Select Committee on Treasury Second Report


SECOND REPORT


The Treasury Committee has agreed to the following Report:

2002 BUDGET

Introduction

1. We have continued the practice of our predecessors, and taken evidence on both the Pre-Budget Report of November 2001[1] and on the Chancellor's 2002 Budget Statement, delivered on Wednesday 17 April. Like them, we have sought to report to the House in time for our report to inform the Second Reading debate on the Finance Bill, to be held on Tuesday 30 April. The period between the Budget Statement and the Second Reading of the Finance Bill, typically in the range of four to six weeks, is this year truncated to less than two, principally as a consequence of the unusually late Budget and the pressures of the Provisional Collection of Taxes Act 1968. This Report therefore serves to provide a first analysis for the House of some of the key taxation and expenditure measures announced by the Government. We may wish to consider some of the Budget's measures and proposals in greater detail at some appropriate time in the future, when we have had time to fully assess their implications.

2. We are grateful to all those who provided evidence, both written and oral, to the Committee. There were three oral evidence sessions for this inquiry. On Monday 22 April, the Committee heard evidence relating to the macro-economic considerations of the Budget from: Ciáran Barr, Chief UK Economist, Deutsche Bank; Professor Tim Congdon, Managing Director, Lombard Street Research; Carl Emmerson, Institute for Fiscal Studies, and Martin Weale, Director, National Institute for Economic and Social Research (NIESR). The second hearing on the same day concerned the micro-economic aspects of the Budget, and the witnesses were: John Appleby, Director of Health Systems, King's Fund; Andrew Dilnot, Director, Institute for Fiscal Studies; Mary O'Mahony, Senior Research Fellow, NIESR; Edward Troup, Head of Tax Policy, Simmons and Simmons; and, Professor Steve Wilcox, Joseph Rowntree Foundation. On Tuesday 23 April, officials of HM Treasury gave evidence before the Committee, namely: Gus O'Donnell, Managing Director, Macro-Economic Policy and International Finance; Nicholas Macpherson, Managing Director, Public Services; Nicholas Holgate, Director of Welfare Reform; Alex Gibbs, Head of Tax Policy; and, John Kingman, Head of Productivity Team. On Wednesday 24 April, the Chancellor of the Exchequer, the Rt. Hon. Gordon Brown MP, accompanied by Ed Balls, Chief Economic Adviser and other officials of HM Treasury, gave evidence before the Committee.


The economy

The recent past

3. Since the year 2000, the global economy has undergone a period of considerable turbulence, and this year's Budget is set against that background. Although none of the fears of serious disruption from the Y2K computer bug and other millennium-related issues materialised at the start of 2000, as the year progressed the United States' economy, considered to be the engine of world growth in recent years, experienced a marked slowing in its rate of growth which persisted into 2001. The slowdown was caused by the effects the deflating asset prices, especially among high-technology sector companies' shares, as growth and profit expectations were downgraded by the financial markets, poor levels of investment, declining inventories, higher energy prices and the lagged effects of monetary policy tightening, to which were added falls in consumer and business confidence that exacerbated the slowdown. Many of the factors behind the US slowdown, as well as the slowdown itself, also adversely affected economic growth around the world, including in the United Kingdom.

4. The terrorist attacks of 11 September 2001 in New York and Washington D.C. caused a major adverse shock to financial markets and the global economy, particularly the already ailing US economy. In November, the US-based National Bureau of Economic Research (NBER) said that the US economy had, on their definition,[2] entered recession in March 2001, noting the impact of the attacks of 11 September in that they "may have been an important factor in turning the episode [of US economic slowdown] into a recession".[3] In regard to the global economy, in December 2001 the International Monetary Fund (IMF) published a special, revised, version of its October 2001 World Economic Outlook, which said that the terrorist attacks in the US had "exacerbated an already very difficult situation in the global economy", and that in the aftermath of the attacks "consumer and business confidence have further weakened across the globe, and there was also a significant initial impact on demand and activity, particularly in the United States".[4] As a consequence, the IMF revised downwards its forecast for global economic growth in 2002, made immediately prior to the terrorist attacks, from 3.5 per cent to 2.4 per cent. This included a downward revision to their forecast of UK economic growth to 1.8 per cent from 2.4 per cent,[5] with the warning that, globally, "the outlook is subject to great uncertainty"[6] and that "a particularly disturbing feature of the current slowdown is its synchronicity across nearly all regions, the most marked for at least two decades".[7]

5. In the Pre-Budget Report 2001, HM Treasury took a similar position to the IMF, and revised down their forecast of GDP growth in the G7 economies[8] in 2002 to ¾ per cent[9] from 2½ per cent.[10] Mr O'Donnell told the Committee's inquiry into the 2001 Pre-Budget Report that, following the events of 11 September, "this is the time when, asked to do a forecast, you might want to answer 'Pass' because there is a much higher degree of uncertainty now".[11] The Treasury's forecasts of the UK economy, published in the 2001 Pre-Budget Report, predicted GDP growth in an "opportunity range"[12] of 2 to 2½ per cent in 2002, and 2¾ to 3¼ per cent in 2003[13]. The Chancellor, in his Pre-Budget Statement, told the House that, while counselling that "no one country can insulate its economy"[14] from the synchronised global slowdown, these forecasts reflected his position of being "cautiously optimistic about the prospects for the British economy".[15]

6. The Committee undertook a visit to New York and Washington D.C. at the end of January, during which it met senior figures from the Government, Congress, the Federal Reserve Bank, IMF and Wall Street banks and research institutions, among others, where discussions included issues relating to the US and global economic outlook. The general tone was positive, and we were told that the US outlook in particular had improved remarkably quickly since the terrorist attacks, aided by the prompt monetary easing by the Federal Reserve and the fiscal measures undertaken. Nevertheless, some cautioned that the outlook for the US economy remained uncertain.

The outlook for the UK economy

7. By the time of the Budget, the IMF said that there were "increasing signs that the global slowdown ... has bottomed out",[16] and the organisation revised upwards (compared to its December forecast) its estimate of global economic growth in 2002 to 2.8 per cent[17], although this remained below their estimate made before the terrorist attacks of 11 September. In the opinion of the Organisation for Economic Co-operation and Development (OECD), it is "the United States [that] is leading the [global] upturn".[18] This increased optimism is shared by the Treasury, who, compared to their Pre-Budget Report forecast, increased their projection of G7 GDP growth in 2002 to 1½ per cent in the Budget,[19] adding that the "downside risks associated with the events of 11 September have clearly diminished".[20]

8. In this year's Budget Statement, the Chancellor told the House that, due to the actions of the Bank of England's interest rate setting Monetary Policy Committee (MPC)[21], which were supported by fiscal policy, the UK had, "despite the difficulties, been able to safeguard both stability and growth",[22] that he maintained his cautiously optimistic outlook for the UK economy,[23] and, compared to the Pre-Budget Report, continued to expect GDP growth of 2 to 2½ per cent this year, but higher growth of 3 to 3½ per cent in 2003[24]. The table below sets out the Treasury's forecast of UK GDP growth, and a number of comparative projections.

Table 1: UK GDP growth forecasts (annual percentage change)



2002

2003

2004

HM Treasury†


2 to 2½

3 to 3½

2½ to 3

European Commission


2.0

3.0


IMF


2.0

2.8


OECD


1.9

2.8


Average of independent forecasts


1.9

2.7


† The Treasury's growth forecasts are presented as opportunity ranges
Source: HM Treasury, Budget 2002, Table B8, p.203, European Commission, European Economy:   Economic Forecasts—Spring 2002, Table 3.15, p. 84; IMF, World Economic Outlook, April 2002, Table   1.1, p. 6; OECD, Economic Outlook No. 71 Preliminary Version: United Kingdom, April 2002; HM   Treasury, Forecasts for the UK Economy: A comparison of independent forecasts, p1


9. Mr O'Donnell told the Committee that "cycles have started in many years but we think in this one we hit a trend point in 2001, Q3. That is when we were at trend according to our estimates.[25] He also told the Committee that the Treasury expects UK "growth to be picking up through the year so you end 2002 with growth quite strong and a high level of GDP, so arithmetically 2003 on 2002 will appear very strong".[26] Mr Barr told the Committee that he viewed the Treasury's forecasts for 2002 and 2003 as "ambitious",[27] and the Centre for Economics and Business Research said that the "biggest doubt" is the 2003 forecast, which they say is based on growth in household consumption and, "more strikingly", strong world trade.[28] The Treasury is forecasting growth in UK exports (in volume terms) accelerate in 2003 to 7¾ to 8¼ per cent (a faster pace than the growth in imports) from -1½ to -1 per cent this year as the world economy recovers.[29] Professor Congdon highlighted that this aspect of the forecast "might raise eyebrows", saying that, while such a swing in export volume growth levels would not be unprecedented, in the past "typically these have been after a big exchange rate movement".[30] The Treasury acknowledged that the "prospects for a sustained upturn in growth continue to depend heavily on the strength of external demand".[31]

10. We now know that the ONS preliminary estimate for GDP growth for the first quarter 2002 was only 0.1 per cent, making the Chancellor's forecast of 2-2.5 per cent for the full year look on the high side. Though ONS growth figures are frequently subject to subsequent revision, we are concerned that the Chancellor's Budget may already be based on over-optimistic projections. Whether the Treasury's growth forecasts are achievable remains to be seen, and we note the view that they are perhaps optimistic given the considerable uncertainties facing the global economy at the present time. In this context, we note that growth in 2001 was at the bottom of the opportunity range forecast by the Chancellor at the time of the 2001 Budget.[32]

Unbalanced growth

11. Although the UK economy has experienced nine years of continuous growth, the longest expansion in more than 30 years,[33] imbalances within the economy have become a feature. The IMF observed that "since 1996, as sterling appreciated strongly, growth has been sustained primarily by domestic demand".[34] Professor Congdon told the Committee that for the last six years, "domestic demand [has been] rising faster than output with growth in consumption being the most conspicuous feature of growth in domestic demand and, associated with that, imports rising faster than exports".[35]

12. The Treasury said that the composition of its GDP growth forecast "shows a return to more balanced growth."[36] While, on the basis of the Treasury's forecast[37], this statement is true, it is important to note that it only means that overall economic growth will be more balanced than recent outturns, rather than fully balanced; indeed, considerable imbalances will persist as Chart 1 illustrates. In 2002, net trade[38] will detract about one percentage point from the rate of GDP growth, while in 2003 and 2004 the Treasury says it is "projected to exert a broadly neutral influence on GDP growth",[39] which means that it will contribute broadly nothing towards economic growth. Domestic demand will continue to be the only source of GDP growth to 2004.

13. Imbalances within the economy may lead to future problems. The Treasury acknowledged that if consumer spending is stronger than they expect it would "present upside risks to UK inflation", and further, if it was funded by households increasing their indebtedness, it would "increase the likelihood of a sharper downward correction in consumption at some point in the future".[40] In regard to the continuing weakness of net trade, Mervyn King, Deputy Governor of the Bank of England, recently cautioned that it "cannot continue for many more years without leading to a trade deficit that would be painful to correct".[41] The imbalances between net trade and domestic demand, and in particular strong consumption growth, may present a challenge to the stability of the UK economy, and we encourage policymakers to remain alert to those risks.

Chart 1: Compositional split of GDP between domestic demand and net exports



Source: own calculations; data from HM Treasury, Budget 2002, Table B9, p.204 (using mid-points of ranges, when applicable)

14. It was the view of experts that the Budget had failed to address directly the issue of imbalances within the economy. Goldman Sachs said that it was "not a Budget to rebalance the economy"[42], adding that the Budget "does nothing to help bring [a slowdown in consumer spending growth] about. Indeed households enjoy a net tax cut of £1 billion in the current financial year".[43] Mr Barr explained that in regard to the "tax increases that we are seeing directly on the consumer sector (a) they are not happening for a year and (b) most of it is being given back in the form of tax credits", adding that, given the Budget's redistributive nature, "it might lead to an expansion in consumer demand".[44]

15. Mr O'Donnell said that although the Treasury does not seek to achieve "fine-tuning with fiscal policy"[45] (although one of the Government's key objectives for fiscal policy is, "over the short term, to support monetary policy"[46]), he believed that "the Budget will help remedy these imbalances".[47] According to the Treasury, the Budget would increase Government consumption, which has a particularly low import content both absolutely[48] and relative to consumer demand.[49] Consumer spending will "ease gradually" during the second half of 2002, with further decreases in the rate of household consumption growth in 2003 and 2004,[50] due to the effects of lower bonuses, moderating house price inflation and the lagged effects of past falls in equity prices.[51] Mr O'Donnell added that, although the increases in National Insurance contributions would not take effect until the next financial year, "when there is talk in the newspapers about increases in taxes, people may look at their consumption plans going forward"; [52] in effect, people may be encouraged to adjust downwards their consumption ahead of the tax increases, by, for example, saving more now in order to allow a smoothing of their consumption levels over the medium-term. Mr Barr was sceptical of the Treasury's overall rationale, viewing it as "interesting" that there are now "both [monetary and fiscal] sides of policy making ... saying to us that consumption is going to slow very aggressively next year ... without really saying how that is going to happen".[53] The Treasury acknowledge that "considerable uncertainty still surrounds the outlook for household consumption".[54] Although the Budget raises additional revenue from direct taxation from 2003 onwards, we note that the Treasury admits to considerable uncertainty about the outlook for consumption. We are therefore not entirely sure of the grounds on which the Treasury claims that consumption will slow. Consequently, we are not clear that the Budget makes any significant contribution to correcting the imbalances in the economy.

Revised estimate of the trend rate of growth

16. The Chancellor announced in his Budget Statement that "the Treasury now estimates trend growth at 2¾ per cent but, as before, we will continue to base our public finance forecasts on a more cautious assumption for economic growth—2½ per cent".[55] The Treasury also published a document, entitled Trend Growth: Recent Developments and Prospects which explained the rationale for increasing the trend growth rate assumption from their previous estimate of 2½ per cent made at the time of Pre-Budget Report 1999. As the Treasury document explains, "the rate of trend (or potential) growth is the rate at which the output of the economy can grow, on a sustained basis, without putting upward or downward pressure on inflation".[56] The trend growth rate has four components: growth in labour productivity (on an hours worked basis), growth in average hours worked, growth in the employment rate, and growth in the population of working age.[57]

17. Mr O'Donnell explained that the Government had received new population figures from the Government Actuary's Department (GAD), just after the Pre-Budget Report,[58] which had led the Treasury to re-consider the effect of demographic changes on the trend growth rate, and indeed to undertake a full review of the trend growth rate,[59] and the assumptions made in the last review of the trend growth rate.[60] The main difference between the assumptions underlying the two projections is the increase in the trend annual change in the population of working age, which now stands at 0.6 per cent from 0.4 per cent, on the basis of the new GAD projections. In addition, the Treasury has revised up its assumption of trend annual employment growth to 0.2 per cent from 0.1 per cent on the basis of trends in activity rates and an assumption of modest additional falls in the non-accelerating inflation rate of unemployment (NAIRU). However, the Treasury decided that, although the "balance of risks on the productivity assumption is on the up side"[61], they would "in the interests of prudence"[62] maintain the assumptions made in the Pre-Budget Report 1999 review[63] of the trend annual growth of labour productivity being 2.1 per cent and 2.0 per cent, for underlying[64] and actual productivity respectively.

18. While not contesting the actual increase in the assumed trend growth rate, Mr Barr questioned the Treasury's reasoning for the change.[65] Mr Weale took a similar stance, and cautioned that "there is an issue with quite wide implications whether faster immigration is going to deliver faster growth in the labour supply",[66] while Ms O'Mahony said there was a "considerable degree of uncertainty" in regard to the Treasury's assumptions of immigration patterns, upon which the assumptions of trend growth in the employment rate and the working age population were dependent.[67] Professor Congdon also questioned the assumption of growth in the trend employment rate of 0.2 per cent, given it was based on past trends which he viewed as unlikely to persist, although he too did not have any "great quarrels" with the increased rate of the assumed trend rate of growth.[68]

19. Professor Congdon cautioned that "the history of Treasury raising its views on trend growth is, however, a very bad one", saying that when it raised its estimate of trend growth in a series of steps in the 1980s, it meant that "all sorts of mistakes were made".[69] Indeed, Mr O'Donnell has admitted that in the 1980s the Treasury "made some bad forecasting errors ... partly because we wanted to believe that the potential growth rate had gone up".[70] The Treasury notes that to incorporate possible productivity improvements into its assumption of the trend growth rate "would risk over-estimating productivity improvements as a result of new policies, a trap that has caught policy-makers in the past".[71] We agree with the Treasury that it is dangerous to assume productivity improvements, and that any change to their assumption of productivity growth should be based on strong and undisputable evidence in order to avoid the mistakes of the past.

THE POTENTIAL FOR PRODUCTIVITY IMPROVEMENTS

20. The Treasury are optimistic that the trend rate of productivity growth will increase in the future, citing four reasons: macroeconomic stability and investment; the Government's productivity agenda; the 'new economy'; and, government policies to raise public sector productivity,[72] and, as noted above, believes the balance of risks to productivity growth are on the upside. Mr Barr was "quite optimistic" that productivity growth would increase, but added "you would have to be a brave person to say they would be very strong".[73]

21. In regard to specific measures in this Budget, Ms O'Mahony said "in general terms there is very little ... which targets productivity specifically. The exceptions are the R&D [Research and Development] tax credit and the pilot measures to improve access to training schemes".[74] The Chancellor, however, argued that "the productivity agenda is advanced by a number of measures in the Budget" in addition to those stated by Ms O'Mahony, such as corporate tax changes, and also said that other recent Government policies, including the new competition policy, would lend support to higher productivity growth.[75] We remain concerned about UK productivity which has lagged behind that of the United States. We agree with the Budget's aim to increase the rate of growth of productivity and recommend that the effectiveness of the various measures included in the Budget for this purpose should be closely monitored and reported on in future Pre-Budget Reports and Budget Statements.

TIMING OF THE ANNOUNCEMENT

22. Mr Geoffrey Dicks, UK Economist at Royal Bank of Scotland, highlighted that the change in the Treasury's trend growth rate assumption "had not been expected".[76] As noted above, the last change in the trend growth rate was announced at the time of the Pre-Budget Report. Although, as Mr O'Donnell told the Committee, the latest GAD figures, upon which the decision to revise the trend growth rate assumption were made, were released after the Pre-Budget Report, the result has been that assumption of the trend growth rate used in the Budget is different from that used in the Pre-Budget Report. Given the critical importance of economic growth assumptions to the Budget arithmetic we believe that in the interests of transparency the Treasury should have published the document Trend Growth: Recent developments and Prospects in advance of the Budget Statement. This Committee and the rest of the House of Commons could then have scrutinised it. We therefore recommend that there should be publication of similarly important technical changes in advance of Budgets and the Pre-Budget Reports. We also recommend that the timing of future changes to the trend growth rate and other key assumptions underpinning the growth and public finance forecasts is such that a common basis can be used for both the Pre-Budget Report and the Budget itself.


1   Treasury Committee, House of Commons, Pre-Budget Report 2001, Session 2001-02, HC 430-i, ii, iii (hereafter PBR01 minutesBack

2   The NBER define a recession as a "significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades" (NBER, Business Cycle Dating Committee, November 26 2001). Back

3   NBER, Business Cycle Dating Committee, 26 November 2001 Back

4   International Monetary Fund, World Economic Outlook (Special Update), December 2001, p1 Back

5   Ibid, Table 1.1, p2 Back

6   Ibid, p1 Back

7   Ibid, p3 Back

8   The G7 is composed of: Canada, France, Germany, Italy, Japan, the United Kingdom and the United States Back

9   HM Treasury, Pre-Budget Report, Sesion 2001-02, Cm 5318, Table A1, p140 Back

10   HM Treasury, Budget 2001, Session 2000-01, Cm 279, Table B8, p176  Back

11   PBR01 Minutes, Q12 Back

12   The Treasury's projections for GDP growth are presented as opportunity ranges which represent alternative views about the supply side performance of the UK economy. Projections for GDP growth at the low end of the opportunity ranges are intended to be deliberately cautious, and make no allowance for any improvement in the supply side performance of the UK economy over recent years. The Treasury's central, or best-guess, of economic growth is represented by the mid-point of the opportunity range. Back

13   HM Treasury, Pre-Budget Report, Table A3, p145 Back

14   Official Report, col 829, 27 November 2001 Back

15   Official Report, col 830, 27 November 2001 Back

16   International Monetary Fund, World Economic Outlook, April 2002, p1 Back

17   Ibid, Table 1.1, p6 Back

18   Organisation for Economic Co-operation and Development, Economic Outlook No. 71 Preliminary Version, April 2002 Back

19   HM Treasury, Budget 2002, Session 2001-02, HC 592, paragraph B4, p182 (also known as the Red Book) Back

20   HM Treasury, Budget 2002, paragraph B42, p194 Back

21   During 2001, the MPC reduced the official repurchase (or repo) rate seven times, by a total of 200 basis points, to the current rate of 4.00 per cent. The pace of repo rate cuts increased after the 11 September attacks, and included the first inter-meeting interest rate move, on 18 September, at a special meeting of the MPC.  Back

22   Official Report, col 578, 17 April 2002 Back

23   Official Report, col 578, 17 April 2002 Back

24   HM Treasury, Budget 2002, Table B8, p203 Back

25   Q198 Back

26   Q106 Back

27   Q3 Back

28   Centre for Economic and Business Research, Brown takes risks with world economy and middle Britain, 18 April 2002, p 3 Back

29   HM Treasury, Budget 2002, Table B7, p200 Back

30   Q20 Back

31   HM Treasury, Budget 2002, paragraph B42, p194 Back

32   Official Report, 17 April 2002, Vol. 130, Col. 578 Back

33   International Monetary Fund, United Kingdom: Staff Report for the 2001 Article IV Consultation, paragraph 1, p.4 Back

34   International Monetary Fund, United Kingdom: Staff Report for the Article IV Consultation, 11 February 2002, paragraph 3 Back

35   Q20 Back

36   Budget 2002, paragraph B38, p193 Back

37   Using mid-points of the Treasury's estimates of the components of GDP growth. Back

38   Net trade is defined as exports less imports Back

39   Budget 2002, paragraph B40, p193 Back

40   HM Treasury, Budget 2002, paragraph B43, p194 Back

41   Mervyn King, Three Questions and a Forecast, speech to the Confederation of British Industry (North East Region), 22 November 2001 Back

42   Goldman Sachs, Budget briefing note, 18 April 2002, p2 Back

43   Appendix 1 Back

44   Q20 Back

45   Q109 Back

46   HM Treasury, Budget 2002, paragraph 2.7, p19 Back

47   Q108 Back

48   HM Treasury, Budget 2002, Box B5, p. 201 Back

49   Q108 Back

50   HM Treasury, Budget 2002, Table B5, p198 Back

51   HM Treasury, Budget 2002, paragraph B54, p198 Back

52   Q121 Back

53   Q20 Back

54   HM Treasury, Budget 2002, paragraph B55, p198 Back

55   Official Report, col 578, 17 April 2002 Back

56   HM Treasury, Trend Growth: Recent Developments and Prospects, April 2002, paragraph 1, p1 (hereafter Trend)  Back

57   Trend, p9 Back

58   Q138 Back

59   Q138 Back

60   See HM Treasury, Trend Growth: Prospects and Implications for Policy, November 1999. Note that this forecast of the trend growth rate was based on productivity in terms of output per workforce job, whereas for the new estimate of trend rate growth the Treasury has been able to dis-aggregate productivity in terms of output per hour, which requires a new variable in the calculation, namely the annual change in hours worked.  Back

61   Trend, paragraph 3.11, p13 Back

62   Trend, paragraph 3.12, p13 Back

63   HM Treasury, Trend Growth: Prospects and Implications for Policy, November 1999, paragraph 2.3.3, p14 Back

64   Where underlying productivity is the actual productivity rate adjusted for changes in the employment rate ie assuming the employment rate had remained constant Back

65   Q16 Back

66   Q11 Back

67   Ev 22 Back

68   Q12 Back

69   Q12 Back

70   The Business Economist, Volume 30, number 3, 1999, p14 Back

71   Trend, paragraph 3.12, p13 Back

72   Trend, paragraph 3.6, p10 Back

73   Q16 Back

74   Ev 12 Back

75   Q365 Back

76   Royal Bank of Scotland, UK Economy: The Budget, 18 April 2002, p.3 Back


 
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