Home

Newsroom & speeches

Economic data & tools

Consultation & legislation

Independent reviews

Enterprise & productivity

Financial services

International issues

Public private partnerships

Public spending & reporting

Tax work & welfare

UK economy

Budget

Pre-Budget Report

Spending Review

About us

Careers

Other HMT sites

Terms & conditions

Annex B: Part 1

The public finances

INTRODUCTION

B1 Chapter 2 describes the Government's fiscal policy framework and shows how the projections of the public finances presented in this Pre-Budget Report are consistent with the fiscal rules. This annex explains the fiscal projections in more detail. It includes:

• six-year projections of the current budget 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.

back to top

B2 As described in Chapter 2, an End of year fiscal report is published alongside this Pre-Budget Report. The Report underlines the Government's commitment to transparency in fiscal policy by providing detailed retrospective information on the state of the public finances in 2000-01 and 2001-02, including their performance against the fiscal rules and against published forecasts and plans. The information set out in the End of year fiscal report supplements the historical and provisional outturn data published in this annex and in the Financial Statement and Budget Report.

B3 The Pre-Budget Report updates the projections of the public finances contained in Budget 2002, to take account of subsequent developments in both the public finances and the world and UK economies. The projections represent an interim forecast update and are not necessarily the outcome the Government is seeking.

B4 Table B1 compares the Pre-Budget Report projections for the current budget and net borrowing with those made in Budget 2002. As explained in Annex A, the short-term outlook for the world economy has weakened since Budget 2002. This has important implications for the UK economy and in turn for public sector receipts and expenditure. Table B1 shows that the current budget has been revised down from a surplus of £3.2 billion to a deficit of £5.7 billion in 2002-03, and from a surplus of £7 billion to a deficit of £5 billion in 2003-04. It also shows that net borrowing has been revised up from £11.2 billion to £20.1 billion in 2002-03 and from £13 to £24 billion in 2003-04. As discussed in Chapter 2, current estimates of the impact of changes in the output gap on the public finances over previous cycles suggest that automatic stabilisers account for £9 billion of the change in the current budget and net borrowing in 2003-04. As a result, the cyclically-adjusted fiscal balances are only slightly changed from their Budget 2002 levels, while the actual fiscal balances are projected to return to their Budget 2002 levels in the medium term.

back to top

MEETING THE FISCAL RULES

B5 Table B2 shows six-year projections for the current budget 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 As explained in Chapter 2, the Government's provisional view is that the current economic cycle started in 1999-2000. Based on the assumptions used in these projections, the economy will next return to trend levels, ending the current cycle, in 2005-06.

B7 The projections show that the Government is firmly on track to meet the golden rule. Over the period of this cycle, from 1999-2000 to 2005-06, the current budget is comfortably in surplus, with an accumulated surplus of £46 billion. Similarly, the average surplus on the current budget is positive since the start of the cycle and throughout the projection period. The same is true were the cycle to start in 1997-98. The cyclically-adjusted surplus, which allows underlying or structural trends in the indicators to be seen more clearly by removing the estimated effects of the economic cycle, is also positive in every year of the forecast.

B8 Following a deficit of 3 per cent of GDP in 1996-97, current budget surpluses of more than 2 per cent were recorded in 1999-2000 and 2000-01 and of about ³/₄ per cent in 2001-02. Largely as a result of cyclical and other temporary factors, the current budget moves into a deficit of about ¹/₂ per cent of GDP in 2002-03 and 2003-04, before returning to surplus in 2004-05 and recovering to a surplus of around ³/₄ per cent of GDP by 2007-08.

B9 The sustainable investment rule is also met comfortably over the projection period. 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 course of the last Parliament, including the decision to use the proceeds from the auction of spectrum licences to repay debt, reduced net debt to around 30 per cent of GDP by the end of 2001-02. It is now projected to grow slowly and stabilise at around 33 per cent of GDP by 2007-08, as the Government borrows modestly to fund increased investment in public services, consistent with the fiscal rules. The projections for core debt, which exclude the estimated impact of the economic cycle, increase more slowly to just over 31 per cent of GDP.

back to top

Media links

• Chart B1: Public sector net debt and net worth

B10 Net worth is the approximate stock counterpart of the current budget balance. Current budget surpluses of over 2 per cent of GDP in recent years have increased net worth to 26.7 per cent of GDP in 2002-03. Modest declines are projected during the projection period. At present, net worth is not used as a key indicator of the public finances, mainly as a result of the difficulties involved in measuring accurately many government assets and liabilities.

back to top

B11 The primary balance is equal to net borrowing excluding net debt interest payments - thus subtracting the implications of past fiscal deficits. If real interest rates exceed trend output growth, a primary surplus is required to stabilise the net debt ratio. The primary balance is projected to show a modest deficit in 2002-03 and 2003-04, but then to return to balance for the remainder of the projection period.

B12 As a result of decisions taken in the 2002 Spending Review, public sector net investment is projected to rise steadily to 2¹/₄ per cent of GDP in 2007-08. These increases are sustainable and fully consistent with the Government's long-term approach and the fiscal rules, since net debt is being held at a stable and prudent level, well below 40 per cent of GDP. This increase in net investment, together with the new projections for the current budget, mean that public sector net borrowing is expected to increase from 0.1 per cent of GDP in 2001-02 to a maximum of 2¹/₄ per cent in 2003-04, before falling back to about 1¹/₂ per cent of GDP in later years. Cyclically-adjusted net borrowing is 1¹/₂ per cent of GDP or lower in every year.

B13 The central government net cash requirement (CGNCR) was 0.3 per cent of GDP in 2001-02. The CGNCR is projected to increase in 2002-03 and subsequent years, mirroring the profile of public sector net borrowing.

B14 Table B2 also shows the Treaty measures of deficit and debt used in the Excessive Deficits Procedure. The reference levels of 3 per cent of GDP for the deficit and 60 per cent of GDP for gross debt are comfortably achieved throughout the projection period.

FORECAST DIFFERENCES AND RISKS

B15 The fiscal balances represent the difference between two large aggregates of spending and receipts, and forecasts are inevitably subject to wide margins of uncertainty. Over the past ten years, the average absolute difference between one-year ahead forecasts of net borrowing and subsequent outturns has been around 1 per cent of GDP. This difference tends to grow as the forecast horizon lengthens. A full account of differences between the projections made in Budget 2000 and Budget 2001 and the subsequent outturns is provided in the End of year fiscal report.

back to top

B16 The uncertainties surrounding the current projections are both global and domestic. Global downside risks include continued volatility in equity prices, the recovery in business investment being delayed, the possibility of renewed rises in oil prices, and the possible disorderly unwinding of current account imbalances. Upside risks include faster productivity growth and quicker global recovery. Domestic risks include house prices continuing to grow steeply, increasing the possibility of a sharp correction, and the emergence of inflationary pressures in the labour market. For these reasons the public finance projections continue to be based on cautious assumptions, including equity prices and trend growth. This helps to ensure that the public finances are sound, that fiscal policy can support monetary policy over the economic cycle and that the Government is on track to meet its tough fiscal rules.

B17 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. Earlier work¹ suggested that if GDP growth were one percentage point higher or lower than assumed over the coming year, net borrowing might be lower or higher by 0.4 per cent of GDP in the first year and by a further 0.3 per cent of GDP the following year. These figures are now closer to 0.5 and 0.2 per cent respectively, as the introduction of the corporation tax instalment system has reduced the lag between profits and tax receipts. However, not all cycles will conform exactly to these parameters, notably because the estimates are based on historical data (since which time both the state of the economy and the tax regime have changed) and because cycles differ in respects other than magnitude.

Media links

• Chart B2: Cyclically-adjusted surplus on current budget

B18 Forecast differences 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.

B19 However, changes in the estimated cyclical position of the economy in relation to its trend - the output gap - will have a permanent effect on prospects. For this reason, the public finances projections are stress-tested against an alternative cautious case, in which the level of output is assumed to be 1 percentage point lower than the Government's central view. This scenario would imply that a greater proportion of any 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 have been comfortably in surplus over the past four years. The impact of the temporary fall in receipts means that it is projected to move into a modest deficit over the short term, before returning broadly to balance towards the end of the projection period. However, since the start of the current cycle, the average surplus on the cyclically-adjusted current budget in the cautious case stays positive in each year, meaning that the golden rule is met, even in the cautious case. The same is true were the cycle to start in 1997-98.

back to top

ASSUMPTIONS

B20 The fiscal projections are based on the following assumptions:

• the economy follows the path described in Annex A. In the interests of caution, the fiscal projections continue to be based on the deliberately prudent and cautious assumption of trend output growth of 2¹/₂ per cent a year up to 2006-07, ¹/₄ percentage point lower than the Government's neutral view. Beyond 2006-07, projections by the Government Actuary imply a slowdown in the growth in the population of working age, due to demographic effects. As set out in the Budget 2002 paper, the Government's neutral view of trend output growth is reduced to 2¹/₂ per cent in 2007-08, and so, to maintain a cautious approach, an assumption of 2¹/₄ per cent is used in the public finance projections in that year, still ¹/₄ percentage point lower than the Government's neutral view. The main economic assumptions are set out in Table B3;
• there are no tax changes beyond those announced since Budget 2002 or in this Pre-Budget Report (see Table B4), and the indexation of rates and allowances. Consistent with the Code for fiscal stability, the forecast does not take account of measures proposed in this Pre-Budget Report for consultation or other proposals where final decisions have yet to be taken;
• firm Departmental Expenditure Limits (DEL) as set out in the 2002 Spending Review up until 2005-06, but adjusted for the impact of policy decisions (see paragraph B64) and DEL/ AME reclassifications (see paragraph B69);
• total Annually Managed Expenditure (AME) is as set out in the 2002 Spending Review up until 2005-06, but adjusted for DEL/AME reclassifications and for the estimated costs of spending measures announced in this Pre-Budget Report or before (see Table B4). The forecast of individual components in AME has been updated with changes absorbed by the AME margin within set total AME;
• prior to spending plans being set in the 2004 Spending Review, real growth in DEL after 2005-06 in line with the economic growth assumption used for the public finances, supplemented by an addition to allow for the five-year health settlement of the difference between planned health growth and health's long term average growth of 3.6 per cent. Other current spending in AME is forecast to grow from 2005-06 onwards at 1³/₄ per cent in real terms in line with its recent trend; and
• within these aggregates, net investment is forecast to increase from 2 per cent of GDP in 2005-06 towards an assumption of 2¹/₄ per cent in 2007-08, while remaining consistent with the sustainable investment rule.

back to top

B21 The key assumptions underlying the fiscal projections are audited by the National Audit Office (NAO) under the three-year rolling review process. Details of all the audited assumptions are given in Box B1. For this Pre-Budget Report, the Comptroller and Auditor General has audited the assumptions for oil prices under the three-year rolling review, and examined extensions to the assumptions covering VAT and tobacco smuggling measures. All three of the assumptions were deemed to be both reasonable and cautious². Revisions to the VAT and tobacco assumptions are described in detail later in this annex, and the effects of changes on receipts projections are shown in Tables B7 and B8.

back to top

PRE-BUDGET REPORT POLICY DECISIONS

B22 Consistent with the requirements of the Code for fiscal stability, the updated projections take into account the fiscal effects of all firm decisions announced in this Pre-Budget Report or since Budget 2002, including the abolition of North Sea Royalty payments and further measures to tackle tax avoidance and establish a modern and fair tax system. The fiscal impact of these measures is set out in Table B4.

B23 In line with the convention adopted in previous Pre-Budget Reports, expenditure measures in AME for future years have been added to total AME. DEL spending measures have only been added to total DEL where they are funded by increased revenue or are the direct result of a decision to increase public spending as a whole. The measures that affect DEL are:

• the decision to reform the Landfill Tax Credit Scheme from April 2003 will release funding to encourage sustainable waste management. The design of this programme will be determined following further work on the management of waste policy. In advance of allocation decisions on the programme, these funds have been added to total DEL and credited to the Reserve;
• as in previous years, the underspend from 2001-02 has been carried forward and added to total DEL in 2002-03; and
• in 2002-03 there is a special reserve addition.

B24 The projections do not take account of measures proposed in this Pre-Budget Report for consultation prior to Budget 2003 and other proposals where final decisions have yet to be taken, including medium to long-term increases in the standard rate of landfill tax.

back to top

FISCAL AGGREGATES

B25 Tables B5 and B6 provide more detail on the projections for the current and capital budgets. The tables show the current budget and net borrowing both including and excluding Windfall Tax and associated spending (WTAS). WTAS now has much less impact and, unless otherwise stated, all projections now cover all public expenditure. Latest estimates of associated spending are given in Table 4.1.

B26 The current budget surplus is equal to public sector receipts minus public sector current expenditure and depreciation. The current budget is projected to show a modest deficit in 2002-03 and 2003-04, before moving back into surplus throughout the rest of the projection period. These temporary deficits are consistent with allowing the automatic stabilisers to operate fully over the economic cycle, while continuing to meet the golden rule.

B27 The cumulative total surplus on the current budget between 1999-2000, the beginning of the current economic cycle, and 2001-02 is £49 billion. If the cycle were to start in 1997-98, the accumulated surplus would be £58 billion. Even after the modest cyclical deficits expected in 2002-03 and 2003-04, the current budget will therefore be comfortably in surplus over this cycle.

B28 Underlying the projections of the current budget are steady increases in the ratios of public sector receipts and current expenditure to GDP, shown in Table B6, largely reflecting measures announced in Budget 2002 and the 2002 Spending Review. By 2005-06, when the current cycle ends under the assumptions used in these projections, the accumulated total surplus over this economic cycle will be £46 billion.

B29 Table B5 also shows that net investment is projected to more than double from £14¹/₄ billion in 2002-03 to £30 billion in 2007-08, as the Government seeks to rectify historical under-investment in public infrastructure. These increases are sustainable and fully consistent with the Government's long-term approach and the fiscal rules, as debt is being held at 33 per cent of GDP or below throughout the projection period, well within the 40 per cent limit set by the sustainable investment rule, as shown in Table B6.

back to top

B30 Table B7 sets out the effects of revisions and forecasting changes, including the effect of the changes to the VAT and tobacco audited assumptions, Pre-Budget Report policy decisions and other discretionary changes since Budget 2002 on the main fiscal aggregates.

back to top

B31 The latest available outturn information for 2001-02 shows current receipts only £0.1 billion lower than estimated in Budget 2002, but current expenditure, including depreciation, £2.8 billion higher. As a result, the current budget surplus was around £3 billion lower than expected at Budget 2002. However, net borrowing was only around £0.1 billion lower, as net investment was around £3 billion lower than estimated in Budget 2002. Further explanation of the differences between outturns and earlier forecasts is given in the End of year fiscal report.

B32 The current surplus for 2002-03 onwards is lower than in Budget 2002, mainly because of lower tax receipts, especially income tax and corporation tax. Further details of these changes are given in the next section. Net borrowing is also increased by the forecasting changes to receipts.

B33 There are only minor forecasting changes to total expenditure in 2002-03 and during the 2002 Spending Review period. However, changes to the composition of expenditure announced in the Spending Review, coupled with the assumptions used to project spending after the end of the Spending Review period, lead to small increases in spending in 2006-07.

RECEIPTS

B34 This section looks in detail at the Pre-Budget Report projections for public sector tax receipts. Table B8 provides a detailed breakdown of the main factors that have led to changes in the overall projections since Budget 2002, while Table B9 shows the changes to the individual taxes. Table B10 sets out projections of the overall tax-GDP ratio and Table B11 shows projections of receipts from major taxes as a per cent of GDP. Tables B12 and B13 give more information on the level of tax receipts in 2001-02, 2002-03 and 2003-04.

Total receipts

B35 As shown in Table B8, relative to Budget 2002, current receipts are projected to be around £7¹/₂ billion lower in 2002-03 and around £11¹/₂ billion lower in 2003-04. Most of these falls are explained by cyclical or other temporary factors. As a result, overall levels of receipts are expected to return to their Budget 2002 levels over the medium term.

B36 Changes to the assumptions audited by the NAO explain only a small proportion of the fall in receipts in 2002-03. However, they have a much larger impact in subsequent years, mainly because of changes in equity prices. The audited assumption underpinning the current projections is that equity prices increase in line with money GDP from the existing level of the FTSE All-Share Index, 1963 in these projections, compared with the Budget 2002 starting point of 2542. As a result, equity prices are 23 per cent lower than the Budget forecast for 2002-03 and 25 per cent lower for 2003-04. Equity price levels are important determinants of capital taxes, stamp duty and, because of their impact on the capital gains of life insurance companies, corporation tax, though the timing of the impact varies from tax to tax, and the size of the impact increases after the first year. Lower equity prices reduce receipts by around £1 billion in 2002-03, by £3¹/₂ billion in 2003-04, and by around £4 billion a year from 2004-05 onwards.

back to top

back to top

back to top

B37 Changes to the audited assumptions for VAT and tobacco add about £¹/₂ billion to receipts in 2003-04 and increasing amounts thereafter, reaching almost £2 billion in 2007-08. These effects are also shown in the audited assumptions section of Table B8. The Government aims to reduce VAT fraud by more than £2 billion a year by 2005-06, but in line with its audited, cautious approach to forecasting a lower figure of £1.4 billion a year is used here.

B38 A large proportion of the temporary shortfall in receipts relative to the Budget 2002 forecast is explained by temporarily lower levels of financial companies' profits resulting from the impact of global events, especially further downturns in international capital markets. This impacts most significantly on the corporation tax paid by financial companies (other than life insurance companies - see paragraph B36) and on income tax, through their impact on the level of salaries, especially bonuses, paid by financial companies to their employees.

B39 The other economic and forecasting effects line in Table B8 is driven by a large number of different, but interrelated, factors working in different directions at different times. Some of these effects are temporary but others persist throughout the projection period. They include changes to other economic determinants such as GDP components and price effects and fiscal forecasting changes, which reflect recent tax receipts data that cannot be explained by changes in economic determinants, and changes arising from the models used to forecast receipts relating to, for example, average tax rates. The more important changes are described in the following tax-by-tax analysis section. The figures for 2003-04 onwards include a fall of about £2 billion a year in respect of the revision to the split of tax credits between their negative tax and expenditure components. This has no overall impact on the current budget or net borrowing, and is explained in more detail in paragraph B47.

Tax-GDP ratio

B40 Table B10 shows the impact of changes to tax projections on the tax-GDP ratio, which is now expected to fall to 36.3 per cent of GDP in 2002-03, compared with a Budget 2002 projection of 36.7 per cent. Similarly, the tax-GDP ratio in 2003-04 is now projected to be 37.0 per cent, compared with a Budget 2002 projection of 37.6 per cent. Thereafter, the recovery of financial company profits and other cyclical and temporary factors mean that the tax-GDP ratio moves back towards Budget 2002 levels. The additional VAT and tobacco duty receipts resulting from changes to the audited assumptions also increase the ratio, by up to 0.2 percentage points in the medium term. Chart B3 shows the tax-GDP ratio from 1978-79 to 2007-08.

back to top

Media links

• Chart B3: Tax-GDP ratio

back to top

Pre Budget report 2002 index