Government and Public Sector Budget 2016 Digest Government and Public Sector Budget 2016 Digest 1
Economic story The background for the economic forecast is a slowing world economy. 2
The Chancellor talked about slow growth across the developed world, slower growth in China (but it is still rapid growth by the standards of western economies), and volatility on financial markets. All this adds to uncertainty, but the real story is the downward revision to the growth potential in the UK domestic economy. The forecast is being driven by recent revisions to historic GDP data (ONS revisions took 18 billion off the size of the economy) and how the OBR have interpreted these to simultaneously close the output gap and lower the estimate of UK trend productivity growth. With no margin of spare capacity in the economy, the best that can be achieved without entering an inflationary boom is growth in line with the long-term trend. And the OBR s judgement is that the trend rate of productivity (and hence GDP) growth is now lower than previously thought. Taken together, that means GDP growth is forecast to be 2.0 to 2.2 per cent in each forecast year, around a quarter of a percentage points lower than forecast in the Autumn Statement. Real GDP 2008Q1 = 100 130 125 120 115 110 105 100 95 90 June 2010 March 2013 November 2015 March 2016 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 The cumulative effect of these adverse changes is to reduce the level of real GDP by 1½ per cent by the end of 2020, and revenues by more than 16 billion in the crucial year of 2019-20, compared to the OBR s Autumn Statement forecast. This could be a pessimistic view; an alternative view would be that the output lost in the great recession was cyclical and will not be permanently lost. The OBR s judgement reflects the continued failure of productivity growth to recover, and it productivity is no longer assumed to return to its pre-crisis rate of growth. The OBR notes that this is similar to the pattern of productivity growth in the US and similar judgements have been made by the US Congressional Budget Office. Note that weak productivity growth is the converse of stronger than expected employment growth, which is pulling in more marginal (and lower skilled) people into the workforce. This is consistent with the picture of weak business investment we have seen throughout the recovery period, as businesses appear to prefer to expand labour over capital. The OBR forecast assumes that the Bank of England base rate is lower than previously forecast, reflecting weaker market expectations. This affects the composition of GDP, encouraging investment in particular, and also reduces the debt interest burden on public expenditure. A key assumption in the OBR forecast is that the UK remains in the EU. The OBR are clear that the merits of this or Brexit are beyond their remit, but they do observe that uncertainty may already be impacting business and consumer confidence, and that a vote to leave would result in an extended period of potentially disruptive uncertainty. The EY ITEM Club winter forecast is more positive than the OBR s Budget forecast, but it predates the recent GDP releases (and also the Budget). The ITEM Club view assumed variability in domestic demand growth would see more of a cyclical pattern in economic activity, with stronger growth in 2016, before slowing as fiscal tightening takes effect, and then picking up again at the end of the forecast period. Source: OBR Government and Public Sector Budget 2016 Digest 3
Economic story OBR Spring forecast, % changes on previous year GDP Domestic Demand Consumer spending Fixed investment Exports Imports 2015 2.2 2.7 2.9 4.2 5.0 6.2 2016 2.0 2.2 2.4 2.9 2.5 3.5 2017 2.2 2.3 2.2 4.5 3.3 3.3 2018 2.1 2.2 2.1 4.1 3.3 3.3 2019 2.1 2.0 2.0 4.0 3.4 3.3 2020 2.1 2.0 1.9 4.3 3.4 3.3 ITEM club Winter forecast, % changes on previous year GDP Domestic Demand Consumer spending Fixed investment Exports Imports 2015 2.2 2.4 2.8 4.4 5.6 5.9 2016 2.6 2.6 2.8 5.1 4.0 4.3 2017 2.3 2.5 2.1 5.7 4.8 5.0 2018 2.2 2.1 1.7 5.1 4.6 4.0 2019 2.5 2.2 1.8 5.1 4.3 3.0 2020 2.7 2.5 2.2 4.9 4.0 3.3 4
Fiscal story Despite the weaker economy, the Chancellor was nevertheless able to revise down the borrowing figure for the current tax year (which many commentators expected to be revised up), and to hit his fiscal mandate in 2019-20. Government and Public Sector Budget 2016 Digest 5
Fiscal story This year s improvement is due to the OBR s optimism that the disappointing public sector borrowing performance of the first ten months will be reversed in February and March. The budget surplus in 2019-20 is achieved through a variety of tax increases and spending cuts, as well as a wholesale reallocation of spending and receipts to and from earlier years. As noted, the underlying tax receipts forecast is weaker than previously, adding 16 billion to borrowing plans in 2019-20. However, this is offset by a number of tax measures and public expenditure cuts apparently targeted to hit the fiscal mandate in 2019-20. billion 12 10 8 6 4 2 0-2 -4-6 -8-10 November surplus forecast Underlying forecast changes Weaker Receipts Higher noninterest spending Lower debt interest March pre-measures deficit forecast Lower departmental current spending Budget policy changes Public service pensions measure Lower departmental capital spending Net tax increase Welfare cuts and other factors March post-measures surplus forecast These include deferring Corporation Tax receipts (scored on a cash not accruals basis), efficiency savings due in 2019-20, bringing forward capital expenditure, and a number of tax measures that bite most significantly in 2019-20, including the headline grabbing new tax on sugary drinks. The sheer number of tax and spending measures with a fiscal impact is the largest for two decades. In aggregate there were increases for large business (despite the headline CT rate cut, which is more than offset by implementing the OECD s recommendations on Base Erosion & Profit Shifting), cuts for small business (through business rate relief), a small increase in indirect taxes (including the new sugary drinks tax), personal tax cuts (personal allowance, ISAs and CGT), and the now familiar raft of anti-avoidance measures. This Budget clearly exposes the flaws in the new fiscal mandate. To achieve the budget surplus by the fixed date of 2019-20, there has to be a raft of measures to tighten policy in that target year. This plan looks increasingly difficult, forcing a sharp fiscal tightening in a pre-election year. The net effect is a planned fiscal tightening of 1.5 per cent of GDP in 2019-20, larger than in any year since 2010-11. In the OBR s forecast this fiscal contraction has no impact on economic growth, which may be too sanguine. As often with fixed rules, the requirement to achieve budget surplus in 2019-20 is driving some unintended behaviours - volatility in tax and spending plans from one fiscal event to the next, some gratuitous shuffling of both tax and spending between years solely to meet the target, and a pro-cyclical pattern in fiscal planning. At the Autumn Statement the fiscal mandate interacted with an improving economy to yield more favourable public expenditure; this is reversed now due to the slower trend growth projections. This pattern of cutting spending when the economy weakens is bad economics, acerbating cyclical swings in the economy. Source: OBR 6
Departmental spending plans are now higher over the next two years, but then move sharply lower than envisaged at the Autumn Statement for 2019-20 and 2020-21, effectively wiping out the bounce that was expected then. There are a few small increases in spending, hypothecated from tax increases (insurance tax to fund flood defences, soft drinks tax to fund an education package), and several infrastructure announcements. The main cuts are to overseas aid (in line with lower GDP); a 3.5 billion departmental efficiency review that will report in 2018 and take effect in 2019-20; a 2 billion increase in pension contributions by public sector employers; and the stricter eligibility criteria for disability benefits announced earlier in the week. Austerity is now extended into the next decade (2020-21), with a 10 billion cut compared to Autumn Statement plans. With all these changes, real public expenditure (i.e. real DEL) is now forecast to be a bit higher in early years (even rising marginally in 2016-17), before big year-on-year cuts in 2019-20 and 2020-21. With the exception of the last two years, the pace of cuts has slowed compared to the first parliament around 1 per cent per annum, compared to over 8 per cent per annum 2010-2015. Overall the cut in real DEL is 3.7 per cent in this Parliament, or 4.3 per cent including the increased public sector pension contributions. In non-protected departments the scale of real cut is much greater, around 13 per cent. There are also a number of deliverability risks: pressures from an ageing population (health, social services); benefit reforms (universal credit, disability benefits); employment costs (wages, NICs, National Living Wage, public sector pension contributions); and the expectation of departmental underspends already baked-into the arithmetic. UK: Change in Real DEL, from 2015-16 ( bn, 2015-16 prices) 5 0-5 -10-15 -20-25 -30-35 -40-45 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21 Source: EY ITEM Club, OBR March 2015 July 2015 November 2015 March 2016 OBR These public expenditure risks, taken together with a planned tightening of 13bn in each of 2019-20 and 2020-21, which that looks both economically and politically challenging, will make it tough going for the Chancellor to meet his target for a budget surplus by the end of the decade. Government and Public Sector Budget 2016 Digest 7
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