Chapter 4

Fiscal Strategy: The Next Three Years

This Chapter explains the Government's fiscal strategy and sets the framework for the conclusions of the Comprehensive Spending Review (CSR).

The key points made in this Chapter are that:

the fiscal stance was tightened very considerably in 1997-98. The new projections in this Report lock in the fiscal tightening projected in the March 1998 Budget;
over the three years 1996-97 to 1999-2000, public sector net borrowing will have fallen by 3½ per cent of GDP-the same fall as in the March Budget; the public sector net cash requirement will have fallen by 2¾ per cent of GDP, again the same as set out in the March Budget;
the Government has set firm plans for overall spending over the remainder of this Parliament based on a careful assessment of: what can be afforded whilst meeting the fiscal rules and the Government's key spending priorities. As such it sets the framework for the conclusions of the CSR. To ensure that the golden rule is met, the CSR will be based on an average real growth of current spending of 2¼ per cent per annum;
an Investing in Britain Fund will be established. Public sector net investment will increase and stabilise at just under 11/2 per cent of GDP by the end of this Parliament, but remain within prudent bounds; and the ratio of net public debt to GDP is projected to decline below 40 per cent of GDP, which is prudent over this economic cycle;
as part of an improvement in managing public sector assets, and as a precursor to Resource Accounting and Budgeting, new Departmental Investment Strategies will be agreed by the Treasury and published, and a programme of disposals will occur; and
the Government's approach to fiscal policy is consistent with the UK's European commitments, in particular the Stability and Growth Pact.

This Chapter explains the broad fiscal parameters that underpin the decisions that will be announced in the Comprehensive Spending Review in July. The importance of maintaining fiscal prudence and economic stability has meant that the bottom-up review of spending priorities will be finalised within the context of a disciplined top-down assessment of what the Government can afford to spend, while still ensuring that the strict fiscal rules and the Government's key spending priorities are met. The Government has concluded that, given the path of receipts set in the Budget, the fiscal rules imply that:

public spending on current goods and services can grow by 2¼ per cent a year in real terms, on average over the next three years, broadly in line with the economy's underlying growth rate;
because investment is lower than required by the national economic interest there should be an Investing in Britain Fund, allowing net public sector investment to increase towards 1½ per cent of GDP by 2001-02, some £13 billion a year. Departments will be required to produce Investment Strategies to make sure that the best possible value for money is delivered from this boost to capital spending;
within these net totals, new (gross) public sector investment will be expanded further as departments sell off idle or unnecessary assets to make room for higher priority investment needs; and
at the same time, the ratio of net public debt to GDP will decline below 40 per cent over this economic cycle, as is prudent and sensible.

This Chapter explains these decisions and shows how they fit into the Government's overall fiscal strategy.

4.1 THE COMPREHENSIVE SPENDING REVIEW

All the Government's spending programmes-current and capital-are being reviewed in the Comprehensive Spending Review (CSR), which was launched in June 1997, and will be completed in July 1998. Government departments are scrutinising their programmes and producing recommendations for change, to refocus their policies and spending on the Government's key priorities, as set out in its Manifesto.

The CSR will produce a new set of detailed departmental spending plans for the medium term, initially to cover the remaining three years of this Parliament. In line with the requirements of the fiscal framework, the plans will distinguish clearly between current spending, to be paid for by current receipts, and capital spending, which can be paid for by taxation or borrowing.

The new plans will reflect a cross-departmental and thematic approach, as well as a programme-by-programme scrutiny. They will contribute, in particular, to advancing the key objectives of the Government as a whole:

growth and investment;
opportunity and fairness; and
efficiency and modernisation.

Departments will continue to be clearly accountable for their spending. Individual departments will be required to use their spending resources to deliver specific outputs and targets on which they will be judged at the end of this Parliament.

The approach to planning and controlling expenditure set out in this document, and in the CSR, is a logical preparation for the next stage of fiscal reform, the move to Resource Accounting and Budgeting (RAB). RAB will build on the clear distinctions made in the Government's fiscal strategy between current and capital expenditure, and will plan and control expenditure on the basis of both resource consumption and capital, rather than on a cash measure alone.

The CSR has looked closely at the scope for greater efficiency in government. Modern and effective service delivery is essential if the public are to enjoy high quality services. Three principles have guided this scrutiny:

tough and stretching objectives and targets;
robust arrangements for monitoring results; and
a pragmatic and innovative approach to service delivery.

Challenging efficiency targets will be put in place for key public services which will ensure that these are delivered in a way which maximises the benefits to the public and provides value for money.

Each department will have for the first time clear objectives and measurable targets under RAB, incorporating an aggregate measure of efficiency. These targets will put pressure on departments to improve the efficiency of their operations over time.

4.2 PUBLIC SPENDING OVER THIS PARLIAMENT

4.2.1 CURRENT SPENDING AND THE GOLDEN RULE

The Government has set firm guidelines for overall spending over the remainder of this Parliament based on a careful assessment of:

what can be afforded while still meeting the fiscal rules; and
the Government's key spending priorities.

By combining both a top-down and bottom-up approach, the Comprehensive Spending Review will thus be grounded firmly on a platform of macroeconomic stability. The important distinction between current and capital spending, which forms the basis of the fiscal rules, is also reflected in a new format of the public finances, discussed further below.

Current spending has been set at prudent levels so that the Government can be confident of meeting the golden rule over the economic cycle. Current spending is planned to grow, in real terms, by 2¼ per cent per annum on average over the next three years. While the Government does not have a target for public spending as a share of national income, this implies that the growth of real current spending matches the trend growth rate of the economy (abstracting from year-to-year fluctuations in output).

This prudent and cautious approach leads to projections of surpluses on the current budget in each of the next three years -something not achieved in the last 25 years except during the unsustainable boom of the late 1980s. It makes allowance for uncertainties, to ensure that the Government will meet the golden rule over the economic cycle on both the Government's central and cautious estimates of the economy's position relative to trend. Nonetheless, additional funds have been allocated to capital spending while also ensuring that net public debt falls to below 40 per cent of GDP.

4.2.2 THE INVESTING IN BRITAIN FUND

Public investment has fallen to such low levels that significantly increased provision is necessary, if the nation's interests are to be served effectively. The Investing in Britain Fund will provide for the renewal, reform and modernisation of the UK's infrastructure by providing a catch-up increase in public investment over the next three years. At the same time, the fiscal position remains prudent and the recent improvement in the fiscal aggregates is locked in.

The Investing in Britain Fund will incorporate new measures to ensure that capital investment is targeted and managed in the best way:

the Treasury will publish by Spring 1999 a compilation of Departmental Investment Strategies. Departments will set out in detail how the resources allocated to finance capital projects in the CSR will be managed so as to deliver the Government's objectives, provide the best value for money and ensure positive social returns. These plans will be scrutinised closely. Departments and the Treasury will work together to examine departmental appraisal, management and evaluation systems to ensure these give sufficient assurance about the quality of investments being proposed. Where the Treasury has doubts about aspects of departmental systems and the quality of their Investment Strategies, it could, for example, tighten the existing thresholds for its approval of capital projects or even suspend firm multi-year plans; and
the Treasury will retain a Capital Modernisation Fund for additional, innovative, capital or PFI projects from 2000-01 which improve key services or public infrastructure and offer good value for money. Resources will be allocated competitively, ranked on merit and on the quality of the Departmental Investment Strategies.

This approach will pave the way for the introduction of capital plans under RAB, from 2000-01 onwards, and will enhance the incentives and systems in place for managing new and existing capital assets, through, for example, the introduction of capital charging and capital planning.

The Investing in Britain Fund will allow progress towards national renewal while ensuring that the fiscal rules are met. Net public investment is projected to increase from its current level of £7 billion (¾ per cent of GDP) to £13 billion (just under 1½ per cent of GDP) by 2001-02, and to continue at this share of GDP thereafter. As a result, Total Managed Expenditure (TME) grows faster than current spending-by 2¾ per cent on average in real terms over the next three years-reflecting the need to catch up on past under-investment. However, taken over the life of this Parliament, growth is a more modest 2 per cent. Moreover, net public debt is projected to fall from 43½ per cent of GDP in 1997-98 to below 40 per cent of GDP from 2000-01 onwards. The Comprehensive Spending Review will set out the implications of the Investing in Britain Fund for individual spending programmes and departments.

PUBLIC-PRIVATE PARTNERSHIPS

Public-private partnerships (PPPs), and more specifically the Private Finance Initiative (PFI), are now firmly established as means of providing value for money services. This approach promotes the efficient use of resources, encourages value for money in public investment and provides a new source of financing for important investment opportunities. PPPs operate through utilising the very best of what the public and private sectors have to offer. They reduce the costs to the public sector of delivering services and, in many cases, remove the need to make large up-front public sector capital payments. In this way, PPPs free up additional resources that can be focused on high priority areas.

Since May 1997, contracts with a combined capital value of just under £2 billion have been signed, in areas as diverse as health, education, environment, defence and information technology. This represents good new long-term business opportunities for the private sector, as well as good value for money for the taxpayer. A number of changes to the process (including focusing on a smaller number of priority projects) and legislative changes have also been implemented, to help smooth the procedure, and to facilitate a steadier flow of signed contracts across Government.

Consequently, PPPs are starting to play a central role in the development of policy in key areas. For example, in health, the Government has recently announced a second tranche of ten PFI hospital schemes, bringing to 28 the overall total of new hospitals now in the programme, altogether worth some £3 billion. And PFI potential has been identified in all areas of the education sector, one of the Government's main priorities. As a result, five pilot projects have been announced under the New Deal for Schools, involving around £200 million of investment, and addressing major infrastructure needs across a large group of schools in each case. In local government too, the Government has pledged support for 40 projects with more to come.

PFI is also becoming an agent for change at a smaller level across a range of other public services; it is being used in the Belfast Hospital Renal Unit; the Highlands and Islands Airports; for IT facilities in Dudley's schools and libraries in Kent; and there is even discussion about using PFI for the new British Embassy in Berlin. PFI is delivering a wide range of public services-large and small-right across the UK, in all areas of public service.

And the Government is looking to develop partnerships further. The Deputy Prime Minister has announced recently plans to bring the private sector in to develop £7 billion worth of infrastructure (as well as an additional £1 billion a year for the next two years) to tackle the investment backlog in London Underground.

An indication of progress made is the increasing number of enquiries and visitors from all over the world, eager to find out about the opportunities PFI has to offer. The Treasury has received delegations from areas as diverse as Australia, Brazil, China, Japan, South Africa, Eastern Europe and the Middle East, as well as our European neighbours such as France, Holland and Spain.

4.2.3 ASSET DISPOSALS

As an important part of its overall investment strategy, the Government will continue to look for the best ways of financing public sector capital projects. It recognises that public-private sector partnerships and privately financed projects can offer benefits for the taxpayer and provide the best use of public sector assets, applying the test of what is in the public's best interest.

Making the best use of public sector assets is a vital part of the Government's economic and fiscal strategy. To that end:

following the publication of the National Asset Register last November, and the introduction of new incentives which allow departments to recycle receipts from disposals into new assets, departments have been scrutinising their holdings. The Government is now projecting central government disposals of around £1 billion per year;
local authorities are projected to dispose of £2¾ billion per year of their existing assets;

the Government has assessed which assets are no longer needed to meet the Government's objectives and can be sold to finance investment in key public services, such as education; which can be exploited better (especially through public-private partnerships and the transfer of risk to the private sector); and which can be retained. In 1999-2000, the Government is planning other public-private partnerships and disposals:

National Air Traffic Services-legislation will be introduced to establish a public-private partnership based on a sale of a majority stake in NATS, to facilitate further investment and improve passenger safety;
Student loans-following the successful sale in March 1998, a further tranche of student loans will be sold in 1999-2000, thus transferring part of the default risk to the private sector and financing the Government's objectives. This will result in paying a subsidy to the purchaser of the debt. The purchaser will be selected through a competitive tender, the outcome of which will reflect the maturity of the debt and market conditions;
Residual debt-the Government will dispose of debt held in British Energy plc;
Radio Spectrum-the Government announced at the end of May that the auction for licences for the 3rd generation of mobile communications services will be held in summer 1999; and
Belfast Port-as part of the Northern Ireland economic strategy announced on 12 May 1998.

In addition:

legislation will be introduced to establish a public-private partnership, including sale of a majority stake in Commonwealth Development Corporation; and
the Royal Mint is to be examined to establish the scope for, and benefits of, greater private sector participation.

Further examinations will be conducted where appropriate.

4.3 MEETING THE FISCAL RULES

4.3.1 THE ECONOMIC OUTLOOK

Developments in the economy since the March Budget have been broadly in line with expectations. As a result, there is no change to the key economic assumptions underpinning the fiscal projections (see Table 4.1).

Table 4.1: Economic assumptions for public finance projections
Percentage change on previous year
	1997-98	1998-99	1999-00	2000-01	2001-02	2002-03	2003-04
Output (GDP)	3	1¾	2	2¼	2¼	2¼	2¼
Prices: RPI excluding MIPs	2¾	2¾	2½	2½	2½	2½	2½
GDP deflator	2¾	3	2½	2½	2½	2½	2½
Money GDP (£billion)	797	834	872	914	958	1004	1052

As in the Budget, the assumptions used represent the lower end of the range of GDP projections. The reasons for this cautious approach are discussed further below.

The main economic indicators released since completion of the March Budget forecast have turned out much as expected:

The latest estimate of GDP growth in the first quarter of 1998, at 0.5 per cent, was exactly in line with the Budget forecast. Within that, the main expenditure components, in particular consumer spending, fixed investment and net trade, were also close to forecast, as was manufacturing production on the output side.
Underlying inflation, as measured by the Retail Prices Index excluding mortgage interest payments, averaged 2.6 per cent in the first quarter, as projected at Budget time; and the rise to 3.0 per cent in April is consistent with the Budget forecast of 3.0 per cent for the second quarter.

Domestic demand growth still looks set to fall back in the second quarter, with latest monthly indicators pointing to a slowdown in consumer spending, and the boost from stock building in the first quarter likely to be temporary.

Moreover, exchange rate and world developments give no clear grounds for revising the forecast for net trade. In the first quarter, sterling was on average a little stronger than projected, reflecting appreciation through March. But its subsequent depreciation has brought it back close to the path assumed for the Budget forecast. The world outlook on balance remains broadly unchanged, underpinned by robust growth in the US and Europe. The central estimate for the impact on the UK economy of financial turbulence in Asia is unchanged. However, recent financial market volatility in Asia and Russia has again highlighted the risks surrounding the world outlook.

Thus, overall, the economic forecast made at Budget time has kept on track and the short-term outlook remains intact. This is consistent with the view of independent forecasters, who have not on average materially revised their short-term forecasts for GDP growth and inflation in recent months. In particular, after a period of above trend growth last year, most forecasters currently predict a period of below trend growth for a while.

There is, of course, always the risk that the current cyclical position of the economy has been assessed incorrectly because of problems either with measuring key economic indicators, or with estimating underlying trends. The main risk is that output is now further above trend than estimated, implying a less healthy underlying fiscal position (ie a larger cyclically-adjusted deficit) and greater than expected inflationary pressure in the pipeline. This explains, at least partly, what went wrong in the late 1980s: initial underestimation of actual GDP growth and over-optimism about the trend level (and growth rate) of GDP meant that output was much further above trend than assumed at the time. These were critical factors for the subsequent deterioration in the public finances.

Early estimates of GDP growth should now be less prone to revision than in the late 1980s. Wide ranging improvements to statistical surveys and better national accounting methods have been progressively introduced since the early 1990s. This appears to have reduced, though possibly has not eliminated, the problem of downward bias in initial estimates of GDP growth during upswings. In the past such bias has tended to be positively associated with the strength of GDP growth.

But, over the recent past, there is little evidence from other economic indicators to suggest that growth has been nearly as strong as in the boom of the late 1980s. At that time, the economy was adjusting to systemic changes in the financial system and, for example, house prices, private sector business surveys, and balance of payments statistics were all indicative of overheating. Recently there have been few similar parallels, with most indicators and anecdotal evidence signalling relatively benign economic conditions. In these circumstances, reasons for expecting upward revisions to initial estimates of GDP growth are further reduced. Nevertheless, it would not be prudent to rule out such

It is vital not to repeat the mistakes of the last economic cycle. For this reason the lessons have been fully reflected in the design of the new fiscal framework. In particular, a cautious assumption for trend growth has been used in projecting the public finances; and alternative fiscal projections are presented based on an assumption that output is 1½ per cent further above trend than assumed for the central projection. This would be pessimistic but within the range of possibilities. Even on this basis, the Government is on track to meet its fiscal rules, though the margin would then be limited (see section 4.3.5 for further discussion).

4.3.2 A BETTER FORMAT FOR THE PUBLIC FINANCES

This Report implements a better format for the public accounts that corresponds more closely to the two fiscal rules and the national accounts and is in line with international practice. The main changes are to separate the current and capital accounts, and to focus on a measure of budget balance that excludes financial transactions. The three principal measures are:

surplus on current budget which shows whether all current spending is being financed by current receipts, and is used to judge whether the golden rule will be met over the economic cycle. It also relates closely to the balance sheet measure of public sector net wealth;
public sector net borrowing which excludes privatisations and other financial transactions. This is a sensible definition for assessing the fiscal stance. It is consistent with the national accounts, and is the concept used for international comparisons of budget deficits. It is equivalent to what has been called the financial surplus or deficit. Unless otherwise stated, the figures for net borrowing used here cover the whole public sector, whereas the Maastricht deficit criterion relates only to general government and excludes net borrowing by public corporations; and
public sector net debt ratio which shows the total debt of the public sector (net of certain liquid assets) as a proportion of GDP. This measure is used to judge whether the Government is meeting its sustainable investment rule.

Financial transactions are shown, along with the public sector net cash requirement (known formerly as the PSBR). However, these are accorded less prominence because they have less effect on the underlying budgetary position than the items which make up public sector net borrowing. Financial transactions (such as privatisations) entail offsetting changes in both the government's assets and liabilities, with no effect on public sector net financial wealth, although they reduce the public sector net cash requirement and public debt.

4.3.3 RECENT FISCAL TRENDS AND SHORT-TERM OUTLOOK

The fiscal stance tightened very considerably in 1997-98 (see Table 4.2). The new projections in this Report lock in the fiscal tightening projected in the March Budget. Over the three years 1996-97 to 1999-2000, public sector net borrowing will have fallen by 3½ per cent of GDP-the same fall as in the March Budget; the net cash requirement will have fallen by 2¾ per cent of GDP, again the same as set out in the March Budget.

Table 4.2: The fiscal tightening¹: cumulative change per cent of GDP
	1997-98	1998-99	1999-00
Public sector net borrowing	-2½	-2¼	-3½
March Budget EFSR 98 update	-2¾	-3½	-3½
Public sector net cash requirement	-2½	-2½	-2¾
March Budget
EFSR 98 update	-2½	-2½	-2¾

Table 4.3 compares the latest outturns and short-term forecasts with the March Budget figures.

Table 4.3: Comparison of updated forecasts of budget balances with March Budget forecasts
	£ billion
	1997-98	1998-99
Current budget surplus¹	-1.3	3.6
March Budget
EFSR 98 update	0	5
Public sector net borrowing¹
March Budget	7.5	3.1
EFSR 98 update	5.9	1.3
Memos:
Public sector net cash requirement¹
March Budget	5	3.9
EFSR 98 update	3.5	3.7
Maastricht deficit²
March Budget	5.7	1.3
EFSR 98 update	3.5	-0.4

1 Excluding windfall tax receipts and associated spending.

2 General government net borrowing. The Maastricht definition does not exclude the windfall tax and associated spending.
The estimate for public sector net borrowing in 1997-98 is £6 billion, £1½ billion lower than forecast in the March Budget. The estimated current budget in 1997-98 is about £11/4 billion better than forecast in March, and is close to balance.

These differences reflect the lower than expected outturn for cash borrowing in 1997-98. The public sector net cash requirement of £3.5 billion was £1.5 billion lower than forecast in March. General government cash receipts in 1997-98 were over £1 billion higher than the Budget forecast. This in part reflected higher than expected income tax receipts and social security contributions (£¾ billion). A further £½ billion may have reflected timing factors, such as early payments of corporation tax and oil duties, which have no effect on the forecasts for future years. VAT was nearly £½ billion lower than expected.

Changes to the forecasts of receipts and spending for 1998-99 are almost offsetting. Forecast receipts (particularly of social security contributions and income tax) have been increased slightly in the light of improved outturns in recent months. However, in view of the timing factors that seem to have affected corporation tax and oil duties, it would be imprudent to assume that all of the higher than expected receipts in 1997-98 carried forward to later years. The projections of receipts have therefore been raised by about £½ billion in 1998-99 (and in each subsequent year) compared with the Budget figures.

As discussed in Chapter 3, the control regime is being reformed. However, there is still some uncertainty about the final 1997-98 outturn, especially as regards local authority spending, where full information will not be available until around the end of this year the existing regime will remain in operation for 1998-99. The Control Total outturn for 1997-98 is now put at around £1½ billion lower than estimated at the time of the last Budget.

In the last Budget, it was announced that the £1½ billion underspend then projected was being reallocated to 1998-99. In view of the larger underspend now estimated, it has been decided to reallocate to 1998-99 a further £¾ billion. This is consistent with the Government's commitment to work within the Control Totals it inherited for the first two years in office. In addition, the projections of spending on cyclical social security have been revised, reflecting an updated unemployment assumption (it is now assumed flat at its April rather than at its January level) and the lower than expected outturn for 1997-98.

These changes to revenue and expenditure result in a somewhat higher forecast of the surplus on current budget in 1998-99, compared with the March projections, and lower public sector net borrowing.

4.3.4 THE FISCAL OUTLOOK IN THE MEDIUM TERM

Tables 4.4 and 4.5 show the updated medium-term projections of the public finances. (Table 4.4 shows the projections in £ billion, Table 4.5 shows them as a per cent of GDP.) The path of public expenditure for the years 1999-00 to 2001-02 is set in terms of current spending growing at 2¼ per cent per year, and public sector net investment rising to just under 1½ per cent of GDP. These define the envelope within which spending will be allocated to programmes in the Comprehensive Spending Review. For later years, it is assumed that current spending continues to grow at 2¼ per cent per year and public investment levels off as a percentage of GDP. Therefore, Total Managed Expenditure grows at an annual rate of 2¼ per cent in line with growth in GDP. It is assumed that there are no tax changes beyond the annual real increases in fuel and tobacco duties and the indexation of rates and allowances.

The surplus on the current budget is projected to rise steadily, to about 1½ per cent of GDP in 2003-04. The golden rule is achieved comfortably. Public sector net borrowing remains low, and net public sector debt falls steadily as a per cent of GDP. However, the net wealth of the public sector recovers only slightly, after its sharp deterioration in the early 1990s.

Chapter 4

Fiscal Strategy: The Next Three Years

1 Excluding windfall tax receipts and associated spending.

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