3 The Public Finances
The structural deficit
42. In its pre-Budget forecast, based on the policies
announced in the March Budget, the OBR estimated that the cyclically-adjusted
deficit on current budget, or structural current deficit, would
fall from 5.3% of GDP in 2009-10 to 1.6% of GDP in 2014-15. To
accelerate the deficit reduction, the Chancellor announced a new
set of measures in the June Budget, which would save £40bn
a year when fully implemented by 2014-15. The measures included
£32bn additional spending cuts, of which £11bn will
come from welfare reform savings, and £8bn of net tax increase,
with the proposed rise in VAT contributing an increase of £13.5bn
in tax revenue.
43. The Chancellor also announced a new fiscal mandate
and a plan to set a fixed target for debt. The mandate is forward-looking
"to achieve cyclically-adjusted current balance by the end
of the rolling, five-year forecast period".[67]
This fiscal mandate will be supplemented by a "target for
public sector net debt as a percentage of GDP to be falling at
a fixed date of 2015-16,"[68]
although the precise target has yet to be announced.
44. Taking the policies in the June Budget into account,
the OBR estimated that the structural current deficit will be
eliminated by 2014-15 (see Chart 1 below). The forecast is now
for a cyclically adjusted surplus of 0.3% of GDP in 2014-15.[69]
Using its central forecasts, the OBR also believes that there
is a greater than 50% chance that the Government will achieve
its fiscal mandate and target for debt. Chart
1: Changes
in OBR's structural current deficit forecast after June Budget
Chart 1 here
Source: OBR, Budget
forecast, p77, table C1 in Budget June 2010; OBR, pre-Budget forecast,
p30, table 4.1
45. We asked Mr Bootle whether the structural deficit
could be eliminated over a slightly longer period, without a significant
impact on market confidence in the UK. He stated that 'the political
process intervenes because what the Government wanted to do was
to eliminate the structural deficit within a Parliament. In straightforward
economic terms, I am not sure it would make a great deal of difference
if the adjustment were over a longer period, but we have to face
the political reality of when parliaments change'. [70]
46. When asked the same question, the Chancellor
admitted that there was political judgement in deciding the timeframe
of eliminating the deficit, but stressed that having a credible
plan to deal with the deficit was also important:
It is a political judgment about what is an economic
necessity, I guess. The Governor of the Bank made it clear within
days of my appointment that the most important thing now is for
the new Government to deal with the challenge of the fiscal deficit.
It was clear on arrival that no-one believed that Britain had
a credible plan to deal with the Budget deficit. The G20 subsequently
called for countries with serious fiscal challenges, and after
all we have got the biggest budget deficit of the G20, to accelerate
the pace of fiscal consolidation. The OECD in a report well worth
reading yesterday said that the Budget was an essential starting
point for future recovery. I think there is quite a lot of international
support for the view that Britain did not have a credible plan
and has introduced one. [71]
Spending cuts vs. tax increases
47. There has been a great deal of debate about the
way to implement the fiscal tightening, in particular about the
balance between cutting spending and increases taxes. In his Budget
speech, the Chancellor stated that:
Our approach is supported by the international evidence,
compiled by the Organisation for Economic Cooperation and Development,
the International Monetary Fund and others, which found that consolidations
delivered through lower spending are more effective at correcting
deficits and boosting growth than consolidations delivered through
tax increases. [...]This is the origin of our 80:20 rule of thumb—roughly
80 per cent through lower spending and 20 per cent through higher
taxes. [72]
48. We
asked our expert witnesses whether they agreed that the majority
of fiscal consolidation should come from spending cuts. Mr Bootle
told us that:
I do not think it is possible to defend, as
it were, precisely 80:20 or 75:25 on the basis of the evidence,
but there is quite a lot of evidence from a range of fiscal consolidations
in the past ranging across Canada in the 1990s, Sweden, Finland...
to suggest that it is more likely that your fiscal consolidation
could be accompanied by sustained economic growth and it is preponderantly
done with regard to spending cuts rather than taxation [...] I
think the evidence is pretty clear that in this country we have
not been suffering from excessively low taxation and we perhaps
have been suffering from excessively high public spending. [73]
Mr Barrell was also unsure about the precise balance
which would be desirable in current conditions:
It is quite clear that in the 1970s and 1980s
and maybe even the early 1990s cutting spending was more effective
than raising taxes because it involved more commitment. The recent
research by the European Commission, who are very much spending-cutters
rather than tax-risers, suggests that that balance of advantage
has actually changed and that, although there may be some advantage
to cutting spending, raising taxes with the right institutions
in place, such as the Office for Budget Responsibility, might
well be equally effective [...], so there is a decision to be
made. Does the economic evidence support the 80:20? If you look
at the last 50 years, yes. If you look at the last 15 years, less
so [...] 80:20, there is some evidence for it, and 60:40, there
is also some evidence for that. [74]
The European Commission research he referred to stated
that:
As regards the composition of successful fiscal consolidation,
the EU experience confirms that cuts in current primary expenditure
are more likely to produce a lasting effect than higher revenues
or large cuts in government investment. However, the validity
of this by now familiar notion is somewhat weakened for consolidations
enacted since the beginning of the 1990s. The composition of adjustment
per se seems to have lost some of its weight in securing the success.[75]
49. There
are precedents for successful fiscal consolidations which were
focussed on spending cuts rather than raising taxes. We also note
more recent work on the impacts of varying ratios of spending
cuts to tax rises. We recommend the Treasury revisit recent literature.
We understand that the 77:23 split will not be reached until the
final year of the forecast period.
Investors' demand for gilts
50. Market interest rates for the UK have fallen
in the last few months. Yields on 10-year gilts are at 3.3%, compared
to 4.0% at the time of the March Budget. More importantly, over
the same period, UK yields have fallen by more than the German
Bund, which is seen as a benchmark for AAA-rated countries. 10-year
yield has fallen by 69 basis points since the March Budget, compared
to the 55 basis points fall in the German Bund.[76]
51. As noted above, the Chancellor considered UK
policy had contributed to these changes:
It is striking, and I am sorry to repeat myself,
that the interest rates for UK businesses are a full 1% lower
than they are for Spanish businesses and that was not the case
at the time of the March Budget. There is a stimulating effect
that is driven by confidence that the UK is able to deal with
its fiscal problems.[77]
52. Market commentaries suggest that the fall in
UK rates partly reflects investors' confidence in the measures
announced in the June Budget. However several other factors, such
as Quantitative Easing, the Eurozone crisis and even speculative
activities could also have led to an increased demand for gilts.
For example, the sovereign debt crisis in the Eurozone has led
to a significant increase in interest rates in the region—in
Spain, interest rates have gone up by 60 basis points since March.[78]
53. Gilt yields
have fallen in the last few months. This appears in part in response
to the Budget. It must be borne in mind that other factors than
the Budget may also affect the demand for gilts.
Credit Ratings Agencies
54. The role of credit rating agencies has come under
increased scrutiny since the start of the financial crisis. Their
poor record in predicting losses on structured products, and the
potential conflicts of interest, when they receive payments from
institutions whose products and debt they rate, led to concerns
about their effectiveness in estimating the creditworthiness of
investment products. Mr Ramsden told us:
Credit rating agencies tend overall to follow rather
than lead the markets. In the vast majority of cases a rating
agency action will reflect what the markets have already concluded
[...][where] rating agencies can be useful, along with international
organisations, is in the surveillance that they provide on an
economy. [79]
55. We asked the Chancellor whether the measures
announced in the June Budget were designed specifically to satisfy
the rating agencies or the credit markets. He stressed that keeping
market interest rates low was a priority:
What I am trying to do is make sure that British
businesses and families can borrow at reasonable market rates
and competitive market rates and obviously I want to finance the
government debt. Those things are both made easier by keeping
the country's AAA credit rating which, as we know, has been put
under question. The good news is that two of the three credit
rating agencies responded very positively to the Budget and the
third wanted to see whether this Parliament had the stomach to
actually implement the measures. Things are looking quite favourable.[80]
56. The
financial crisis has shown the credit rating agencies can be wildly
wrong. Excessive reliance on credit rating agencies for an assessment
of credit risk is now recognised as having been a mistake. We
welcome the positive comments from the agencies following the
June Budget, but also acknowledge the Chief Economic Adviser's
recognition that agencies tend to follow rather than lead the
markets.
67 HM Treasury, Budget 2010, June 2010, p 12 Back
68
HM Treasury, Budget 2010, June 2010, p 12 Back
69
HM Treasury, Budget 2010, June 2010, p 99, table C.10 Back
70
Q 116 Back
71
Q 290 Back
72
HC Deb, 22 June 2010, col 168 Back
73
Q 123 [Mr Bootle] Back
74
Q 123 [Mr Barrell] Back
75
European Commission, Received wisdom and beyond: Lessons from
fiscal consolidation in the EU by Larch and Turrini, April 2008,
p 4 Back
76
Financial Times, www.ft.com/marketsdata, accessed 19 July
2010 Back
77
Q 219 Back
78
Financial Times, www.ft.com/marketsdata, accessed 19 July
2010 Back
79
Q 169 Back
80
Q 267 Back
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