June 2010 Budget - Treasury Contents

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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Prepared 23 July 2010