production in 2005 (the Budget forecast had assumed only a very modest decline) and higher than anticipated capital expenditure by producers";[152] and
National insurance contributions (£1.6 billion): the increase is expected as a result of strong growth in receipts from wages and salaries especially in the financial sector.[153]

The overall shortfall in tax receipts for 2005-06 compared with the level of receipts forecast in Budget 2005 appears moderate given that the Treasury's forecast for GDP growth for 2005 was reduced from 3 per cent to 3½ per cent at the time of the Budget to 1¾ per cent at the time of the 2005 Pre-Budget Report.

58. We note that receipts from corporation tax are forecast to increase from £41.8billion in 2005-06 to £50.1billion in 2006-07, as a consequence of a healthy financial sector, the impact of anti-avoidance measures and higher equity prices increasing expected receipts from life assurance companies.[154] Given that uncertainties remain in the global economy, we encourage the Treasury to monitor developments closely to ensure that its forecasts of corporation tax receipts remain realistic.

THE TREASURY'S REVENUE FORECASTING RECORD

59. The Treasury's forecasting record shows that current receipts for the forthcoming financial year were under-estimated in the period from 1998 to 2000 and have been over-estimated in each of the five years since 2001. On average, in terms of absolute deviations, the average estimation error is approximately £8.5 billion or 2.1 per cent of current receipts, as the following table shows:

Table 5: Treasury forecasting record for current receipts

	Current Receipts
	Forecast	Outturn	Difference
Budget 1998	330.1	334.5	4.4
Budget 1999	345	357.2	12.2
Budget 2000	375	382.9	7.9
Budget 2001	398.4	388	-10.4
Budget 2002	407.2	393.2	-14
Budget 2003	428.3	419.2	-9.1
Budget 2004	454.7	448.4	-6.3
Budget 2005	486.7	483 (e)	-3.7 (e)
Average (absolute)	400.8	8.5

Source: Various Budgets 1998-2005

Note: (e) - based on forecasts in Pre-Budget Report 2005

60. The Treasury has historically described its forecasting as "cautious". Mr Ed Balls, the then Chief Economic Adviser in the Treasury, told the then Committee in 2000: "Our policy is to have central forecasts based upon cautious assumptions. Our assumptions are cautious so that should always mean that the outturns are better than our projections."[155] Giving evidence on Budget 2005, Mr Cunliffe said that "all of the public finance projections are cautious in the sense that we project them on a weaker economy than is our central forecast."[156] As in previous Budgets and Pre-Budget Reports, Treasury officials continued to defend robustly the general accuracy of their revenue forecasts. Mr Cunliffe said that the Treasury were "better than most countries in the European Union … better than the IMF … better than the OECD and … better than the position that applied before the new framework was introduced".[157]

61. Mr Weale thought that the main influence leading to over-optimistic forecasting was the fact that the Treasury was "highly bound by the fact it cannot show forecasts which show the [golden] rule not working, not being met or close to not being met".[158] Although much of the fall in forecast revenue receipts can be attributed to lower forecasts for economic growth, our predecessors noted that Treasury forecasts for revenue receipts were higher than those foreseen by many outside forecasters at the time of the 2004 Pre-Budget Report so that our predecessors noted last year that "there are significant risks to this forecast".[159] The Chancellor of the Exchequer said that "we have not been over-optimistic by inclination. We have seen changes in the world economy that we could not have anticipated at every time we set our budgets …Over the course of the last eight years we [have] come out in surplus because of our caution".[160] Given the uncertainties over oil prices and oil price volatility during 2005, an estimation error of only around £3.7 billion (or 0.8 per cent of current receipts) appears to be an improvement on the Treasury's forecasting record in recent years. However, the Treasury has now over-estimated receipts for five consecutive years. It is important that official forecasts for tax receipts avoid any systemic bias either to exaggerate or underestimate revenue receipts, particularly towards the end of the economic cycle when forecasts are likely to come under particular scrutiny.

Expenditure

INVESTMENT EXPENDITURE

62. During the last Parliament our predecessors expressed concern that capital spending consistently failed to match the levels forecast by the Treasury. In January 2005 the Committee noted that a very large surge in public sector net investment in the final quarter of 2004-05 would be needed to meet the Treasury's forecast.[161] In 2004-05, public sector net investment was £3.4 billion lower than projected due to lower capital expenditure.[162] This follows the trend of recent years whereby departments, local authorities and public corporations have found it difficult to deliver investment to the level of the Government's plans.[163] Ms Mridul Brivati, Director, Public Spending, HM Treasury, took comfort from the fact that the extent of the under-spend was smaller than in previous years and thought that "departments are getting better at actually spending and realising their investment plans".[164] She also noted that it "may be the right and best value for money decision on the part of any given department to delay expenditure from one year to another".[165]

63. The Pre-Budget Report shows that net investment is projected to increase from £18.9 billion in 2004-05 to £31billion in 2007-08.[166] The Chancellor of the Exchequer told us that investment "has risen this year to £26 billion, so it is five times what it was. It will rise next year to £29 billion and then in 2008 to £31 billion. That is very considerable public investment in our economy and that allows us not only to more than quadruple the investment on schools and hospitals; it is also allowing us to invest in transport, in infrastructure, roads and so on, particularly around new housing developments, but also, of course, in the Olympics and sport, so there is very considerable capital investment planned for the next few years".[167] The Chancellor of the Exchequer said that "the Committee should be clear that public investment will continue to rise right throughout the course of this Parliament".[168] The OECD has noted that, even after the share of government investment in GDP has risen to just under 2½ per cent of GDP next year, "it still remains relatively modest compared with many other OECD countries and may be inadequate to correct years of neglect."[169] The Treasury also indicated that, as part of the Comprehensive Spending Review, there will be a zero-based review of capital spending with the objective of maximising the impact of capital spending.[170] We note the Government's commitment to a sustained increase in capital spending in the period to 2007-08 and we look forward to examining proposals in the Comprehensive Spending Review to maximise the effectiveness of capital spending. We will continue to monitor how the Government delivers on its plans for increased net investment expenditure.

CURRENT SPENDING AND END-YEAR FLEXIBILITY

64. The 2005 Pre-Budget Report indicates that central government current expenditure in 2005-06 is 4.1 per cent higher than in the corresponding period of 2004-05, which represents lower growth than in the Pre-Budget Report estimate for 2005-06 as a whole.[171] Treasury officials explained that current expenditure during 2004-05 had followed an unusual pattern, with expenditure more concentrated in the earlier months of the financial year. They expected expenditure to follow a different pattern in 2005-06, so that the end of year financial forecasts were likely to be met.[172]

65. In recent years, the pattern of central government expenditure has been affected by the use of end-year flexibility which allows departments to carry forward resources and capital not used at the end of a financial year for use in future years which would hitherto have had to be surrendered to the Treasury. The authority granted to departments to retain this money is intended to prevent the wasteful end-year surges which previously characterised departmental spending.[173] Our predecessors welcomed the continued use of end-year flexibility, but noted a theoretical risk to the Government's overall fiscal position if substantial stocks were drawn down at a particular time. The Committee called for clarification of the systems used by the Treasury to monitor the draw down of end-year flexibility stock and recommended that figures for departmental entitlements not drawn down by re-published at the time of the Pre-Budget Report and the Budget.[174] In response the Treasury indicated that it regularly reviewed drawdown "to ensure that public services are delivered within the fiscal rules"; it also stated that firm figures on entitlements were only available at the time of publication of the Public Expenditure Outturn White Paper.[175]

66. At the time of the 2004 Pre-Budget Report the stock of end-year flexibility was around £8.8 billion. The Public Expenditure Outturn White Paper for 2004-05 indicates that the total amount carried forward at the end of that financial year was about £11.8 billion of which over 20 per cent is accounted for by the devolved administrations.[176] Ms Brivati confirmed that the Treasury monitored departments' ability to use end-year flexibility and indicated that there was a dialogue with departments about the use of end-year flexibility stock.[177] In terms of ensuring the effective control and use of public expenditure, we think that the maintenance of substantial end-year flexibility stocks by departments is an encouraging development. There seems no reason to believe that these stocks will be used quickly or unexpectedly. However, we share the view of our predecessors that the House of Commons should be kept abreast of the position with regard to such stock more than once a year. We recommend that provisional estimates of end-year flexibility stock held by each department be published as part of each Pre-Budget Report and Budget, taking account of amounts proposed to be drawn down in the Winter and Spring Supplementary Estimates respectively.

LONGER TERM EXPENDITURE PLANS AND THE COMPREHENSIVE SPENDING REVIEW

67. Departmental and overall totals for public expenditure for financial years 2005-06, 2006-07 and 2007-08 were established in the 2004 Spending Review.[178] The Pre-Budget Report indicates that, apart from a small rise for 2005-06 and other changes resulting from discretionary measures announced in the Pre-Budget Report, spending plans for these years remain in line with the allocations set out then.[179] Total managed expenditure is expected to increase from the outturn of £487.3 billion in 2004-05 to an estimated £519.9 billion in 2005-06 and a projected £550.1 billion in 2006-07, annual growth rates of 6.7 per cent and 5.8 per cent respectively,[180] compared to growth rates for money GDP of 4.2 per cent and 4.7 per cent.[181]

68. In July 2005, the Government announced that there would be no Spending Review in 2006; instead, there would be a new Comprehensive Spending Review—comparable to that reported on in 1998—which would consider expenditure from a zero base and report in 2007. The Comprehensive Spending Review will establish expenditure totals for 2008-09 to 2010-11; departmental allocations for 2007-08 will be held to the totals already announced as a result of the 2004 Spending Review.[182] During the period covered by the 2004 Spending Review, expenditure is expected to have grown by more than GDP. In the period to be covered by the next Comprehensive Spending Review, fiscal projections indicate that public spending may grow by less than GDP. Mr Chote estimated that current expenditure was expected to grow by 1.8-1.9 per cent during that period. Given the likely commitments to continuing increases in expenditure on health, education and international development assistance, he expected spending by other departments to be "squeezed that much harder", with annual expenditure growth for other departments possibly as low as 0.8 per cent in real terms.[183]

69. The Chancellor of the Exchequer made it clear that the figures provided for the purposes of the fiscal projections represented "working assumptions" only and should not be treated as an indicator of the likely outcome of a Comprehensive Spending Review that has not yet begun.[184] However, Treasury officials did not deny that difficult decisions would need to be taken as part of the Comprehensive Spending Review. Mr Cunliffe said that "clearly public spending cannot grow indefinitely faster than the rate of growth of the economy". He said that expenditure had to be allocated to maximise value for money and to fit government priorities: "in every finance ministry around the world when those two things come together there is tension and you have an iterative process to resolve it".[185]

70. The Comprehensive Spending Review will have two public stages. In the summer of 2006 a report will be published on the spending challenges, including a zero-based review of the Government asset base. The Chancellor of the Exchequer indicated that, when this report was published, "you might be in a better position to look at what resources may be available to the other services then".[186] The final report on the outcome of the Comprehensive Spending Review will emerge in the course of 2007. Although it would be inappropriate to expect Government commitments on the level of public spending between 2008-09 and 2010-11 at this stage, the overall fiscal situation suggests that the Comprehensive Spending Review may take place at a time when public expenditure is not expected to grow at the same pace as during the current planning period. In this context, we welcome the Government's commitment to a two-stage process, with a report on spending challenges to be published in the summer of 2006. We recommend that this report be framed so as to maximise opportunities for discussion within the House of Commons and consideration by its select committees on the spending options and challenges before final decisions are announced in 2007.

95 Pre-Budget Report 2005, p 15, paras 2.6-2.7 Back

96 Reforming Britain's Economic and Financial Policy: Towards Greater Economic Stability, HM Treasury, 2002, p 157. Back

97 Ibid., p 156 Back

98 Pre-Budget Report 2005, p 15, para 2.7 Back

99 Q 50 Back

100 Q 42 Back

101 OECD, survey of the United Kingdom, October 2005, p 3 Back

102 Q 48 Back

103 IMF: United Kingdom-2005 Article IV Consultation, Concluding Statement of the IMF Mission, 19 December 2005, para 7 Back

104 Budget 2005, p 32, paras 2.53-2.55 Back

105 HC (2004-05) 138, para 27 Back

106 Treasury Committee, Second Report of Session 2002-03, The 2002 Pre-Budget Report, HC 159, paras 39-41 Back