This paper[1] updates earlier Treasury analysis[2] of the effects of the cycle on the public finances. The paper also takes a more disaggregated look at the behaviour of individual taxes and components of expenditure over the cycle. An important element in this analysis is a careful adjustment of the time series for receipts for the effects of discretionary policy measures.
This analysis enables us to assess the respective contributions of cyclical factors and underlying trends to developments in the public finances. The cycle affects both tax receipts and government expenditure. For example, in a recession higher unemployment increases benefit expenditure and reduces income tax receipts and national insurance contributions. Similarly, lower high street spending means lower excise duties and VAT receipts, and lower company profits mean lower corporation tax receipts. In practice nearly all tax revenues vary with the cycle. By contrast, government expenditure, apart from cyclical social security and a few other items, does not vary automatically with the cycle.
Even so the ratio of general government expenditure (GGE) to GDP will change over the cycle just by virtue of movements in the denominator of the ratio. On the tax side, changes in receipts over the cycle are often broadly proportionate to changes in output, so they have little effect on the ratio of General Government Receipts (GGR) to GDP. There are notable exceptions, eg corporation tax, where receipts respond more than proportionately to changes in output, so the GGR/GDP ratio falls in a recession. In total the cycle has a greater effect on the GGE/GDP ratio than on the GGR/GDP ratio.
Specifically, a 1 per cent increase in output relative to trend is estimated after two years to:
The estimates are of course subject to a margin of error. Uncertainties arise both in defining the cycle and in estimating the responsiveness of taxes and spending to it.
It is easier to assess underlying trends in the public finances once these cyclical effects are removed from the observed fluctuations in the GGE, GGR and PSBR ratios. The estimates in this paper suggest some improvement in the underlying fiscal position between 1979-80 and 1992-93. In cyclically adjusted terms, both the share of government spending in GDP and the PSBR/ GDP ratio were lower in 1992-93 than in 1979-80, while the net effect of the tax measures over this period was to reduce the underlying GGR/GDP ratio.
[1] Data shown in the charts are as they were at the time the estimation work was carried out, but are not necessarily the latest data.
[2] See "Fiscal developments and the role of the cycle", Treasury Bulletin, volume 2, issue 1, Winter 1990-91.