Annex B: The Public Finances (Part One)

INTRODUCTION

B1. Chapter 2 describes the Government's fiscal framework and shows how the updated projections of the public finances are consistent with meeting the fiscal rules. This annex explains in more detail the Government's performance against the fiscal rules. It includes:

• five year projections of the current budget surplus and public sector net debt, the key aggregates for assessing performance against the golden rule and the sustainable investment rule respectively;
• projections of public sector net borrowing, the fiscal aggregate relevant to assessing the impact of fiscal policy on the economy;
• projections of the cyclically-adjusted fiscal balances; and
• detailed analyses of the outlook for government receipts and expenditure.

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MEETING THE FISCAL RULES

B2. The Pre-Budget Report provides an update of the projections of the public finances contained in Budget 2001, taking account of developments in both the public finances and the economy since then. The public finance projections in the Pre-Budget Report present an interim forecast update and do not necessarily represent the final outcome the Government is seeking.

B3. Table B1 compares the Pre-Budget Report projections for the current budget and net borrowing with those made in Budget 2001. These projections inevitably involve a considerable element of uncertainty and are therefore based deliberately on cautious assumptions of key economic variables, including the trend rate of growth of the economy. A cautious asymmetric approach to fiscal policy helps ensure that the public finances are well placed to deal with the impact of the world economic slowdown by building in a safety margin against unexpected events.

B4. Reduced economic growth has implications for both public sector receipts and spending. However, the tough decisions on taxation and spending taken by the Government over the past four years to repay debt mean that fiscal policy is able to support monetary policy this year and next in maintaining economic stability, while continuing to meet the two fiscal rules. The revised fiscal projections show that the current budget will remain in surplus throughout the economic cycle. The outturn for 2000-01 shows a £2 ¾ billion higher surplus on the current account and a £3¾ billion higher net repayment. A current budget surplus of £10 billion is projected for 2001-02, compared with the Budget projection of £16 billion. The current surplus in 2002-03 has also been revised downwards to £3 billion. Similarly, public sector net borrowing of £2.5 billion is now expected in 2001-02, compared with a projected net repayment of £5 billion in the Budget. However, as the economy moves back to trend, the fiscal position moves back towards its Budget 2001 profile.

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Table B1: Fiscal balances comparison with Budget 20011

1 Includes windfall tax receipts and associated spending.
2 The 2000-01 figures were estimates in Budget 2001.

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B5. Table B2 shows five year projections of the current budget surplus and public sector net debt, the key aggregates for assessing performance against the golden rule and the sustainable investment rule respectively. Outturns and projections of other important measures of the public finances, including net borrowing and net worth, are also shown.

B6. The projections show that the Government remains on track to meet the golden rule over the forecast period, with the average surplus on the current budget from 1999-00 projected to be at least 1.1 per cent of GDP throughout the next five years. The current budget balance improved slightly in 2000-01 to a surplus of just over 21/2 per cent of GDP. The surpluses are projected to fall temporarily over the short term, mainly reflecting the effects of weaker growth, the impact of the audited assumptions, and weaker financial company profits (these are discussed in more detail below). Over the medium term, stronger economic growth and a return in financial company profits to their long term trend will push the current surplus back towards Budget 2001 levels.

B7. Net borrowing is equal to net investment minus the surplus on the current budget. Public sector net investment is projected to be approximately 1.3 per cent of GDP in 2001-02, implying net borrowing of 0.3 per cent of GDP. The ratio of net investment to GDP is projected to increase steadily to 1.8 per cent of GDP in 2004-05 and remain at that level thereafter. The rapid growth of net investment, in conjunction with the effects of slower economic growth, will result in modest levels of net borrowing over the remainder of the period, consistent with meeting the sustainable investment rule.

Table B2: Summary of public sector finances

1 General government net borrowing on an ESA95 basis.
2 General government gross debt.

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B8. The primary balance is equal to net borrowing excluding net debt interest payments - thus abstracting from the implications of past fiscal deficits. If real interest rates exceed trend GDP growth, a primary surplus is required to stabilise the net debt ratio. The primary balance is projected to be in surplus by 1 1/2 per cent of GDP in 2001-02. Surpluses of between 1/2 per cent and 3/4 per cent of GDP are projected over the next five years.

B9. The central government net cash requirement was a repayment of 3 ¾ per cent of GDP in 2000-01, higher than expected at Budget 2001. This largely reflects the receipts from the auction of licences to access the electromagnetic spectrum. The net cash requirement is projected to move into deficit from 2001-02 onwards, mirroring the profile of public sector net borrowing. The approximate stock counterpart to the public sector net cash requirement is public sector net debt.

B10. In 1996-97, public sector net debt stood at 44 per cent of GDP. The tough decisions on taxation and spending taken by the Government over the past four years, including the decision to use the proceeds from the auction of spectrum licences to pay off debt, mean that net debt is now projected to be around 31 per cent of GDP in 2001-02, the lowest of all the G7 countries. The net debt-GDP ratio is expected to stabilise at around 31 per cent for the rest of the projected period - well below 40 per cent and comfortably meeting the sustainable investment rule.

B11. The approximate stock counterpart to the current budget balance is public sector net worth. Current budget surpluses of over 2 per cent of GDP a year have begun to raise net worth to an estimated 21 ½ per cent of GDP in 2001-02. At present, net worth is not used as a key indicator of the public finances, due mainly to the difficulties in measuring accurately many government assets and liabilities.

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B12. Table B2 also shows the updated estimates of the cyclically-adjusted current budget and net borrowing as a per cent of GDP. These allow underlying or structural trends in the indicators to be seen more clearly, once the estimated effects of the economic cycle are removed.

B13. The cyclically-adjusted current budget balance has moved from a deficit of over 2 per cent of GDP in 1996-97 to a surplus of over 2 per cent of GDP in 2000-01. As with the unadjusted figures, the strong increases in investment and the global economic slowdown result in reduced surpluses in 2001-02 and 2002-03, before the surpluses return towards Budget levels.

B14. Similarly, cyclically adjusted net borrowing of 3 per cent of GDP in 1996-97 has moved to a repayment of around 11/2 per cent in 2000-01 before returning to a modest deficit over the short and medium term, consistent with the sustainable investment rule.

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Forecast errors and risks

B15. The fiscal balances represent the difference between two large aggregates of spending and receipts and are inevitably subject to wide margins of forecast error. Over the past five years, the average absolute error (the average error irrespective of whether the errors have been positive or negative) for one-year ahead forecasts of net borrowing has been around 1 per cent of GDP. The error tends to grow as the forecast horizon lengthens. Much of this error arises from forecast errors of GDP.

B16. Short-term forecasts of the public finances are critically dependent on the path of the economy, as most tax revenues and some public expenditure - notably social security - vary directly with the economic cycle. Work published by the Treasury1 suggests that if GDP growth were 1 percentage point higher or lower than assumed over the coming year, net borrowing might be lower or higher by around 0.4 per cent of GDP in the first year and by a further 0.3 per cent in the following year. Allowing for the reduction in the lag between profits and corporation tax receipts resulting from the introduction of the instalment system (discussed in Box B2), these figures are now closer to 0.5 and 0.2 per cent. However, not all cycles will conform exactly to these parameters, notably because the estimates are based on historical data (since which time both the economy and tax regime have changed) and because cycles differ in respects other than their magnitude.

B17. Errors in short-term growth forecasts may have only a temporary effect on the public finances. For a given path of trend output, higher or lower growth in the short-term will be followed by lower or higher growth later on, and the public finances may be little affected on average over the cycle. However, errors in estimating the cyclical position of the economy in relation to its trend - the output gap - will have a permanent effect on prospects.

B18. For this reason, the public finance projections are deliberately based on assumptions for key economic variables, including the trend rate of growth of the economy in the medium term. These are audited by the National Audit Office (NAO) to ensure they remain both reasonable and cautious. Details of these assumptions are given in Box B1.

B19. In addition, the public finance projections are stress-tested against an alternative cautious case, in which the output gap is assumed to be 1 percentage point higher than the central view. This scenario would imply that a greater proportion of the projected surplus on the current budget was due to the cyclical strength of the economy: a 1 per cent larger positive output gap reduces the structural surplus on the current budget by about 3/4 per cent of GDP a year. This is illustrated in chart B2. Even in this more cautious case, the cyclically-adjusted current budget is estimated to remain comfortably in surplus over the past 4 years. The impact of the temporary fall in receipts means that it moves into deficit over the short term, before returning to surplus in 2005-06. However, the average cyclically-adjusted current budget is forecast to be in surplus over the economic cycle.

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ASSUMPTIONS

B20. The fiscal projections are based on the following assumptions:

• the economy follows the path described in Annex A. The fiscal projections continue to be based on the deliberately prudent and cautious assumption of trend growth of 2 ¼ per cent a year. The main economic assumptions are summarised in Table B3;
• firm Departmental Expenditure Limits (DELs) as set out in the 2000 Spending Review, adjusted for subsequent changes;
• Annually Managed Expenditure (AME) totals as set out in Budget 2001, adjusted to allow for estimated costs of spending measures announced in the Pre-Budget Report (see Table B4);
• prior to firm spending plans being set in the 2002 Spending Review, current expenditure in DEL is projected to grow by 2 ½ per cent a year in real terms over 2004-05 and 2005-06 from a baseline excluding capital to resource switches made by the devolved administrations. This is in line with the neutral view of trend. Current expenditure in AME is projected to grow by 1 ¾ per cent a year in real terms, in line with recent trends;
• net investment more than doubles by 2003-04 and is forecast to end the projection period at 1.8 per cent of GDP. This makes a significant contribution toward tackling the historical under-investment while remaining consistent with the sustainable investment rule by ensuring the net debt-GDP ratio remains well below 40 per cent throughout the projection period; and

there are no tax changes beyond those already announced before or in this Pre-Budget Report (see Table B4) and the indexation of rates and allowances.

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Table B3: Economic assumptions for public finance projections

1 Used for revalorising excise duties in current year and uprating income tax allowances and bands and certain social security benefits in the following year.
2 RPI excluding housing costs, used for uprating certain social security benefits.
3 Not seasonally adjusted.

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B21. The key assumptions underlying the fiscal projections are audited by the NAO under the three-year rolling review. The key assumptions and conventions used for the Budget 2001 public finance projections are unchanged. Details of all the audited assumptions are given in Box B1.

1 Audit of Assumptions for the July 1997 Budget Projections, 19 June 1997 (HC3693).
2 Audit of Assumptions for the Pre-Budget Report, 25 November 1997 (HC361).
3 Audit of Assumptions for the Budget, 19 March 1998 (HC616).
4 Audit of the Unemployment Assumption for the March 1999 Budget Projections, 9 March 1999 (HC294).
5 Audit of the Oil Price Assumption for the Pre-Budget Report, November 1999 (HC873).
6 Audit of Assumptions for the March 2000 Budget, 21 March 2000 (HC348).
7 Audit of Assumptions for the Pre-Budget 2000 Report (HC959).
8 Audit of Assumptions for the March 2001 Budget, 7 March 2001 (HC304).

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PRE-BUDGET REPORT MEASURES

B22. The impact on the fiscal projections of measures announced since Budget 2001 and in this Pre-Budget Report are set out in table B4. In line with the convention adopted in previous Pre-Budget Reports, expenditure measures in AME for future years have been added to total AME, while measures in the current year have been deducted from the AME margin. In 2002-03, lower debt interest payments have enabled £1 billion to be reallocated from AME to resource DEL to fund additional spending on health. Changes to the forecast for individual AME programmes have otherwise been offset in the AME margin. The interim forecast shows that the AME margin is now expected to be around £0.2 billion in 2001-02, £1.2 billion in 2002-03, and £1.5 billion in 2003-04 (see table B13).

B23. Consistent with the requirements of the Code for Fiscal Stability, the forecast does not take account of:

• measures proposed in the Pre-Budget Report for further consultation in the run up to Budget 2002, including the research and development (R&D) tax credit for large companies; and
• other proposals where final decisions on rates have yet to been taken; these include the Working Tax Credit and the Child Tax Credit.

Table B4: Estimated costs for Pre-Budget Report measures and other measures announced since Budget 2001

*Negligible.

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FISCAL AGGREGATES

B24. Tables B5 and B6 provide more detail on the projections for the current and capital budgets. The tables show the current surplus and net borrowing, both including and excluding windfall tax and associated spending. Windfall tax and associated spending now has much less impact and, unless otherwise stated, all the projections in this annex now cover all public expenditure. Latest estimates of associated spending are given in Table 4.1.

Table B5: Current and capital budgets

1 Windfall tax receipts and associated spending.
2 General government net borrowing on an ESA95 basis.
3 General government gross debt.

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B25. The current budget surplus in 2001-02 is estimated to be £10.3 billion. Net investment is estimated to be £13 billion, resulting in net borrowing of £3 billion. The current budget surplus is projected to fall in 2002-03 to a surplus of £3 billion. Net investment rises to £15 billion, which increases net borrowing to £12 billion in 2002-03.

B26. Significant repayments of net borrowing over the last three years have resulted in a declining net debt-GDP ratio. Public sector net debt is projected to fall again in 2001-02 to 303/4 per cent of GDP from 311/4 per cent of GDP in 2000-01. The net debt-GDP ratio rises to a sustainable level of around 31 per cent by the end of the projection period, well below the 40 per cent guideline set by the sustainable investment rule.

B27. Table B6 shows the Treaty measures of the deficit and debt used in the Excessive Deficits Procedure of the Treaty. The reference levels of 3 per cent of GDP for the deficit and 60 per cent of GDP for debt are achieved comfortably throughout the projection period.

Table B6: Current and capital budgets

1 Windfall tax receipts and associated spending.
2 General government net borrowing on an ESA95 basis.
3 General government gross debt.

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B28. Table B7 sets out the effects of forecasting changes, Pre-Budget Report measures and other discretionary changes since the Budget on the main fiscal aggregates. The table gives a further breakdown of the large forecasting changes to receipts.

B29. The latest available outturn information for 2000-01 shows current receipts £1 billion lower than estimated in Budget 2001. However, this was more than offset by lower spending so that the surplus on the current budget was £2 3/4 billion higher, and net borrowing £3 3/4 billion lower than the Budget forecast.

Table B7: Fiscal balances compared with Budget 2001

1 The 2000-01 figures were estimates in Budget 2001.

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B30. The current surplus for 2001-02 onwards is much lower than in Budget 2001, mainly because of forecasting changes to receipts. Further details of these changes are given in the next section. Net borrowing is also adversely affected by the forecasting changes to receipts.

B31. There are no forecasting changes to total spending during the 2000 Spending Review period. However, the split between current and capital expenditure changes and as a result of the different assumptions made about current and capital spending after 2003-04 (see paragraph B20) total expenditure then is slightly higher than in the Budget.

RECEIPTS

B32. Changes to the projections of the main taxes since the Budget are shown in Table B8. Table B9 gives projections of receipts as a percentage of GDP and Table B10 sets out the Budget and Pre-Budget Report projections of the overall tax-GDP ratio. A more detailed breakdown of receipts is given in Table B11, while Table B12 looks in more detail at the changes for receipts between 2000-01 and 2001-02.

Table B8: Changes in current receipts since Budget 2001

1 Gross of company tax credits.
2 Includes company tax credits.
3 Capital gains tax and inheritance tax.
4 Fuel, alcohol and tobacco duties.
5 Includes council tax and money paid into the National Lottery Distribution Fund, as well as other central government taxes.

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B33. As shown in Table B8, total receipts in 2001-02 are now expected to be around £7 billion lower than in Budget 2001. This means that current receipts are now expected to grow by 2 per cent, compared with 4 per cent in Budget 2001.

B34. The estimated effect of changes since Budget 2001 to the assumptions for GDP and its components is shown in Table B7. These changes account for around £1 billion of the drop in receipts in 2001-02 and £2 billion in 2002-03. Although economic growth in 2003 is expected to be higher than in Budget 2001, the cumulative effect on levels of the main tax bases (wages and salaries, industrial and commercial company profits and consumers' expenditure) is such that the effect on tax receipts in 2003-04 is still negative. However, the impact of the economic forecast means that receipts are expected to be slightly higher at the end of the projection period, consistent with a higher level of money GDP. The main taxes affected by these changes are income tax, corporation tax and VAT.

B35. Changes to some of the other assumptions have large effects on tax receipts. In particular, equity price levels are important determinants of capital taxes, stamp duty and corporation tax, mainly because of the effect on the capital gains of life insurance companies. The audited assumption that underpins the current projections is that equity prices increase in line with money GDP from the existing level of the FT - All Share Index - in this case 2579. Compared with the Budget 2001 starting point of 2902, this means that equity prices are about 14 per cent lower in the current forecast. This reduces receipts by about £½ billion in 2001-02 and by around £2 billion from 2002-03 onwards, due to the lags in the payments of capital taxes.

B36. Changes in other assumptions audited by the NAO also have a significant impact on receipts, particularly in the early years. Oil prices are $1.7 a barrel lower than at the time of Budget 2001, reducing receipts by about £½ billion a year throughout the period. Much of the change in the "other audited assumptions" line of Table B7 is explained by lower market expectations of 3 month market interest rates than in Budget 2001. This has an impact on income tax deducted at source from bank and building society interest payments and, with a lag, on the extra tax paid on interest income by higher rate taxpayers. It also has a large impact on non-tax receipts of the public sector, such as interest receipts.

B37. As discussed in Box B2, corporation tax receipts in 2001-02 are expected to be £4 ½ billion lower than in the Budget projections. Some of this reflects changes in the tax paid by industrial and commercial companies, largely due to changes in the economy. This element is included in the GDP line of Table B7. However, much of the fall in receipts is due to a fall in the taxable profits of financial companies. This is not directly reflected in forecasts for GDP. The "financial companies" line in Table B7 shows the impact on the fiscal balances of the reduction in corporation tax receipts due to the lower assumption about financial company profits. This excludes life insurance companies, whose profits forecast is based on equity prices. The "financial companies" line also includes falls in income tax because of changes stemming from lower bonuses paid by financial companies to their employees. These have recently had a substantial impact on PAYE receipts.

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Table B9: Current receipts

1 Gross of company tax credits.
2 Includes company tax credits.
3 The Working Families' Tax Credit will be replaced in 2003 by a new system of tax credits.
4 Includes oil royalties, petroleum revenue tax and North Sea corporation tax.
5 Fuel, alcohol and tobacco duties.
6 Includes Council Tax and money paid into the National Lottery Distribution Fund, as well as other central government taxes.
7 Includes VAT and 'own resources' contributions to EU budget. Net of income tax credits. Cash basis.
8 Excludes Children's Tax Credit, and other tax credits which score as a tax repayment in the national accounts.
9 Accruals basis.

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Total taxes

B38. The remaining changes to receipts cover a wide variety of different changes to the forecasts for individual taxes. Many reflect the effects of outturn data.

B39. Table B10 and Chart B3 show the tax-GDP ratio, measured as net taxes and social security contributions as a percentage of GDP. The revision to the tax-GDP ratio in 2000-01 largely reflects upward GDP data revisions which also feed through in later years. The lower levels of tax receipts now expected in 2001-02 and 2002-03 lead to larger falls in the ratio than in the Budget 2001 projections.

Table B10: Net taxes and social security contributions¹

1 Net of tax credits; cash basis.
2 The 2000-01 figures were estimates in Budget 2001.

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