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Budget
This annex sets out the economic background to the Budget and discusses economic prospects.
The key points are:
A.01 The UK economy continues to suffer from a number of underlying structural weaknesses. As noted in Chapter 1, the level of GDP per head is below that in the other G7 economies and below the OECD average. In part, this reflects the UK's relatively low capital stock per person employed - the result of years of under-investment. But it also reflects the failure of previous Governments to face the challenge of removing barriers to employment and growth. The Government is now set on providing the economic framework and opportunities to raise the economy's sustainable rate of growth. As described in the main chapters of this report, it is developing a comprehensive range of economic policies to achieve this objective, through promoting economic stability and encouraging work and enterprise.
A.02 However, at the same time as putting in place policies aimed at improving the country's long-term performance, the Government has had to address the short-term pressures facing the economy. By the middle of last year, the economy had largely used up its spare capacity and output was growing at an unsustainable rate, putting upward pressure on inflation. Both the monetary and fiscal policy action which has been taken since last May should ensure that domestic demand will slow through the course of this year, putting the economy back on track for more sustainable growth.
A.03 As in the November Pre-Budget Report, the projections for output growth are presented as ranges. These are intended to give an indication of how differing degrees of supply side improvement could affect the prospects for the economy over the next few years. The Budget takes a further step forward in introducing policies which will encourage outcomes towards the more favourable ends of the ranges. But the actions of private individuals and businesses - for example, in avoiding excessive wage increases - will also be important in determining whether the more favourable prospects materialise. Responsible wage bargaining offers the opportunity to promote jobs.
A.04 The ranges are not an indication of the degree of forecast uncertainty. There are substantial risks to the short-term outlook which could result in outcomes well outside the ranges. If domestic demand were to have more momentum than expected, the economy could face a more pronounced cycle of strong growth and inflationary pressure, followed by a sharper slowdown. On the other hand, there is also a risk that demand could slow more rapidly than expected, for example if there were to be a further deterioration of the situation in Asia, in which case inflationary pressure could undershoot the forecast. Another, and perhaps the most unpalatable, risk is that output could currently be further above its sustainable level than estimated, implying greater inflationary pressure already in the pipeline, and the prospect of a sharper slowdown.
A.05 UK economic growth has averaged around 2 1/4 per cent a year since the mid-nineteenth century and, despite a rather better performance during the 1950s and 1960s, this average, or trend, growth rate has not been improved upon over the post-war period as a whole.
A.06 The figures at the lower ends of the forecast ranges are intended to be deliberately cautious, and make no allowance for any improvement in the supply side performance of the economy over the next few years. They are based on a trend growth rate of 2 1/4 per cent a year, in line with both the post-war average and the average over the last full cycle, and are the basis of the projections of the public finances set out in Annex B. However, the Government has set its sights higher - the July 1997 Budget set out the Government's aim of raising the trend rate of growth.
A.07 One way of achieving a better outcome is through a decline in the sustainable rate of unemployment (or NAIRU - the non-accelerating inflation rate of unemployment), which would allow a period of faster output growth and higher employment, consistent with meeting the inflation target. The upper ends of the forecast ranges are based on the assumption that improved labour market performance delivers a fall in the sustainable rate of unemployment over the next three years, equivalent to trend output growing by 2 3/4 per cent a year through 1998 and 1999 and gradually reverting to the assumed rate of 2 1/4 per cent by the end of 2000.
A.08 At the time of the November Pre-Budget Report, the economy was judged to be on trend, on average, in the first half of 1997. There has been no reason to change this view. But with output growth in the fourth quarter weaker than expected in November, GDP is now estimated to have been around 1/2 per cent above its trend level (a positive output gap) in the final quarter of last year, compared with the 3/4 per cent estimate in the Pre-Budget Report.
A.09 The view that the economy is currently operating above trend appears consistent with a wide range of labour market indicators:
A.10 There is also continuing evidence of recruitment difficulties and skill shortages:
A.11 Taken together, this evidence points to a labour market that is tightening to the stage of putting upward pressure on inflation. Moreover, it seems likely that labour market participation is now close to its current trend level, further suggesting that there is no longer any cyclical slack left in the labour market. Despite the working age activity rate (the proportion of the working age population either in employment or unemployed) remaining around 2 percentage points below its pre-recession peak in 1990, cyclical increases in recent years have probably been offset by rising numbers of Incapacity Benefit claimants, students, and people taking early retirement. As a result, the working age activity rate has been fairly flat at around 78 1/2 per cent during the current upswing. The box on page 87 discusses recent trends in male and female activity and employment.
A.12 The UK's working age employment rate is currently around 73 per cent, and the Government is aiming to raise this on a sustainable basis, with a dual approach of encouraging labour market participation among currently inactive people (i.e. raising the activity rate) and reducing the sustainable unemployment rate. Around 11 3/4 per cent, or almost 4 1/4 million, of working age people in the UK are still without work and wanting a job, despite the unemployed component having fallen to around 1.9 million. Moreover, the number of inactive people who say they want a job as a proportion of the adult population is higher in the UK than in any other European Union country.
Male and female employment rates have moved very differently since the early 1980s. Adjusting for the economic cycle, the female rate has continued on its longer-term upward trend, while the male rate has at best arrested its longer-term downward trend. These different employment trends are in part explained by changing participation (the female activity rate has been on a broadly upward trend while the male activity rate has been falling), but also by lower unemployment rates for women (in particular since 1990).
The female unemployment rate was far less affected by the deep recession in the early 1990s than the male rate (both having previously been similar). Although male unemployment has fallen by proportionately more than female unemployment during the present upswing, the male rate remains higher than its previous trough in 1990, whereas the female rate has been below its previous trough for the past two years.
There are a number of potential explanations for these different trends: for example, the continued relative decline of manufacturing (which disproportionately employs men) and expansion of the service sector; an increase in family-friendly practices in the workplace; women choosing to have fewer children and having them later in life; an increase in the proportion of single women; improved female educational attainment; and changing social attitudes towards female employment.
Looking ahead, the New Deal programmes, tax and benefit reform and other policy measures discussed in Chapter3 should help to promote both higher male and female employment rates. In particular, the New Deals for the young and long-term unemployed (who are disproportionately male) should help to improve on past trends in the male employment rate. The national childcare strategy and the New Deal for lone parents should help to boost female participation.
A.13 The New Deal programmes for the young and long-term unemployed will enable these groups to compete more effectively for jobs. Furthermore, the New Deals for lone parents and the long-term sick and disabled should increase the effective labour supply by re-integrating the target groups into the labour market. The measures announced in the Budget for reforming the tax and benefit system will also increase the effective labour supply by reducing disincentives to work. As a result, more labour will be supplied at any given real wage rate. This equates to a reduction in the NAIRU.
A.14 To the extent that these policies are successful, the economy will be able to sustain a higher level of GDP in the longer term, and a faster rate of growth over the transition period.
A.15 After expanding at an annualised rate of 3 1/2 per cent on average between the end of 1996 and the middle of 1997, GDP growth slowed to an annualised rate of 2 1/2 per cent in the fourth quarter of last year. In 1997 as a whole, GDP is estimated to have risen by 3 per cent, compared with the 3 1/2 per cent Pre-Budget Report forecast.
A.16 The slackening in the pace of output growth at the end of last year largely reflected a deterioration in net trade performance, as the appreciation of sterling over the past eighteen months began to impact on trade volumes. Abstracting from a comparatively weak figure for the third quarter of 1997 (which appears to have reflected the timing of spending out of windfall receipts and the effects of the Princess of Wales' funeral in September), domestic demand growth has so far shown little sign of softening.
A.17 The impact of sterling's appreciation has also become evident in a growing divergence between the manufacturing and service sectors. Service sector output (which accounts for around two thirds of total output) rose by almost 4 1/2 per cent in the year to the fourth quarter of 1997. In contrast, manufacturing output (around a fifth of the economy) rose by around 1 per cent over the same period, having stalled around the middle of last year and fallen since the autumn.
A.18 Latest monthly indicators show continued buoyancy of consumer demand into 1998. Both January retail sales and car registrations showed strong growth, and the underlying trends do not yet show convincing signs of a slowdown. Consumer confidence has dipped from its autumn highs, but remains well above normal levels.
A.19 In order to offset the inflationary pressures created by the positive output gap and to meet the inflation target by the end of next year, it is likely that GDP will need to grow below its trend rate for a time to generate a negative output gap.
A.20 Net trade is expected to continue to make a negative contribution to growth through this year and the first half of next, reflecting the appreciation of sterling and the impact of financial turbulence in Asia - which has increased since November (details are set out in the box on page 104). In addition, domestic demand growth is likely to slow through the course of the year in response to the increases in interest rates since last May and a tightening fiscal stance.
A.21 Depending on the extent of any improvement in labour market performance, GDP is forecast to grow by between 2 and 2 1/2 per cent this year, slightly below the Pre-Budget Report forecast reflecting recent developments in Asia. The counterpart to this, and a slight downward revision to the estimated output gap at the end of last year, is that growth in 1999 is forecast to be a little stronger than in the Pre-Budget Report forecast, consistent with meeting the inflation target. Growth is projected at 1 3/4 to 2 1/4 per cent in 1999, and 2 1/4 to 2 3/4 per cent in 2000.
A.22 1997 saw strong growth in personal spending. Aggregate consumers' expenditure grew by 4 1/2 per cent, well above its long-run average, more than enough to account for the growth of GDP last year. Spending on consumer durables rose by almost 11 per cent, a rate of expansion last seen in the late 1980s.
A.23 The major driving force was the strength of households' finances. Real personal disposable income grew by 4 1/4 per cent last year, driven by cyclically strong employment growth and an acceleration of average earnings. Meanwhile, a buoyant equity market led to an increase of £375 billion (25 per cent) in personal sector net financial wealth in the course of the year. The rapid growth in consumers' expenditure can therefore be readily explained by movements in income and wealth. These forces put into context the more modest contribution to spending resulting from the £35 billion of "windfall" payments received by households during 1997 from the flotation of building societies and insurance companies.
A.24 The profile of consumer demand last year now points to one-off windfall-related expenditure having turned out lower than envisaged at the time of the Pre-Budget Report. Based on the MORI survey conducted last August, a transitory boost to spending of some £3 1/2 billion in 1997 had been expected, adding around 3/4 percentage points to consumption growth for the year as a whole. In some areas, windfall effects have been obvious, for example the summer boost to sales of household goods. Elsewhere, they are more difficult to pinpoint, but the general run of indicators now suggests a boost to consumption of more like 1/2 percentage point last year, with the largest impact recorded during the second quarter.
A.25 Underlying growth in consumers' expenditure has clearly been running at an unsustainable rate, but it is expected to slow through this year, partly in response to the increases in interest rates since last May. Already the impact is evident in the housing market where, according to most measures, the recovery in prices has slowed. However, wider signs of a slowdown in consumer demand have yet to become so clear. Consumers' expenditure ended 1997 strongly, up 5 per cent on a year earlier, and the latest indications are that it has begun 1998 at a similar pace.
A.26 But such momentum seems unlikely to be maintained in the face of the contractionary forces expected to be acting this year. The "windfall" effect has probably already died away. Higher interest rates meanwhile take time to bite on spending, partly as consumers assess the permanence of policy tightening, and as Annual Review Schemes trigger increases in mortgage payments. As the economy slows in response to the tighter policy stance, a downturn in the growth of real incomes is also expected. In particular, employment growth is likely to abate and the exceptional growth in financial income seen in recent years (reflecting strong growth of dividend income) is expected to weaken. On the other hand, asset prices have continued to be firm.
A.27 Perhaps the major uncertainty is the degree to which consumers will cushion spending through lower saving as income growth slows. As noted in previous reports, the persistence of high personal sector saving has been one of the major features of the current upswing.
A.28 This contrasts markedly with the 1980s, when the saving ratio (saving as a percentage of disposable income) fell sharply, associated with a one-off stock adjustment to financial liberalisation and rising expectations of future income growth as the economy boomed. The housing market appeared to play a key transmission role at that time, with rapidly rising prices encouraging individuals to spend more on the back of rising wealth, partly through a surge in secured borrowing to finance everyday spending.
A.29 The current upswing has not been associated with systemic changes in the financial system, and has also been rather different in at least two other ways. First, the house price to income ratio has been more stable relative to previous cycles, and the housing wealth to income ratio has yet to recoup the losses of the early 1990s, dampening the willingness of individuals to borrow to finance consumption. Second, growth in real disposable income has been heavily buoyed by rapid growth in financial income over the past three years, particularly dividend receipts. Analysis suggests that such income exerts only a modest influence on consumer spending, which is not surprising as the bulk of it flows to pension funds rather than directly to households. This has helped to hold the measured saving ratio high.
A.30 Nevertheless, the saving ratio is expected to decline over the next three years. In part, this will reflect the relatively muted impact on spending of weaker financial income growth. But, in addition, high levels of confidence and record levels of financial wealth may encourage somewhat lower saving as real growth in wages and salaries eases back for the first time during this recovery. Further gains in housing wealth may also underpin some downward movement in the saving ratio although, as noted above, any such movement is unlikely to be large.
| Percentage changes on a year earlier | ||||
| Forecast | ||||
| 1997 | 1998 | 1999 | 2000 | |
| Consumers' expenditure | 4 1/2 | 3 3/4 to 4 | 1 3/4 to 2 1/4 | 2 1/4 to 2 1/2 |
| Real personal disposable income | 4 1/4 | 2 to 2 1/2 | 1 1/4 to 1 3/4 | 2 to 2 1/4 |
| Saving ratio (level, per cent) | 11 | 9 1/2 | 9 1/4 |
9 |
A.31 Overall, consumer spending is forecast to grow by 3 3/4 to 4 per cent this year. While this would remain well above sustainable rates, it conceals a considerable slowdown through the year, and growth of 1 3/4 to 2 1/4 per cent is forecast for 1999. The saving ratio is assumed to decline to around 9 per cent by 2000, which is well above the levels recorded in the late 1980s, and more so in underlying (inflation adjusted) terms.
A.32 As discussed in Chapter 4, the UK's ratio of whole economy investment to GDP has been low by international standards and, although non-residential and business investment ratios have been more on a par with other major economies, the UK has invested out of a lower level of GDP per head. Consequently, UK investment per worker has been relatively low, leading to a deficient capital stock per worker. This is one key factor in explaining why the UK has a lower level of labour productivity than other major economies.
A.33 In order to catch up with major competitors in terms of GDP per head, it will be necessary to create the conditions for applying capital and labour more efficiently, so as to encourage higher investment and realise higher productivity. Reversing the UK's relatively poor investment performance is therefore a key element in the Government's strategy for raising the trend rate of GDP growth. The relationship between investment and growth is discussed in the box on page 93.
A.34 In the present upswing, investment has been relatively subdued. Whole economy investment fell as a share of GDP until last year, primarily reflecting falling general government investment, and relatively subdued residential investment. Business investment has been rising as a share of GDP since 1994.
A.35 However, whole economy investment grew more strongly in 1997, rising by 4 3/4 per cent, its fastest growth rate since 1989. A further fall in general government investment was more than offset by a 7 3/4 per cent rise in business investment, led by the manufacturing sector.
A.36 Looking ahead, it seems likely that investment will retain some momentum. There is widespread evidence of capacity constraints - both the CBI and BCC surveys report capacity utilisation in the manufacturing and service sectors at similar levels to those seen in the late 1980s and early 1990. The cost and supply of finance is also favourable for investment growth. The equity market is buoyant and the CBI survey reports that the cost of finance is far less of a constraint on manufacturing investment than it was in the late 1980s.
A.37 But the anticipated slowdown of demand more generally will act as a restraining influence. In particular, manufacturing investment is expected to be broadly flat this year as output prospects are depressed by the high exchange rate.
Recent theories of growth have focused on explaining the pace of technical progress. For example, spillovers associated with investment in new technologies, knowledge-based industries and tertiary education, open up the possibility that investment in physical and human capital might permanently raise the growth rate. In any case, a rise in the investment-GDP ratio could significantly raise the growth rate of GDP for a protracted period, even if not permanently, as the economy goes through the transition to the higher GDP path.
Increases in capital productivity can compensate in part for low rates of investment, as appears to have been the case for the UK over the past two cycles. But this increase may partly have been attributable to opportunities to catch up with best practice. As such, it may have been a once and for all effect, which cannot be counted on to continue. For a given capital-output ratio, the investment ratio required to sustain steady output growth needs to be sufficient to expand the capital stock at the same rate as output after covering depreciation.
Currently, the ratio of investment to GDP stands around 12 per cent for business investment, or 14 per cent for non-residential investment, and the ratio of the business sector capital stock to GDP is of the order of 2 1/2 :1. Consequently it can be calculated that if capital productivity were unchanged (i.e. a constant capital-output ratio), then the current investment ratio would be sufficient to sustain trend GDP growth of 2 1/4 per cent a year only if the depreciation rate of the business sector capital stock were no more than around 2 1/2 per cent a year. It seems likely that the depreciation rate exceeds this (possibly to a substantial degree). In that case, some rise in the current investment-GDP ratio would be required even to support trend growth of 2 1/4 per cent a year, unless capital productivity were to improve. If the UK is to raise its trend growth rate and catch up with other major countries in terms of GDP per head, then it seems almost certain that some considerable increase in the investment-GDP ratio will be required.
However, a higher investment-GDP ratio will not come about of its own accord. There must be the incentive to invest more, and it will only be worthwhile if the future returns outweigh the cost of forgone current consumption. Faster total factor productivity growth or a lower cost of capital would encourage investment. Policy measures to create a stable macroeconomic environment, remove tax distortions (e.g. through reform of the corporate tax system), and otherwise promote enhanced efficiency, are designed to contribute to this end. Typically higher total factor productivity will go hand in hand with a higher capital-output ratio, and raising its growth rate is the key to sustained higher economic growth.
A.38 Overall, business investment is forecast to decelerate this year, although it is projected to continue to rise as a share of GDP. Whole economy investment is forecast to rise faster than business investment, as the large falls in general government investment of recent years come to an end. The sharp rebound in general government investment in 1998, following its sharp fall in 1997, partly reflects investment under the local authority Capital Receipts Initiative and the New Deal for schools, but also the profiling of expenditure: financial year figures show a much smoother path. The whole economy investment-GDP ratio is expected to rise to around 18 1/4 per cent by 2000, a little above its long-run average.
| Percentage changes on a year earlier | ||||
|
Forecast |
||||
| 1997 | 1998 | 1999 | 2000 | |
| Whole economy(1) | 4 3/4 | 4 3/4 to 5 1/4 | 2 3/4 to 3 1/4 | 2 1/2 to 2 3/4 |
| of which: | ||||
| Business(2),3 | 7 3/4 | 4 1/2 to 5 | 3 to 3 1/2 | 2 1/2 to 3 |
| Housing(2) | 7 1/2 | 4 1/4 to 4 1/2 | 1 3/4 to 2 1/4 | 1 3/4 to 2 |
| General government(2),4 | -15 3/4 | 14 | 4 1/4 | 1 1/2 |
1 Includes transfer costs of land and existing buildings.
2 Excludes net purchases of land and existing buildings.
3 Private sector and public corporations (except National Health Service Trusts) non-residential investment. Includes investment under the Private Finance Initiative.
4 Includes National Health Service Trusts.
(1) The forecast is based on the assumption that the exchange rate moves in line with an uncovered interest parity condition, consistent with the interest rates underlying the economic forecast. A full set of charts and tables relating to the economic forecast is available on the Treasury's internet site (http://www.hm-treasury.gov.uk), and copies can be obtained on request from the Treasury's Public Enquiry Unit (0171 270 4558).
(2) Full details of the forecast ranges and their interpretation are provided with the additional material referred to in the previous footnote.
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