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Bending the rules? By Carl Emmerson

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05 August 2005

When does the UK's economic cycle start and end? Whenever the chancellor chooses, say his critics. That view is too cynical, argues Carl Emmerson – but we could do with a more forward-looking approach to forecasting

The Treasury continues to reject claims by many independent commentators that it will need to introduce tax raising measures if it is to finance its spending plans without contravening the chancellor's fiscal rules. The latest Treasury calculations, which show that the current economic cycle actually began two years earlier than previously thought, make it easier for these rules to be met over the current cycle. But they do not change the likelihood that further tax increases, or tighter public spending plans, will be needed.

This highlights an oddity in the current fiscal framework: revisions to data several years in the past that do not affect the current strength of the government's finances can still affect whether or not the rules have been met. Improvements to the current fiscal rules, and their assessment, could have advantages for the credibility of the fiscal framework and potentially also lead to better policy-making.

The chancellor uses two fiscal rules to help him determine the extent to which the government's spending can be financed through borrowing rather than from tax (and non-tax) revenues. These are the 'sustainable investment rule' and the 'golden rule'.

The sustainable investment rule limits public sector net debt (the stock of previous government borrowing) to 40% of the amount produced by the UK economy in one year.

The golden rule states that the government should borrow only to fund investment spending, and that other (current) spending must be covered by government receipts.

The rationale for the sustainable investment rule is that larger levels of public sector debt could place too great a burden of repayments on future generations. In a similar vein, the justification behind the golden rule is that while borrowing to finance spending that benefits future generations might be appropriate, borrowing to finance spending that benefits only the current generation might not be.

The golden rule is assessed over the course of an economic cycle. This has the advantage of allowing the Treasury to borrow to pay for non-investment spending during periods of relatively weak economic performance as long as it runs surpluses of equal or greater magnitude during periods of relatively strong economic performance.

The Treasury judges compliance with the golden rule by summing the current budget (which is the difference between total receipts and total non-investment spending) as a share of national income over an entire economic cycle.

This raises the difficulty of knowing when the economic cycle began and when it is likely to end. Measuring the total amount of income produced by the UK economy in a year is a very difficult task. Even harder is assessing when this level of income is 'on trend', that is at a level consistent with stable inflation (ie, a period of neither relatively strong nor relatively weak economic performance).

The Treasury produces a measure of the 'output gap' – the difference between the estimated level of activity in the UK economy and the (also estimated) level that it believes can be sustained. An economic cycle is judged to end, and a new one to begin, when the economy moves from being in a period of relatively weak economic performance to a period of relatively strong economic performance (ie, the output gap moves from being negative to being positive).

Figure 1 shows the latest Treasury estimates of the output gap alongside those published in the March 2005 Budget. The key difference between the two series is that the Treasury previously believed that the economy was operating relatively weakly during spring 1999 (the output gap was negative) and that summer 1999 marked the start of the current economic cycle.

Data revisions since the Budget suggest that the economy actually performed better than previously thought during 1999. As a result, the Treasury now believes that the economy was not operating below its sustainable potential during 1999 (the output gap was not negative) and that the current economic cycle began in 1997. This highlights the extent to which a relatively small revision can lead to large changes in the dating of the economic cycle.

A similar issue applies to the end date of the current cycle. Some independent forecasters, such as the National Institute of Economic and Social Research, believe that the economy moved into a period of relatively strong economic performance during the summer of 2004.

If so, a new economic cycle would have already begun. In contrast the Treasury believes that this did not occur and that the current economic cycle will close during the financial year 2005/06. It is also quite possible that weaker-than-expected economic growth this year will lead to the economic cycle actually closing sometime in 2006/07 (or even later).

Figure 2 shows the estimated size of the current budget from 1997/98 to date, and the latest Treasury predictions for the evolution of the current budget going forwards. If the current economic cycle did begin in 1997, this will make it easier for the chancellor to comply with the golden rule. This is because of the 1.0% of national income surplus on the current budget (£12.5bn in today's terms) that was banked over 1997/98 and 1998/99.

If the Treasury's forecasts are correct, the dating of the cycle will not matter and the chancellor will be proved correct in his statement to Parliament that: 'We would meet the golden rule irrespective [of whether the current cycle began in 1997 or 1999].'

If, alternatively, the IFS Green Budget forecast for 2005/06 for a current budget deficit of 1.1% of national income proves correct then the golden rule would have been met if the current cycle ran from 1997/98 to 2005/06 – but not if it ran from 1999/2000 to 2005/06.

Precisely dating an economic cycle is an impossible task, and the chancellor's judgement that the current economic cycle might have begun in 1997 rather than 1999 looks reasonable. The fact that it makes it easier for him to comply with his fiscal rules is unfortunate for two reasons.

First, cynics might believe that the chancellor would not have revised the estimated start date of the current economic cycle had that made complying with his fiscal rules more difficult. This could erode the credibility of the current fiscal framework.

Secondly, the timing of the start of the economic cycle does not in any way affect the underlying strength of the government's fiscal position. Whether or not changes to fiscal policy are required depends solely on whether the current level of debt, and the likely level of future borrowing, is deemed appropriate.

The potential for changing the dating of the economic cycle for inappropriate reasons could be removed by handing responsibility to an independent organisation, such as the Bank of England.

A more radical approach would be to adopt a more forward-looking assessment of measuring likely compliance with the golden rule. This seems particularly appropriate as the sustainable investment rule constrains debt, which is a function of past government borrowing.

Those interested in assessing the state of the public finances could assess compliance with the golden rule by judging whether or not future government revenues were likely to be sufficient to finance the government's non-investment spending plans. At the moment the Treasury expects very strong growth in tax revenues over the next four years to deliver increasing current budget surpluses through to the end of this decade (as shown in figure 2) and therefore for the golden rule to be met in the future.

Other forecasts, such as those produced by researchers at the Institute for Fiscal Studies, suggest that tax revenues will also grow strongly but not sufficiently for us to reasonably expect the golden rule to continue to be met in the future.

Should these forecasts be correct then further tax increases, or tighter public spending plans, will be needed to continue to comply with the golden rule. This type of forward-looking approach would aid credibility in the fiscal framework, and potentially improve policy-making, since it would focus attention on the underlying strength of the government's finances rather than on less crucial issues such as whether an economic cycle began six or eight years ago.

Carl Emmerson is deputy director at the Institute for Fiscal Studies