Select Committee on Treasury Minutes of Evidence


Memorandum submitted by Mr David Walton, Goldman Sachs

  The public finances in the UK are coming in much worse than expected. Despite this, the Chancellor has announced various tax credits and ambitious plans for the funding of the National Health Service. To fund these, taxes may need to rise by up to £12 billion by the end of the Parliament in 2005-06.

  Since the March 2001 Budget, there has been a marked deterioration in the near-term prospects for the public finances despite the fact that the government's GDP growth forecasts were barely touched. In the Pre-Budget Report, public borrowing is now projected to be £7 billion higher in 2001-02 and £10 billion higher in 2002-03. On top of this, the Chancellor gave away £2¾ billion to pensioners by 2003-04. He also intends to introduce various tax credits in next year's Budget that are likely to cost at least as much again.

  The government's two fiscal rules are still met but with less comfort than before. However, there was a sting in the tail of the PBR. The government's medium-term assumption is that current spending will rise by around 2¼ per cent a year. In practice, it will probably have to rise by around 3¼ per cent a year if the government is to meet its ambitious plans for public spending, such as increasing health spending to the EU average in 2005. In this case public spending in 2005-06 will be around £12 billion higher than the government currently expects. If the government's rules are still to be met, it follows that taxes will need to rise by a similar amount by the end of the Parliament.

PUBLIC FINANCES WORSEN MARKEDLY IN 2001-02

  The Treasury made only small revisions to its economic forecasts in the PBR. Its forecast for GDP growth in the financial year 2001-02 was lowered by ¼ per cent to 2 per cent next year's growth forecast was left unchanged at 2¼ per cent and the 2003-04 forecast was raised by ¼ per cent to 2½ per cent.

  Such modest changes as these should have caused barely a ripple to the Treasury's forecasts for public sector net borrowing (PSNB). On the government's rules of thumb, the public finances should have worsened by £¾ billion in 2001-02 and £2 billion in 2002-03 before returning to the previous path.

  The actual revisions were much larger than this—a worsening of £7.2 billion in 2001-02 and £10 billion in 2002-03 compared with Budget 2001. All of the revisions were on the receipts side, due mainly to a shortfall in corporation tax. The projections for public spending were broadly unchanged. As a result, the Treasury now expects a budget deficit of £2.5 billion this year compared with its forecast of a budget surplus of £4.7 billion in March 2001 Budget. In 2002-03, the Treasury has revised its forecast of the deficit from £2 billion to £12 billion.

BETTER THIS YEAR WORSE NEXT

  The Treasury has almost certainly been too pessimistic about the likely outturn for the public finances this year. In the first seven months of the financial year, central government current spending was up 5.3 per cent over the previous year. For the year as a whole, the government projects an increase of 6.6 per cent. This implies a sharp acceleration in the final five months of the year that is unlikely to be seen. Spending could easily undershoot by around £3 billion this year. Hence I expect a small budget surplus of £0.3bn.

  However, a much larger budget deficit is likely next year of £20 billion (1.9 per cent of GDP). Two factors are responsible:

  I expect greater cyclicality in the economy with GDP growth of 1¾ per cent in both 2001-02 and 2002-03 balanced by growth of 3 per cent in 2003-04. In Goldman Sachs' projections, tax receipts in 2002-03 are £4 billion less than the Treasury expects.

  This year's undershoot in public spending may be carried forward to next year under the government's "End-Year Flexibility" scheme. In our projections, public spending is £3½ billion higher than the Treasury expects in 2002-03. (There is a further £6.7 billion of previous years' underspends that could in principle be spent by government departments next year which the PBR is silent about.)

  Our medium-term forecasts are about 0.4-0.5 per cent of GDP a year higher than the Treasury's, in part because we assume that the government will spend around £4 billion a year on the measures announced for consultation in the PBR. The Treasury sees PSNB peaking at 1.3 per cent of GDP in 2003-04 and it falls to 1.1 per cent of GDP by the end of the Parliament.

  On these projections, the government's two fiscal rules are met but with less comfort than before (see Chart 1):

  The golden rule requires current spending to be financed from taxes over the economic cycle. This means that the current budget must be in balance or surplus. On our forecasts, the government runs a deficit on the current budget in the next couple of years but return to a surplus of 0.3 per cent of GDP in 2005-06. Between 1999-2000 and 2005-06, the current budget is in surplus on average by 0.9 per cent of GDP a year.

  The sustainable investment rule requires the ratio of net public sector debt to be held stable at below 40 per cent of GDP over the economic cycle. In our projections, the net debt ratio stabilises around 31 per cent of GDP in line with the Treasury's forecasts.

TAX RISES NEEDED TO FUND IMPROVEMENTS IN PUBLIC SERVICES

  There was a sting in the tail of the PBR. Our medium-term forecasts are based on the working assumptions that net public investment will stabilise at 1.8 per cent of GDP and current spending will grow by 2½ per cent a year—the Treasury's projections assume slightly slower growth in current spending. But the implication of the PBR is that considerable resources will need to be found in coming years to fund the improvement in public services that the government wants to see. The spending plans will be decided in next year's Spending Review; the headline totals are likely to be decided by the time of the 2002 Budget next March.

  To prepare the ground for this, the government published an interim report by Derek Wanless on the resources required for the health service over the next 20 years. A day after the PBR, the Prime Minister committed the government to raise health spending to the EU average over the next four years. Comparable data are only available for health spending in 1998 but they show that UK spending was 6.8 per cent of GDP while spending in the rest of the EU ranged from 8.0 per cent (simple unweighted average) to 8.7 per cent (weighted by GDP). The Treasury claims that health spending will be up to 7.6 per cent of GDP by 2003-04. But that still leaves a gap of between 0.4 to 1.1 per cent of GDP to be filled, equivalent to £5 to £14 billion in 2005-06. Moreover, the government has strong aspirations for improvements in education and transport as well as health.

  Rather than getting in to the detail of every individual programme. I have conducted the following exercise. Suppose current spending grows by 3¼ per cent a year in real terms from 2003-04 onwards—the first year covered by the Spending Review. This is not an extreme assumption—current spending is planned to grow slightly faster than this on average in the three years from 2000-01. On these assumptions, public spending in 2005-06 will be £12 billion higher than the government currently expects. If the government's rules are to be met, it follows that taxes will need to rise by a similar amount by the end of the Parliament (see Chart 2).

  There is one final consideration. The Treasury states that the government's plans meet the EU Stability and Growth pact on a "prudent" interpretation. This is a curious use of the word prudent. The government is aiming for a medium-term budget deficit of around 1 per cent of GDP while the SGP requires governments to aim for budget balance or surplus over the medium-term. This might become a serious issue if the British government decided to push for EMU entry in this Parliament.


3 December 2001


 
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