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CHAPTER TWO: A FRAMEWORK FOR STABILITY

2.1 Economic stability is an essential precondition for achieving the Government's objective of high and stable levels of growth and employment. The macroeconomic policy framework which the Government has introduced is designed to deliver stability and avoid a return to the cycles of boom and bust that have characterised the British economy in the past.

2.2 Economic instability imposes significant costs on the economy and society:

• it makes it difficult for individuals and firms to plan ahead, especially over the longer time horizons which business investment needs. Low levels of investment reduce the potential for long-term growth;
• high volatility in output growth - the stop-go cycles which the UK economy has experienced - results in a deterioration in the skills of people made unemployed, often having the largest impact on those with the lowest incomes; and
• high and volatile inflation has significant costs. Prices are a signal for the efficient market allocation of resources. Volatile inflation makes it more difficult to distinguish price movements caused by changes in demand and supply for particular goods and services from general increases in the price level due to excessive demand. The consequence is inefficient allocation of resources.

2.3 The UK's economic record has made clear the importance the establishing a macroeconomic policy framework which promotes stability:

• between 1980 and 1997, among G7 countries the UK had the second highest average inflation (over 6 per cent) and greater inflation variability than all other G7 countries except France and Italy;
• over the same period, the UK suffered two of the deepest and longest recessions since the war, and had one of the worst records on growth instability of any of the G7 countries;
• interest rates have also been more volatile in the UK than in other G7 countries: for example, between January 1985 and April 1997, official interest rates in the UK were over twice as volatile as those in the US;
• and as a consequence of economic instability, as well as other factors, the UK's record on investment has been poor: before 1999, the UK invested less of its national income than the G7 average in every year since at least 1965.

2.4 The economic outlook when the Government took office meant that the task of tackling economic instability had to be addressed urgently. GDP was growing at an unsustainable rate, household consumption was increasing sharply and, with rising equity and house prices and windfall payments from building society demutualisations, this trend was set to continue. Inflationary pressures were building, requiring a rise in interest rates to prevent a sharp rise in inflation. In addition, the public finances had deteriorated rapidly in the early 1990s, and in 1996-97 public sector net borrowing stood at £28 billion.

2.5 The immediate task was to ensure domestic demand was restrained and to prevent inflation from accelerating, while at the same time bringing the public finances into line with what the economy could afford. The Government recognised the importance of tackling the problem within a well-defined and transparent framework for macroeconomic policy, which set clear rules and long-term objectives for policymaking.

The macroeconomic framework

2.6 The Government therefore put in place new frameworks for both monetary policy and fiscal policy to achieve economic stability for the long term. The monetary policy framework aims to deliver low and stable inflation, while the fiscal policy framework is designed to achieve sound public finances over the medium term, and to support monetary policy over the short term. Sound public finances are also a prerequisite of sustainable investment in public services.

2.7 The policy framework is underpinned by four key propositions:

• there is no long-run trade-off between inflation and unemployment;
• for an open economy in a world of liberalised capital markets, a monetary policy framework based on rules which rely on a stable relationship between money and prices does not provide a reliable anchor for policy;
• the discretion necessary for the effective conduct of economic policy can only be exercised within a framework that commands credibility in the markets and generates public trust; and
• the credibility of a policy framework depends on clearly defined long-term policy objectives, a high degree of openness and transparency and policymakers' accountability to Parliament and the public. Accountability, openness and transparency all work together in a mutually reinforcing way to enhance the credibility of the policy framework.

2.8 The importance of a credible framework to achieve stability is even greater now than in the past, as other economies have liberalised their capital account regime, floated their exchange rates and global capital flows have grown rapidly. The development of global markets emphasises the importance of global stability - as well as delivering economic stability at home, the Government is committed to promoting economic stability and growth and employment in the global economy (see Box 2.1).

The monetary policy framework

2.9 The UK's long-standing poor inflation record prior to the introduction of the current monetary policy framework reflected shortcomings in the previous design and conduct of monetary policy. Monetary policy in the UK did not have well-specified objectives, was not sufficiently forward-looking and lacked transparency and accountability. Decisions were too easily subject to the influence of short-term political considerations, harming credibility; and the roles and responsibilities of the Government and the Bank of England were not clear or consistent. The monetary framework implemented from 1997 onwards addressed these concerns and has helped to keep inflation close to the Government's target.

2.10 Under the framework introduced in May 1997, the objectives of monetary policy are clear and precise. The primary objective of monetary policy, set out in the Bank of England Act 1998, is price stability. The Monetary Policy Committee (MPC) is required to hit a specific inflation target - 21/2 per cent for the 12-month increase in the Retail Prices Index excluding mortgage interest payments (RPIX) - at all times. This provides an anchor for inflation expectations and allows the MPC's performance to be assessed objectively. The fact that the target is symmetric - deviations below target are treated as seriously as those above - means that there is no incentive for the MPC to drive inflation below target at the cost of lost output and employment.

2.11 Policy is implemented by an independent Monetary Policy Committee. Interest rate decisions are therefore removed from short-term political pressures and based solely on the long-term interests of the economy. While the main monetary policy instrument of the MPC is the two-week repo rate, and UK exchange rate policy is set by the Government, the MPC also has limited foreign exchange reserves available for intervening in the foreign exchange market to support its monetary policy objective (see Box 2.2).

2.12 Improving the transparency and accountability of monetary policy tends to increase its credibility. The MPC is accountable to Parliament through the appearances of its members before the Treasury Select Committee and the Lords Select Committee on the MPC. Transparency is achieved through various different channels: the MPC publishes the minutes of its meetings and the voting record of its members as well as a quarterly Inflation Report. 2.13 Monetary policy is able to respond sensibly to shocks. The monetary policy framework allows flexibility in the MPC's response to economic shocks (see Box 2.3). However, if inflation deviates from target by more than one percentage point, the Governor of the Bank must send an open letter to the Chancellor explaining why this has happened, the corrective policy action being taken by the MPC, the period within which inflation is expected to return to target and how the MPC's approach is consistent with the Government's objectives for growth and employment. The open letter system ensures that monetary policy is fully transparent and accountable during periods of possible stress and makes it possible to respond sensibly to shocks.

The fiscal policy framework

2.14 The public finances deteriorated rapidly in the early 1990s. By 1997, the ratio of net debt to GDP had risen to over 44 per cent and the current deficit exceeded £20 billion. This impacted on the quality of public services. Public investment as a share of GDP had fallen sharply and public sector net worth was falling. Fiscal policy failed to promote stability, with an insufficient focus on the long term. A lack of clear and transparent fiscal objectives and an inadequate basis for full and effective public and parliamentary scrutiny of fiscal policy contributed to the earlier deterioration in the public finances.

2.15 The Government therefore took significant steps to strengthen the framework for fiscal policy. It implemented a new framework based on a set of five principles - transparency, stability, responsibility, fairness (including between generations) and efficiency. These principles were enshrined in the Finance Act 1998 and the Code for Fiscal Stability, approved by the House of Commons in December 1998. The Code sets out how these principles relate to the formulation and implementation of fiscal policy in practice.

2.16 The Government's key objectives for fiscal policy are:

• over the medium term, to ensure sound public finances and that spending and taxation impact fairly both within and across generations; and
• over the short term, to support monetary policy; and, in particular, to allow the automatic stabilisers to play their role in smoothing the path of the economy.

2.17 These objectives are embodied in the Government's two fiscal rules, against which the performance of fiscal policy can be judged:

• the golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending. It is met when, over the economic cycle, the current budget is in balance or surplus; and
• the sustainable investment rule: public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level. Other things equal, a reduction in public sector net debt to below 40 per cent of GDP over the economic cycle is desirable.

2.18 The golden rule distinguishes between current spending, which benefits the current generation, and capital spending which benefits both current and future generations. By allowing the current generation to borrow only to fund capital spending, with current spending met by current receipts, the golden rule helps to match the cost and benefits of public spending over time. This is consistent with the Government's objective of generational equity. The golden rule also enhances the efficiency of government spending because it means that growth-enhancing public investment is not sacrificed for current spending. The sustainable investment rule complements the golden rule by ensuring that borrowing for public investment is conducted in a responsible way.

2.19 Consistent with these objectives and the strict fiscal rules, firm action has been taken to return the public finances to a sound footing. Difficult decisions were required. The Government worked within the spending plans it inherited from the previous Government for its first two years. The Government also made a number of tax decisions, for example, continuing until the Pre-Budget Report 1999 announcement to raise fuel duties by more than inflation in line with the escalator introduced by the previous Government. This fiscal prudence led to a cumulative structural fiscal improvement of about 41/2 per cent of GDP between 1996-97 and 1999-2000, returning the public finances to a sustainable position.

2.20 Sound public finances which are sustainable over the economic cycle are not only essential to ensure economic stability, they are also necessary for sustainable investment in public services1

The new public spending framework

2.21 In parallel with the strict control of public expenditure in the first two years of this Parliament, the Government undertook a root and branch assessment of spending needs. The Comprehensive Spending Review in 1998 addressed the issue of strategic reforms to planning and control of public spending, as well as setting new plans for the remaining three years of the Parliament. These plans were extended to 2003-04 in the 2000 Spending Review which reported in July. The Government's spending framework is based on:

Department Expenditure Limits (DEL) which have now been set for all government departments. The DELs provide departments with a solid basis for planning their own costs effectively; and

Annually Managed Expenditure (AME) which covers those elements of spending which cannot reasonably be subject to firm multi-year limits and are instead subject to tough annual scrutiny as part of the Budget process. This Pre-Budget Report provides revised projections of individual AME programmes.

2.22 Together DEL and AME sum to Total Managed Expenditure (TME). For each department, separate budgets are set for resource (current) and capital spending, consistent with the distinction in the fiscal rules. Departments are required to manage their resource and capital budgets separately. This removes the bias against investment that was present in the previous planning regime. The switch to resource accounting and budgeting in the 2000 Spending Review builds on the previous arrangements by requiring departments to plan, control and account for their spending on a full accruals basis.

2.23 Ensuring modernisation of public services and a focus on efficient and effective service delivery is also an important element of the new spending framework. Each department is committed, through Public Service Agreements (PSAs), to achieve specific performance targets. Departments have also drawn up Departmental Investment Strategies (DIS), first published in March 1999, to show how they will manage capital effectively and how investment decisions are taken on a robust basis so as to maximise the benefits of the extra investment.

2.24 PSAs were first published after the 1998 Comprehensive Spending Review and have since been developed further. Progress against targets is monitored quarterly, with performance considered by Cabinet level committee. New PSAs form an integral part of the 2000 Spending Review settlement, with fewer targets that are more focused on outcomes. Service Delivery Agreements (SDAs) have been devised to complement and underpin the PSAs, providing more operational detail on how priorities will be delivered efficiently and effectively. These were published on 3 November and revised Departmental Investment Strategies will be published shortly.

2.25 The envelope for current spending announced in the 1998 EFSR set real growth in current spending at 21/4 per cent a year over the three year period covered by the Review, in line with what could be afforded while ensuring the fiscal rules were satisfied. This allowed more efficient long-term management and planning of public spending, while ensuring that fiscal consolidation was successful in delivering savings in debt interest and social security expenditure as the fiscal position moved into surplus and unemployment continued to fall. These savings have helped make room for the additional investment announced in the 2000 Spending Review.

Performance of the frameworks

2.26 Collectively, these reforms to the monetary and fiscal frameworks and public spending regime have created a broad and coherent strategy to put the UK economy on a sustainable path to deliver high and stable levels of growth and employment.

2.27 The new macroeconomic framework has helped to deliver economic stability and avoid large and destabilising fluctuations in output. Despite a large external shock in 1998, output growth has remained stable and above 2 per cent in each of the last three years, with growth of 3 per cent expected this year. The latest economic forecast indicates that growth is expected to remain in the range of 21/4 to 23/4 per cent next year and thereafter.

2.28 Large swings in output have been avoided for a number of reasons:

• interest rate decisions have been made in a forward-looking manner, taking account of the fact that they impact on output and inflation with a lag. Interest rates have thus been set pre-emptively to counteract any large swings in output and inflation before they occur. Rates have peaked at a much lower level than in previous economic cycles when they often responded to economic shocks too late; and
• fiscal policy has supported monetary policy throughout the economic cycle. The substantial fiscal tightening in 1997-98 and 1998-99 supported monetary policy when output was above its trend level, while also eliminating the large structural deficit. The fiscal tightening continued in 1999-2000, at a time when inflationary pressures were mounting. The MPC raised the repo rate until February this year. Since then it has remained unchanged at 6 per cent, while market interest rate expectations have fallen by over 50 basis points.

2.29 Since May 1997, RPIX inflation has moved in a narrow band between a low of 1.9 per cent and a high of 3.2 per cent, averaging 2.5 per cent over this period, in line with the Government's target (see Chart 2.1).

Supporting Docs & Media

• Chart 2-1: Inflation performance against target

2.30 Inflation expectations, as measured by survey and financial markets data, show that inflation is expected to remain close to the Government's target, having fallen from over 4 per cent in 1997. This suggests that the MPC continues to command a high degree of credibility and that wage and price setters in the economy may be keeping increases in real wages and prices more in line with increases in productivity and profits.

2.31 The new fiscal framework has restored the public finances to a healthy and sustainable position, making possible the investment in public services awarded in Spending Review 2000, while allowing fiscal policy to support monetary policy through the economic cycle.

FISCAL STRATEGY

Budget 2000

2.32 The Government's fiscal strategy continues to be underpinned by the macroeconomic framework. Building on the achievement of sound public finances and the platform of stability which is now being delivered, Budget 2000 set a firm spending envelope for the three years covered by the 2000 Spending Review. The Budget locked in the fiscal tightening of Budget 99 and ensured that the Government remained on track to meet its fiscal rules, while also releasing resources for vital public services, allowing:

• an increase in real current spending of 21/2 per cent a year in line with the Government's neutral view of the economy's trend rate of growth; and
• a more than doubling of net investment by 2003-04.

2.33 These spending increases were also consistent with meeting the fiscal rules in a more cautious case where the level of trend output is assumed to be 1 percentage point lower than in the central case. Maintaining this cautious approach is essential, given the inherent uncertainties surrounding projections of the public finances.

2000 Spending Review

2.34 The 2000 Spending Review in July provided a detailed breakdown of spending plans for the next three years, consistent with the spending limits announced in Budget 2000. Revised economic and fiscal projections were not published as part of the Spending Review outcome, but estimates of AME were revised incorporating the effects of updated assumptions. Within the Budget envelope, the Government was able to allocate additional resources to key public services as a result of prudent management of the public finances. Among the areas in which the Government has made savings are:

• lower growth in spending on social security, through cutting the cost of worklessness; and
• reduced debt interest payments resulting from lower interest rate expectations and the debt repayment following the auction of mobile phone licences.

As a result, changes in social security benefits and debt interest payments are expected to account for 17 per cent of the change in TME in the period 2000-01 to 2003-04. This compares to 42 per cent in the period 1978-79 to 1996-97. Table 2.1 illustrates this and includes the impact of Pre-Budget Report measures. This means that a greater share of extra resources are available for priority public services.

Table 2.1: Changes in Total Managed Expenditure accounted for by social security benefits and debt interest payments

1 For the purpose of comparison, social security includes Working Families' Tax Credit and Disabled Persons Tax Credit.

2.35 The Government also decided in the 2000 Spending Review to manage prudently the DEL underspends. The actual outturn for the DEL underspend in 1999-2000 was £2 billion above the Budget 2000 estimate of £1 billion. Instead of carrying forward the full amount, the Government used £1/2 billion of the additional underspend to repay debt and carried forward only £11/2 billion. This £11/2 billion was spread equally between 2000-01 and 2001-02 to help smooth the path of public spending.

2.36 The additional resources provided for in the 2000 Spending Review settlement will have an important impact on the productivity and sustainable growth of the economy. They will improve economic infrastructure and the skills of the labour force enhancing capital accumulation. They will support research and development and improve the way technology brings together these resources. Important areas of investment include:

• increased capital investment in schools amounting to £7.8 billion over 2000-01 to 2003-04;
  
• the Ten Year Plan for Transport which set out a balanced package of investment in high quality public transport and targeted improvements to the road network; and
  
• a £1 billion Science Research Investment Fund, in partnership with the Wellcome Trust, to boost investment in buildings, laboratories and equipment over two years.

2.37 This investment programme demonstrates the Government's commitment to the renewal and modernisation of the capital stock, reversing years of under-investment by delivering rapid growth in public investment over the next three years. Chapter 5 provides more details.

2.38 At the same time, the Government has ensured that economic stability is not put at risk. The Government adhered to the fiscal rules in setting the firm spending envelope in Budget 2000, and in the Spending Review announcement in July.

2.39 The challenge for this Pre-Budget Report is to ensure that the Government not only remains on track to meet its strict fiscal rules over the economic cycle, but that it also underpins the 2000 Spending Review settlement by putting in place policies that will improve public services and create higher levels of productivity and employment. In doing so, it remains important that fiscal policy continues to support monetary policy over the cycle.

RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS

2.40 The Pre-Budget Report presents an update on the position and outlook for the economy and the public finances, taking into account economic and other developments since the Budget. The two are interdependent, and this section looks at the economy first before discussing the impact on public finances. This is the first full update covering the economy, receipts and spending to incorporate the outcome of the 2000 Spending Review.

Recent economic developments

2.41 The UK economy has witnessed continued strong growth combined with low inflation since Budget 2000. GDP grew by 0.7 per cent in the third quarter and 2.9 per cent on a year earlier, exceeding its estimated trend rate. The balance of growth has also improved, with stronger world demand boosting net exports and domestic demand growth moderating in 2000 - for example, in volume terms, total UK manufacturing exports grew by more than 12 per cent in the year to July 2000 despite the continued weakness of the euro against the pound. Domestic costs have decelerated significantly keeping RPIX inflation close to 2 per cent despite stronger external pressures, in particular due to the further sharp rise in oil prices. The combination of a pre-emptive monetary policy and supportive fiscal policy continues to ensure that there should be no repeat of the late 1980s. Then, an inappropriate macroeconomic policy stance failed to restrain aggregate demand in line with sustainable levels which resulted in a rapid rise in the output gap and inflation, precipitating a deep and long recession in the early 1990s when policy was forced to tighten.

2.42 Favourable economic developments in 2000 and recent years reflect a clear underlying improvement in labour market performance. The Labour Force Survey (LFS) measure of employment has risen by 330,000 over the past year, driving unemployment to its lowest rates since the 1970s. Underlying earnings growth has, nevertheless, fallen just below 41/2 per cent, with the headline measure falling further in 2000 as the impact of strong bonuses and millennium-related payments dissipated. With no upward trend in unit wage cost growth in recent years, it appears that the sustainable rate of unemployment (NAIRU) has fallen broadly in line with actual unemployment, to around 51/2 per cent on the ILO measure.

2.43 This has contained inflationary pressures and helped to keep interest rates historically low. Box A1 examines some possible explanations, in particular highlighting sharp falls in long-term unemployment related to a succession of labour market reforms including the New Deals. Nevertheless, the judgement on the NAIRU is subject to considerable uncertainties, with important implications for trend output and the public finances. This chapter later shows that the Government would remain on course to meet its fiscal rules even on much more cautious assumptions concerning the current cyclical position of the economy.

The economic cycle

2.44 Growth in domestic costs and measures of domestically-generated inflation have remained relatively subdued since the first half of 1997, when the economy is previously judged to have been on trend. The evidence suggests that output returned to potential around mid-1999, after moving above trend in 1997 and 1998, and was followed by a small deviation below trend in early 1999. Since then most survey measures of capacity and labour utilisation have begun to move above their long-run averages. Buoyant output growth - averaging just over 21/2 per cent between the first half of 1997 and mid-1999 - therefore appears to have been matched by a corresponding expansion in potential output over the same period.

2.45 This assessment of the probable shape of the UK economic cycle since 1997 is broadly unchanged from Budget 2000. But recent revisions to measured GDP have increased estimates of potential output and trend growth over recent years. The Treasury's revised assessment is set out in detail in Annex A. Although trend growth has been boosted by sustainable increases in employment, underlying productivity growth has yet to improve. This is surprising, especially given increased ICT usage in the UK economy. The contrast with developments in the US may partly reflect measurement issues, but this productivity gap also highlights both the necessity and opportunity for a stronger performance in the period ahead.

2.46 Given the closeness to trend throughout 1997 to 1999, possible measurement errors and the prospect of future data revisions, it is difficult to conclude for certain whether the economy has completed a full, albeit short and shallow, economic cycle between the first half of 1997 and mid-1999. For the purposes of this Pre-Budget Report and the assessment of the performance against the fiscal rules, the provisional judgement remains that a cycle may have been completed by mid-1999 when the current cycle is assumed to begin. On these bases, the fiscal rules were clearly met over this period.

Economic prospects

2.47 Buoyant output growth can be accommodated for a period, given the starting position of RPIX inflation below the Government's 21/2 per cent target. However, as argued in Budget 2000 and as noted by the Bank of England's MPC, it is important that domestic demand falls back to sustainable rates. Interest rates were raised pre-emptively in the six months up to the Budget, with the full impact on private spending likely to build further into 2001. Household consumption growth has already slowed markedly, reinforced by slower growth in wealth. As in Budget 2000, GDP growth is forecast to ease from 3 per cent in 2000 to its estimated sustainable rate of 21/4 to 23/4 per cent in 2001 and later years.

Table 2.2: Summary of forecast

2.48 RPIX inflation has remained subdued, despite the inflationary impulse of dearer oil. Firms have experienced difficulties passing on increases in costs, particularly in manufacturing. However, stronger import price inflation overall, and a less negative contribution from falling business margins, is expected to return RPIX to the Government's target rate by mid-2001. Further moderation in domestic demand should help keep earnings growth within sustainable limits, though there remain some clear upside risks. In particular, the recent fall in the net household saving ratio has been unexpectedly sharp, as a result of higher borrowing by households, notwithstanding lower precautionary saving due to low inflation and greater economic stability (see Box A4). Chapter 5 describes the steps the Government is taking to promote savings.

2.49 The inflation outlook, nevertheless, remains very finely balanced. In the short run, a stronger than forecast compression of retail margins is entirely plausible. The medium-term mix of growth and inflation might be more permanently improved through an underlying improvement in supply performance. Manufacturing firms will be looking to build on recent improvements in productivity growth to restore profitability. Moreover, the Pre-Budget Report forecast does not assume any underlying improvement in productivity growth associated with the rapid adoption of new economy technologies and associated diffusion of related know-how across the economy. Box A2 looks at these supply-side opportunities in more detail.

RECENT FISCAL TRENDS AND OUTLOOK

2.50 The public finance projections in the Pre-Budget Report have a different status to those included in the EFSR and FSBR at Budget time. They present an interim forecast update and do not necessarily represent the outcome the Government is seeking. The fiscal effect of firm decisions announced now have been incorporated into the fiscal projections in accordance with the requirements of the Code for Fiscal Stability. In addition, a number of possible transport measures, detailed in Chapter 6, are subject to consultation, costing in the order of £13/4 billion a year. Decisions on these and other issues will be taken in the Budget and, along with revised forecasts for the public finances and the economy, will impact on the final Budget forecast.

2.51 Nonetheless, the projections allow for an updated assessment of progress against the Government's two fiscal rules. They update the projections in Budget 2000 for the latest information and are presented in line with the November 1999 Treasury paper Analysing UK Fiscal Policy, under the five key themes of fairness and prudence, sustainability, economic impact, financing and European commitments. Full details of the updated fiscal projections are set out in Annex B.

2.52 While the economic forecast is based on a neutral estimate of 21/2 per cent a year trend growth looking forward over the projection period, the public finances projections continue to be based on the deliberately prudent and cautious trend growth assumption of 21/4 per cent a year. The Government is determined not to repeat the mistakes of the past by assuming a potential improvement in trend growth before this has demonstrably been achieved and audited. The public finances will continue to be projected on the cautious assumption of 21/4 per cent a year trend growth in Budget 2001.

2.53 The trend growth assumption is just one of a number of key assumptions audited by the National Audit Office (NAO) under a three-year rolling review established in Budget 2000. For this Pre-Budget Report, the NAO has reviewed the assumptions for equity prices, price deflators and VAT receipts. In each case the Comptroller and Auditor General has concluded that it is reasonable that the assumptions continue to be used. In addition, the NAO has audited the performance of these assumptions in the past three years as well as the assumption underlying the projected savings from Spend to Save programmes. The public finances projections which follow show the Government's central projection, based on these cautious assumptions and the latest information on receipts and public expenditure.

Receipts

2.54 Receipts for 2000-01 are now expected to be stronger than expected in the Budget. Full details of changes in tax and spending since the Budget are in Annex B. The better than anticipated position for receipts reflects a number of factors, including:

• higher outturns in 1999-2000 than expected at the time of Budget 2000, in particular for income tax. This has raised the forecast base, affecting the profile into future years;
• buoyant current year receipts, notably income tax and North Sea revenues, where outturns have been better than expected; and
• greater than expected proceeds from the radio spectrum auction which have increased receipts on an accruals basis and have also resulted in lower debt interest payments and higher receipts of interest and dividends.

However, some offsets to these gains arise from lower expected receipts from corporation tax and capital gains tax.

2.55 The detailed forecast shows that, while the outturn for receipts in the first half of this fiscal year has been strong in comparison to the equivalent period last year, the comparative increase for the second half of the year is expected to be less. Table B12 shows, in particular, the effects of corporation tax reforms to the timing of receipts in year. For April-September, receipts are £1 billion higher than the comparable period last year. Based on early outturns for October, the forecast is that receipts for October - March will be £3 billion lower than the same period last year. In addition, the forecast also shows that, based on a lower than expected outturn for receipts in 1999-2000 and latest information on asset disposals, the projection for this year for capital gains tax is £0.4 billion lower than expected at the Budget.

2.56 Higher forecasts for receipts this year raise the forecast base for future years and the projections, based on the cautious assumptions, indicate that receipts will be higher than expected in the Budget throughout the forecast period. Higher income tax receipts resulting from stronger employment and earnings growth continue to offset reductions to the corporation tax forecast.

Annually managed expenditure

2.57 On public expenditure, projections for TME are unchanged for 2000-01 from the Spending Review White Paper. Projections for DEL from 2000-01 to 2003-04 are also unchanged compared to the Spending Review except for a single classification change which means a transfer from DEL to AME detailed in table B13. Since the Budget there have been significant savings in social security benefits and debt interest payments, before the effect of new Pre-Budget Report measures is taken into account. Table 2.3 decomposes the elements into those which were included in the Spending Review projections due to updated assumptions and further changes for this Pre-Budget Report.

Table 2.3: Savings in Annually Managed Expenditure (AME) since Budget 2000 due to social security and debt interest payments

1Changes in social security benefits, including Housing Revenue Account Subsidy, due to updated assumptions in unemployment, spend to save and interest rates.

2Excluding PBR measures.

2.58 Before taking into account the new measures, social security and debt interest payments are forecast to be about £1 billion lower this year and around £3 billion lower in 2001-02 than at the Spending Review, although there are some increases to forecasts for other AME spending programmes. Table B19 shows further details, including the offset in the AME margin.

Discretionary policy changes

2.59 In considering the impact of additional discretionary policy changes on the fiscal position, the Government has considered:

• the importance of ensuring that the fiscal rules are met over the economic cycle;
• its broader, medium-term fiscal policy objectives, including the need to ensure sound public finances and that spending and taxation impact fairly both within and across generations; and
• the need to ensure that fiscal policy supports monetary policy.

2.60 Within these strict constraints, and in the light of improved forecasts, it has been possible to:

• release additional resources for pensioners worth £21/2 billion a year by 2002-03;
• introduce a package of tax reforms to encourage UK productivity, while protecting the environment in the longer term.

In the light of a reduced forecast for AME expenditure in the current year, the £50 increase in this year's winter fuel payment and the rebate of lorry VED, costing £0.7 billion in total, have been absorbed within the AME margin in 2000-01. From 2001-02, the additions to AME arising from discretionary policy changes have been added to TME.

2.61 Table B4 gives further details of the measures. As noted above, the Pre-Budget Report also includes a number of transport measures which have not been included in the forecast since they are subject to consultation. These would cost in total around £13/4 billion a year if they were all to be implemented1. Decisions on these measures will be taken in the Budget when the Government will also review its AME forecast and the AME margin. In line with the usual convention adopted in previous Pre-Budget Reports, changes to the forecast for AME programmes have been offset in the AME margin. The interim forecast shows that the interim AME margin has increased over the level set in the 2000 Spending Review by £1.7 billion for 2001-02, £1.6 billion in 2002-03, and £1.6 billion in 2003-04.

FISCAL POSITION AND MEDIUM-TERM PROJECTIONS

2.62 Table 2.4 compares the medium term projections for the surplus on current budget and public sector net borrowing with those in Budget 2000. The changes are decomposed into those explained by the policy measures and those explained by forecasting revisions and other changes. Annex B gives greater detail on these revisions, including the decisions taken in the Spending Review. Table B4 sets out the detail of the PBR policy measures.

Table 2.4: Fiscal balances comparison with Budget 20001

1 Excluding windfall tax receipts and associated spending. Figures may not sum due to rounding.

2 The 1999-2000 figures were estimates in Budget 2000.

1Tax changes subject to consultation are not included in projections of the net tax burden set out in Table B10.

If implemented, they would have the following impact: (per cent of GDP)

2.63 The fiscal position for 2000-01 has improved since the Budget. A current budget surplus of £161/2 billion is now expected for 2000-01, around £21/2 billion higher than the Budget 2000 forecast. The net borrowing position is also better than expected at the time of Budget 2000. A repayment of about £10 billion is now estimated for 2000-01, about £31/2 billion higher than the Budget forecast.

2.64 The table distinguishes between the headline figures and the underlying structural position, which includes adjustments for the effects of the economic cycle. This is necessary because the Government takes care not to treat cyclical improvements to the public finances as structural improvements. The cyclically adjusted current surplus for 2000-01 is projected to equal 1.5 per cent of GDP, up on the Budget forecast of 1.3 per cent.

2.65 Looking at Public Sector Net Borrowing (PSNB) on a cyclically-adjusted basis, a surplus of 0.8 per cent of GDP is estimated for the current fiscal year, compared with the Budget 2000 estimate of 0.5 per cent of GDP. In each year of the projection period, the fiscal stance - as measured by the cyclically-adjusted PSNB - is on track to be at least as tight as set out in Budget 2000. The Pre-Budget Report projections show that fiscal policy is continuing to support monetary policy, promoting economic stability.

Table 2.5: Summary of public sector finances1

1Excluding windfall tax receipts and associated spending.

2Including windfall tax receipts and associated spending.

3Previously net wealth.

4General government net borrowing on an ESA95 basis. The Maastricht definition includes the windfall tax and associated spending.

5General government gross debt.

Golden rule

2.66 Table 2.5 demonstrates that, given non-discretionary changes to receipts and spending and after releasing additional resources, the Government remains well on course to meet both fiscal rules. The surplus on current budget represents the difference between current receipts and current expenditure, including depreciation. It measures the degree to which current taxpayers meet the costs of paying for the public services they use and so is an important indicator of the generational fairness of the finances.

2.67 The surplus on current budget is projected to be equivalent to 1.7 per cent of GDP in 2000-01. It is then projected to decline to 0.7 per cent of GDP by 2003-04, because of the increased current spending provided by 2000 Spending Review , thereafter remaining broadly stable.

2.68 On a cyclically-adjusted basis, the current surplus remains clearly positive through the period. The average surplus since 1999-2000, which on the Government's provisional judgement is the start of the current cycle, also stays positive, remaining over 1 per cent over the next five years. On this basis, the Government is on track to meet the golden rule.

Supporting Docs & Media

• Chart 2-2: Meeting the fiscal rules -- cyclically adjusted surplus on current budget and public sector net debt

Sustainable investment rule

2.69 Net debt has declined more sharply than predicted. With the benefits of sound public finances, lower interest rate expectations and the proceeds from the auction of spectrum licences, the public sector net debt ratio is projected to fall to around 32 per cent of GDP this year and then to about 30 per cent in 2002-03, thereafter remaining broadly stable and well below 40 per cent. Debt interest payments are forecast to be £6 billion a year lower in 2003-04 than in 1997-98. The Government is firmly on track to meet the sustainable investment rule, while also releasing resources for investment in priority public services and maintaining a cushion against further shocks. Chart 2.2 shows the projections of the current budget remaining in surplus and falling net debt.

2.70 Another measure of the sustainability of public finances is net worth, the difference between the total assets and liabilities of the Government. Net worth is projected to rise to at least 20.3 per cent of GDP by 2003-04. This follows a prolonged period in which the poor state of the public finances led to net worth falling below 15 per cent of GDP. The primary balance (PSNB excluding debt interest payments) also remains in surplus over the forecast period. It is forecast to be 3.3 per cent of GDP for 2000-01, falling to 0.5 per cent by 2005-06.

Economic impact

2.71 The overall impact of fiscal policy on the economy can be assessed by examining changes in PSNB. The interim forecast for net borrowing is set out in Chart 2.3 which shows the actual and cyclically-adjusted figures as a percentage of GDP. The cyclically-adjusted PSNB is projected to be tighter this year than the Budget 2000 forecast by an amount equivalent to 0.3 per cent of GDP. The difference between this cyclically-adjusted figure and the headline figure (amounting to 0.3 per cent of GDP for 2000-01) shows the effect of the automatic stabilisers, which are continuing to dampen the cycle. Looking forward, PSNB is projected to move into deficit by 2003-04 because the Government is planning to borrow modestly to fund its increased investment in the country's capital stock. This is fully consistent with the Government's long-term approach and the fiscal rules since net debt is being kept at a stable and prudent level, well below 40 per cent.

Supporting Docs & Media

• Chart 2-3: Public sector net borrowing - actual and cyclically-adjusted 

Financing

2.72 The forecast for the central government net cash requirement (CGNCR) has been revised from - £4.9 billion to -£28.2 billion, a difference of £23.3 billion. This revision is largely due to the proceeds from the spectrum licence auction which were £19.5 billion higher than the Budget assumption. It was decided that these proceeds should be used to reduce net debt. In light of this, a revised Gilts Remit for 2000-01 was published on 12 June 2000. Planned gross gilt sales were cut by £2.2 billion to £10.0 billion and fixed at that level for the remainder of the financial year. Additionally, the remaining contingencies outlined in the Debt Management Report 2000-01 were exercised. It was also announced that further decisions on allocating the proceeds in the light of the revised forecast of the CGNCR would be announced at the time of the Pre-Budget Report. The further reductions in net debt in 2000-01 will be achieved by:

• increasing the total of planned debt buy-backs by £1.5 billion;
• increasing the reduction in the Ways and Means advance by £1.6 billion;
• reducing the planned Treasury Bill stock for end March 2001 by a further £4.5 billion; and
• planning for the residual cash position of £6.3 billion (to be reduced over the next three financial years).

2.73 The rest of the financing requirement is accounted for by a further forecast decline of £0.7 billion in net financing from National Savings. Full details of these measures and an updated table for the Government's Financing Requirement for 2000-01 can be found in Annex B. Gross gilt sales for the financial year to date have been £4.9 billion with a further £5.1 billion planned.

European commitments

2.74 The Government also remains on course to meet the Maastricht Treaty and Stability and Growth Pact commitments. These require Governments to keep general government net borrowing below 3 per cent of GDP and general government gross debt below 60 per cent of GDP. The Pre-Budget Report projections indicate that these values will comfortably be achieved.

The need for caution in the public finance projections

2.75 Projections of the public finances necessarily involve a significant element of uncertainty. Public revenue and spending projections depend heavily on forecasts of economic growth and, in particular, on assumptions made about the position of the economy in relation to its long-term trend path. This means that projections of strong public finances in the medium term can quickly deteriorate if most of the strength was cyclical and if the economy slows to below trend over the forecast horizon. Therefore, it is important to build in a safety margin, as well as forecasting with cautious and prudent assumptions.

2.76 Chart 2.4 illustrates a cautious case in which the level of trend output is assumed to be 1 percentage point lower in relation to actual output than in the central case. Even on this basis, the Government is on track to meet the golden rule over the economic cycle. This increases the probability of meeting the fiscal rules and, by minimising the need for unexpected changes of direction, allows a smoother path for public spending.

The outlook for trend growth

2.77 The Government entered office against an uncertain economic background. The Government judged that it was sensible to present its forecasts for economic growth in the form of opportunity ranges around a deliberately cautious assumption for trend growth of 21/4 per cent a year. This illustrated the potential for supply-side improvements to deliver stronger growth above the prudent 21/4 per cent a year assumption used for the fiscal projections.

Supporting Docs & Media

• Chart 2-4: Cyclically-adjusted surplus on current budget 

2.78 The factors that influence trend growth can be grouped under those that determine trend population growth, the trend employment rate and those that determine trend labour productivity. The November 1999 Pre-Budget Report gave a firmer indication of the outlook for trend growth - on the basis of a careful and balanced assessment of past and future trends, the Government's neutral estimate of the UK's trend growth rate year-on-year over the future was raised to 21/2 per cent. This assessment is unchanged.

2.79 This neutral assessment of trend output growth is, however, subject to considerable upside potential. Government policies to secure further progress towards full employment and continued responsibility in wage bargaining can help prolong the recent improvement in underlying labour market performance. But the key challenge now facing businesses, individuals and Government is to secure significantly stronger growth in productivity. In the US, rapid adoption of 'new economy' technologies and related diffusion of 'know-how' associated with ICT has been credited with securing a significant improvement in productivity and hence sustainable growth potential. Building on the UK economy's foundation of economic stability and policies to raise investment and innovation in a competitive business environment, there is the opportunity for firms to emulate US performance. These factors create the potential for stronger sustainable growth beyond the upper limits of the Pre-Budget Report forecast ranges. Chapter 3 describes the action which the Government is taking to build on this potential to improve productivity.

¹See Planning Sustainable Public Spending: Lessons from Previous Policy Experience, HM Treasury, November 2000.

Internal links

• Pre-Budget Report 2000 index