Select Committee on Treasury Second Report


Fiscal policy

Assumptions underlying the fiscal projections

23. As noted above, the Treasury has increased the trend growth rate assumption to 2¾ per cent. However, as in the past, for the projections of the public finances, the Treasury assumes a cautious trend growth rate ¼ per cent lower than its central view.[77] Therefore, the assumption of the trend growth rate for the public finances projections has increased to 2½ per cent from the 2¼ per cent which was used in the Pre-Budget Report. Otherwise, the nature of the assumptions underlying the forecasts remain unchanged. However, while the Comptroller and Auditor General concluded that the revised trend growth assumption for the fiscal projections was "reasonable and cautious", he noted that "using it ... would be less cautious than the previous assumption".[78] Mr Emmerson said that "these current set of forecasts [of the public finances] are less cautious than they were in, say, the previous Budget because of the change in trend growth assumption".[79] Goldman Sachs believed it was "quite reasonable" for the Treasury to assume a trend growth rate of 2½ per cent for its public finance projections, but also questioned the Treasury's claim that it was a cautious assumption.[80]

24. It is perhaps ironic, given recent errors in forecasting the Public Sector Net Borrowing (PSNB), that the Treasury has decided to change its assumption of the trend rate of growth this year. As the table below illustrates, in recent years the Treasury has been too pessimistic in regard to the position of the public finances in its one-year ahead forecasts. In November 2000, Mr Balls defended the Treasury's PSNB forecasting record to our predecessor Committee, saying that "our assumptions are cautious so that should always mean that the outturns are better than our projections, so they are not mistakes at all".[81] However, these cautious assumptions, including of course the 2¼ per cent trend growth rate assumption, also underpinned the Budget 2001 projection which turned out to be the first one-year ahead Treasury PSNB projection that was too optimistic. If the Treasury had used its new assumption of the trend growth rate of 2½ per cent central, this error would have been larger. If the less cautious assumptions adopted in Budget 2002 are maintained, it may be advisable for the Treasury to maintain a budget strategy which allows for a continued projection of surpluses on the current budget balance, in order to ensure that the fiscal rules are still met in the event of GDP growth being significantly weaker than expected.

Table 2: Recent Treasury one-year ahead forecasting errors of the PSNB (£ bn)


projection

actual

error

Budget 1998‡

1.6

 ­5.5

 ­7.1

Budget 1999

4

 ­16.3

 ­20.3

Budget 2000

­5

 ­15.9

 ­10.9

Budget 2001

­5

 1.3

 6.3

where a negative figure indicates a surplus on the PSNB

† PSNB projections including windfall tax and associated spending

‡ In Budget 1998, the PSNB was referred to as the Financial Deficit

Source: Budget 98, Table B2, p110; Budget 99, Table B5, p.151; Budget 2000,Table C4, p.196; Budget    2001, Table C4, p.188; Office for National Statistics and HM Treasury, Public Sector Finances, press    release, 17 April 2002, Table PSF1

25. The Red Book helpfully contained estimates for the effect on the public finances, relative to the Pre-Budget Report, of the revised assumption of the trend rate of growth[82]. The figures showed that the effect would be a saving of £1 billion extra in each year—so in 2002-03, this will be worth £1 billion, in the second year, 2003-04, £2 billion and so on, culminating in 2006-07, the final year of the Treasury's five-year projections, in a £5 billion saving. Goldman Sachs estimates that, in 2005-06, that the change in assumption will finance a quarter of the extra government spending of £17 billion planned for that year.[83] Mr Weale noted, however, that "even the Chancellor cannot vary the actual rate of growth in the economy simply by announcing a different trend."[84] In order to take account of this, the table below includes a row of adjusted figures to reflect the 2¼ per cent rate of trend growth assumed in the Pre-Budget Report.

The Public Finances

Table 3: Treasury projections of Public Sector Net Borrowing* (£ billion)


Outturn

Projections


2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

Budget 2002

 1.3

11

13

13

17

18

Budget 2002 adjusted†

 1.3

12

15

16

21

23

Pre-Budget Report

 2.5‡

12

15

13

13

13

Budget 2001

 ­5‡

 2

10

11

12


where a negative figure indicates a PSNB surplus

* PSNB projections including windfall tax and associated spending

† Adjusted for 2¼ per cent trend growth rate assumption

‡ These figures were projections in Pre-Budget Report 2001 and Budget 2001.

Source: Budget 2002,Table C4, p.213; Pre-Budget Report 2001, Table B5, p.171; Budget 2001,Table    C4, p.188

26. The latest Treasury figures appear to show that the PSNB will be better than projected in Pre-Budget Report 2001 for 2002-03 and 2003-04, before deteriorating relative to the November forecasts in 2005-06 and 2006-07. However, a more appropriate comparison of the two forecasts can be made by adjusting the latest Budget PSNB projections for the extra savings made by the increase in the trend growth rate assumption. This adjustment means that both the Pre-Budget Report 2001 and Budget 2002 are underpinned by the same assumption of the trend growth rate. Such an adjustment (shown by the row of figures in Table 3 entitled "Budget 2002 adjusted") shows that there is no underlying improvement in the PSNB projection for 2002-03 and 2003-04, compared to the Pre-Budget Report. Further, the deterioration in the PSNB in 2005-06 and 2006-07 is more pronounced; in 2006-07, the public finances are forecast to be £10 billion further in deficit than anticipated at the time of the Pre-Budget Report.

27. In addition, there is the issue of off-balance sheet finance. The accumulated future PFI and PPP commitments amount to £43.5 billion, a proportion of which represents contingent liabilities. We recommend that the Red Book should include an annual estimate of these contingent liabilities.

SCOPE OF THE PROJECTIONS

28. The Chancellor's announcement of a five-year plan for health spending to 2007-08 means that the final year of the spending plan, namely 2007-08, is not covered by the Treasury's medium-term projections of the public finances. The IFS estimate that the extra health spending in 2007-08 will cost "an additional 0.7% of GDP, which in current terms is approximately £7bn", although cautions that this may not necessarily lead to financing difficulties at that time.[85] The Chancellor told the Committee that "by tradition we will publish the 2007-08 borrowing requirement at the time of the November pre-Budget Report".[86] Nevertheless, we note that the Chancellor in his evidence did not to say whether health spending in 2007-08 was covered by existing tax plans or whether new tax, borrowing or expenditure changes in the future might be necessary. Mr Balls highlighted that the figures for the year beyond the 2002 Spending Review included in the Government's projections, namely 2006-07, takes into account the extra planned health spending[87], adding that "obviously that trend and that number continues to 2007-08 too",[88] although these figures are not stated in the Red Book. Mr Balls also highlighted that Annex A of the Red Book shows the illustrative long-term fiscal projections, where the Red Book states that the Treasury's "long-term fiscal projections ... show that the UK's public finances are broadly sustainable over the long term".[89] However, specific figures for 2007-08 are not available for Parliament to scrutinise, even though the Treasury's Code for Fiscal Stability imposes no restriction on the maximum number of years for the Treasury's projections of the public finances.[90] If specific spending figures are to be committed on a five year basis, we want to see that complete period covered by the Treasury's published medium-term fiscal projections. Given the significance of the additional spending on the NHS, the Chancellor should have published at the time of the Budget, the borrowing requirement for the final year 2007-08.

THE TREASURY'S FISCAL RULES

29. The Treasury has two fiscal rules, namely:

·    the golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending; and

·    the sustainable investment rule: public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level. Other things being equal, net debt will be maintained below 40 per cent of GDP over the economic cycle.[91]

30. The Chancellor told the Committee that he would continue to meet his fiscal rules "comfortably", highlighting that "they are met on the cautious case and they are met having based our assessment on cautious assumptions. I think that when people look at the figures they will say that we have left a great deal of room for manoeuvre".[92] Mr Emmerson noted that, even if the Treasury had not increased their assumed trend growth rate, "the Treasury forecasts would still suggest that the fiscal rules were going to be met" although less comfortably than currently forecast.[93] We note that the change in trend growth rate assumed in the Pre-Budget Report and the Budget would not, however, lead to a breach of the fiscal rules, even if the trend growth rate turned out to be at the lower level of the Pre-Budget Report.

COMPLIANCE WITH THE STABILITY AND GROWTH PACT

31. The Stability and Growth Pact (SGP) was set out in the European Union's 1997 Amsterdam Treaty, which states that: "The Member States commit themselves to respect the medium­term budgetary objective of positions close to balance or in surplus set out in their stability or convergence programmes and to take the corrective budgetary action they deem necessary to meet the objectives of their stability or convergence programmes, whenever they have information indicating actual or expected significant divergence from those objectives".[94]




Table 4: Treasury projections of the "Treaty deficit" (£ billion)


Outturn

Projections


2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

Budget 2002

 0.2

1.0

1.1

1.1

1.4

1.5

Pre-Budget Report 2001

 0.2‡

1.1

1.3

1.1

1.0

1.0

where a negative figure indicates a Treaty surplus

† General government net borrowing

‡ This figure was a projection in Pre-Budget Report 2001

Source: Budget 2002,Table 2.7, p33; Pre-Budget Report 2001, Table 2.6, p26

32. In response to the figures published in the Pre-Budget Report, which were also used in the Treasury's Convergence Programme[95] submitted to the European Commission, the European Economy and Finance Council (better known as ECOFIN) said in its assessment made in February that: "The Council, ... in view of a sustained deficit of 1% of GDP, or thereabouts, which is based on a very cautious growth assumption, notes the requirements of 'close to balance or surplus in the medium term' contained in the Stability and Growth Pact. Therefore the Council encourages the government to be alive to any deterioration in public finances".[96]

33. The updated forecasts of the Treaty deficit show a better position in 2002-03 and 2003-04, but a deterioration in 2005-06 and 2006-07, relative to the forecasts assessed by ECOFIN in February. Further, the forecasts are now based on a less cautious assumption of the trend growth rate. Nevertheless, the Red Book says that "the projections are consistent with the Government's prudent interpretation of the Stability and Growth Pact which takes into account the economic cycle, sustainability and the important role of public investment (as specified in Article 104 of the EU Treaty)".[97] The Chancellor added that "I believe a prudent and sensible interpretation of the Stability and Growth Pact would find us working within it".[98] The latest projections of the public finances are further from a strict interpretation of the Stability and Growth Pact than those Treasury projections submitted to the EU in December 2001. We share the Government's view that the Stability and Growth Pact should be reformed to take account of issues such as the economic cycle, debt sustainability and the accounting for investment expenditure. We urge the Government to work with other Member States to find agreement on the definition and interpretation of the Stability and Growth Pact as soon as possible.

Tax receipts

Table 5: Forecasts of aggregate taxation (per cent of GDP)



Estimate

Projections



2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

Net taxes and social security contributions






37.0

36.7

37.6

38.1

38.3

38.3

Current receipts







39.1

38.7

39.9

40.2

40.4

40.5

"Net taxes and social security contributions" is the Treasury's preferred measure. Current receipts is the definition used in the National Accounts.

Source: Budget 2002, Table C9, p.218

34. The Institute of Directors note that the Budget's projections for the tax burden, as measured by the net taxes and social security contributions definition, "have increased by around 1 per cent of GDP per annum, from 2003-04 onwards" from those projections made in the Pre-Budget Report.[99] The IFS calculate that "the effect of the Budget measures is to increase taxes by £8bn a year by 2005-06, even if the full cost of the new tax credits for families with and without children are counted as reductions in tax rather than increases in spending".[100] They note that, in contrast to the "large tax raising Budgets of Summer 1997 and Spring 1993 which had the stated aim of reducing borrowing", on this occasion "the net increase in taxes from the Budget measures ... is being used to increase public spending".[101] The Chancellor told the Committee that the tax burden would initially decline, before increasing from 2003-04 onwards, commenting that "there is no secret about that, that is a rise in taxation to pay for the development of our public services and to pay for our health services".[102]

The forthcoming Spending Review

35. The Budget set out the "envelope" for public spending in the forthcoming Spending Review 2002 (SR2002), which will cover the years 2003-04 to 2005-06. The Red Book states that the envelope will allow:

·     current spending, excluding spending on health, to increase by 2½ per cent a year in real terms in 2004-05 and 2005-06. Current spending will rise in total by an average of 3.3 per cent a year in real terms over the same period; and

·   public sector net investment to rise from the 2003-04 target of 1.8 per cent of GDP to 2 per cent by 2005-06, to address the historic under-investment in Britain's public infrastructure.[103]

36. The IFS estimate that overall government spending (known as Total Managed Expenditure) will annually increase by an average of 4.3 per cent in real terms over the SR2002 period, or 3.7 per cent excluding NHS spending. Their analysis indicates that the Government can "continue increasing education and social security spending at the rate seen since April 1999 and still allow the rest of Government spending to grow at 3.1% a year in real terms over the next three years. This is faster than expected real growth in the economy". The IFS also note that "the increase in overall spending in 2003-04 is larger than the increase forecast for 2004-05 and 2005-06 [which] will mean that some departments will find that their settlements will imply greater real growth in spending next year than in the following two years".[104]

37. Although most spending allocations will be made at the time of SR2002, the Chancellor announced a commitment to increase health spending by an average of 7.4 per cent per annum for the period of SR2002 and a further two financial years beyond that, and also stated that "education will receive the priority to deliver further substantial improvements".[105] The Chancellor told the Committee that total spending allocations in SR2002 would use the "approach of matching money with modernisation leading to results". He said that "before committing the Treasury to additional expenditure we need to know of all departments whether spending is a priority, whether there is a clear strategy for reform to deliver value for money, and the track record of increased resources leading to improved results".[106]

The issue of underspending

38. A feature of the recent three-year spending reviews has been the level of underspending by some government departments. The IFS note that "it is not completely clear why there has been so much underspending over the last four years".[107] Mr Macpherson said that the underspend had "tended to emerge in the capital part of the Budget", noting that "following years of really quite low public sector investment, there was not the sort of capacity in place to get those projects going immediately". Pointing to an increase in public net investment to £12 billion in 2001-02 from £5.7 billion in 2000-01, Mr Macpherson said that "we are pretty confident now that the capacity is there".[108] However, Mr Macpherson warned that there are "big sanctions" that the Treasury can use to address underspending, and, while noting that it depended on the reasons for the underspend, said that it was "conceivable" that a department that did not spend all of its allocated resources could be punished. He said that if a department was delivering the required outputs but did not need its full financial allocation to achieve this, it is a "perfectly legitimate choice in a spending review to reallocate that sort of surplus provision to a department which needs it".[109] The Chancellor told us that the "underspend on health 2000-01 was £692 million, 250 of that was planned, was carried forward as a contingency"[110]. However, we remain concerned that some departments seem to be experiencing difficulties in delivering on the Government's agenda of increasing public sector investment, and that under-spending has been significant in some departments. We believe that the comparison of departmental spending with planned intentions should be reviewed quarterly in the process outlined to us by the Chancellor. We also welcome the Treasury's acceptance that the relevant quarterly figures will be made available to the Treasury Committee.

39. On the issue of underspending, and of the matching of money to reforms, promised by the Chancellor, for SR2002, it remains far from clear what sanctions are proposed and how they might be implemented.

FISCAL STANCE

40. The fiscal stance indicates the extent to which fiscal policy is supporting economic growth, and can, as a first approximation, be measured by taking differences in the cyclically-adjusted PSNB.[111] The absolute fiscal stance, which is the change in the fiscal stance from year to year, can be calculated by subtracting the previous year's cyclically-adjusted PSNB from the current year's. On this basis, it is the case that a fiscal boost will be imparted to the economy in 2002-03 and 2003-04, of 0.7 per cent and 0.3 per cent of GDP respectively. The relative fiscal stance is the comparison of the latest Budget projections of the cyclically-adjusted PSNB with previous forecasts, in this case those projections published in the Pre-Budget Report. On this basis, as the Chancellor told the House, the Budget would "implement—compared with the pre­Budget report—a small tightening of the fiscal stance over the next two years".[112] Mr O'Donnell explained that "what is the news for the MPC is the difference between our Budget projections and the PBR projections".[113]

Table 6: The projected change in the relative fiscal stance (% GDP)


2002-03

2003-04

2004-05

2005-06

2006-07

Relative fiscal stance

­0.2

­0.2

­0.1

0.3

0.4

Absolute fiscal stance

0.7

0.3

0

0.2

0

where a negative figure indicates tightening in the fiscal stance
Source: Budget 2002,Table 2.8, p37;

The impact of the Budget on monetary policy

41. In respect to the continuing imbalances in the economy, Mr Barr said that "with the Chancellor deciding to largely bypass many voters in his bid to raise extra revenue, the burden is on the MPC to slow above trend household spending".[114] As a result, Mr Barr increased his forecast for the Bank of England repo rate to 5 per cent by the end of this year, from 4.5 per cent. Schroders commented that, in the light of the Budget, "the job of slowing consumption and thereby rebalancing the economy now lies with the Bank of England".[115] As discussed above, however, there has been only a small change in the projections of the fiscal stance since the Pre-Budget Report and therefore, in this respect, the Budget did not contain any major surprises for the MPC.

42. In his Budget statement, the Chancellor re-affirmed that monetary policy would continue to a symmetrical inflation target of 2.5 per cent.[116]

43. In regard to the exchange rate, Mr O'Donnell confirmed that the Treasury was still pursuing a "stable and competitive pound in the medium-term"[117], although while sterling had "not been fluctuating enormously", in respect to competitiveness, "if there are some other exchange rates that are severely out of line it is quite difficult for to us manage that".[118] The Chancellor told the Committee that he did "want a stable and competitive pound",[119] but did not detail how a competitive value of sterling might be achieved, although, as Mr O'Donnell pointed out, in regard to bilateral exchange rates, "it takes two to tango".[120] It was interesting to note that the analysis in the Red Book of the UK's trade and balance of payments[121] did not explicitly consider the role of the value of sterling, a major contributory factor in the overseas competitiveness of the UK's exports, and also the price of imports. Mr O'Donnell told the Committee that the growth in the world economy is the "dominant factor" behind the UK's trade performance, but added that "the exchange rate certainly has not helped",[122] although the "strong" exchange rate had, in the view of Mr O'Donnell, caused UK exporters to "perform even better to improve their productivity".[123]


77   HM Treasury, Budget 2002, paragraph B35, p191 Back

78   National Audit Office, Audit of Assumptions for the 2002 Budget, Session 2001-2002, HC 760, paragraph 30, p5 Back

79   Q4 Back

80   Appendix 1 Back

81   Treasury Committee, House of Commons, 2000 Pre-Budget Report, Minutes of Evidence, Session 1999-2000, HC 988 iii, Q370 Back

82   HM Treasury, Budget 2002, Table 2.5, p31 Back

83   Appendix 1 Back

84   Q5 Back

85   Appendix 1 Back

86   Q442 Back

87   HM Treasury, Budget 2002, paragraph C22, pp210-211 Back

88   Q445 Back

89   HM Treasury, Budget 2002, paragraph A22, p151 Back

90   HM Treasury, Code for Fiscal Stability, November 1998, paragraph 24 Back

91   HM Treasury, Budget 2002, paragraph 2.8, p19 Back

92   Q189 Back

93   Ev 5 Back

94   European Council, Presidency Conclusions: Amsterdam European Council, Annex I: Resolution of the European Council on the Stability and Growth Pact, 17 June 1997 Back

95   HM Treasury, Maintaining Economic Stability: Convergence Programme for the United Kingdom, December 2001  Back

96   ECOFIN, United Kingdom: Council opinion on the updated Convergence Programme, 2000-01 to 2006-07, Press Release, 12-2-02,  Back

97   HM Treasury, Budget 2002, paragraph 2.65, p38 Back

98   Q293 Back

99   Appendix 2 Back

100   Appendix 2 Back

101   Appendix 2 Back

102   Q206 Back

103   HM Treasury, Budget 2002, paragraph 6.33, p119 Back

104   Ev 4 Back

105   Official Report, col 588, 17 April 2002 Back

106   Q183 Back

107   IFS, Green Budget: January 2002, p16 Back

108   Q155 Back

109   Q159 Back

110   Q338 Back

111   HM Treasury, Analysing UK Fiscal Policy, paragraph 4.12, p14 Back

112   Official Report, col 579, 17 April 2002 Back

113   Q119 Back

114   Deutsche Bank, UK Budget Special, 17 April 2002, p3 Back

115   Schroders, UK Budget Note, 18 April 2002 Back

116   Official Report, Col 578, 17 April 2002 Back

117   Q115 Back

118   Q116 Back

119   Q290 Back

120   Q116 Back

121   HM Treasury, Budget 2002, paragraphs B62 to B65, pp200-202 Back

122   Q112 Back

123   Q114 Back


 
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