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Budget
This chapter sets out how the Government is developing the macroeconomic policy framework to create economic stability, based on low inflation and sound public finances.
The key points are:
2.01 Economic stability is vital if the Government is to achieve its central objective of high and stable levels of growth and employment. Instability in the recent past has contributed to the UK's poor growth performance, not least by holding back the long-term investment that is the foundation for a successful economy.
2.02 Although it cannot insulate the UK from the effects of world events, such as the financial difficulties in Asia, the Government has a crucial role to play in creating a stable macroeconomic environment. High and volatile inflation, or unsustainable public finances, discourage investment directly by raising long-term interest rates, as well as indirectly by making it difficult to plan for the future.
2.03 Repeated cycles of boom and bust have been particularly damaging to the UK's long-term economic performance. Recessions lead to premature scrapping of productive capacity and increase both short-term and long-term unemployment. Reversing these effects can be a long and costly process: the economy is still suffering from the adverse effects of the deep recessions of the early 1980s and early 1990s.
2.04 Similarly, booms channel too many resources into speculative activities and not enough into others, hampering economic progress. The fleeting gains that such episodes bring are invariably far outweighed by the pain of the downturn that must follow. The box below explains how inflation damages economic growth. High inflation is also unfair, not least in the way that it arbitrarily redistributes income and wealth.
2.05 Low inflation and sound public finances are both essential building blocks for long-term growth. The new monetary policy arrangements, giving the Bank of England responsibility for setting interest rates to achieve the Government's inflation target, have put monetary policy on a credible long-term footing and have given greater assurance that low inflation will be sustained. The Government is also taking steps to strengthen the fiscal framework further, in particular by giving the Code for Fiscal Stability a statutory basis, to ensure that fiscal policy, too, fosters stability and is always set in the UK's long-term interests.
2.06 The Government has an essential part to play in promoting economic stability. However, it cannot do so on its own. Lasting results depend on government, business and individuals working together. For the immediate future, the outcome of wage bargaining will affect the extent to which growth will need to slow in order to meet the inflation target. If wage increases rise above sustainable levels, interest rates will need to be higher than they would otherwise have been, with an inevitable impact on growth and employment. In its latest Inflation Report, the Monetary Policy Committee (MPC) of the Bank of England noted that wage increases higher than 4 1/2 per cent a year could not be sustained in the long run without domestically-generated inflation rising above 2 1/2 per cent.
Inflation - whether or not it is anticipated - and uncertainty over inflation distort the allocation of resources, which is likely to reduce economic growth. Through its effects on technical change, including the role of investment and research and development, inflation has a significant impact on both the long-run sustainable rate of growth and the path along which an economy approaches it.
Two broad channels of influence can be identified:
In practice, high inflation also tends to be associated with volatile inflation, so it can be difficult to distinguish the precise influences of these two aspects.
2.07 The Government's inflation target, as defined by the 12-month increase in the Retail Prices Index excluding mortgage interest payments (RPI ex MIPs), is confirmed as 2 1/2 per cent. Last May, the Bank of England was given responsibility for setting interest rates to meet the inflation target. The monetary framework is currently being given a statutory basis under the Bank of England Bill, which is expected to receive Royal Assent later in the Spring. The Government will monitor the target and the measure of inflation in the light of the practices of the European Central Bank, and the ability of the British economy to sustain growth with low inflation.
2.08 The inflation target is 2 1/2 per cent at all times: that is the rate which the MPC is required to achieve and for which it is accountable. The effectiveness of the target will depend on the seriousness with which breaches of the target are treated. Temporary deviations from target may occur as a result of unforeseen developments which affect the price level. If such deviations do occur, the onus is on the MPC to justify its actions. In any case, if inflation is more than 1 percentage point higher or lower than the target, an open letter will be sent by the Governor to the Chancellor so that the public is fully informed as to:
2.09 RPI ex MIPs inflation since last May has ranged between 2.5 and 3 per cent, averaging 2.7 per cent. This compares with a post-war average inflation rate of around 6percent. While recent inflation has been low by the standards of the 1970s and 1980s, and has not diverged from target sufficiently to trigger an open letter, it has so far been above the target rate most months. The effort and vigilance required to maintain low inflation should not be underestimated.
2.10 Monetary policy affects inflation with a lag. The new monetary policy framework has been in place since only last May, so the actions taken by the MPC will not yet have had their full effect on inflation.
2.11 Inflation was higher than the target throughout most of 1997, despite downward pressure from the effects of exchange rate appreciation. The present Government came into office at a time of increasing inflationary pressure, which required higher interest rates to prevent a sharp rise in inflation over the next two years. Since May, official short-term interest rates have been raised by 1/4 point on five occasions, from 6 per cent to 7 1/4 per cent.
2.12 In January 1998, inflation fell back to the 2 1/2 per cent target rate, although it is expected to pick up a little over the next few months of the year. In its latest Inflation Report, the MPC said that "monetary policy is more finely balanced than at any point since the inflation target was introduced in 1992". Upside risks to inflation were noted from higher earnings growth and the tightening in the labour market, and downside risks from the expected slower growth in the economy, and in particular, developments in Asia.
The UK Harmonised Index of Consumer Prices (HICP) is a relatively new measure of inflation, prepared according to internationally agreed criteria in order to provide a more consistent way of comparing inflation across countries within the European Union. The HICP is designed specifically for cross-country comparisons and has narrower coverage than the RPI, which remains the best measure of UK inflation. HICP inflation in the UK was 1.5 per cent in January and has averaged 1.8 per cent since last May. This compares with the average of 1.6 per cent for the European Union as a whole since May.
2.13 Inflation expectations, measured on a variety of bases, have fallen since the new monetary framework was introduced. Chart 2.2 shows some measures of inflation expectations immediately before the announcement of the new monetary framework and now. This fall has contributed to lower long-term interest rates, as shown in Chart2.3, which are currently at their lowest level for over 30 years. It also supports the view that the new arrangements have enhanced the credibility of monetary policy.
2.14 It is natural that inflationary expectations should fall in this way, given the rigour and transparency of the new monetary arrangements. In time, the sure expectation that inflation will average 2 1/2 per cent over a long period will give a firm basis for far-sighted wage bargaining and price-setting decisions. Such a long-term anchor is a tangible example of the benefits that flow from, and arrangements that deliver, monetary stability.
2.15 Five important principles lie at the heart of the Government's fiscal policy framework:
2.16 These principles are fundamental to a commonsense approach to fiscal management. They are reaffirmed in the Code for Fiscal Stability, which the Government is now taking steps to give a statutory basis in the Finance Bill. The Code sets out the requirements for an open, transparent and accountable approach to managing the public finances, which will ensure that fiscal policy is set in the UK's long-term interests.
2.17 Fiscal policy is based on the two fiscal rules announced in the July 1997 Budget:
2.18 These rules mean that fiscal policy will operate in a way that is consistent with the principles of fiscal policy. The golden rule promotes stability and responsibility in current spending and taxation. It also promotes fairness between generations because it means that the cost of public investment is met by those who benefit from that investment. A stable and prudent debt ratio will ensure that fiscal policy is run in a responsible way and does not threaten the stability of the economy.
2.19 In the Pre-Budget Report, the Government proposed to implement a Code for Fiscal Stability to improve the conduct of fiscal policy and the management of the public finances. The Code would establish a framework for fiscal policy with the same emphasis on openness and credibility as the new monetary policy framework. In particular, the Code would require the Government to commit to:
2.20 The Government has decided to proceed as planned and will give the Code a statutory basis in the forthcoming Finance Bill. Legislation demonstrates the strength of the Government's commitment to maintaining and strengthening the credibility of its economic policies. It will make policy more transparent and governments readily answerable for any departure from the Code.
2.21 In addition to the broad proposals discussed in the Pre-Budget Report, it is now intended to cover aspects of debt management policy in the Code. The key elements of the Code are outlined in the box below. Separately, the International Monetary Fund is preparing, at the suggestion of the UK Government, a Code of Good Fiscal Practice which is likely to cover similar ground as the UK Code for Fiscal Stability.
Under the Code, the Government will undertake the following commitments. It will:
2.22 Progress towards reducing the public sector deficit and meeting the Government's fiscal rules has been more rapid than expected at the time of the July Budget. The current balance is estimated to have been close to balance in 1997-98, following many years of deficit. The debt burden is now falling, as it should at this stage of the economic cycle, after rising very sharply over the first half of the 1990s. Table 2.1 summarises the new public finances forecast, which is described in detail in Annex B.
| per cent of GDP | |||||||
| Outturn | Forecast | Projections(1) | |||||
| 1996-97 | 1997-98 | 1998-99 | 1999-00 | 2000-01 | 2001-02 | 2002-03 | |
| Current balance(2) | -2 3/4 | - 1/4 | 1/2 | 1 to 1 1/2 | 1 1/2 to 2 1/4 | 2 to 3 1/4 | 2 to 4 1/4 |
| GGFD(2),(3) | 3 3/4 | 1 | 1/4 | - 1/2 to 0 | -1 1/2 to - 1/2 | -2 1/2 to -1 | -3 1/4 to -1 1/4 |
| PSBR(2) | 3 | 3/4 | 1/2 | - 1/4 to 1/4 | -1 1/4 to - 1/4 | -2 1/4 to - 3/4 | -3 1/4 to -1 |
| Net public sector debt(4) | 45 | 43 1/2 | 42 | 40 to 41 | 37 to 39 | 34 to 37 | 29 to 34 |
| General government gross debt(4),(5) | 54 1/4 | 52 | 50 1/2 | 49 | 46 to 47 | 42 to 44 | 37 to 42 |
1 Based on three illustrative assumptions for spending growth (see Annex B).
2 Excluding windfall tax receipts and associated spending.
3 UK National Accounts definition.
4 Figures from 1999-2000 rounded to nearest per cent.
5 Defined on a Maastricht basis.
2.23 The PSBR in 1997-98 is expected to be about £8 1/4 billion lower than forecast in the July 1997 Budget. However, downward revisions to the PSBR forecast in subsequent years are much less. While some factors, such as higher than expected tax receipts, are expected to reduce borrowing in future years, several of the factors reducing the PSBR this year are expected to be temporary:
| £ billion | |||
| Outturn | Forecast | ||
| 1996-97 | 1997-98 | 1998-99 | |
| Current balance | -20.2 | -1.3 | 3.6 |
| GGFD(2) | 28.3 | 8.2 | 3.0 |
| PSBR | 22.7 | 5.0 | 3.9 |
1 Excluding windfall tax receipts and associated spending.
2 UK National Accounts definition.
2.24 The faster than expected fall in government borrowing has brought forward part of the ongoing tightening of fiscal policy that was implied by previous forecasts. The PSBR in 1997-98 is estimated to have fallen £17 3/4 billion from the previous year, excluding windfall tax receipts and associated spending, compared with the July 1997 forecast of a £9 1/2 billion fall. Notwithstanding the temporary nature of some of the factors that have reduced the PSBR this year, budget deficits are forecast to fall further in 1998-99, and to a lower level than was expected last July.
2.25 The deficit reduction plan set out in the July 1997 Budget showed how the Government has set policy to meet its two fiscal rules over the economic cycle. A key feature of the Government's responsible approach to fiscal policy is to make allowance for the extent of uncertainty over the medium-term outlook for the public finances. Even now, it would only take a relatively modest misreading of the cyclical position of the economy to make achievement of the fiscal rules considerably less certain. This was why the July Budget showed progress in meeting the fiscal rules against both a central and a cautious assessment of the output gap.
2.26 Experience has shown (1) how quickly an apparently sound position can deteriorate into an unsustainable one, unless caution is exercised in setting fiscal policy; and that the costs of reversing a deteriorating fiscal position can be large. Governments have found it much easier to reduce taxes or increase public spending than to do the reverse. Moreover, uncertainty about the underlying fiscal position means that it can take time to recognise fully the extent of any deterioration.
2.27 The Pre-Budget Report set out how the Government intends to assess progress against its fiscal rules. Both rules are to be applied over the economic cycle, with 1997-98 representing the starting point of the cycle as the economy is thought to have been close to its sustainable level in that year. Taking the two rules in turn:
2.28 In the Pre-Budget Report, the Government also signalled its interest in public sector balance sheet data and public sector net wealth. Although net wealth is not at this stage being given a formal role in the fiscal framework, meeting the golden rule over the economic cycle should halt the sharp decline in the ratio of public sector net wealth to GDP that has occurred since 1988. The projections shown in Chart 2.5 show some modest recovery in the net wealth ratio, albeit from low levels in comparison with the 1970s and most of the 1980s.
The economic cycle is one of the most important short-term influences on the UK public finances. The high growth phase of the cycle is usually characterised by higher tax receipts and falls in spending on social security, principally through unemployment-related benefits. Conversely, the low part of the cycle is marked by lower tax receipts and higher social security spending. These effects help to stabilise the economy, for instance by putting more money into the economy when demand is weak, although their overall effect may not be particularly powerful. The benefits from these "automatic stabilisers" are one of the reasons why the Government has set its fiscal rules over the economic cycle.
Cyclical fluctuations in the public finances, however, can make it more difficult to distinguish underlying trends. Looking only at the headline measures of the public finances can give a seriously misleading picture: for instance, present estimates suggest that virtually all of the PSBR surplus in the late 1980s was due to the effects of the cycle. Since July, the Government has published its key measures of government borrowing adjusted for the effects of the cycle. These are based on Treasury work, published in September 1995, that suggested that a one per cent increase in output relative to trend would reduce the PSBR by around 1/4 per cent of GDP in the first year, and around 3/4 per cent of GDP in the second and subsequent years.
Both these estimates and the assessment of the cyclical position of the economy are, of course, subject to a margin of error. Nevertheless, work by the OECD and other independent commentators has produced similar estimates. Moreover, it is much better to make an assessment of the contribution of the cycle to the fiscal position, and to publish that assessment for others to see and to comment on, than to base policy on unadjusted and potentially misleading figures.
2.29 In assessing progress against the fiscal rules, it is essential to take into account both the effect of the economic cycle and the extent of uncertainty surrounding the medium-term economic and fiscal outlook. Measures of the current balance and the PSBR adjusted for the effect of the economic cycle are shown in Charts 2.4 and 2.6. These provide a useful way of illustrating the effect of uncertainty over the cyclical position of the economy, but they do not take account of other potential forecast errors, such as errors in revenue projections for given levels of GDP.
2.30 Cyclically-adjusted measures have been calculated on two bases. The first is based on the assessment that output was approximately on trend in the first half of 1997. Chart 2.6 shows that the Government inherited a structural deficit, that had been 2 1/4 per cent of GDP in 1996-97. This case is consistent with a reasonable assessment of the evidence, but one that is far from certain. The second case assumes that output is 1 1/2 per cent further above trend, which would be pessimistic but well within the possible range. On this cautious case, the margin of error in meeting the golden rule would be small. Moreover, achievement of the fiscal rules is dependent on the rising tax burden over the medium term that would result from the effects of real fiscal drag and overindexation of fuel and tobacco duties.
2.31 The projections in Charts 2.4 and 2.6 show that, on both the central and the cautious assessment of the cyclical position, the Government is on track to meet its fiscal rules over the forecast period. However, experience of the late 1980s and early 1990s shows how quickly the fiscal position can deteriorate and underlines the need for continued caution in setting fiscal policy.
2.32 A key aspect of the Government's approach to economic stability is maintaining firm control of public expenditure. This involves both planning spending for the medium-term, which is the purpose of the Comprehensive Spending Review (CSR), and continuing discipline in the short term, which is provided by the commitment to work within existing spending ceilings for the first two years of the Parliament.
2.33 This summer, the CSR will produce spending plans for the years beyond 1998-99, following a rigorous scrutiny of all spending programmes. These plans will channel expenditure to the Government's priorities, while abiding by the two fiscal rules and the principles set out in the Code for Fiscal Stability. In this Budget, as in July 1997, projections of spending for 1999-2000 and beyond are based on three illustrative paths for spending, pending the conclusion of the CSR.
2.34 Some of the emerging conclusions from the CSR are reflected in those Budget measures that reallocate money to particular priorities for 1998-99. The main measures include:
2.35 These reallocations for 1998-99 are made possible by the prudent financial discipline exerted in 1997-98, which has released resources for the Government's priorities within the overall ceilings for the two years. The £1 1/2 billion estimated underspend for 1997-98 is being carried forward into 1998-99. Of this, £500 million has been allocated to the Reserve and the remainder used to fund spending on the key priorities outlined above.
2.36 The estimated outturn for the general government financial deficit - the deficit measure used in assessing the Maastricht criteria - was 1 3/4 per cent of GDP for 1997, well below the 3 per cent reference value and lower than the other major European countries. The Maastricht debt measure - general government gross debt - is estimated to have been 53 1/2 per cent of GDP at the end of 1997. This is, again, well below the reference value of 60 per cent and is the second lowest debt ratio in the European Union.
2.37 As well as meeting the Maastricht convergence criteria, the fiscal prospect continues to be consistent with the terms of the European Union Stability and Growth Pact.
The single currency - the euro - will be launched on 1 January 1999. The UK Presidency of the European Union in the first half of 1998 will see the key decisions taken on which countries will join.
A successful single currency will bring benefits to the UK and other countries. It will build on existing achievements by helping to deliver macroeconomic stability through an entrenched commitment to low inflation and sound public finances. At the microeconomic level, Economic and Monetary Union (EMU) will reduce transactions costs and remove exchange rate uncertainty. Price transparency will benefit consumers and firms, increase competitiveness and open up new opportunities for trade and investment.
The Government believes that British membership of a successful single currency would benefit Britain. Provided the economic benefits are clear and unambiguous, Britain should join. At present, there is not sufficient convergence to be sure that the British economy can have stability and prosperity in EMU. The Government has therefore notified our European partners that Britain will not be joining in 1999.
In order to have a genuine choice in the future, Britain needs to prepare now, so that there is a real option of making a decision early in the next Parliament to join, should the Government, Parliament and people decide to do so. The macroeconomic framework will play a critical role in delivering the period of stability and convergence that is necessary before we are ready to join. In addition, the Government is informing business of the preparations it needs to make for the launch of the euro in 1999, and has established a Standing Committee on preparations for EMU to advise on the strategic and practical implications.
The introduction of the single currency in 1999 will affect Britain, whether we are in or out. It is in Britain's economic interest to ensure that the single currency is successful. We are therefore working with other Member States during our Presidency to ensure that EMU goes ahead on a sustainable basis. In particular, the Government is promoting a deeper discussion of economic reform ideas, backed by properly thought out action plans for Member States to deliver.
Economic reform is essential if Europe is to realise the full potential of EMU. To deliver higher levels of job creation and investment, sustainable convergence between economies must be coupled with the ability to respond more flexibly to changes in economic circumstances.
The Government is committed to such reform, which will assist in delivering the stability needed to prepare the British economy for EMU membership and help to ensure that its citizens receive the fruits of open and competitive markets. The Government is promoting greater flexibility in the British economy to contribute towards its objective of high and stable levels of employment and to ensure that we could live comfortably in EMU.
The UK is already doing much to make its markets more flexible. The Government is offering new opportunities for education, work and training for the unemployed and a new approach to tax and welfare to make work pay; promoting decent minimum standards without imposing unnecessary rules on business; and working to ensure fair and open competition in goods and services markets. To boost entrepreneurship, the Government will be working to improve access to finance and reduce barriers to the movement of capital in Europe.
2.38 Resource Accounting and Budgeting (RAB) will bring the financial reporting of central government closer to the practices of both the private sector and much of the rest of the public sector. RAB will underpin the golden rule by making a clear structural distinction between current and capital spending, and by capturing the full costs of resources consumed during the reporting period.
2.39 Government departments are on course to produce the first full set of published resource accounts for the financial year 1999-2000. Making use of that information, resource budgeting - planning and controlling public expenditure on a resource accounting basis - will be fully implemented for the financial year 2001-02.
2.40 Following the publication of the National Asset Register in November 1997, the Government is encouraging departments and other bodies to review their asset holdings and make better use of the assets that they retain. From April 1998 until the new resource budgeting arrangements are in place, the Treasury will allow government departments to reinvest all receipts from the disposal of assets in new capital spending, subject only to certain limits necessary to ensure that these sales do not distort the Government's overall spending allocation.
2.41 Separately, the Treasury is carrying out a scoping study, jointly with the National Audit Office and other relevant bodies, into the merits and feasibility of producing whole of government accounts. The study, which should report preliminary conclusions in the summer, will consider the possible benefits of whole of government accounts and set out what further action would be required for their production.
2.42 The Government is looking at ways of developing the usefulness of the public sector balance sheet, which it believes contains valuable information for fiscal policymaking. The advent of Resource Accounting and Budgeting presents a major opportunity in this respect. The Treasury is working, with the Office for National Statistics, on how best to use the information from RAB and whole of government accounts to improve the quality of data for public sector balance sheets.
2.43 The Treasury is also working with the National Institute for Economic and Social Research and the Bank of England on a project to construct generational accounts for the UK. Generational accounting provides a framework for comparing the net burden of tax and transfer payments faced by current and future generations. Similar work in other countries has highlighted the extent to which future trends in the public finances, for instance the effect of ageing populations on pensions, might impact on future generations.
2.44 These developments will take time to implement and to have their full effect. Nevertheless, they offer the prospect of further strengthening the basis for making fiscal policy decisions. Moreover, the Government's reforms to the macroeconomic policy framework need to be complemented by reforms elsewhere, to encourage work and enterprise and to lay the foundations for a dynamic and flexible economy.
(1) See the discussion paper, "Fiscal policy: lessons from the last economic cycle", published in November 1997 and available from the Treasury's Public Enquiry Unit.
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