Select Committee on Treasury Minutes of Evidence

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 outcome.

  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[1].

  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 public sector.


  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 surplus.

  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[2] 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 tax increases.


  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[3] 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 event.

  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 depreciation.


  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 2002?

  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?

April 2002

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

2   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

3   "Over the economic cycle the Government will borrow only to invest and not to fund current spending". (FSBR, 1998, p 26). Back

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