Closer to the edge of prudence

Is it the end of the game, with the success of the UK Chancellor’s Budget heavily dependant on getting his economic forecast right? Tony Haggar writes

Gordon Brown, presenting his 10th and probably last Budget as the UK’s Chancellor, was ebullient regarding his stewardship of the economy over the last 10 years. “We are… the only Government in British history to be entering the 10th year of uninterrupted economic growth.” The opposition’s response to these claims was at best theatrical and at worst puerile, lacking in any real examination of the evident vulnerabilities contained in the Red Book. In reality, although the Budget was scattered with popular measures which cost little in relative terms (£380m next year and £1.5bn over the next three years), it lacked conviction that the immediate economic pressures facing the Chancellor had been adequately dealt with.

Over the past year, the economy has started to slip and there was little or nothing which addressed the underlying questions that still confront the economy over tax and public spending. The Chancellor is continuing to rely on growth to increase the rise in revenue, and consequently offset the need to increase taxation rates or make further borrowings. There are considerable doubts expressed by analysts over whether the Chancellor’s growth forecasts will be achieved. He is, however, a Chancellor with an important job opportunity in mind, and it is not surprising he is loath to be too restrictive on public expenditure policies in the coming year which could curb his ambitious political programme.

The Budget estimates that the economy will expand by about 2.25% this year and about 3% in 2006/07 and 2007/08, but, importantly, the source of this growth has changed and now relies on a stronger consumer sector and a weaker business investment than that predicted in the Pre Budget Report (PBR), despite the steep fall in consumer spending at the start of the year. In recent years consumer spending has increased ahead of GDP growth and has been unprecedented in post-war years. The Treasury is forecasting that consumer expenditure will continue to grow between 2% and 2.5% this year, up from 1.75% to 2.25% range forecast in the PBR. This assumes that growth will recover from the 2005 level of 1.75% (a 14-year low) to 2.25% this year.

Revenue rise

For the immediate future, the economy has been revived as, in recent months, there has been an unforecasted rise in revenues due to high corporate tax and North Sea oil receipts which have put on track the revenue forecasts for 2005. In addition, by extending the economic cycle to 12 years, the Chancellor has just been able to meet his golden rule, which has enabled him to keep within his self-imposed financial guidelines.

Turning to spending plans, the Chancellor has been tougher this year with the spending increases falling to 3% and 2.6% in 2006/07 and 2007/08, down from the 5% averaged (well ahead of GDP growth) between 2000 and 2005. Even though public spending is slowing, it still outstrips economic growth in 2006/07. In an attempt to ensure value for money the Chancellor has instigated a rigorous efficiency review of public spending in the Comprehensive Spending Review (CSR). He has said he would be implementing a 5% real terms cut in spending in the Treasury, Cabinet Office and Department of Works and Pensions, to meet his goal of £1bn savings. There is, however, considerable scepticism as to whether these ambitious targets can be achieved. Post Budget, the Chancellor has been criticised for not investing more in the beleaguered National Health Service (NHS). In reality, the last few years has seen the NHS receive unprecedented levels of growth in real terms, but, according to the Treasury efficiency index (widely criticised), it has made disappointing progress in reforming itself into a modern service. Instead of investing resources to bring about the changes needed, it has been beset by successive administrative reorganisations to the detriment of service improvement. It now faces significant financial problems, many of which must be laid at the doors of successive ministers who have continually instigated unsustainable cost increases without a corresponding increase in efficiency. The achievements made in the waiting lists reductions have in the main been achieved through engaging external contractors rather than by internal improvements, hardly what the Chancellor intended with the additional resources he made available.

To add further to the Chancellor’s problems, the external trading position for the UK has again continued to decline; there has been no trade surplus to contribute to economic growth since 1995 and the trading balance has moved even further into deficit.

The culmination of these disappointing performances in economic growth forced the Chancellor to revise his forecast of borrowing in his PBR in December by nearly £18bn over five years, and by £2bn to £36bn for 2006/07. This brings the Chancellor tantalisingly close to breaching his own budgetary rules.

The first and golden rule is that the Government should balance its Budget excluding net capital investment over the economic cycle. This, according to the Treasury, began in 1997 and will end in 2009. During this period there have been extraordinary swings in the budgetary situation with large surpluses between 1998 and 2002, followed by even larger deficits between 2002 and 2007. As the surpluses are greater than the deficits in the period, the net result is a surplus that will amount to only 0.1% of the GDP, precariously close and very vulnerable to the optimistic growth projections.

The second rule is that of sustainable investment, where net debt is kept below 40% of the GDP so that the financing of public debt is a reasonable burden and can be financed without undue pressure on the economy. The forecast now stands at 38.4% in 2009/10, which leaves the Chancellor little if no room for further borrowings.

The difficulty the Chancellor is now facing is one of credibility.

• Most analysts believe the revenue forecasts are over-optimistic and the rise in GDP from 39.7% to 40.9% in 2007/08 will be difficult to sustain, especially as the Treasury has over-projected the revenue forecasts in the last six Budgets. The International Monetary Fund, the Institute of Fiscal Studies and the Organisation for Economic Cooperation and Development all project a lower growth pattern.
• Public expenditure is planned at a much lower rate than previously. At 1.8% above inflation after 2008, this is significantly lower than the 4.8% over the past few years. With the problems arising in health and the ambitions in education, this leaves precious little room for other programmes or for any drift in financial control. The Chancellor has made much of next year’s CSR and the savings expected to materialise. For this to be effective it will mean lean pickings across the spending departments for a number of future years.
• The perceived lack of confidence in meeting his own economic rules of balancing the Budget over the economic cycle (which was only achieved by extending the economic cycle), and, perhaps more importantly, keeping to the sustainable investment rule, which many believe has been compromised by the private investment initiative.

Gordon Brown has, however, gained the reputation as an iron Chancellor with an uncanny strategic approach to political adversity. He has made much of his prudent approach to the economy with strong public finances and low inflation. Britain, as he was keen to expand in his Budget presentation, has enjoyed a record period of economic prosperity under his chancellorship. He has also done much to reform the national economic planning with the introduction of the PBR, has made transparent the reporting of government finances, given independence to the Bank of England via the Monetary Policy Committee for interest rates, and has instigated the auditing of financial assumptions of his Budget by the National Audit Office. He has also regularly sustained his position, despite the often gloomy predictions of analysts.

Conversely, on the basis of this Budget, it does look like the end of the game and now summer camp appears to be over. Gordon Brown is more aware than most that the spending decisions he has made in this Budget, and an ability to sustain economic growth, will probably be the last opportunity before a general election to create the parameters and scope within which ministers can operate. More importantly for him, it will determine the scope for the future prime minister. He has made much in his rhetoric of his desire to invest in public service and social improvement, and has castigated the opposition’s plans as unsustainable leading to cuts in services, many of which he believes are vital to improving our society. On the basis of this Budget, the success of his economic forecast is too close to call and, if it doesn’t materialise, the remedy will be to increase taxation which, given our already high level of public expenditure, will lead to a whole new raft of economic challenges.

Tony Haggar is professor of strategic management at Middlesex University, UK.