UK: Spend, Tax and Borrow

The Chancellor Gordon Brown delivered his Pre-Budget Report (PBR) to Parliament. Along with the annual Budget in the spring, this is the opportunity to outline the government's latest economic and fiscal plans. Here we analyse why the upbeat Chancellor may be just too optimistic.

Overview

The UK Chancellor Gordon Brown gave as upbeat a view of the UK economy as one is likely to hear. With a general election likely next May, this assessment should not come as a big surprise. What would be a bigger surprise is if it turns out to be as rosy as the Chancellor says. But by the time we can judge, the Chancellor will hope that the general election is already behind us. Although one suspects that the Chancellor may want the election to be as early as possible, next May is most likely. Between now and then expect to hear a continued upbeat view of the UK, with Thursday's message being repeated in the spring Budget.

There were three key areas to analyse in the PBR:

First, the Treasury's economic forecasts that appear too optimistic;

Second, the Chancellor's fiscal sums. Based on what is already happening this year, the fiscal numbers may turn out worse than expected even if the Chancellor is right on economic growth. If he is wrong on economic growth and the outlook is weaker, then the fiscal numbers could miss by a long way. The risks are on the downside;

Third, the Chancellor highlighted some of the longer-term competitive challenges facing the UK, notably from Asia. Yet if the UK is to face up to these challenges then the whole debate on fiscal policy needs to be shifted within the UK. At present, the relentless upward trend in public spending looks set to continue. This is turn has led to higher taxes and soon could lead to higher borrowing. However, if the UK is to be competitive against Asia, then it is taxes that need to be restrained, both for the corporate and personal sector. If taxes are the main benchmark, then this in turn should be the factor that limits spending and borrowing.

The Economic Numbers

The UK has enjoyed strong growth and low inflation for some time. This track record is in sharp contrast with the Continent and fully justifies the UK's decision not to join the European single currency. Being able to set its own policy framework has been good news for the UK. However, as good as this has been, one wonders whether it will be able to be sustained. Chancellor Gordon Brown clearly thinks so or at least with an election looming he is not prepared to admit otherwise.

After strong growth of 3.25% this year, he still expects the economy to grow 3.0-3.5% next year. By 2006, the spare capacity in the economy will have been used up, leading growth to slow towards its trend. The Treasury now sees trend growth as being 2.75% until the end of 2006 and then, because of demographics, slowing to 2.5% thereafter. If anything this highlights the challenge the UK, as well as Europe, faces compared with the young vibrant economies across Asia.

This upbeat view for 2005 may prove too optimistic, but much depends on the global economy. For not only is the Chancellor expecting still strong growth, he is outlining better balanced growth, with the pace of consumer spending slowing, while both exports and investment rise sharply. On these he may be right about slowing consumption, but it remains to be seen if investment and exports will be as strong as he expects.

UK exports have lost some market share recently, as shown in table 1. It is clear that the Treasury believes this is a temporary feature and that exports will bounce back. As the Chancellor said, he expects UK exports to grow 6.5-7.0% in 2005. However, if this rebound has not occurred by the time of the March Budget, one would expect to see it being revised down. Moreover, sterling's recent rebound will not help.

The Fiscal Plans

Spend, tax and borrow. In his first two years the Chancellor kept a tight hold on public finances. Since then, spending has been on a steady upward trend. Spending on public services has in fact shifted from famine to feast. In turn, the tax take has risen steadily. Now UK borrowing, which as a proportion of GDP is still relatively low in relation to other countries, is on an upward trend.

Ahead of the Pre-Budget Report, the main focus was on whether the Chancellor would breach his self-imposed Golden Rule. When he became Chancellor in 1997 the Chancellor announced two rules. Firstly, the Golden Rule implied that over the course of the cycle, the government should only borrow to invest and thus the current balance should sum to zero over the cycle. Secondly, the sustainable investment rule stated that the level of government debt should not exceed 40% of GDP, which is likely to be met.

Based on his upbeat economic view, the Chancellor does not break his Golden Rule. However, he would if growth disappoints. Yet, there is an additional worry, namely that despite the economy performing in line with the Chancellor's previous forecast for this year, his borrowing figures are higher than planned. Spending is rising above trend. Revenues are disappointing. The Treasury's attempt to explain these away may not stand the test of time. Because of accounting changes, the Treasury's view is that the previous bunching of departmental spending that used to occur towards the end of the fiscal year will not take place, lessening concerns on the spending side. Whilst in terms of revenues, they see the shortfall as being largely temporary, based partly on financial companies using up allowances. Even if this is so, it still leaves public finances vulnerable to economic disappointment.

The PBR also was far more expansionary than anticipated. It added a net GBP715mln to the economy this year. This takes into account the GBP520mln the Chancellor unveiled Wednesday as an addition to the special reserve because of the war. Although £715mln may be small in the overall scheme of things, it compares with the GBP725mln that was added in the March Budget. Thus this was a fiscal stimulus. The PBR also added GBP365mln and GBP225mln in each of the coming years.

Golden Rule

It is important that even if the Golden Rule is broken the Chancellor avoids any pro-cyclical tightening in fiscal policy. That is, if an economic downturn accounts for a further deterioration in the fiscal numbers, the last thing the Chancellor should do is raise taxes. In fact, he may still have some leeway on the Golden Rule. Just like the European Growth and Stability Pact, the Chancellor could decide to temporarily breech his rule, whilst remaining committed to the general principle. This issue, he hopes will be delayed until after any general election. However, there is another way. Currently the Treasury's fiscal plans are based on economic growth numbers 0.25% less than their actual forecast. They could decide to change this. That certainly would be preferable to any tax rises, but if the rule is broken the solution should be to raise borrowing rather than taxes. As the Governor of the Bank of England suggested in a speech this week, longer-dated borrowing would meet the desire of many pension funds who are keen to buy longer dated debt to match their future liabilities. Overall, with UK borrowing low and inflation low, the cost of such increased borrowing should not be too high.

Of course, the main desire should be some greater control over public spending. Yet, with spending plans already outlined in the summer Comprehensive Spending Review, the UK looks set for increased government expenditure. This points to a number of potential problems and should be linked in to the last part of the Chancellor's Pre-Budget Report, when he focused on the need for the UK to face up to the challenge from Asia.

Time to Change the Terms of the Debate

The whole framework of the debate on public finances needs to change. Up to now, it is spending that trends higher and has to be funded by taxes or borrowing. However, if the UK is to be truly competitive, facing up to the challenge from Asia, then this should set a limit to tax increases. Approaching this way, would then force a slower pace of spending growth.

Also, the full consequences of increased public spending have yet to be seen. Since 1997, around 0.5mln workers in the public sector have been added. Many are on final salary pensions that are unfunded. The Chancellor did not address the pensions' issue in his Statement, but this is a further future liability that needs to be funded.

There is a view that increased public spending will allow a more regionally balanced economy, helping the output-inflation trade off, but given the skill shortages in the economy, it could if anything force a regional inflation problem. Already there are regional employment hot spots and the likelihood is that the private sector may need to bid up wages to attract staff. There is a data vacuum that prevents the full consequences from being seen. Also, the further one moves from London, the more local housing markets are underpinned by public sector employment. This may of course allow the housing market to be more resilient on the downside, particularly when combined with the shortage of properties in the south-east of England. However, the housing market is already off its peak and its vulnerability is one of the domestic risks that must still concern the Chancellor.

At least, interest rates at 4.75% look unlikely to rise further for now. Yet, with public spending continuing to grow above trend, the Bank of England may decide to keep rates high, relative to the current 1.2% targeted rate of inflation, in order to ensure the private sector grows below trend, thus maintaining balance in the economy.

An increasing share of the public sector is not the best way to ensure that the UK faces up to the challenges from Asia that the Chancellor alluded to. We have spoken and written on this issue many times before. There are a number of issues. There clearly is a need for the UK to become more competitive, particularly in higher value added areas. This points to the need for the UK to break out of its longer-term trend of under-investment. However, the UK must also see Asia as an opportunity, not just a threat; as the Chancellor said in his speech, a region to export to and invest in.

Overall, the market impact from the PBR was limited. Although there is undoubtedly scepticism about the Chancellor's economic and fiscal forecasts, the markets were relieved that there were no shocks in his projections. For now, the view will be that UK interest rates are unlikely to fall. Even though sterling already looks too strong for its own good against the dollar, it may rise further near term. It may not yet be boom and bust for the UK economy, but it will undoubtedly be a rise and fall for sterling as we move into 2005.

Dr Gerard Lyons
Chief Economist and Head of Global Research
Standard Chartered