Memorandum submitted by Mr David Walton,
The public finances in the UK are coming in
much worse than expected. Despite this, the Chancellor has announced
various tax credits and ambitious plans for the funding of the
National Health Service. To fund these, taxes may need to rise
by up to £12 billion by the end of the Parliament in 2005-06.
Since the March 2001 Budget, there has been
a marked deterioration in the near-term prospects for the public
finances despite the fact that the government's GDP growth forecasts
were barely touched. In the Pre-Budget Report, public borrowing
is now projected to be £7 billion higher in 2001-02 and £10
billion higher in 2002-03. On top of this, the Chancellor gave
away £2¾ billion to pensioners by 2003-04. He also intends
to introduce various tax credits in next year's Budget that are
likely to cost at least as much again.
The government's two fiscal rules are still
met but with less comfort than before. However, there was a sting
in the tail of the PBR. The government's medium-term assumption
is that current spending will rise by around 2¼ per cent
a year. In practice, it will probably have to rise by around 3¼
per cent a year if the government is to meet its ambitious plans
for public spending, such as increasing health spending to the
EU average in 2005. In this case public spending in 2005-06 will
be around £12 billion higher than the government currently
expects. If the government's rules are still to be met, it follows
that taxes will need to rise by a similar amount by the end of
The Treasury made only small revisions to its
economic forecasts in the PBR. Its forecast for GDP growth in
the financial year 2001-02 was lowered by ¼ per cent to 2
per cent next year's growth forecast was left unchanged at 2¼
per cent and the 2003-04 forecast was raised by ¼ per cent
to 2½ per cent.
Such modest changes as these should have caused
barely a ripple to the Treasury's forecasts for public sector
net borrowing (PSNB). On the government's rules of thumb, the
public finances should have worsened by £¾ billion in
2001-02 and £2 billion in 2002-03 before returning to the
The actual revisions were much larger than thisa
worsening of £7.2 billion in 2001-02 and £10 billion
in 2002-03 compared with Budget 2001. All of the revisions were
on the receipts side, due mainly to a shortfall in corporation
tax. The projections for public spending were broadly unchanged.
As a result, the Treasury now expects a budget deficit of £2.5
billion this year compared with its forecast of a budget surplus
of £4.7 billion in March 2001 Budget. In 2002-03, the Treasury
has revised its forecast of the deficit from £2 billion to
The Treasury has almost certainly been too pessimistic
about the likely outturn for the public finances this year. In
the first seven months of the financial year, central government
current spending was up 5.3 per cent over the previous year. For
the year as a whole, the government projects an increase of 6.6
per cent. This implies a sharp acceleration in the final five
months of the year that is unlikely to be seen. Spending could
easily undershoot by around £3 billion this year. Hence I
expect a small budget surplus of £0.3bn.
However, a much larger budget deficit is likely
next year of £20 billion (1.9 per cent of GDP). Two factors
I expect greater cyclicality in the economy
with GDP growth of 1¾ per cent in both 2001-02 and 2002-03
balanced by growth of 3 per cent in 2003-04. In Goldman Sachs'
projections, tax receipts in 2002-03 are £4 billion less
than the Treasury expects.
This year's undershoot in public spending may
be carried forward to next year under the government's "End-Year
Flexibility" scheme. In our projections, public spending
is £3½ billion higher than the Treasury expects in 2002-03.
(There is a further £6.7 billion of previous years' underspends
that could in principle be spent by government departments next
year which the PBR is silent about.)
Our medium-term forecasts are about 0.4-0.5
per cent of GDP a year higher than the Treasury's, in part because
we assume that the government will spend around £4 billion
a year on the measures announced for consultation in the PBR.
The Treasury sees PSNB peaking at 1.3 per cent of GDP in 2003-04
and it falls to 1.1 per cent of GDP by the end of the Parliament.
On these projections, the government's two fiscal
rules are met but with less comfort than before (see Chart 1):
The golden rule requires current spending to
be financed from taxes over the economic cycle. This means that
the current budget must be in balance or surplus. On our forecasts,
the government runs a deficit on the current budget in the next
couple of years but return to a surplus of 0.3 per cent of GDP
in 2005-06. Between 1999-2000 and 2005-06, the current budget
is in surplus on average by 0.9 per cent of GDP a year.
The sustainable investment rule requires the
ratio of net public sector debt to be held stable at below 40
per cent of GDP over the economic cycle. In our projections, the
net debt ratio stabilises around 31 per cent of GDP in line with
the Treasury's forecasts.
There was a sting in the tail of the PBR. Our
medium-term forecasts are based on the working assumptions that
net public investment will stabilise at 1.8 per cent of GDP and
current spending will grow by 2½ per cent a yearthe
Treasury's projections assume slightly slower growth in current
spending. But the implication of the PBR is that considerable
resources will need to be found in coming years to fund the improvement
in public services that the government wants to see. The spending
plans will be decided in next year's Spending Review; the headline
totals are likely to be decided by the time of the 2002 Budget
To prepare the ground for this, the government
published an interim report by Derek Wanless on the resources
required for the health service over the next 20 years. A day
after the PBR, the Prime Minister committed the government to
raise health spending to the EU average over the next four years.
Comparable data are only available for health spending in 1998
but they show that UK spending was 6.8 per cent of GDP while spending
in the rest of the EU ranged from 8.0 per cent (simple unweighted
average) to 8.7 per cent (weighted by GDP). The Treasury claims
that health spending will be up to 7.6 per cent of GDP by 2003-04.
But that still leaves a gap of between 0.4 to 1.1 per cent of
GDP to be filled, equivalent to £5 to £14 billion in
2005-06. Moreover, the government has strong aspirations for improvements
in education and transport as well as health.
Rather than getting in to the detail of every
individual programme. I have conducted the following exercise.
Suppose current spending grows by 3¼ per cent a year in real
terms from 2003-04 onwardsthe first year covered by the
Spending Review. This is not an extreme assumptioncurrent
spending is planned to grow slightly faster than this on average
in the three years from 2000-01. On these assumptions, public
spending in 2005-06 will be £12 billion higher than the government
currently expects. If the government's rules are to be met, it
follows that taxes will need to rise by a similar amount by the
end of the Parliament (see Chart 2).
There is one final consideration. The Treasury
states that the government's plans meet the EU Stability and Growth
pact on a "prudent" interpretation. This is a curious
use of the word prudent. The government is aiming for a medium-term
budget deficit of around 1 per cent of GDP while the SGP requires
governments to aim for budget balance or surplus over the medium-term.
This might become a serious issue if the British government decided
to push for EMU entry in this Parliament.
3 December 2001