House of Commons - Budget 2009

Budget 2009 - Treasury Contents

3 Public finances

State of the public finances

36. The 2009 Budget revealed a sharp increase in public spending, and a severe reduction in tax revenues as a result of the recession.[101] Government borrowing is now forecast to be higher than at any time since World War II, and the national debt is set to remain high for at least a generation. The forecasts for the public finances were also subject to an even greater degree of uncertainty than previously, as the Chancellor acknowledged: "Inevitably in forecasting, which is difficult even when times are pretty settled, the uncertainty around in this country and other countries makes matters more complicated".[102] Table 1 below sets out the key fiscal projections from Budget 2009:

Table 1: Summary of fiscal projections.

Source: HM Treasury, Budget 2009, p 20, Table 2.2

37. At the time of the 2008 Budget, the Treasury forecast that the current budget would move into surplus in 2010-11. In our Report arising from that document, we noted that this forecast was subject to "considerable downside risks".[103] Our scepticism was vindicated by the 2008 Pre-Budget Report (PBR), which projected a significant further deterioration in the public finances, with the current budget in deficit throughout the forecast period, peaking at 5.3% of GDP in 2009-10, and then falling to 1.1% by 2013-14. The cyclically-adjusted current deficit was forecast to fall from 4.4% of GDP in 2009-10, to 1.0% in 2013-14, when the economy was "projected to return to trend, driven by a recovery of tax receipts and lower spending growth".[104]

38. The 2009 Budget announced a further marked deterioration in the borrowing forecasts. Projections for the current budget deficit in each and every year until the end of the forecast period (2013-14) had increased by at least £50 billion from those made at the time of PBR 2008.[105] Net borrowing, which also includes net investment, is set to peak in this financial year at £175 billion, an alarmingly high 12.4% of GDP. Chart 1 places the size of public sector borrowing in some historical context and shows that since 1946 at least, borrowing has not been so high as it is projected to be this year.

Chart 1: Public sector net borrowing.

Source: HSBC, "UK Budget 2009: Living on borrowed money", 23 April 2009

39. The Chancellor explained that borrowing had increased because, on the income side, revenue from the financial services sector was "way down" not least because of lower revenues arising from corporation taxes and taxation of financial sector bonuses, and stamp duty revenues were lower too "because of the general slowdown in the economy". Secondly, borrowing had risen because of the fiscal stimulus, which included deliberate policy choices such as the temporary VAT reduction, the increase in personal allowances, and various other measures set out in the Pre-Budget Report and the Budget. Thirdly, borrowing had risen because of the "automatic stabilisers", via which the cost of welfare payments rises with unemployment.[106]

40. Roger Bootle, writing in the Daily Telegraph, pencilled in a more pessimistic prediction of peak borrowing of £230 billion, or 16% of GDP next year, compared with the Chancellor's forecast of £173 billion.[107] In oral evidence, he explained that the reason why he took a different view from the Government on the future of the public finances was primarily because he took a more pessimistic view of the economy in general—"If I believed the Chancellor's economic forecast, I suspect my fiscal forecast would be largely the same".[108] Mr Ramsden, defending the Budget's forecasts, pointed out that they were less optimistic than the average of new independent forecasts had been prior to the Budget's publication, and advised us that this was because some of the Treasury's underlying assumptions "do build in some caution". He accepted that other forecasters predicted higher borrowing, but nevertheless considered the Budget's projection to be a realistic forecast.[109]

41. According to the Budget, in 2009-10 public sector net borrowing will be 12.4% of GDP, of which 9.8% of GDP (or 79% of borrowing) is accounted for by structural, rather than cyclical factors.[110] A structural deficit represents borrowing that is not going to disappear when the economy returns to growth. Mr Ramsden explained that the large structural deficit in 2009/2010 resulted from the way in which the Treasury's method for making cyclical adjustments recognised the 5% permanent loss of productive capacity in the economy caused by the recession. If the recession's impact on the supply side of the economy turned out to be less than 5%, then the percentage of the deficit that was structural would be correspondingly lower.[111]

42. The Budget announced that public sector net debt (PSND) would increase rapidly through the forecast period. PSND excluding liabilities and unrealised losses from financial sector interventions, rises over the period to 2013-14, in particular in 2009-10 and 2010-11, reflecting the surge in additional borrowing in these years. By 2013-14 PSND on this measure reaches 76.2% of GDP. The inclusion of potential impacts arising from financial sector interventions on PSND makes for even worse reading—by 2013-14, PSND on this basis stabilises at around 79% of GDP.[112]

43. Until Pre-Budget Report 2008, public sector net debt had been limited by the Sustainable Investment Rule, which stated that PSND should be maintained below 40% of GDP in each and every year of the economic cycle.[113] The Treasury chose to depart from this Rule in PBR 2008, until such a time as the global shocks had worked their way through the economy in full.[114] The parlous state of the public finances can be ascertained when it is recognised that, if the Sustainable Investment Rule were still in force in 2013-14, the projected PSND would have been double that permitted by the rule. Indeed, a return to the 40% level is by no means imminent. The IFS has calculated that, based on Budget 2009 assumptions, this would not occur until February 2032. Chart 2 below portrays this trajectory for the national debt.

Chart 2: Public sector net debt.

Source: IFS, Public finances: two parliaments of pain, 23 April 2009

44. The Chancellor's forecasts for public borrowing and national debt make sobering reading. By any measure, those forecasts, along with those of many other OECD countries, are extremely high: they have exceeded the fiscal rules from which the Government departed in PBR 2008 by a wide margin and these figures represent the worst fiscal outlook since the Second World War. We are very concerned about the state of the public finances. What is now of critical importance is that the public, and crucially the markets, believe that the Chancellor is working to an adequate, and credible, plan to restore the public finances to good health. The credibility of any attempt to restore the public finances will depend on an acceptance that the structural deficit must be addressed as well as the consequences of the current extraordinary circumstances. We discuss this plan in the next section of this Report.

Recovering the public finances

45. The Chancellor told us there were two elements to his approach to fiscal policy. On the one hand, he was "trying to support the economy now" but, on the other, he was scheduling in "quite a substantial tightening as we come into recovery", because it was important "to send a clear signal that whilst you support the economy now, like all countries, like all businesses, you have got to live within your means in the medium and longer term and we have got to have sustainable public finances".[115] In Mr Chote's opinion, the credibility of the public finances depended crucially "on the quality of the plan the Government has in place to repair the underlying problem" and whether people believed that the Government, or a future government, was going to pursue the sort of fiscal tightening over the next Parliament, that was necessary.[116]

46. The Chancellor argued that the reason why borrowing and debt were "much, much higher" than previously was because of "the extraordinary circumstances" of the last couple of years. But he added that he was in no doubt that it was absolutely necessary, "to have a pretty clear view that this level of borrowing and the levels of debt need to come back down". In line with that recognition, the 2009 Budget set a path for halving the deficit over the next five year period.[117] It also reaffirmed the Government's commitment to ensuring sound public finances and protecting fiscal sustainability:

118

In order to ensure such sound public finances, the Budget set out tax and spending measures to be implemented at a time when the economy is forecast to be recovering and able to support fiscal consolidation. These plans "will deliver an average adjustment of over 0.8% a year in the cyclically-adjusted current budget between 2010-11 and 2013-14".[119] Mr Chote explained that this plan gave somewhat limited information about where that tightening would fall:

120

Mr Chote observed that "there is an awful lot of detail that needs to be filled in", not least where any cuts would fall within current spending and within capital spending across departments.[121]

47. Professor David Heald argued that the "key feature of Budget 2009 is the collapse of tax revenue projections" between November 2008 and April 2009.[122] A decline in revenues is, of course, to be expected in a recession, as firms make lower profits and incomes fall. This recession has seen particularly sharp declines in revenues from the financial sector, both through corporation and income tax receipts. Financial company corporation tax had accounted for around 25% of overall corporation tax, and the sector provides significant amounts of income tax and national insurance contributions on salaries and bonuses. The housing sector provides revenue directly through stamp duty, inheritance tax and capital gains tax and indirectly through the VAT collected on housing-related consumption. Receipts from these sectors dropped sharply in 2008-09 and are expected to fall further in 2009-10. The Budget suggested that receipts were then expected to recover but not to the levels experienced in 2007-08.[123] Chart 3 below shows the Budget's projections for housing and financial sector receipts.

Chart 3: Housing and financial sector receipts.

Source: HM Treasury, Budget 2009, p 229

48. Mr Weale was sceptical of the Budget's projections for the recovery of the financial sector, believing that they were "grossly optimistic".[124] He pointed out that the Treasury was expecting housing and financial sector receipts as a proportion of GDP to rebound to 1999 levels by 2013[125] and doubted whether this was likely.[126] But if revenues from financial services and housing do not bounce back fully, Mr Whiting contended, it was difficult to see which sectors would provide any substitute revenue growth:

127

Karen Ward, HSBC's UK Economist, has observed that, even if growth were to return to the levels projected by the Budget, that growth could well see "a very different mix" of sectoral contributions.[128] In his Budget, the Chancellor expressed his vision of growth rebalanced towards investment by businesses in low-carbon, advanced manufacturing and communications.[129] But, Ms Ward observed, this was likely to generate "significantly less revenue" than growth driven by financial services, because whilst the financial sector only accounts for 3% of jobs, it accounted for 9% of total household income.[130]

49. One of the important determinants of the restoration of health to the public finances is the extent to which tax revenues are able to rebound from their current low levels. It should be recognised that even before the current crisis the UK was running a structural deficit, although the scale of that deficit has been disputed and has been justified by the Chancellor on the grounds that this was a necessary investment. In our view, any restoration is not merely contingent on the economy meeting the challenging growth projections set in this year's Budget. What is also of importance is the composition of that growth. We note the inevitable shift away from the UK economy's dependence on financial services, and the Chancellor specified several industrial sectors which had promising futures. But it would be wrong to assume that these, or other sectors, will necessarily be as profitable as financial services. We recommend, therefore, that future Pre-Budget Reports and Budget documents provide a sectoral analysis of tax revenues, so that the basis of Treasury forecasts in a changing economy can be scrutinised. The Treasury already has the means to provide this information, as evidenced by its commentary on the financial and housing sectors, so to do this should not be particularly onerous.

Delaying the difficult decisions?

50. The Budget's proposes a consolidation in the cyclically-adjusted current budget so that balance is achieved in 2017-18. In the years to 2013-14, this consolidation path derives from policy decisions and the projected recovery in the economy, but from 2014-15 onwards, the consolidations needed in each year of 0.8% of GDP, are merely "illustrative projections".[131] For this period, no information is provided in the Budget as to what a consolidation of 0.8% of GDP per year would mean in policy terms. Chart 4 below depicts the consolidation in the public finances: green bars represent consolidation from announced policies; white bars represent illustrative projections, and so do not represent any specific policy choices.

Chart 4: Balancing the cyclically-adjusted current budget

Source: HM Treasury, Budget 2009, p 35, Chart 2.2

51. Mr Chote said that it was "understandable" that there was "a degree of vagueness at this stage" regarding whether an incoming government in 2014 ought to be relying more or less on tax increases rather than spending cuts, and doubted whether a fully detailed plan would be any more credible than specifying "the broad orders of magnitude" as set out in the Budget document.[132] Mr Weale agreed that it would be wrong for the Chancellor to say now what the balance between taxation and spending was going to be in five years' time, not least because there could be two general elections between now and then, but he thought that "some sense of how things might turn out and how the gap could be remedied purely as a guide would be quite helpful".[133] Mr Bootle said that in "normal circumstances" macroeconomists were not particularly concerned about how future Governments would plug any gaps in the public finances, and that, largely, this decision could be left to the politicians. However, he argued that these were not normal times, and thought that a consolidation in the public finances based on tax rises would have a worse macroeconomic impact than one based on spending cuts:

134

Mr Weale disagreed, suggesting that the economy could bear a tax burden of, say, 38-39% of GDP," without the economy falling apart", should that be needed.[135]

52. In the medium term, the options for returning the public finances to balance present uncomfortable choices for the Government and consequences for the public, the broad alternatives being substantial tax increases, unprecedented cuts in public services, or a combination of the two. We recommend that in the Pre-Budget Report 2009, the Government sets out a range of options for closing the projected fiscal gap.

The fiscal framework

53. The Code for Fiscal Stability defined two rules against which the Government's stewardship of the public finances could be assessed.[136] In October 2008, the Chancellor announced that the Government would temporarily depart from these two fiscal rules.[137] In their stead, the Government introduced a Temporary Operating Rule

138

54. Roger Bootle and Martin Weale both labelled the Temporary Operating Rule as a "tautology" rather than a rule. Mr Weale explained what he meant as follows:

139

55. Budget 2009 stated that the temporary operating rule was designed "to underpin a sustained fiscal consolidation once the economy is recovering",[140] and contended that "on the assumption that the Government delivers a further consolidation of 0.8% of GDP a year in the cyclically-adjusted current budget beyond 2013-14", the fiscal projections were consistent with the Rule.[141]

56. We do not see how the Temporary Operating Rule acts as any kind of constraint at all on the current fiscal decisions made by the Chancellor, and we struggle to imagine any course of action he might have taken in this year's Budget that would have been inconsistent with it. For this Rule to have any bite whatsoever, the identification of the point in time at which "the global shocks have worked their way through the economy in full", cannot be left to the judgement of the Treasury alone, but should be subject to parliamentary scrutiny. It is clear to us that the only real financial discipline that is currently imposed on the Chancellor is the opinion of the gilt market on the sustainability of the public finances.

57. Following our inquiry into PBR 2008, we concluded that:

142

58. The Government rejected our recommendation, stating that "in advance of the public finances reaching cyclically-adjusted current balance, the Government will set out how it will apply the fiscal framework in future to continue to deliver its objectives".[143] In oral evidence, the Chancellor said his "main focus at the moment … was to work towards reducing the amount of borrowing and reducing the amount of debt".[144]

59. Mr Chote argued strongly that there should be a rethink of the fiscal framework, stating that such a framework was inadequate if it only saved enough for "normal times". Over the next 30-40 years, in his view, it was quite likely that there would be another recession, and so fiscal policies should be designed "with the aim of saving up for the next disaster instead of on the assumption that there will not be any more disasters".[145] Although the Government had only 'temporarily departed from', rather than abandoned, the fiscal rules, Mr Bootle did not wish to see a return to the same fiscal framework. He contended that the 40% ceiling set by the Sustainable Investment Rule had "come out of the blue without very much rationale" and had turned out to have been "extraordinarily high" when confronted with the events of the last two years:[146]

147

Mr Bootle expressed the hope that there would be an effective national debate about the fiscal rules because they "had done an enormous amount of harm in this country": "they were misconceived, misapplied and they provided a smokescreen for a very destabilising policy".[148]

60. We believe that the Chancellor should now engage in what we regard as a crucial debate about the future of the UK fiscal framework. The majority of our expert witnesses found fault with the Golden Rule and Sustainable Investment Rule, so an eventual return to an unreformed framework would seem misguided. We sense that there is little consensus on what the best framework might be, which is all the more reason to commence a thorough analysis of all the options, drawing on international best practice, practical experience and academic theory. We are not suggesting that a new framework should be implemented now, but that the Treasury should open up a debate. To this end, we renew our recommendation made in our Report on PBR 2008 for a full public consultation.

Gilt demand

61. The burgeoning budget deficit, combined with the cost of financial sector interventions, has fed through to a substantial increase in the Central Government Net Cash Requirement to £220.8 billion, and a net financing requirement of £237.8 billion in 2009-10, the vast majority of which—£220 billion—is to be raised by gross gilt issuance.[149] The Treasury forecasts that its rate of interest will stay roughly the same (albeit on a much larger stock of debt).[150]

62. Richard Lambert, director-general of the CBI, said that "the key question for this Budget was whether it set out a credible and rigorous path for restoring the public finances to health. The CBI's preliminary judgment must be that it does not." He regarded as optimistic the Chancellor's economic forecasts of a rapid end to the recession and growth well above trend from 2011-2014. In his view, "with annual government bond issue expected to exceed £200bn in the coming years and debt doubling by 2013, the government is running too much of a risk with the willingness of investors to finance UK debt".[151] The risk would be that a reduction in demand for gilts would increase the financing costs of the UK Government at a time when the stock of debt was exceptionally high.

63. However, Mr Ramsden, for the Treasury, was bullish about the market, telling us of his confidence that appetite for gilts, which had been "very strong" throughout 2008-09, would be sustained in 2009-2010 because "at the macro level we think we have set out a transparent and realistic set of forecasts and a credible consolidation plan into the medium term".[152] Martin Weale added support to this prediction, telling us that the best forecast of future interest rates was what the long-term bond market was indicating, and that was saying rates were likely to stay in the 4-5% range for the foreseeable future.[153]

64. The sustained demand for Government debt investments might be considered surprising by some, as there could be an expectation of upward pressure on yields stemming from the supply shock of increased debt issuance over the fiscal forecast period, and the potential that the market might lose faith in the credibility of the Government's stewardship of the public finances. On the other hand, in recessions there tends to be a flight to quality. Because Government debt is considered lower-risk than other assets such as corporate debt, investors seek the safety, and relative liquidity, of gilts rather than corporate bonds. In addition to other factors, the UK Government is, of course, in competition with other governments in its issuance of Government Stock. However, there is relatively buoyant demand for UK gilts from UK banks for regulatory reasons, and the Bank of England is also now buying gilts as part of its quantitative easing programme. The Chancellor added that investors liked the fact that UK sovereign debt was "comparatively longer dated than a lot of the stock that is available in the European markets".[154]

65. Mr Bootle viewed the Treasury's assumption about costs of financing as by no means unreasonable or outrageous:

I should have thought it was quite unlikely that we would get both a prolonged recession, or the absence of recovery, which produced even worse borrowing numbers than we have here and, therefore, a vastly increased supply of gilts and lack of demand for gilts at existing interest rates because if we were to get a very, very weak real outturn then that would bring on the deflationary prospect I was talking about earlier on and it would surely underpin a prolonged period of effectively zero short-term interest rates. On that basis I could imagine the demand for gilts being very strong indeed. In fact, historically there are a number of examples of this. It has tended to be when bond issuance has been terribly high that yields have been very low and one particular example of that is Japan in the 1990s, not unlike the position we are currently in—the numbers are slightly different—but at one point, despite the government having a huge deficit, not quite as large as ours but around about 8% of GDP, ten year Japanese Government bonds fell to a yield of 0.6%.

66. David Miles, of Morgan Stanley, argued in the IFS Green Budget in January 2009 that "there was no reason yet to be alarmed about borrowing costs rising significantly, but clearly there is huge uncertainty either way".[155] Mr Chote observed that this was "a classic example" of a case where it was just as important for the Government to say how it would respond if things turned out differently from the central forecast, as whether the central forecast itself was credible.[156] The Chancellor admitted that there was uncertainty—"we are in uncertain times but so far there appears to be a healthy demand for our gilts"[157]—but when we asked him, given this uncertainty, what he would do if the gilt markets started to lose faith in the Government's ability to manage the public finances, he said it was "quite pointless" to speculate on "something that I do not anticipate being the case".[158]

67. One of the harbingers of such an eventuality would be if there were to be a sequence of uncovered gilt auctions by the Debt Management Office (DMO). One such uncovered auction did occur on 25 March 2009.[159] Mr Bootle was unconcerned by the failure of this single gilt auction, because it was "perfectly possible to have a situation in which a gilt auction fails for whatever reason and yet the demand for gilts is still very strong over a prolonged period". He would be more concerned if there were to be a series of uncovered gilt auctions as demand for gilts dried up. In this scenario, bond yields would "shoot up very considerably", which would result in the Government's cost of financing increasing significantly. He did not say that this eventuality was likely—indeed, he believed that the Treasury's projection that the cost of borrowing would remain low was "reasonable" on recent form—but it was "plausible", and if it happened, then we would be "in serious trouble".[160] Nor had Mr Weale detected any great concern from the gilt market about the public finances, at least not from expectations of long-term interest rates on Government debt, which remained low. He cautioned that "obviously the market can be wrong, but at the moment the market does not appear to be frightened".[161]

68. We note the reaction of the debt markets to the Treasury's ambitious borrowing plans. We believe there are strong reasons why the costs of financing the Government debt could well remain low. But if the gilt market were to lose its appetite for Government debt, which is by no means impossible, the cost of financing that debt could climb to perilous levels. Financial markets can be very volatile, and, as we have recently learnt in the financial crisis, can be quite poor at pricing risks initially, with any subsequent pricing corrections being sudden and unexpected. Under these circumstances, we consider that it would be prudent for the Treasury to work up contingency plans for a weakening of demand for Government debt.

101 Budget 2009, p 226, table C4 Back

102 Q 242 Back

103 Treasury Committee, Ninth Report of Session 2007-08, The 2008 Budget, HC 430, para 31 Back

104 HM Treasury, Pre-Budget Report 2008, Cm 7484, November 2008, p 190 Back

105 Budget 2009, p 225, table C3 Back

106 Q 243 Back

107 "If the Budget was a numbers game, the Chancellor definitely lost", Daily Telegraph, 23 April 2009 Back

108 Q 36 Back

109 Q 137 Back

110 Budget 2009, p 222, table C2 Back

111 Q 112 Back

112 Budget 2009, para 2.82 Back