16 October 2008
The short-term outlook for the economy is bleak, and a huge increase in borrowing is inevitable. So what can the Pre-Budget Report do to address the structural problems in the public finances? Carl Emmerson and Gemma Tetlow report
After Gordon Brown's ten years as chancellor, a period he hailed as 'the end of boom and bust', he now looks set as prime minister to preside over the deepest slump that the UK has seen since at least the early 1990s. This would hit the public finances hard and, with the war chest that he built up in his early years as chancellor long since spent, the government has no surplus left to cushion this blow.
Given that the Treasury hopes the taxpayer will eventually be reimbursed for the funds used to nationalise the Northern Rock and Bradford & Bingley banks, and to purchase £37bn of shares in Royal Bank of Scotland, Halifax Bank of Scotland and Lloyds TSB, the Pre-Budget Report should focus on the strength of the public finances excluding these debts. Despite this, other pressures on the government's finances mean that the chancellor still faces some difficult issues.
The Treasury's forecast at the time of the March 2008 Budget was that the economy was then operating slightly below its output trend level (the sustainable economic output that would be expected given the UK's resources). In boom times there tends to be a positive output gap and in recession a negative one. The Treasury estimates that economic activity would fall slightly further below trend before moving slowly back over the next three years. This is shown in the figure on page 26. Events since the Budget, however, suggest that this was too rosy a picture of prospects for the UK economy.
In August, the Bank of England published its latest assessment of the outlook for the UK economy. Taking the 'cautious' assessment used by the Treasury that trend output now grows at 2.5% a year, the Bank's latest forecasts for economic growth suggest that the economy would be operating more than 3% below its potential in 2010. If this materialised, it would be almost as large a slump as we saw in the early 1990s under the previous Conservative administration. As the Bank's forecast was made before the recent turmoil in financial markets we might expect that its next set of predictions will look even gloomier.
If the August forecast turns out to be correct, the knock-on effect on tax receipts and public spending would be substantial. If growth does fall as far behind the Treasury's Budget expectations as the Bank's figures show, then the Treasury estimates, based on past experience, suggest that the government would need to borrow about an additional £8bn this year, £23bn in 2009/10 and £30bn in 2010/11.
However, there are at least two further reasons to suspect that, in the absence of any further policy changes, the additional borrowing required is likely to be substantially larger than this. First, since March's Budget, the government has announced three discretionary tax cuts. Secondly, figures so far this year suggest that tax receipts are weaker and public spending is higher to a greater extent than during previous periods of similarly weak economic performance.
Giveaways this year have further weakened the public finances. Since March's Budget, a significant handout to taxpayers has been announced every other month. First, in May, Chancellor Alistair Darling announced a cut in income tax to help some basic rate taxpayers at a cost of £2.7bn this fiscal year. The aim was to compensate for the abolition of the 10p tax band. So far the government is committed to this policy only for this financial year but discontinuing it would make millions of families worse off. So ministers might be reluctant not to continue it in some form.
Secondly, in July, the government delayed the inflation adjustment to fuel duties planned for October 2008, at a cost of £550m this year. Recent history suggests that this too might be hard for the current government ever to implement, but it would cost £1.1bn a year to make permanent. Thirdly, in September, the government announced a one-year suspension of stamp duty on the purchase of residential properties worth between £125,000 and £175,000, at a cost estimated by the Treasury at £600m. There is probably a better chance of this policy not being made permanent than either of the others. All of these measures represent unfunded tax cuts in the sense that they have all been financed by extra borrowing.
Receipts and spending so far this year also look worse than expected. Lower economic growth reduces tax receipts and increases public spending. History gives us a guide to how large this effect might be for a given shortfall in growth, assuming that the current period of economic slowdown has features similar to those that we have seen in the past. By this assessment, the government might be expected (as mentioned earlier) to borrow an additional £8bn this year to close the extra gap between receipts and spending. However, figures for tax receipts and spending so far this year (which don't yet take account of any of the cost of the tax giveaways) suggest that higher borrowing might be needed.
If receipts and spending perform over the rest of this financial year as they have so far, the government would need to borrow an additional £11bn on top of what we would normally expect as a result of weaker growth and the cost of the giveaways.
This gap in the public finances over and above what history suggests might typically occur is likely due to the specific nature of the shocks hitting the economy. For instance, stamp duty receipts in August 2008 were
half those in August 2007, reflecting a sharp decline in the volume of property transactions and one that might be greater than would normally occur with an economic downturn of the current magnitude. If this is the case, these revenues could recover as the economy bounces back.
However, at least in part, it could be that this additional borrowing represents a structural hole in the government's finances. If this is the case, the government should think about how to tighten fiscal policy in the medium term to close this gap.
So what outlook is there for the fiscal rules? Let us assume that the Bank's forecast for the economy turns out to be right, the government renews its policy on income tax and permanently abandons October's inflation adjustment to fuel duties, and that the additional hole in the government's finances this year persists. Under these assumptions, the government would need to borrow 4.4% of national income this year, more than 5% of national income over each of the next two years, falling to about 4.5% in 2011/12.
If this were to materialise, then public sector net debt would reach 50% of national income by 2011/12, rather than remaining below 40% as the Treasury forecast in March.
This would make it highly unlikely that the government could continue to comply with either of the two fiscal rules that Brown chose to commit to when he was chancellor. The first of these is the 'golden rule', which states that the government should borrow only to invest and therefore should balance its current budget over the economic cycle. This rule is incompatible with increases in future borrowing of the scale suggested above, regardless of when the Treasury thinks the current economic cycle began and ends.
The 'sustainable investment rule' commits the government to keeping public sector net debt below 40% of national income at all times. This might be achieved this year by a whisker, but it is difficult to see how it would sensibly be met next year or subsequently.
Changes to the way the chancellor chooses to assess the strength of the public finances seems more likely than continued compliance with either of these two rules. However, the likely increase in borrowing and debt over the next few years is not unprecedented. The fact that it would lead to a breach of both fiscal rules reflects the extent to which successive Treasury plans for the public finances over recent years have not contained sufficient caution.
So can the government close the gap? If it renews its income tax policy and permanently abandons October's inflation adjustment to fuel duties, and if only the unexplained gap between receipts and spending this financial year proves to be structural, then the government would be left with a hole in its finances worth around 1% of national income, or £15bn in today's terms.
If the economy were unable to rebound fully over the next few years, then the size of this structural gap would be even larger. With the UK economy struggling in the wake of the credit crunch, increased energy prices, and the slowdown across many developed countries, there are good reasons not to implement immediate fresh tax-raising measures or further cuts in public spending to close this gap.
However, the government should consider how to bring about a significant tightening over the medium term and start to put in place the necessary painful measures to do so. In the short and medium term, no sensible fiscal policy tightening would be sufficient to avoid the death knell for the current fiscal rules. But in this case their demise would have been caused more by the government choosing to plan the public finances with insufficient caution, rather than the rules being inflexible to the now likely deterioration in the public finances over the next few years.
Carl Emmerson is deputy director and Gemma Tetlow is a senior research economist at the Institute for Fiscal Studies