Select Committee on Treasury Sixth Report


3  The context

The fiscal rules and the planning assumptions

14. The new regime for planning and controlling public expenditure was put in place in 1998 together with a new fiscal framework designed to ensure long-term sustainability in the public finances. The new Code for Fiscal Stability required the Government to state the rules through which fiscal policy would be operated. In the words of the Treasury,

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.[27]

There are currently two fiscal rules stated as part of the fiscal policy framework:

  • 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.[28]

In the economic cycle which the Treasury currently considers began in 1997-98 and estimates will end in 2007, the sustainable investment rule is formulated as requiring that the Government maintain net debt below 40% of GDP in each and every year of the cycle. The Government has not yet responded definitively to our recommendation that it clarify whether the same formulation will be used in the economic cycle forecast to begin in 2007.[29]

15. There is an element of retrospection in the golden rule as currently formulated. Calculations about compliance with the rule depend upon a judgement about the start-date and end-date of an economic cycle. The Treasury reserves the right to alter its judgement about the start-date in the light of new economic data, as happened in July 2005 when the Treasury's judgement on the start-date of the then current economic cycle was changed from a start in 1999-2000 to one in 1997-98.[30] However, the fiscal rules are intended to be principally forward-looking in their operation. They thus depend to a substantial degree on forward projections of revenue receipts and of public expenditure—both current expenditure (in relation to the golden rule) and capital expenditure (in relation to the sustainable investment rule).

16. For the purposes of forecasting fiscal prospects in order to judge likely compliance with the fiscal rules, the Government makes a series of planning assumptions beyond the period for which firm allocations have been made under the new planning and control regime. Thus, an assumption about levels of current spending in 2008-09 was included in the 2003 Pre-Budget Report, an assumption about current spending in 2009-2010 was included in the 2004 Pre-Budget Report and an assumption about current spending in 2010-11 was first provided in the 2005 Pre-Budget Report. In each case, it was assumed that current public expenditure would grow by 1.9% a year in real terms.[31] During our inquiry into the 2005 Pre-Budget Report, we asked the Chancellor of the Exchequer whether those projections represented the overall spending envelope for the Comprehensive Spending Review. He replied:

These have been our working assumptions for a number of years, but these are not necessarily the final figures.[32]

At the time of the 2006 Budget, the assumption about the level of current spending in 2008-09 was changed from earlier assumptions, with the new assumption being that current spending in that year would grow by 2.0% in real terms.[33]

The overall spending envelope and the capital/current divide

17. In the Budget, the Chancellor of the Exchequer announced the overall spending envelope for the period covered by the 2007 Comprehensive Spending Review. This followed the practice in 2002 and 2004, when overall Spending Review totals had been announced in the preceding Budget.[34] He announced that the overall public spending envelope from 2008-09 to 2010-11 would be "consistent with the figures set out in the 2005 and 2006 Budgets and the most recent Pre-Budget Report".[35] It was thus announced that public sector current expenditure would rise by 2.0% in real terms in 2008-09 and by 1.9% in real terms in both 2009-10 and 2010-11, with the overall growth rate of current public spending being at an average of 1.9% a year in real terms over the period as a whole.[36]

18. Totals for capital spending for the period covered by the Comprehensive Spending Review (and for 2011-12) had previously been announced in the 2006 Pre-Budget Report.[37] The figures for current expenditure, unlike those for capital expenditure, were set out in terms of percentage increases rather than on the basis of actual figures. Columns 3 to 5 of Table 1 set out approximations for total current spending and for Total Managed Expenditure in 2008-09, 2009-10 and 2010-11 based on the latest information on public spending in 2007-08, the latest GDP deflator figures and the information available on capital spending.

Table 1: Capital public expenditure, and approximations of current public expenditure and of Total Managed Expenditure, 2007-08 to 2010-11, £ million
2007-08
2008-09
2009-10
2010-11
Average annual growth in real terms over CSR period

(%)
Capital expenditure within TME
48,000(1)

51,000(1)

54,000(1)

57,000(1)

3.1
Approximation of current expenditure within TME
539,000(2)

564,000(3)

590,000(4)

618,000(5)

1.9
Approximation of Total Managed Expenditure
587,000(6)

615,000(7)

644,000(7)

675,000(7)

2.0

Notes: (1) Figures in this row derived from HC Deb, 6 December 2006, col 313 and rounded to nearest £1 billion; (2) figure for 2007-08 derived from PESA 2007, Table 1.1, p 11, rounded to nearest £1 billion; (3) calculation based on GDP deflator of 2.70% (PESA 2007,Table F2, p 210) and real terms increase of 2.0% (Budget 2007, para C.26, p 275), rounded to nearest £1 billion; (4) calculation based on GDP deflator of 2.70% (PESA 2007,Table F2, p 210) and real terms increase of 1.9% (Budget 2007, para C.26, p 275), rounded to nearest £1 billion; (5) calculation based on GDP deflator of 2.70% (PESA 2007,Table F2, p 210) and real terms increase of 1.9% (Budget 2007, para C.26, p 275), rounded to nearest £1 billion; (6) figure for 2007-08 derived from PESA 2007, Table 1.1, p 11, rounded to nearest £1 billion; (7) figures derived from addition of figures in preceding rows of the same column

The figures in Table 1 for Total Managed Expenditure, although an approximation, tally with the Government's statement that total public spending will rise by an average of 2.0% a year in real terms in the period from 2008-09 to 2010-11.[38]

Overall spending in historical context

19. For the purposes of public finance projections, the Government has assumed that the economy will grow at 2½% in each of the years covered by the Comprehensive Spending Review—2008-09, 2009-10 and 2010-11.[39] This means that public expenditure is projected to grow more slowly than the economy as a whole in each of those years, so that public spending would fall as a share of national income. This is in contrast with the outcome of the 1998, 2000, 2002 and 2004 Spending Reviews, each of which planned increases in public spending as a share of national income.[40] This change of direction was, to some extent, anticipated in evidence to us by Mr Jon Cunliffe, Second Permanent Secretary, Macroeconomic Policy and International Finance, HM Treasury, in December 2005 when he said "clearly public spending cannot grow indefinitely faster than the rate of growth of the economy".[41]

20. In 1996-97, the last fiscal year before the present Government was first elected, total public spending stood at 40.8% of national income.[42] This proportion fell to 37.1% of national income in 1999-2000 due to strong economic growth and reductions in public spending in real terms.[43] Significant increases in public spending thereafter saw public spending rise steadily as a proportion of national income, and that share is projected to reach 42.5% in 2007-08.[44] Based on the Treasury's own assumptions, the Institute for Fiscal Studies has estimated that public spending will fall to 41.9% of national income in 2010-11.[45] The projected level of spending in 2010-11 as a proportion of national income would be higher than that when the present Government come to power (40.8% in 1996-97), but lower than the average seen during either the period 1990-97 (42.9% of national income) or the period 1979-90 (44.9% of national income).[46]

21. There are limitations to the value of assessing levels of public spending by reference to those levels as a proportion of national income, not least because figures are affected by changing levels of economic growth as well as trends in levels of public spending. The different phases of growth of public spending levels since 1997 are more readily apparent by examining public expenditure growth rates in real terms over the last decade. During the period from April 1997 to March 2008 as a whole, the average annual growth of Total Managed Expenditure is expected to be 3.2%, compared with a projected average growth rate of 2.0% a year in real terms in the period from 2008-09 to 2010-11. The figure for the period 1997-2008 as a whole, however, disguises several different phases of growth. Chart 1 shows the annual growth rate of Total Managed Expenditure in real terms in each year since 1997-98, using latest estimated outturn figures for 2006-07 and latest plans for 2007-08.

Chart 1: Annual real terms growth (%) in Total Managed Expenditure, 1997-98 to 2007-08


Sources: TME cash data for 1996-97 to 2000-01 from PESA 2002-03, Table 1.15; TME real terms data from 2001-02 onwards from PESA 2007, Table 1.2; cash data adjusted to 2005-06 prices using latest GDP deflators (March 2007)

Notes: (1) estimated outturn; (2) latest plans

Total Managed Expenditure fell slightly in real terms in the period between April 1997 and March 1999 (by -0.2%), but rose or is planned to rise at an annual average rate of 4.0% between April 1999 and March 2008.[47] The Chief Secretary to the Treasury readily acknowledged the significance of the change between the rate of growth in public spending in recent years and the rate of growth planned for the period from 2008-09 to 2010-11:

The CSR is going to be building on the longest sustained increase in public spending we have seen since World War Two … In the three years of the current Spending Review period, average annual real growth of Total Managed Expenditure is 3.5%. In the previous period it was 4.8% … Our spending projections in the Pre-Budget Report show average real growth of less than 2% in the CSR years. So, that is quite a significant change, a change of trajectory, that will present us with some challenges.[48]

He subsequently referred to the Comprehensive Spending Review taking place in a "more constrained environment".[49] Public spending is projected to rise in real terms during the period covered by the current Comprehensive Spending Review as a whole at half the rate of growth provided for during the period covered by the four preceding Spending Reviews taken together.

The division between Annually Managed Expenditure and Departmental Expenditure Limits

22. Overall levels of public spending within Total Managed Expenditure for the period from 2008-09 to 2010-11 have already been set. However, as we noted earlier, Total Managed Expenditure is divided between Departmental Expenditure Limits to be set for a three-year period in the Comprehensive Spending Review and Annually Managed Expenditure.[50] Annually Managed Expenditure comprises those elements of public spending that the Government does not consider it appropriate to subject to firm multi-year limits at a departmental level. Annually Managed Expenditure includes expenditure on social security benefits and tax credits, locally-financed government expenditure, central government gross debt interest and net expenditure transfers to EU institutions. Forecasts of Annually Managed Expenditure are regularly revised outside the context of Spending Reviews. The division of Total Managed Expenditure for the period from 2008-09 to 2010-11 between Departmental Expenditure Limits and Annually Managed Expenditure will be set out when the final outcome of the Comprehensive Spending Review is announced.[51]

23. Chart 2 shows separately the rates of growth in real terms of Departmental Expenditure Limits and of Annually Managed Expenditure in each year from 1998-99 to 2007-08, based on outturns up to 2005-06, the latest estimated outturn for 2006-07 and the latest plans for 2007-08.

Chart 2: Annual real terms growth (%) in Total Annually Managed Expenditure and Total Departmental Expenditure Limits, 1999-2000 to 2007-08


Source: Data from 1999-2000 to 2000-01 from PESA 2004, Table 1.3 and adjusted to 2005-06 prices; data from 2001-02 onwards from PESA 2007, Table 1.2 (2005-06 prices)

Notes: (1) estimated outturn (2) latest plans

During the period since the new planning and control regime was introduced in 1998, Annually Managed Expenditure has generally grown more slowly than Total Managed Expenditure as a whole, principally due to the savings in social security expenditure from falling unemployment and the reductions in debt interest payments arising from improvements in the overall state of the public finances.[52] This has had two beneficial effects on spending on programmes, both capital and current, within Departmental Expenditure Limits. First, it has meant that the Government could plan to increase spending within Departmental Expenditure Limits more rapidly than public spending as a whole: the late David Walton, in evidence to our predecessors in 2002, estimated on the basis of the 2004 Spending Review settlement that discretionary spending would rise by 5% a year in real terms over the lifetime of the last Parliament.[53] Second, shortfalls in spending within Annually Managed Expenditure compared with forecasts have enabled additional resources to be assigned to programme expenditure in addition to those initially allocated in Spending Reviews.[54]

24. When the concept of Annually Managed Expenditure was introduced, the Government stated that Annually Managed Expenditure would be "based on cautious estimates".[55] In 2004, the Chancellor of the Exchequer stressed that forecasts of Annually Managed Expenditure did not take account of external estimates of falling unemployment, so that any such falls would produce gains from reductions in Annually Managed Expenditure not accounted for in the forecast.[56] During the period covered by the 2004 Spending Review, Annually Managed Expenditure was forecast at the time of that Spending Review to grow at 2.1% a year on average in real terms, compared with growth in Departmental Expenditure Limits of 4.2% a year in real terms over the same period.[57] Table 2 compares initial forecasts for Annually Managed Expenditure set out in the earliest relevant Spending Review with the outturns up to 2005-06, the latest estimate of outturn for 2006-07 and the latest forecast for 2007-08.[58]

Table 2: Comparison of initial estimates of Annually Managed Expenditure in Spending Reviews with outturns, 1998-99 to 2007-08
Year
(1) Initial Spending Review forecast of Annually Managed Expenditure

£ million
(2) Outturn for Annually Managed Expenditure(1)

£ million
Difference between (1) and (2)

£ million
Difference between (1) and (2)

%
1998-99
164,800
153,300
-11,500
-7.0
1999-2000
172,400
151,900
-20,500
-11.9
2000-01
179,900
161,000
-18,900
-10.5
2001-02
189,500
164,700
-24,800
-13.1
2002-03
186,200
179,500
-6,700
-3.6
2003-04
193,900
189,200
-4,700
-2.4
2004-05
201,700
207,700
6,000
3.0
2005-06
210,400
220,400
10,000
4.8
2006-07
227,800
230,700(2)
2,900
1.3
2007-08
239,500
242,600(3)
3,100
1.3

Sources: CSR 1998, Table 2, p 16; SR 2000, Table 1.1, p 4; SR 2002, Table 1.1, p 6; SR 2004, Table 1.1, p 5; PESA 2004, Table 1.1, p 8 (for 1998-99 outturn); PESA 2005, Table 1.1, p 8 (for 1999-2000 outturn); PESA 2006, Table 1.1, p 11 (for 2000-01 outturn); PESA 2007, Table 1.1, p 11 (for all figures in column 3 from 2001-02 onwards)

Notes (1) All figures in column 3 rounded to nearest £100 million; (2) estimated outturn; (3) latest plans

25. Spending within Annually Managed Expenditure is, in the Treasury's own words, "volatile and demand-led".[59] It is precisely for those reasons that the Government does not seek to subject such spending to firm multi-year planning at a departmental level. Estimates of Annually Managed Expenditure are subject to periodic review, and those shown in column 2 of Table 2 are the very earliest estimates for the financial years concerned. Nevertheless, from analysis of Chart 2 and Table 2, it is possible to draw the following conclusions:

  • although the Government has stated that forecasts of Annually Managed Expenditure are "based on cautious estimates",[60] and the caution of the Government's initial estimates is evident from outturns up to 2003-04, the initial estimates for 2004-05 and 2005-06 have been exceeded and the initial estimates for 2006-07 and 2007-08, may be exceeded;
  • the average rate of growth of Annually Managed Expenditure in the period from 2005-06 to 2007-08 seems likely to exceed the Treasury's initial forecasts for those years, although the proportionate difference seems likely to be smaller in 2006-07 and 2007-08 than in 2005-06; and
  • the overall rate of growth for Total Managed Expenditure as a whole proposed in the spending envelope for the period from 2008-09 to 2010-11 is lower than the actual rate of growth of Annually Managed Expenditure so far during the years covered by the last two Spending Reviews.

26. The forecasts and assumptions made about the path of growth of Annually Managed Expenditure in the years from 2008-09 to 2010-11 need to take account both of the pattern of such spending in recent years and the factors which may affect levels of spending within Annually Managed Expenditure in coming years. Based on our work in the present Parliament to date, we can identify the following factors which have the potential to exert upward pressure on Annually Managed Expenditure during the spending period covered by the Comprehensive Spending Review:

  • public sector net debt is projected to be higher than during the period covered by the 2004 Spending Review and rising in each year up to 2010-11,[61] thus potentially increasing debt interest payments (subject to interest rates and financing arrangements);
  • tax credits expenditure is forecast on the basis of existing take-up rates, while the Government is seeking ways to increase take-up rates, particularly the low take-up rate of 25% of entitlement in 2004-05 for Working Tax Credit among those entitled to claim it and childless;[62]
  • the Government is committed to halving the rate of child poverty by 2010-11, and the achievement of that commitment is likely to depend in part on increased expenditure on tax credits and child benefit;[63] and
  • net contributions to EU institutions (although a small proportion of total Annually Managed Expenditure) are projected to rise in real terms as a result of the financial agreement up to 2013 reached at the December 2005 European Council.[64]

27. Such areas of Annually Managed Expenditure with a potential for increase may be offset by other areas with a potential for reductions. Also, forecasts for Annually Managed Expenditure traditionally include a substantial margin or contingency. In the case of the 2004 Spending Review, this margin was £2 billion in the first two years of the planning period and £3 billion in the third year.[65] Such a margin might cover some of the less predictable increases in expenditure. The Chief Secretary to the Treasury was optimistic about the overall prospects for Annually Managed Expenditure:

Looking forward, I am hopeful about the prospects. At the moment we are seeing the unemployment claimant count falling (it has fallen, I think, three months in a row now) and we are starting to see inroads into the very long-standing issue of incapacity benefits, thanks to the Pathways Programme—we have started to see reductions there—and so, looking at the CSR period and the prospects for AME spending, I think we are going to be in good shape.[66]

28. The forecasts for Annually Managed Expenditure up to 2010-11 set out when the final outcome of the 2007 Comprehensive Spending Review is announced will be crucial in determining the total amount of resources available within Departmental Expenditure Limits for allocation among departments consistent with the Total Managed Expenditure ceilings established in the 2007 Budget. In recent years, outturns for Annually Managed Expenditure have exceeded initial forecasts, and the initial forecasts for 2006-07 and 2007-08 made at the time of the 2004 Spending Review may prove over-optimistic. We recommend that the Government ensure an appropriate margin of caution in its equivalent forecasts in the 2007 Comprehensive Spending Review for the period up to 2010-11.

Fiscal constraints

29. Decisions on the planning and control of spending take place within the context of overall fiscal policy and considerations about the fiscal rules. As we noted earlier, the fiscal rules—the golden rule and the sustainable investment rule—are designed to act as a constraint upon spending or, in the case of the golden rule, on increases in spending without appropriate increases in revenue receipts.[67]

30. During the economic cycle which the Government now believes began in 1997 and which the Government expects to end in 2007, the initial Departmental Expenditure Limits set out in the various Spending Reviews, although characterised as firm, multi-year limits, have been subject to upward revision. Table 3 compares initial plans for Departmental Expenditure Limits set out in the earliest relevant Spending Review with the outturns up to 2005-06, the latest estimate of outturn for 2006-07 and the latest plans for 2007-08.[68] Table 3 demonstrates the extent of such upward revisions, and shows that they have been more limited in scope in recent years.

Table 3: Comparison of initial plans for Departmental Expenditure Limits in Spending Reviews with outturns, 1998-99 to 2007-08
Year
(1) Initial Spending Review Departmental Expenditure Limits

£ million
(2) Outturn for Departmental Expenditure Limits(1)

£ million
Difference between (1) and (2)

£ million
Difference between (1) and (2)

%
1998-99
168,800
179,400
10,600
6.3
1999-2000
179,200
189,000
9,800
5.5
2000-01
190,100
205,300
15,200
8.0
2001-02
200,200
224,600
24,400
12.2
2002-03
229,300
241,300
12,000
5.2
2003-04
245,700
266,700
21,000
8.5
2004-05
279,800
283,500
3,700
1.3
2005-06
301,000
303,000
2,000
0.7
2006-07
321,400
321,500(2)
100
0.0
2007-08
340,500
344,100(3)
4,000
1.1

Sources: CSR 1998, Table 2, p 16; SR 2000, Table 1.1, p 4; SR 2002, Table 1.1, p 6; SR 2004, Table 1.1, p 5; PESA 2004, Table 1.1, p 8 (for 1998-99 outturn); PESA 2005, Table 1.1, p 8 (for 1999-2000 outturn); PESA 2006, Table 1.1, p 11 (for 2000-01 outturn); PESA 2007, Table 1.1, p 11 (for all figures in column 3 from 2001-02 onwards)

Notes (1) All figures rounded to nearest £100 million; (2) estimated outturn; (3) latest plans

31. The differences between initial Departmental Expenditure Limits and outturns are due to a range of factors. A number of changes have arisen from conscious decisions by the Government to utilise the flexibility inherent in the spending regime. First, Spending Reviews held every two years have provided an opportunity to revise totals for the third year of a spending period, initial limits for which were set in the preceding Spending Review. For example, the limit for 2003-04 was set at £439.6 billion in the 2000 Spending Review, but revised upwards to £454.6 billion in the 2002 Spending Review.[69] Similarly, the limit for 2005-06 was set at £511.4 billion in the 2002 Spending Review, but revised upwards to £520.8 billion in the 2004 Spending Review.[70] Second, as was apparent from Table 2, the years up to 2001-02 saw outturns for Annually Managed Expenditure markedly below initial forecasts, giving freedom for resources to be re-allocated to spending within Departmental Expenditure Limits without exerting upward pressure on Total Managed Expenditure. In the past, the Chancellor of the Exchequer has acknowledged the scope for flexibility in initial spending totals within Departmental Expenditure Limits. In evidence to our predecessors on the 2002 Spending Review, he readily conceded that initial totals within Departmental Expenditure Limits had been and could be increased, subject to compliance with the fiscal rules:

We have got to beat our fiscal rules. We have got to meet the rules I set down, which means that there has got to be a current balance and also debt has got to be at a sustainable level. The spending plans I have set down are affordable and they are affordable on the basis of the revenues which we have raised … The spending plans could only be increased if it was affordable to do so ... We would have to base that [a decision to increase expenditure beyond initial limits] on the meeting of our fiscal rules.[71]

32. Public sector net investment is constrained by the sustainable investment rule, which in the economic cycle which the Treasury now considers began in 1997-98 is formulated as requiring that net debt be maintained below 40% of GDP in each and every year of the economic cycle.[72] Limits on capital spending have been set for the period covered by the Comprehensive Spending Review, with such expenditure rising to £57 billion by 2010-11.[73] On the basis of these limits, the Treasury's latest forecast is that public sector net debt will increase to 38.5% of GDP in 2008-09, rise further to 38.8% of GDP in 2009-10 and remain at that level in 2010-11.[74] The margin available before the sustainable investment rule limit would be breached is thus smaller than during previous Spending Review periods,[75] although two points need to be borne in mind. First, there has been a consistent pattern for outturns for public sector net investment to be below initial plans.[76] Second, as we have already noted, the Government has not clarified whether, during the new economic cycle, the limit on net public sector investment of 40% under the sustainable investment rule will apply to each year of that economic cycle or will be applied as an average over the cycle.[77]

33. As far as current expenditure is concerned, the relevant fiscal rule is the golden rule. The golden rule need not operate directly as a constraint upon public expenditure, because that rule is concerned with the overall state of the current budget balance over an economic cycle. Thus, short-term increases in the current budget deficit, whether caused by increases in spending or reductions in revenue or a combination of both, can be off-set by current budget surpluses at other phases in what is judged by the Government to be the same economic cycle. Also, increases in spending can be off-set by increases in revenue. These can take the form of explicit increases in rates of taxation, sometimes intended to pay for increased spending, such as increases in national insurance contributions in 2002 to fund increases in National Health Service funding,[78] or of the effects of fiscal drag, or of instances when tax receipts exceed initial forecasts.

34. Despite the absence of a direct and necessary relationship between levels of current public expenditure and prospects for compliance with the golden rule, there are reasons why this fiscal rule might operate as a significant constraint on such expenditure during the Comprehensive Spending Review period. First, according to the Government's current forecasts and fiscal practice, the new economic cycle is expected to begin with a current budget deficit, which will need to be matched by current budget surpluses later in the same economic cycle if the golden rule is to be complied with.[79] Second, for much of the economic cycle which the Treasury now estimates began in 1997-98, the Government's forecasts of tax receipts proved to be underestimates, so that actual receipts significantly exceeded forecasts. More recently, forecasts of revenue receipts have had to be revised downwards rather than upwards, and there are signs that revenue receipts are not responding as positively to increased rates of economic growth as on some occasions in the past.[80] Finally, the overall tax burden, measured as a proportion of GDP, is high by historic standards. In 2008-09, the tax-GDP ratio is projected to be 38.0%, rising slightly to 38.1% in both 2009-10 and 2010-11.[81] These are the highest levels reached since the mid-1980s.[82] The high levels of the tax-GDP ratio by recent standards might mean that the public appetite for further tax increases to off-set any additional increases in current public expenditure would be limited.

35. In the periods covered by earlier Spending Reviews, initial limits on spending within Departmental Expenditure Limits have been subject to subsequent upward revision. In some cases, this has been as a result of the use of the flexibility offered within the fiscal framework. In the period to be covered by this Comprehensive Spending Review, the Government's freedom to increase such public expenditure beyond initial allocations while continuing to comply with its fiscal rules is likely to be more constrained than has been the case during much of the last decade.

How real are "real terms"?

36. The general practice of the Government in announcing early spending settlements and the overall spending envelope as part of the Comprehensive Spending Review has been to express increases or reductions in percentages in "real terms". This approach is generally clearer than describing percentage increases in "nominal terms"—in other words, without taking account of the effect of inflation. The use of nominal terms has the effect of overstating increases. For the purposes of determining "real terms", the Treasury uses the GDP deflator, which is a measure of general inflation in the domestic economy.[83] For the years covered by the Comprehensive Spending Review, the Treasury is currently using a GDP deflator of 2.70% in each year.[84] Thus, if the Departmental Expenditure Limit of a particular department is said to be frozen in real terms over the period covered by the Comprehensive Spending Review, it can be assumed that that Limit will rise by 2.7% a year in nominal terms in 2008-09, 2009-10 and 2010-11.

37. The use of the GDP deflator in describing public sector budgets is a long-standing practice of the Treasury, but this measure can be of limited value in understanding the actual effect of expenditure allocations of a particular size in particular areas, partly due to the Relative Price Effect—in other words, the movement over time of a specific price index relative to a general price index such as the GDP deflator.[85] For example, although the Ministry of Defence no longer publishes an index of defence specific prices, there are independent analyses which suggest that defence equipment prices rise at about 10% a year in real terms.[86] There are other instances where the GDP deflator may be inadequate as a measure for understanding pressures on spending in particular departments, for example where a high proportion of spending takes place abroad.

38. A substantial component of public spending is used for the public sector wage bill. The Government has stated that

Over the 2007 CSR period controlling pay spending will be essential in delivering value for money from public spending and keeping inflationary pressures in check. The Government has made clear that pay settlements must be consistent with the achievement of the CPI inflation target of 2% and demonstrated this commitment by announcing on 1 March 2007 that the overall headline awards for Pay Review Body groups in 2007-08 are to be less than the 2% inflation target, averaging 1.9%, the lowest level of awards in over 10 years. In preparation for the 2007 CSR, key departments will prepare pay and workforce plans setting out how they will achieve the Government's objectives in pay policy and service delivery throughout the period.[87]

The Chief Secretary to the Treasury emphasised the importance of containing overall public sector pay budgets, implying that higher pay settlements would lead to public sector job reductions. He emphasised the importance of

affordability of public services in the CSR period … I think it is important that we do not, through excessively high pay increases, reduce the number of people who can be employed in the public service.[88]

Migration and demography

39. There are likely to be additional pressures on public spending in the period covered by the Comprehensive Spending Review as a result of population increase. According to the Government,

Official population projections produced by the Government Actuary's Department (GAD) suggest a moderate acceleration in population growth over the decade from 2007, with the population expected to reach 64 million by 2017 in the principal projections … Natural change is projected to account for 50 per cent of UK population growth between 2007 and 2017 because the number of births is expected to exceed the number of deaths … Positive net migration is projected to account for the other half of UK population growth 2007-2017 under GAD's principal projection.[89]

The extent to which population growth, arising in particular from positive net migration, is likely to have an effect within the planning period is apparent from the Government's decision, in December 2006, to revise upwards its neutral estimate of trend output growth for the post-2006 period by a ¼ percentage point to reflect an upward revision to its estimate of working age population growth.[90]

40. During our inquiry into the 2006 Pre-Budget Report, Dr Martin Weale of the National Institute of Economic and Social Research noted that there was no evidence that the Government had taken account of population growth in its public expenditure plans, as opposed to its estimates of trend growth. Mr Robert Chote of the Institute for Fiscal Studies also drew attention to the fact that population growth would lead to a downward pressure on public spending per head, with implications for the quality of public services.[91] In evidence for the current inquiry, the Local Government Association stressed the pressure on demand for local authority services from high levels of inward migration, levels which some local authorities considered significantly exceeded estimates by the Office for National Statistics.[92]

41. In response to such concerns, Treasury officials confirmed in December 2006 that "we have not put into the revenue projections or the expenditure projections the ways in which immigration might particularly increase one aggregate or another aggregate", but pointed to a study which suggested that "immigrants contribute more fiscally than they consume".[93] The Chief Secretary to the Treasury pointed out that the effect of demographic change on public expenditure varied from sector to sector: thus, for example, pressures on health might increase because of a growth in the number of over 85 year olds, but the number of children would fall.[94] With specific regard to positive net migration, he said:

We are looking at all the pressures and departments are looking at all the pressures they are expected to need to address … In terms of the big long-term challenges we have talked particularly about demography and I think that is going to be quite a big influence on the shape of public services looking over the period. Certainly there will be some more impact from migration, but I would not expect that to be on the same sort of scale.[95]

42. In view of the long gestation period of the Comprehensive Spending Review and the extent to which the Government has sought to promote debate on and analysis of long-term challenges, the Government could have provided more information on the likely impact of net migration on demand for public services over the period covered by the Comprehensive Spending Review. We note the Government's implied view that the overall fiscal effect of net inward migration will be positive over this period, with benefits in terms of revenue receipts outweighing the costs of additional public expenditure. However, public spending and tax receipts are different in kind. Increases in receipts are a matter for Treasury forecasting. Public expenditure is subject to firm limits, and must be planned for by Government departments, local authorities, health bodies and others. We recommend that, in advance of the final outcome of the Comprehensive Spending Review, the Treasury commission an analysis of the impact of net migration on demand for individual public services, to be published as part of the final announcement on the outcome.

43. The pressures on particular local services arising from net inward migration are one example of changes in population levels across the United Kingdom. The Government also expects changes in coming years in the distribution of population between England, Scotland, Wales and Northern Ireland, with the population of England expected to rise faster than that in other parts of the United Kingdom.[96] Over time, this will exert downward pressure on the relative size of the block grants to devolved authorities. The Chief Secretary to the Treasury indicated that such allocations would continue to be made in accordance with the Barnett formula.[97] More recently, the Chancellor of the Exchequer has confirmed that spending available to the Northern Ireland Executive will increase at least in line with inflation up to 2010-11.[98]


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

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

29   HC (2006-07) 389-I, para 33 Back

30   Treasury Committee, Second Report of Session 2005-06, The 2005 Pre-Budget Report, HC 739, para 43 Back

31   Pre-Budget Report 2004, para B.26, p 197; Pre-Budget Report 2005, para B.28, p 213 Back

32   HC (2005-06) 739, Q 389 Back

33   Budget 2006, para C.27, p 255 Back

34   Budget 2002, para 6.33, pp 118-119; Budget 2004, para 6.27, p 138 Back

35   HC Deb, 21 March 2007, col 818 Back

36   Budget 2007, paras C.26 and 6.47, pp 275, 152 Back

37   HC Deb, 6 December 2006, col 313 Back

38   Budget 2007, para 6.47, p 152 Back

39   Ibid, Table C3, p 275 Back

40   Institute for Fiscal Studies, The IFS Green Budget, January 2007, p 124 Back

41   HC (2005-06) 739, Q 206 Back

42   IFS Green Budget, p 126 Back

43   Ibid, p 126 Back

44   Ibid, pp 126-127 Back

45   Ibid, p 127 Back

46   Ibid, p 127 Back

47   IFS Green Budget, Table 7.2, p 129 Back

48   Q 2 Back

49   Ibid Back

50   See paragraph 4. Back

51   Budget 2007, para 6.47, p 152 Back

52   Q 6 Back

53   HC (2001-02) 1092-ii and ii, Qq 1, 38 Back

54   Ibid, Q 50 Back

55   CSR 1998, Annex B, p 117 Back

56   HC (2003-04) 906-i and ii, Q 183 Back

57   SR 2004, para 1.11, p 5 Back

58   In each case, the initial Spending Review figure is the first forecast given, so that, for example, the figure for 2005-06 is taken from SR 2002, not SR 2004. The calculations take no account of definitional and classification changes relating to outturn data. Back

59   SR 2004, para 1.10, p 5 Back

60   CSR 1998, Annex B, p 117 Back

61   Budget 2007, Table C4, p 278 Back

62   HC (2006-07) 389-I, paras 43-45 Back

63   Ibid, paras 46-48 Back

64   HC (2005-06) 994-I, para 61 Back

65   SR 2004, Table A.1, p 182 Back

66   Q 6 Back

67   See paragraph 14. Back

68   In each case, the initial Spending Review figure is the first total given, so that, for example, the figure for 2005-06 is taken from SR 2002, not SR 2004. The calculations take no account of definitional and classification changes relating to outturn data. Back

69   SR 2000, Table 1.1, p 4; SR 2002, Table A.2, p 165 Back

70   SR 2002, Table A.2, p 165; SR 2004, Table 1.1, p 5 Back

71   HC (2001-02) 1092-i and ii, Qq 339-343 Back

72   See paragraph 14. Back

73   See paragraph 18 and Table 1 of this Report. Back

74   Budget 2007, Table C1, p 270 Back

75   For example, the Budget preceding the 2002 Spending Review forecast that public sector net debt would be 31.0% of GDP in the last year of the projection period, 2006-07 (Budget 2002, Table C2, p 207) and the Budget preceding the 2004 Spending Review forecast that public sector net debt would be 36.4% of GDP in the last year of the projection period, 2008-09 (Budget 2004, Table C1, p 244). Back

76   HC (2006-07) 389-I, paras 26-27 Back

77   See paragraph 14. Back

78   Budget 2002, paras 6.41-6.45, p 124 Back

79   Budget 2007, Table C1, p 270; HC (2006-07) 389-I, para 29 Back

80   HC (2006-07) 389-I, paras 17-22 Back

81   Budget 2007, Table C10, p 286 Back

82   HC (2005-06) 944-I, Figure 1 and para 53 Back

83   http://www.hm-treasury.gov.uk/economic_data_and_tools/gdp_deflators/data_gdp_index.cfm  Back

84   PESA 2007, Table F2, p 210 Back

85   Ev 117 Back

86   Defence Committee, Memorandum from Keith Hartley submitted for inquiry into UK defence: commitments and resources, available at http://www.publications.parliament.uk/pa/cm200607/cmselect/cmdfence/ucsnd4/ucm02.htm  Back

87   Budget 2007, para 6.29, p 148 Back

88   Q 38 Back

89   Long-term opportunities and challenges, paras 3.8-3.10, p 28 Back

90   HC (2006-07) 115, para 20 Back

91   Ibid, para 26 Back

92   Ev 112 Back

93   HC (2006-07) 115, Q 162; Institute for Public Policy Research, Paying their way: the fiscal contribution of immigrants in the UK, April 2005 Back

94   Q 157; Long-term opportunities and challenges, Chart 3.2 and para 3.19, p 32 Back

95   Qq 158-159 Back

96   Long-term opportunities and challenges, Chart 3.2 and para 3.12, p 29 Back

97   Qq 80-82 Back

98   HC Deb, 8 May 2007, col 2WS Back


 
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