11 November 2005
Will the chancellor manage again to use his Treasury black arts to keep within his economic rules, or will he now have to admit that his forecasts were optimistic? The forthcoming Pre-Budget Report should offer some clues, says Robert Chote
Gordon Brown has unveiled three big tax-raising Budgets since becoming chancellor eight years ago, each of them in the 12-month honeymoon period following one of Labour's election victories. Will history repeat itself in the wake of the party's latest win at the polls in May? Brown's Pre-Budget Report, expected in the next few weeks, should give us a hint.
Many independent observers, including the Institute for Fiscal Studies, argued well before polling day that the public finances were likely to be weaker over the next few years than the Treasury claimed. If we are right, the chancellor will need fresh tax increases to pay for his existing spending plans and to keep the government's finances on the Treasury's desired trajectory.
But Brown has yet to countenance any such suggestion. If – and it remains a very big if – he plans to U-turn in next spring's Budget, he might use the PBR to start softening people up.
But why might he need to do so? Well, this PBR looks like being the seventh Budget or Pre-Budget Report in succession in which the chancellor has had to concede that his previous predictions for the public finances were over-optimistic. The main problem has been that tax revenues have come in weaker than he has expected, above and beyond any weakness related to the strength of the economy.
As a result, the twin targets for public sector borrowing and debt he set himself on taking office – which looked relatively undemanding a few years ago – are now in danger of being missed over the next few years in the absence of policy changes. This does not imply a crisis in the public finances, but it would be a blow to Brown's credibility.
Government borrowing is declining, but not as quickly as the Treasury hoped. In the first half of this financial year, the current budget deficit – the shortfall between non-investment spending and tax revenues – was 17% smaller than in the same period last year. If this holds true over the next six months, the deficit for 2005/06 will come in at £15.6bn. This is well above the £5.7bn predicted by the Treasury in the March Budget and higher even than the £13.4bn predicted by the IFS in our Green Budget two months earlier. (In PBR 2001, the Treasury was predicting a surplus this year of £8bn.)
The current budget deficit is overshooting the Budget forecast even though spending has risen more slowly over the first six months of the year than the Budget implied for the year as a whole. But this is more than offset by the weakness of revenues – they are up by 7.2% on last year rather than by the 8.5% implied by the Budget forecast. Independent forecasters were particularly sceptical of the 28.4% rise in corporation tax revenue projected by the Treasury in the Budget this year – the increase so far is fractionally over 16%.
Movements in the public finances are notoriously hard to predict even over a short time horizon, so the trend might yet take a turn for the better. The chancellor and his officials have doubtless been cheered by reports of big profits by financial firms in the City. Some should flow their way in the form of corporation tax payments or income tax paid on annual bonuses. This could perk up the revenue figures later in the year.
On the face of it, the chancellor should also benefit from higher oil prices. The Treasury assumed in the Budget that oil prices would equal the average independent forecast at the time – $40.60 per barrel in 2005 and $37.80 in 2006. Since then, the average forecast has risen to $55.50 this year and $54.30 in 2006. If this materialises, extra revenues from oil-related taxes would be worth an extra £1.75bn this year and next.
However, Brown will be under pressure to hand back some of this gain by again delaying scheduled rises in fuel duty for motorists. More expensive oil will also raise costs for firms elsewhere in industry, reducing the tax payments the Treasury can expect from them.
All this suggests that in the PBR the chancellor might well predict a current budget deficit this year somewhere between the £5.7bn he forecast in the Budget and the £15.6bn implied by a mechanical extrapolation of the trends of the past six months. If so, what would this imply for his chances of meeting his fiscal targets?
The chancellor has set himself two main goals in managing the public finances, the 'golden rule' and the 'sustainable investment rule'. Most attention has focused on the golden rule, which requires the government to borrow no more than it requires to pay for investment spending. This in turn implies that the current budget should be in balance or in surplus.
The rationale for the golden rule is that the government should borrow only to finance spending that future taxpayers are likely to benefit from. However, the distinction between investment and current spending in the national accounts offers only a very rough approximation of what benefits future taxpayers and what does not.
The golden rule does not have to be met every year, only on average over the ups and downs of the economic cycle. It makes sense to allow the government to borrow more when the economy is weak – thereby injecting more spending power – as long as it runs offsetting surpluses when activity is buoyant. At Budget time the Treasury said that it regarded the current economic cycle as encompassing the seven financial years from 1999/2000 to 2005/06. That would imply that the golden rule would be met as long as the current budget deficit this year is no bigger than £9bn – which would be a very close run thing.
However, shortly before Parliament rose for the summer, the Treasury published a lengthy analysis that drew attention to revisions to the national accounts showing that economic activity was slightly higher than previously estimated in 1999. It concluded from this that the cycle started two years earlier in 1997/98. Thanks to the big current budget surplus recorded in 1998/99, this means that the Treasury now can borrow £21.7bn on the current budget this year without breaking the rule.
Not surprisingly, this fortuitously timed statistical judgement has been greeted with considerable cynicism. Bearing in mind the methodology the Treasury uses to date the cycle, the decision to include the two extra years does not in itself look unreasonable. But the case for making the change is not overwhelmingly stronger now than it was at any point in the past three or four years.
Brown has chosen to make the change at precisely the point when it might determine whether the rule is met or not. This risks undermining the credibility of his commitment to the principles behind the rule and strengthens the case for asking an independent body to take over the task of dating the economic cycle for this purpose. Even better, the Treasury should think again about judging whether the rule is met by looking at the current budget over a cycle defined by fixed dates in this way.
The dating of the cycle is likely to remain controversial because of the weakness of the economy over the past year or so. Treasury figures suggest that the cycle almost ended in early 2004 when the amount of spare capacity in the economy had shrunk to about one-eighth of 1%. Since then this 'output gap' has widened again and the economy might now be running about 1.5% below full capacity, the weakest position since Brown took office.
If so, the economy would have to grow much more quickly over the next few months than most City economists expect for the cycle to close this year, more likely it will happen in 2006/07.
Having been attacked for 'moving the goalposts' at the beginning of the cycle, the Treasury would certainly come under fire for moving the goalposts at the other end too. But this would only make the rule easier to meet if the current budget were to be in surplus next year – the Treasury forecast in the Budget that it would be, but we have forecast a deficit.
Whether or not the rule is met in this cycle, the IFS and international commentators, such as the International Monetary Fund and the Organisation for Economic Co-operation and Development, are more concerned that the Treasury is being overoptimistic about the rule being met looking further into the future. The Treasury is expecting tax and other revenues to rise by more than 2% of national income over the next five years without having to announce any further tax-raising measures. Most of us expect them to fall about 1% of national income short.
If revenues come in this weakly, not only is the government unlikely to meet the golden rule over the next cycle, but it is also likely to break its second rule. This 'sustainable investment rule' commits the government to keep the public sector's net debt below 40% of national income. We predicted in the Green Budget that on current policies this is likely to be breached in 2008/09.
Neither rule should be treated as Holy Scripture. Breaking them by a small margin would have little direct economic impact, but would be embarrassing for the chancellor. He could make the rules easier to meet either by statistical sleight of hand or by announcing some fresh tax increases to bring in extra revenue. He needs to think carefully about which would serve his credibility better in the long term.
Robert Chote is director of the Institute for Fiscal Studies