UK: Budget 2005 Tight, but not quite as tight as it looks

Roger Bootle, Deloitte's Economic Adviser, comments on the Budget:·

• For a pre-election Budget, this was a pretty restrained affair. Indeed, the tax and spending measures add up to a small fiscal tightening of £265m in 2005-06, a far cry from the giveaway of up to £5bn some commentators had expected.

• The true "tightness" of the Budget is exaggerated a bit, however, by the fact that the tax cuts and spending measures are partly financed by a projected reduction in tax avoidance, worth up to £1bn in 2006-07. Moreover, the usual reduction in the margin included in the spending plans, and an increase in projected asset sales, also help to keep the borrowing numbers in check.

• Mr Brown made much of his fiscal responsibility in abstaining from a pre-election bonanza, but the reality is that he had very little money to play with. Even after the £3bn windfall from the reclassification of road spending, he expects to meet his Golden Rule with just £6bn to spare over the economic cycle. There is still a real danger that the Rule will be broken.

• Whether the Rule is broken or met, however, the big picture is one of a major deterioration in the public finances over the last five years. Even the Chancellor’s fiscal forecasts suggest that borrowing will decline only very gradually in the future, still totalling £24bn in 2008-09.

• What’s more, these forecasts are based on optimistic assumptions for the economy. In particular, by sticking to his prediction of 3% to 3.5% GDP growth in 2005, Brown has made no allowance for the slowdown in household spending growth which recent data suggest is already underway.

• Accordingly, it remains very likely that Brown or his successor will have to take action after the election to put borrowing on a more decisive downward path. I continue to expect tax increases of the order of £10bn p.a., the bulk of which is likely to come in the 2006 Budget.

• In the markets, the modest size of the giveaway should help to ease fears of another interest rate hike. Rates could still rise again over the next few months, but even if they do, I expect them to fall later in the year as the slowing housing market dampens household spending and overall activity.

Roger Bootle
Economic Advisor
Deloitte

The Budget measures

The Budget package was rather more modest than expected, with the tax and spending measures adding up to a small net revenue gain of £265m in 2005-06. This turns into a small giveaway of £65m in 2006-07 and a larger giveaway of £590m in 2007-08. Still, this is a far cry from the tax cuts of up to £5bn expected by some commentators.

The key measures were the increase in the stamp duty threshold from £60,000 to £120,000, which will cost £250m p.a.; the council tax refund for the over 65s, which will cost £800m in 2005-06; the delay in the revalorisation of fuel duty at a cost of £235m and the increase in child tax credit, which will cost nearly £500m p.a. by 2007-08. The measures were paid for by a raft of policies to reduce tax avoidance by up to £1bn in 2006-07, the "modernisation" of North Sea corporation tax, expected to raise £1.1bn next year, and a reduction in relief in stamp duty land tax.

The economic forecasts

As Table 1 shows, the Chancellor left his forecasts for the economy largely unchanged from those in December’s Pre- Budget Report (PBR). No doubt encouraged by his foresight in correctly predicting GDP growth of between 3% and 3.5% last year (the outturn was 3.1%), the Chancellor maintained his forecast of a similar expansion in 2005.

But I continue to see two major downside risks to this forecast. First, it relies on only a modest slowdown in the growth of household spending, from 3.1% last year to between 2¼% and 2¾% this year. I suspect that a weaker housing market will prompt a rather more abrupt slowdown in spending growth and recent data has suggested that such a slowdown is already underway. I expect spending growth of around 1.5% this year.

Second, while the growth of exports has recently picked up, the Chancellor’s prediction of an expansion of 6% to 6½% this year looks optimistic in the light of a likely slowdown in global GDP growth and the continued strength of the exchange rate. I expect exports to grow by 4%, with imports growing even faster and net trade acting again as a drag on growth. Overall, I expect GDP growth to be around 2% this year, a full 1% below the Chancellor’s forecast, rising only marginally to about 2.2% next year.

The fiscal forecasts

Table 2 compares the new fiscal forecasts presented in the Budget with those in the 2004 PBR. The forecasts for public sector net borrowing (PSNB) are a touch lower than I had expected, with the projection for next year actually revised down by £1bn to £32bn and those for later years left largely unchanged.

As the table shows, the single biggest change in the borrowing numbers is the reduction of the AME margin (the old Contingency Reserve), which has fallen by almost £2bn in 2005-06. It was this which allowed Mr Brown to revise down his forecast for borrowing next year, despite the fact that tax receipts are now expected to be around £2bn lower than previously predicted. A projected increase in asset sales of around £1bn also helps to keep the borrowing forecasts down.

The forecasts for current borrowing (i.e. borrowing excluding investment) are also rather lower than I expected. Although this year’s estimate has been raised from £12.5bn to £16bn, next year’s figure has fallen from £7bn to £6bn.

The fiscal rules

Where do the new forecasts leave the Chancellor’s fiscal rules? Needless to say, Mr Brown’s numbers continue to suggest that the Golden Rule will be met in the current economic cycle, expected to end in late 2005. But the margin for error remains uncomfortably slim at just £6bn, down a touch from the £8bn margin estimated in the PBR. This is less that the Treasury’s average forecasting error of £10bn in forecasting borrowing one year ahead. Accordingly, the normal uncertainty surrounding the fiscal forecasts suggests that there is still a real danger that the Rule will be broken.

On top of this, there are two more specific dangers. First, if I am right in expecting the economy to grow significantly less quickly than the Chancellor expects, this alone could result in much higher levels of borrowing. The Treasury’s own equations suggest that each 1% reduction in GDP growth boosts borrowing by some 0.7% of GDP, or £8bn, after two years. The black columns in Chart 1 show the profile for borrowing produced if we apply this rule of thumb to my less optimistic GDP forecasts. Other things equal, public borrowing could be some £10bn p.a. higher than the Chancellor’s forecasts by 2007-08. Needless to say, an even weaker economic performance would result in even higher borrowing.

Second, even if Mr Brown is right about the economy, he might still be wrong about the public finances. After all, tax revenues have met his forecasts this year only with the help of unexpectedly high oil prices. What’s more, as already mentioned, the new forecasts rely on both a significant clampdown on tax avoidance and greater revenue from public sector asset sales than previously assumed, which together add up to an extra £2bn p.a. from 2006-07. These projections may turn out to be correct, but they carry rather more uncertainty than revenue increases based on firm tax increases.

Fiscal consolidation ahead

Even if Mr Brown’s optimism towards the economy and public finances proves correct and the Golden Rule is met, I suspect that he, or whoever is Chancellor after the election, will still want to take action to put borrowing on a rather more decisive downward path than the current forecasts suggest. After all, Chart 2 shows that Gordon Brown raised taxes sharply, by £7bn and £8bn per annum respectively, after the last two general elections, even though the public finances were in rather better shape than they are today.

Source - HM Treasury

Accordingly, I continue to expect a period of fiscal consolidation once the general election is out of the way, the bulk of which is likely to take the form of tax increases worth close to £10bn per annum in the 2006 Budget. This in turn means that the public sector, a source of strong support for the economy over the last few years, is likely to become a drag on growth over the next few.

Conclusions and market implications

The fact that the modest tax and spending measures are partly paid for by uncertain predictions of reduced tax avoidance and higher asset sales suggests that the Budget was not quite as tight as it looked at first sight - should tax avoidance fail to fall as expected, higher borrowing will presumably have to take the strain. Nonetheless, for a pre-election Budget, this was still a pretty restrained affair.

But while Mr Brown made much of his fiscal responsibility, the truth is that he had very little money to play with. There is still a real danger that the Golden Rule will be broken in this cycle and, even if it is not, the current projected path for public borrowing is undesirably high. Taxes are therefore set to rise significantly in a year’s time.

How will the Budget be greeted in the markets? If anything, its relative tightness might help to ease recent concerns over further rises in interest rates. Rates could yet rise again in the next few months, although it’s my bet that they won’t. Either way, however, I continue to expect them to fall later this year as the weaker housing market dampens household spending and GDP growth.

Longer-term market interest rates could come under upward pressure, however, from the publication of next year’s gilt financing arithmetic projecting sales of £53bn in 2005-06, and the confirmation of a forthcoming 50 year gilt issue. Of course, this was widely expected, but the signal that the Treasury is attempting to address the problem of very low long bond yields might at least help to reduce the degree of inversion at the long end of the yield curve.

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