Memorandum submitted by Mr Martin Weale,
the National Institute of Economic and Social Research
The National Institute is Britain's leading
independent economic and social research institute. It has no
political affiliation. It produces quarterly forecasts of the
UK and World economies; central banks and finance ministries throughout
the world use the macroeconomic models which underly these forecasts
for policy analysis.
The Institute is also known for its work on
education and training, productivity and economic growth, foreign
trade and international investment, labour markets and employee
relations and pensions and savings behaviour.
1. The UK economy is recovering after the
pause in growth at the turn of the year. We are, however, sceptical
that growth will be as rapid as the Economic Statement suggests.
2. There has been a large fall in the projected
growth rate of government consumption as compared to the Pre-Budget
Review. The reasons for this are not clear but may indicate
that the Government expects a significant part of the growth in
"real" public spending to be absorbed in cost increases,
and most notably in increased salaries.
3. There is a substantial risk that the
increase in employers' national insurance contributions will encourage
firms to save money by moving away from defined benefit pension
schemes to defined contribution schemes, reducing their pension
contributions in the process.
4. There is no firm evidence that economies
with large public sectors perform worse than those with small
public sectors. The position changes from time to time.
5. The budget has added £13 billion
(1 per cent of GDP) to the fiscal deficit by 2006-07. The faster
growth rate assumed by the Chancellor will not affect the actual
6. The full implementation of Mr Wanless'
"solid progress" scenario will add a further 2.1 per
cent of GDP to tax needs. The amount will be even larger if an
improved health service reduces the demand for private treatment.
7. The fiscal rules adopted by the Chancellor
did not point to the need for immediate tax rises next year to
fund the increased spending plans.
8. There is a cumulative surplus on the
current budget of about £50 billion over the current cycle
so far, and the fiscal rules allow this to be spent.
9. However, our view is that this indicates
that the rules need revising rather than that the Government should
run deficits of the magnitude which the rules now permit.
1. The budget raises a number of important
issues about the management of fiscal policy and the likely sustainability
of the long-term fiscal position. There are also some more minor
questions about the precise definitions of the variables in the
budget statement, with implications for the allocation of spending
between current and capital expenditure.
2. After no growth in the fourth quarter
of last year the economy is gradually accelerating. We estimate
that, in the first quarter of this year the economy expanded by
0.2 per cent with the pace of recovery likely to increase. Last
year the UK was the fastest-growing of the major economies, but
this year it is likely to be beaten by both the United States
and Canada. An important factor behind the good performance of
the United Kingdom (and the recovery in the United States) has
been the expansion of government expenditure. The Economic
Statement indicates that the volume of public sector consumption
is now likely to expand less than was previously thought (3¼
per cent rather than 4¾ per cent in 2002) Much of the change
is due to data revisions, but it seems that costs are now expected
to be ½ per cent point higher than was thought in November,
presumably because it is now recognized that public sector wages
need to increase in order to attract the staff necessary to deliver
increased output of public services.
3. We are sceptical that growth, either
this year or next year, will reach the centre of the government's
range, particularly after the slow start to the year. This is
one of the factors behind our view discussed below that the budgetary
situation is less favourable than the Financial Statement suggests.
4. The national insurance contribution increase
is split between employers' and employees' contributions. We regard
this distinction as one of form rather than substance, at least
in the long run. In a reasonably competitive market it should
make little difference whether a tax on labour income is charged
to the employer or the employee. Both taxes should, eventually,
be expected to affect wages rather than profits.
5. In the short term, however the situation
may be rather different. The increase in employers' contributions
is an increase in wage costs. Firms looking for ways of offsetting
this will look for means of reducing wage costs. In the current
environment this is likely to encourage them to make further reductions
in employers' pension contributions. This has the impact that
more of the tax is likely to be paid out of savings than would
otherwise be the case. In other words, although it will raise
revenue, it will be less effective at reducing the pressure of
demand in the private sector of the economy.
6. As compared with previous budget statements
and pre-budget reports, the 2002 Budget shows a substantial increase
in spending on the health service combined with an increase in
taxation. There seem to be other large increases in current spending
planned, relative to the Pre-Budget Report, but the Financial
Statement is unfortunately not detailed enough to allow one
to identify these.
7. The questions addressed in this note
concern the long-term fiscal implications of the budget and the
fiscal strategy as balanced against the Chancellor's Fiscal Rules
rather than the rights or wrongs of any particular size for the
8. Compared with the pre-budget report the
2002 budget shows, by 2006-07 the same surplus on the current
budget (£9 billion), but an overall deficit rising from £13
billion to £18 billion. The equality of the current budget
is, however, misleading. £5 billion of extra revenue accrues
from the increase in the rate of growth which the Chancellor has
assumed for the economy, with a further £2 billion arising
from other unspecified forecasting changes. This presumably has
no bearing on the actual rate of growth and thus it must be assumed
that, relative to the actual outcome the current budget surplus
is £7 billion lower than it would have been with the taxation
and spending plans of the pre-Budget review.
9. The National Institute takes the view
that the Government's projections for tax revenue are probably
optimistic. Our forecasts had shown the Government meeting the
fiscal position shown in the Pre-Budget Report, but, of course,
using the growth rate which we actually forecast. The latter is
slightly above 2½ per cent rather than 2¼ per cent.
Thus we now expect the budget surplus at this horizon to decline
by about £7 billion as compared to our earlier forecasts
for 2006-07. This leaves only a small but still perfectly adequate
10. In terms of the effect on the overall
economy, however, the impact is augmented by the fact that an
additional increase in public sector investment is planned, taking
the latter from £21 billion to £27 billion. Overall,
after taking account of rounding effects, there is a fiscal stimulus
of £13 billion implied in the Budget Statement (Table
C6, p 215) by 2006-07.
11. Looking at the longer term and judging
the situation against the proposals for increased spending on
health services, it is plain that substantial further tax increases
will be needed if public spending on health is to reach the proportion
of GDP proposed by Mr Wanless. The budget plans take the share
of spending to 7.8 per cent of GDP in 2006-07 (Economic Statement,
p 121) while Mr Wanless, under the path he describes as solid
progress, proposes a further rise to 9.9 per cent of GDP, with
a further 1.2 per cent of GDP being spent privately
to give the overall figure of 11.1 per cent of GDP. We note that
the size of the size of the private sector will tend to rise in
line with income, but is likely to fall if the quality of National
Health Service treatment increases. On balance this could add
to the burden on the public purse.
12. The National Institute completed, ahead
of the budget, an assessment of the Government's long-term fiscal
position. This was done by comparing the present discounted value
of the Government's receipts against the value of its expenditures
similarly capitalized. In essence the exercise was the calculation
of a balance sheet for the Government in which assets and liabilities
include not only what we conventionally include in a balance sheet,
but also today's values of future taxes and spending commitments.
The exercise takes account of the changing age structure of the
population. It has to be recognized that, as with all projections,
it relies on a large number of assumptions and should not therefore
be regarded as particularly precise.
13. Our study found that, in order to balance
receipts against spending taxes need to rise by about ½ per
cent of GDP. There are a number of risks in the projection. Most
notably it assumes, in accordance with government policy, that
many social security benefits will remain indexed to prices rather
than to wages. It also assumes that the take-up of the pension
credit and the minimum income guarantee will not spread excessively,
despite the fact that they are an obvious deterrent to making
private pension provision. These caveats aside, we were happy
to interpret our finding as representing a public sector which
was broadly in balance.
14. The figures set out above indicate,
however, that now considerable further tax rises are needed in
order to restore solvency to the public sector. The worsening
of the public finances which amounts to 0.4 per cent of GDP even
after crediting the effects of the forecast changes, combines
with the extra spending needed to pay for Mr Wanless' proposals
beyond the figures for 2006-07 shown in the budget.
15. If in practice the adjustment to tax
rates runs behind the increase in spending plans, then the extra
fiscal stimulus may add to inflationary pressures in the economy.
With the current monetary arrangements, this means that interest
rates will be higher than otherwise. It is, however, difficult
to quantify this effect which, in any case, depends on the extent
to which consumers save up in advance to make provision for future
16. We do not doubt that to have increased
spending in the manner proposed by the Chancellor without any
offsetting increase in taxation would have been irresponsible.
It would have added very substantially to demand and created a
need for substantially higher interest rates. It is nevertheless
worth noting that the Chancellor's fiscal rules did not require
him to raise taxation.
17. Since the start of the business cycle
in 1999 the Government has run a cumulative surplus of over £50
billion. The first fiscal rule
implies that this can be spent, provided that the spending takes
place within the current cycle. If the cycle has a life of five
more years, then in each of these years the Government could have
chosen to run a deficit of £10 billion, and still meet the
second rule. There are good macro-economic reasons for not running
a deficit of this magnitude, but the key point is that the rule
is not a useful guide to policy. The position is further compounded
by the fact that the duration of the cycle is essentially a random
event. If the current cycle ends soon (or is thought to have ended
because of the weak growth in the fourth quarter of last year)
then the money is not available to be spent, while if the cycle
continues it is available. One can question whether it is sensible
to let an issue of this importance depend on an essentially random
18. A second aspect of the rule is that,
because it is one-sided, there is a tendency for the Government
to adopt a precautionary position, aiming for a surplus so as
to ensure that the rule will be met even if things turn out worse
than expected. This contrasts with the inflation target which
is designed to be symmetric. It is not clear why a symmetric rule
should be sensible for one of the key macro-economic policy targets
while, the other target should be defined asymmetrically.
19. There are a number of ways in which
the rule could be made to work better. One might be to say that
the Chancellor will normally aim for a balance between current
income and expenditure, and that in practice this means the balance
is likely to be between +1 and -1 per cent of GDP. If it moved
outside this range he would report to the House of Commons on
the issue, explaining either what he was doing to return it to
its target range or why it was desirable that it should remain
outside its target range. The target range could, of course be
defined round a positive central figure for the current account
surplus if the Government felt there was a case for that.
20. If events conspire to give a succession
of surpluses or deficits, there is some logic to the argument
that policy should offset these. The Chancellor could adopt a
clear target for the component of national debt not matched by
public-sector capital, and set fiscal policy within his target
range to steer the deadweight debt back to its target level.
21. Such an approach would guarantee the
continuing solvency of the public sector (except in the case of
a Chancellor who repeatedly reported to Parliament that he intended
to run deficits larger than those specified in the target range),
but attention would still need to be paid to the implications
of future spending plans. It would be sensible for the Chancellor
also to require that the discounted value of government receipts
did not deviate from the discounted value of future spending by
more than some agreed amount. The principles underlying the calculations
could be audited by the National Audit Office, in the same way
as are the current forecast assumptions. The requirement for long-term
solvency would be a valid reason for moving outside the target
rate described above.
22. Ministers frequently talk about "investing"
in the National Health Service when they actually mean spending
money on the health service. This gives rise to a suspicion that,
at some point, the boundary between current and capital expenditure
will be blurred, although that has not yet happened. However,
it is questionable whether the level of net investment is quite
as large as the Government claims. The figures include investment
by the public sector net of depreciation of public sector assets
and this is quite correct. However, they also include capital
grants to the private sector. These cover new investment and it
is not clear where or how the depreciation of these assets, which
is likely to be of the order of £1 billion or so is recorded.
It would be helpful if the Government could clarify that the figures
shown in the Financial Statement are indeed net of all
1. Can the Government explain why it applies
an asymmetric rule to the public finances, while the inflation
target has a symmetric target zone round it?
2. What margins around a balance between
the discounted value of revenues and the discounted value of spending
does the Government regard as consistent with long-term solvency?
3. Is the Government concerned that the
application of its second fiscal rule "over the cycle"
could introduce a random element, associated with the arbitrary
length of the cycle, into the management of public finances?
4. To what extent does the Government expect
the increase in employers' national insurance contributions will
accelerate the move away from defined benefit pension schemes?
Is the Government concerned about this?
5. Can the Government explain why the volume
of public sector consumption is now expected to grow considerably
less than had been anticipated in the Pre-Budget Report in
6. Could the Government confirm that the
figures for net investment shown in the Budget Statement take
full account of the depreciation of private sector assets which
have been financed by capital grants?
1 The measurement of public sector growth "in
real terms" can be a source of confusion. It refers to the
increase in spending by the public sector after adjusting for
the general increase in costs in the economy. If public sector
wages increase faster than this, without any corresponding increase
in the productivity of public sector workers, then the output
volume of the public sector will increase less than the growth
of the public sector "in real terms". The discrepancy
will be increased if higher than average wage increases are needed
to attract new workers into the sectors providing public services.
This is likely to happen since, over the last few years public
sector wages have gone up by less than wages in the economy as
a whole. Back
In practice, with more money being spent by the National Health
Service, spending by private patients may well decline, putting
further strain on the budget. Back
"Over the economic cycle the Government will borrow only
to invest and not to fund current spending". (FSBR, 1998,
p 26). Back