Select Committee on Treasury Written Evidence

Memorandum submitted by Mr Martin Weale, National Institute of Economic and Social Research


The Economic Outlook

   The growth projected for next year is slightly faster than the National Institute's expectation of 2½% although we have similar views about prospects in the world economy and the Euro Area. The forecast record of the Treasury is similar to that of the National Institute[1]. The main cause of the difference is that we see import volumes rising faster than export volumes while the Treasury sees these two moving in step

The trend rate of growth

  The increase in the trend rate of growth allows the Chancellor of the Exchequer to project revenue growth faster than would otherwise be the case. Only hindsight will tell whether the change to the trend is justified; at this point it is probably safest to accept that there is a margin of uncertainty substantially greater than that indicated by Table 4 on page 21 of Trend Growth: New Evidence and Prospects. Recent growth in the economy has been facilitated by a surge in immigration from Central and Eastern Europe; it seems most unlikely that these very high levels of immigration are going to continue, and indeed the policy with respect to Rumania and Bulgaria is designed specifically to prevent this. Thus the Treasury's assumption that immigration will continue at the 2005 level is questionable.

  But of perhaps greater concern is the implication for the public finances if immigration does continue at a high level. The Treasury projections assume that, while there is a favourable impact on the revenue side as a result of faster growth, there are no implications for public spending. It is true that, because immigrants are disproportionately young adults, their arrival is fiscally favourable but it is unlikely that there will be no upward pressure on spending, or alternatively increasing complaints that services are congested. The reality is that faster trend growth arising from immigration is likely to lead to higher public spending.

The Cycle

  The chart on p 198 of the Pre-budget Report shows plainly that the current cycle began late in 2003. The political need is nevertheless to maintain the artefact of the long cycle which started in1997 and continues until next year so as to ensure that the Golden Rule is met on Treasury calculations. Although the cycle is not itself a government or national statistic, the repeated redefinition of the cycle may be one of the factors which has led to a low level of public trust in statistics. The re-definition of the cycle is accompanied by a re-evaluation of the scale of spare capacity in the economy. In the 2006 Budget this was postulated to be 1.5% of GDP whereas it is now estimated at 0.5% of GDP, in line with the National Institute's estimates.

  The end of the cycle as identified by the Treasury creates an opportunity to consider how to learn from the experience using the Golden Rule since 1997. Suggestions for a revised rule are presented below.

The Budgetary Position

  The table below shows that the current budgetary position has been tightened by £5 billion since the 2005 Budget. Taxes have risen slightly more because these data take account of extra expenditure on items such as increased winter fuel payments. The underlying budgetary position has worsened by £10 billion, since the projected surplus of £4 billion for 2007-08 has fallen to a deficit on £1 billion. The discretionary tightening, combined with the slow projected growth in public spending in the years ahead suggest that the government has now addressed the problem of structural fiscal weakness identified by bodies such as the National Institute.

Table 1

Discretionary Revision PRB 2005 2
Discretionary Revision Budget 20061
Discretionary Revision PBR 20062
Total Discretionary Revision since Budget 2005 5
Change to forecast current balance since 2005 Budget -5

  The National Institute continues to expect a position worse than that shown in the Pre-budget Report with the deficits likely to be £5 billion or so worse than the Treasury forecasts However with an average absolute error of £13 billion in Treasury forecasts one year ahead, this difference is not of great importance. Even with our figures the current budget is still expected to move into surplus eventually and the budgetary position is sustainable.


  The end of the economic cycle as imminent makes this an ideal time for the Select Committee to review the working of the Golden Rule and to consider what other options might be available. Although it is likely that the Golden Rule has played a valuable role in keeping government expenditure under reasonable control, its working in real time has been less than satisfactory. There have been two main problems and a third minor one. The most fundamental point is that the rule does not deliver "fairness and prudence". A prior issue is that, whatever budgetary target is set, policy has to be such that it is achievable in a reasonable time.

  The existing Golden Rule is one way of setting the target. But whatever target is set a means for assessing whether that target is being delivered needs to be in place. At present the Golden Rule offers a great deal of flexibility at the start of the cycle and very little at the end; indeed by the end of cycle policy is constrained by the events of several years ago. Furthermore the current assessment "over the cycle" is clearly discredited. A sensible replacement which addresses the question of inflexibility would be provided by a simple forward-looking rule. Such a rule might state that, if the budget balance is currently off-target, the government should aim to return to target over some relatively short horizon- say three years. A horizon of this length provides time for the government to ride out the normal economic cycle without allowing them to defer any adjustment far into the future.

  However, the Golden Rule may not be appropriate. It is perfectly possible for the current budget to be in balance but the structure of policy to be such that deficits will emerge in the future, or to imply that taxes will need to rise. Such a situation can arise as a result of an ageing population with state pensions funded on a pay as you go basis. In such circumstances fairness- defined by keeping expected future tax and contribution rates constant- would imply a surplus on the current budget. The government explores these issues in the Long-term Public Finance Report: an Analysis of Fiscal Sustainability but they stand outside the structure of the fiscal rules. A revision of the Golden Rule to deliver fairness between generations would, instead of adopting a target for the current balance of "in balance or surplus over the cycle" choose a target to keep expected future tax rates approximately constant, after allowing for any definitive policy choices that tax rates should change over time.

  As at present, both rules could be implemented without any formal external assessment. The structure would, however, be much stronger if there were an independent group with the task of assessing both the budgetary target consistent with fairness between generations and the government's plans to take the current budget back to target after any divergence.

  This structure does not take any account of the "40% rule"—that government debt should not exceed 40% of GDP. When the Golden Rule is met, such a rule serves to limit public investment. Our view is that the desirability of public investment is determined by means of cost-benefit analysis to establish whether the social return on the investment is adequate. Estimates of social return need to take into account the dead-weight cost of raising the taxes needed to service public borrowing. If instead the 40% rule is used to determine the extent of public investment it is highly likely that the amount of public investment will be sub-optimal and the nation's resources will not be allocated efficiently. Thus the 40% rule needs to be replaced by audit of public investment projects to establish whether they offer value for money.

11 December 2006

1   See "Forecast Comparisons" National Institute Economic Review, July 2005 by Ray Barrell, Simon Kirby and Robert Metz. Back

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