2
Delivering macroeconomic stability
The forward-looking macroeconomic framework put in place by the Government is delivering greater economic stability:
-
the monetary policy framework is delivering low and stable inflation;
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the fiscal policy framework has restored the public finances to a healthy and sustainable position and allowed fiscal policy to support monetary policy through the cycle; and
-
early indications suggest that the economy may have completed a full economic cycle since 1997-98. If so, the Government met both of its fiscal rules over the cycle.
The Budget maintains the commitment to stability and prudence and ensures the Government remains on track to meet the fiscal rules and deliver steady growth. The key messages in this chapter are:
-
latest fiscal outturns and projections are better than expected, with much of the improvement being structural. This Budget locks in the fiscal tightening over the next two years to an even greater extent than projected in Budget 99, while releasing substantial new resources for the Government's key public service priorities;
-
The Government's Budget judgement ensures that the fiscal rules will be met over the coming years and that the outcome of the Budget is consistent with the continuing commitment to prudence and responsibility. In the Budget the Government is:
-
implementing a Budget package to promote enterprise and work and release extra resources to tackle child and pensioner poverty;
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setting firm overall limits for public spending for the period of the 2000 Spending Review, allowing;
-
current spending to increase by 21/2 per cent a year in real terms in the three years to 2003-04, in line with the Government's neutral view of the economy's trend rate of growth; and
-
a more than doubling in net investment, rising to 1.8 per cent of GDP by 2003-04. This makes a significant further contribution to tackling the legacy of underfunding of Britain's public infrastructure while remaining consistent with the sustainable investment rule.
-
allocating an additional £3 billion of current spending in 2000-01 and an additional £1 billion of capital spending within DEL in 2000-01.
The Government will continue to entrench the monetary and fiscal frameworks, delivering stability and steady growth and avoiding a return to the boom and bust of the past.
|
THE MACROECONOMIC FRAMEWORK
Delivering stability
2.1 The UK has a history of poor economic performance in comparison with other G7 economies. Much of the blame for this poor performance can be attributed to policy errors made in the past. The Government's macroeconomic framework has been designed to avoid a repeat of mistakes which led to boom and bust cycles and relative underperformance. In the face of the uncertainty and unpredictability of ever more rapid financial flows, the Government believes it is vital to:
-
set clear, long-term policy objectives;
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adopt predictable, well-understood procedural rules for monetary and fiscal policymaking; and
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keep markets properly informed, and ensure that objectives and the relevant institutions which implement them are seen to be credible, through increased openness, accountability and transparency.
2.2 In keeping with this approach, the Government introduced new frameworks for the operation of both monetary and fiscal policy. These frameworks are highly transparent, forward-looking and are underpinned by legislation. Their design helps prevent macroeconomic policy being set on the basis of short-term political interests, rather than in the interests of the economy and country as a whole. This macroeconomic framework is delivering much more stable growth and employment than in the past, based on low inflation and sound public finances.
The monetary framework
2.3 Price stability is a key requirement for achieving the Government's central economic objective of high and stable levels of growth and employment. Low and stable inflation helps individuals and businesses to plan for the long term. This in turn improves the quality and quantity of long-term investment, both in physical and human capital, and helps raise productivity.
2.4 The UK's poor inflation record over most of the past 30 years reflected shortcomings in the previous design and conduct of monetary policy. In the past, objectives were often inappropriate or unclear, roles and responsibilities were ill-defined, and a lack of transparency hindered the accountability and credibility of policymakers.
2.5 On entering office, the Government undertook fundamental reforms of the monetary policy framework. Recognising the importance of price stability, the Government made this the key objective of monetary policy. The objective was defined as a single and unambiguous inflation target to avoid any risk of a return to policies (such as attempting to target both inflation and the exchange rate) that caused instability in the past. Thus a clear inflation target of 21/2 per cent for the annual increase in the Retail Prices Index excluding mortgage interest payments (RPIX) was set and is reaffirmed in this Budget. To ensure that monetary policy is forward-looking and supports the Government's growth and employment objectives the Government also made the inflation target symmetrical, so that deviations below target are treated equally seriously as those above.
2.6 The Government's monetary policy framework also sets out clear roles and responsibilities: the Government sets the inflation target, while the task of the Bank of England's Monetary Policy Committee (MPC) is to set interest rates to meet that target. Interest rate decisions are thus now made by independent experts, unencumbered by short term political pressures. The MPC's decisions are based on rigorous analysis and take into account all available information, including regional and sectoral information provided by the Bank's network of 13 regional agents, which covers the whole of the UK.
2.7 The inflation target applies at all times, and the MPC is accountable for any deviations from it. The framework recognises, however, that any economy can at some point be subject to unexpected events which can cause inflation to depart from its desired level. In such cases, the onus is on the MPC to explain how it proposes to return inflation back to target. If inflation is more than one percentage point below or above the target, the Governor of the Bank of England is required to write an open letter to the Chancellor, explaining why this divergence has occurred, the policy action being taken to deal with it, the period within which inflation is expected to return to target, and how this approach is consistent with the Government's objectives for growth and employment.
2.8 The granting of operational independence to the Bank was also accompanied by a range of measures aimed at improving the transparency and accountability of monetary policy. Minutes of the MPC's meetings are published within two weeks of its decisions, while the quarterly Inflation Report reviews recent monetary policy decisions, assesses developments in inflation and indicates the expected approach to meeting the Bank's objectives. In addition, members of the MPC are subject to full scrutiny by Parliament, through the Treasury Committee and a specially established House of Lords Committee.
2.9 A key feature of the monetary policy framework is the forward-looking and pro-active approach taken by the MPC. Inflation outturns have been a poor guide to prospects in previous cycles (see Box B4). This highlights the fact that policymakers need to look ahead when making decisions, given that the effects of monetary policy flow through to inflation with a lag, and because upward or downward pressures on inflation take time to build following either an upturn or a slowing in growth. The new monetary arrangements provide a more credible framework in which unexpected developments can be addressed as they arise. By acting promptly, policymakers can help to contain inflationary pressures, thereby reducing volatility in both inflation and output.
The fiscal framework
2.10 The Government has also introduced a new framework for fiscal policy to ensure that the same high standards of transparency, responsibility and accountability which now underpin monetary policy also apply to fiscal policy decisions.
2.11 The previous fiscal framework left the Government, on taking office, faced with a large structural deficit, low net investment, rising public debt and falling public sector net worth. This situation had come about, in part, as a result of a lack of clear and transparent fiscal objectives, together with fiscal reporting that did not permit full and effective public and parliamentary scrutiny.
2.12 The Government therefore implemented a new framework for fiscal policy based on a set of five central principles - transparency, stability, responsibility, fairness (including between generations) and efficiency. These principles were enshrined in the Finance Act 1998 and repeated in the Code for Fiscal Stability, approved by the House of Commons in December 1998. The Code explains how these principles are to be reflected in the formulation and implementation of fiscal policy in practice.
2.13 As outlined in the March 1999 EFSR, the Government is committed to ensuring
that households are fully informed about tax and spending decisions and in due course intends to amend the Code for Fiscal Stability to guarantee this. It is considering the most effective way to take this forward, including the distribution to households of a leaflet, as set out last year.
2.14 The Government's key objectives for fiscal policy are:
-
over the medium term, ensuring sound public finances and that spending and taxation impact fairly both within and across generations. In practice, this requires that:
-
the Government meets its key tax and spending priorities while avoiding an unsustainable and damaging rise in the burden of public debt; and
-
as far as possible, those generations who benefit from public spending also meet the costs of the services they consume.
-
over the short term, supporting monetary policy where possible, by:
-
allowing the automatic stabilisers to play their role in smoothing the path of the economy in the face of variations in demand; and
-
where prudent and sensible, providing further support to monetary policy through changes in the structural (cyclically-adjusted) fiscal position.
2.15 These objectives are reflected in the Government's two strict fiscal rules, against which the performance of fiscal policy may be judged:
-
the golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending; 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.
2.16 The golden rule is met if, on average over a complete economic cycle, the current budget is in balance or surplus. The Government has also said that, other things equal, a reduction in net public sector debt to below 40 per cent of GDP over the economic cycle is desirable.
The public spending framework
2.17 The Government has also implemented a new regime for planning and controlling public spending with the following main features:
-
three-year plans have been set for all the main government departments through Departmental Expenditure Limits (DEL). These limits provide departments with a solid basis for planning and an incentive to manage their own costs effectively. A spending review is taking place currently, and will be completed by July 2000 (see Box 2.2);
-
Annually Managed Expenditure (AME), which cannot reasonably be subject to firm multi-year limits, is subject to tough annual scrutiny as part of the Budget process; and
-
within DEL and AME - which together equate to Total Managed Expenditure (TME) - a distinction is made between current and capital spending for each department, consistent with the distinction in the fiscal rules. This removes the bias against investment inherent under the previous planning regime.
2.18 Each department is also committed, through Public Service Agreements (PSAs), to testing performance and efficiency targets for the modernisation of public services. Departments have also drawn up Departmental Investment Strategies (DIS), first published in March 1999, to show how they manage capital effectively and how investment decisions are taken on a robust basis so as to maximise the benefits of the extra investment.
Performance of the frameworks
2.19 The new monetary policy framework has been in operation now for almost three years. As Chart 2.1 demonstrates, the MPC's record so far in meeting the Government's inflation target is a good one. Since May 1997, RPIX inflation has averaged 2.5 per cent, moving in a narrow band between a low of 2.1 per cent and a high of 3.2 per cent.
Chart 2.1: Inflation performance against target
2.20 Survey and financial market data also suggest that the MPC has established a high degree of credibility, with inflation expected to remain close to target in the future. Since the Government's monetary policy framework was introduced, expectations of inflation ten years ahead have fallen from over 4 per cent to around 21/2 per cent, consistent with the inflation target.
Chart 2.2: Inflation expectations 10 years head
2.21 The MPC has acted quickly and pre-emptively to maintain price stability1:
-
from mid to late 1997, the MPC raised interest rates four times and successfully headed off mounting inflationary pressures;
-
between late 1998 and the first half of 1999, the MPC cut rates aggressively in response to the global downturn, action that not only lessened the risk of a significant undershoot of the inflation target but which was also widely credited with helping to avoid a sharp slowdown in domestic activity; and
-
since autumn 1999, the MPC has again moved pre-emptively, in four measured steps, to avoid a build up of inflationary pressures. Base rates have been raised to 6 per cent in response to the improved global economic outlook, strong growth in consumer spending and tighter labour market countries.
2.22 By focusing on price stability, the Government's monetary policy framework has allowed interest rates to be lower and more stable than in the past. Despite recent increases, official rates remain well below their latest peak and are less than half the level seen in the late 1980s and early 1990s. In addition, long-term interest rates are at historically low levels and are currently below equivalent rates in other major European countries.
2.23 The new fiscal framework has restored the public finances to a healthy and sustainable position, while allowing fiscal policy to support monetary policy through the economic cycle. The necessary fiscal tightening during 1997-98 supported monetary policy when the economy was above trend, and Budget 99 locked in that tightening. The Budget 2000 projections show this tightening is more than locked in, with the Government continuing to meet the fiscal rules, including on more cautious assumptions.
2.24 Early indications suggest that the new macroeconomic framework is delivering valuable results. In contrast to the boom and bust of the past, the UK economy has enjoyed a period of stability and steady growth since the introduction of the new monetary and fiscal policy frameworks, (see Chart B3), with output and employment at high and stable levels. With its focus on economic stability, increased employment opportunity, higher productivity, and responsibility in wage setting, the Government is aiming for stronger sustained growth.
2.25 A high degree of economic stability will also help to provide the foundations for the necessary convergence should the UK decide to join EMU in the next Parliament (see Box 2.1).
| Box 2.1: EMU AND EMU PREPARATIONS
The UK economy is closely linked to the economies of the eleven member countries of EMU. Almost 50 per cent of the UK's trade is with the euro zone and the UK and the euro area are each other's largest trade and investment partners. The Government is therefore committed to playing its part in ensuring a successful single currency.
Government policy on UK membership of the single currency remains as set out by the Chancellor of the Exchequer in a statement to Parliament in October 1997, and as restated by the Prime Minister when he launched the first Outline National Changeover Plan in February 1999.
The determining factor underpinning any Government decision on membership of the single currency is whether the economic case for the UK joining is clear and unambiguous. Because of the magnitude of the decision, the Government believes - as a matter of principle - that if the decision to enter is taken by Government, it should be put to a referendum of the British people. Government, Parliament and the people must all agree.
The Government has set out five economic tests which will have to be met before any decision to join can be taken. These are: whether the UK has achieved sustainable convergence with the economies of the single currency; whether there is sufficient flexibility in the UK economy to adapt to change and unexpected economic events; whether joining the single currency would create better conditions for business to make long term decisions to invest in the UK; the impact membership would have on our financial services industry; and, ultimately, whether the single currency would be good for employment. The Government has said that it will produce another assessment of the five tests early in the next Parliament.
The Government is committed to ensuring that preparations are made so that, should the economic tests be met, the British people would be in a position to exercise genuine choice in a referendum. The Government has recently published its second Outline National Changeover Plan, which shows that, through making targeted preparations during 1999, the UK has maintained the option to make a decision early in the next Parliament, for a smooth and cost-effective changeover should Government, Parliament and the people - in a referendum - decide to join. This has been achieved both by preparations in the public sector, and through a co-ordination of planning effort across the whole economy.
The Government has also been helping small and medium sized enterprises (SMEs) to consider what impact the euro has on the way they do business. Some three quarters of a million SMEs have trading links with the European Union. The Government will continue to work with business to provide them with the information that they need. Further details are set out in the Treasury's Third Report on Euro Preparations.
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RECENT ECONOMIC AND FISCAL DEVELOPMENTS
Recent economic developments
2.26 The past 18 months have provided an important test for the Government's monetary and fiscal frameworks. This time last year, many commentators foresaw weak short-term prospects for the UK economy. Global financial turbulence from summer 1998 prompted a period of slow growth in UK export markets and delivered a severe shock to global and domestic confidence. UK economic growth came to a temporary standstill in late 1998, mainly due to falling export volumes. Business surveys also deteriorated sharply, though these were clearly heavily influenced by global conditions, as domestic demand, particularly investment spending, remained quite firm.
2.27 The Budget 99 forecast, by contrast, projected much greater buoyancy in UK activity. With inflation under control, helped by a significant fiscal tightening during 1997 and 1998, monetary policy was able to respond pro-actively to events. By the time of Budget 99, base rates had already been reduced by 2 percentage points from a relatively low peak of 71/2 per cent in mid-1998, and subsequently fell to a trough of 5 per cent in summer 1999. With private sector balance sheets in good health, the prospect of continued growth in domestic demand underpinned the more buoyant Budget 99 forecast of 1 to 11/2 per cent growth in 1999, strengthening in 2000 as trade pressures eased.
2.28 Developments over the past year broadly confirm those Budget forecasts. Activity strengthened rapidly through 1999, with quarterly GDP growth rising from 0.4 per cent in the first quarter of 1999 to an average rate of 0.9 per cent during the second half. The balance of growth also improved in 1999, with manufacturing output and export volumes recovering rapidly from mid-year, and all regions of the UK sharing in the strengthening in activity (see Box B1). GDP rose by 2 per cent overall in 1999, exceeding the upper end of the Budget 99 forecast range. Underlying strength in private sector demand has in fact been much greater than anticipated. Household consumption growth, in particular, significantly exceeded all earlier forecasts.
2.29 The labour market also performed strongly in 1999, with LFS employment rising by 290,000 during the course of the year. The strengthening of output growth did, however, outstrip employment gains, yielding a marked recovery in non-oil productivity growth to over 11/2 per cent by the fourth quarter of 1999. Broadly as anticipated in the Pre-Budget Report forecast, this is now much closer to the rate underpinning the Government's neutral 21/2 per cent estimate for trend output growth. Growth in unit wage costs eased somewhat through 1999 as a consequence.
2.30 Unemployment has declined further with both the claimant count and ILO measures now standing at 20-year lows, and the employment rate approaching its previous peak. It seems quite likely that the sustainable level of unemployment has fallen over recent years, though the recent upturn in earnings growth sounds a cautionary note. The key to further sustained increases in the employment rate therefore lies increasingly in expanding the effective supply of labour by re-attaching the inactive to the labour market and further tackling persistent long-term unemployment. This will be helped by continued improvements in regional labour market balance reflected, for example, in lower dispersion in ratios of unemployment to vacancies across the UK (see Box B2). The Government's strategy to increase employment opportunity for all is described in Chapter 4.
2.31 RPIX inflation has remained just below target since April 1999. Underlying price deflation in the retail goods sector more than accounts for these subdued outturns. Sterling's strength and falling import prices have sharpened competitive pressures on domestic producers and retailers, with retail goods inflation rates recently at 40-year lows in many sectors. Core service sector inflation, by contrast, rose to 51/2 per cent during the course of 1999. With services less directly exposed to sterling, this provides a much clearer reflection of the rapid growth in demand and a tight labour market. Nominal earnings have accelerated sharply recently and are now growing in excess of the 41/2 per cent rate that the Bank of England has said is consistent with the inflation target in the medium term.
Recent fiscal developments
2.32 The decisions taken in Budget 99 were designed to lock in the substantial fiscal tightening that had been achieved since 1997-98, and allowed fiscal policy to support monetary policy over the cycle. In the event, stronger than anticipated growth, coupled with other structural factors, improved the position of the public finances beyond that projected in Budget 99.
2.33 The surplus on the current budget in 1999-2000 is now estimated to be £17.1 billion, compared with a forecast of £2 billion at the time of Budget 99. A similar improvement is observed for public sector net borrowing (PSNB). A repayment of £11.9 billion is now expected in 1999-2000, compared with a projected deficit of £3 billion in Budget 99. These surpluses are also higher than expected at the time of the Pre-Budget Report.
Table 2.1: Changes in the surplus on current budget and net borrowing
| £ billion |
| Outturn | Estimate |
| 1998-993 | 1999-00 |
| Surplus on current budget1,2 |
| Budget 99 | 4.1 | 2 |
| Contribution due to higher receipts | 1.6 | 11.4 |
| Contribution due to lower spending | 1.8 | 3.3 |
| Budget 2000 | 7.5 | 17.1 |
| Net borrowing1,2 |
| Budget 99 | -1.0 | 3 |
| Contribution due to higher receipts | -1.6 | -11.4 |
| Contribution due to lower spending | -0.2 | -3.3 |
| Budget 2000 | -2.8 | -11.9 |
1 Excluding windfall tax receipts and associated spending.
2 Figures may not sum due to rounding.
3 1998-99 figures were estimates in Budget 99.
2.34 Higher than expected surpluses in 1999-2000 primarily reflect:
-
higher than projected receipts of £11.4 billion, due to:
-
a more favourable composition of GDP; and
-
higher than expected GDP growth;
-
lower than projected current expenditure of £3.3 billion.
2.35 It is important to distinguish between the cyclical and structural components of the fiscal improvement. Cyclical adjustment is not an exact science, as neither the level nor the growth of potential output is directly observable. However, based on the Treasury's methodology for cyclical adjustment2, while some of the improvement in the public finances in 1999-2000 reflects stronger than anticipated growth, much of the improvement appears to have been structural.
2.36 Table 2.2 shows the cumulative fiscal tightening that has taken place since 1996-97. The 4.2 per cent of GDP cumulative tightening to 1999-2000 is equivalent to nearly £40 billion.
Table 2.2: The fiscal tightening - cumulative change since 1996-97
| Percentage points of GDP |
| Outturns | Estimate |
| 1997-98 | 1998-99 | 1999-2000 |
| Public sector net borrowing (cyclically-adjusted)1 |
| Budget 99 | -2.0 | -3.0 | -3.2 |
| PBR 99 | -1.8 | -3.0 | -3.2 |
| Budget 2000 | -1.8 | -3.1 | -4.2 |
1Excluding windfall tax receipts and associated spending.
Performance over the cycle
2.37 The two fiscal rules are set over the economic cycle. This provides an inbuilt capacity for fiscal policy to respond to changing economic circumstances. The economy was judged to have been on trend in the first half of 1997. Output fell below trend towards the end of 1998, but only for a very short time, before returning to trend again in the middle of 1999. Thus, early indications suggest the economy may have completed a full economic cycle - albeit a short and shallow one by historical standards - since 1997-98. Given the closeness to trend and possible measurement errors, this conclusion can only be provisional at this stage. If the monetary and fiscal frameworks are successful, a reduction of cyclical movements in the economy over time is to be expected.
2.38 Based on this assessment, the Government met both its fiscal rules over this short cycle. For the period 1997-98 to 1999-2000, the average annual surplus on the current budget was 0.7 per cent of GDP. This contrasts with the cycle from 1986-87 to 1997-98 during which there was an average annual current budget deficit of 2 per cent of GDP. The sustainable investment rule has also been met, with net debt standing at 37.1 per cent of GDP in 1999-2000.
THE ECONOMIC AND FISCAL OUTLOOK
2.39 The health of the public finances and the state of the economy are interdependent. This section looks first at the economic outlook before examining what this means for the public finances, and the implications for this year's Budget decisions.
Economic outlook
2.40 Latest economic indicators have yet to provide clear evidence of any slowing in domestic demand growth in early 2000. Household spending in particular looks set for continued robust growth in the short term.
Table 2.3: Summary of forecast
| | Forecast |
| 1999 | 2000 | 2001 | 2002 |
| GDP growth (per cent) | 2 | 23/4 to 31/4 | 21/4 to 23/4 | 21/4 to 23/4 |
| RPIX inflation (per cent, Q4) | 21/4 | 21/4 | 21/2 | 21/2 |
2.41 Domestic demand is expected to grow by 31/2 to 4 per cent in 2000, a full percentage point higher than forecast in the Pre-Budget Report. Consumer confidence remains at very high levels, boosted by the recent sharp acceleration in house prices. The saving ratio is now expected to fall to 51/2 per cent this year, with the result that much stronger growth in household consumption of 31/2 to 33/4 per cent is now forecast in 2000. Stronger domestic demand growth overall is likely to be offset by a weaker net trade performance. This partly reflects correspondingly faster growth in import volumes, but also slower growth in export volumes reflecting sterling's recent strengthening. GDP is expected to grow by 23/4 to 31/4 per cent in 2000, an upward revision of 1/4 percentage point since the Pre-Budget Report forecast.
2.42 RPIX inflation is currently a little below the Government's 21/2 per cent target and some downward price pressures can be expected to persist for a while. This creates headroom for above trend growth this year, with the output gap projected to rise to around 1/2 per cent of GDP by the end of the year. Hence, it is vital that the economy does not exceed its trend growth rate in later years, so more sustainable rates of expansion in domestic demand must be achieved3. The MPC has pre-emptively increased interest rates by a full percentage point since September 1999. Much in line with the independent consensus, GDP growth is expected to ease back to its trend rate of 21/4 to 23/4 per cent in both 2001 and 2002.
2.43 RPIX inflation is forecast to remain below target throughout 2000, with sterling's recent appreciation sustaining competitive pressures and accounting for the more persistent inflation undershoot compared to the Pre-Budget Report forecast. However, firms' margins are unlikely to continue to be squeezed at their current rate and rising import prices are expected to make a much stronger contribution to inflation from now on. These factors are likely to offset a gradual easing in domestic costs growth, returning RPIX inflation to 21/2 per cent by early 2001.
2.44 There are clear upside risks to the outlook. Stronger than expected growth in domestic demand would lead to greater labour market cost pressures and a sharper rise in RPIX inflation during the course of 2001. In particular, recent rapid growth in house prices, transactions and borrowing could lead to much stronger growth in household consumption than forecast. Accelerating house prices would pose some risk to economic stability.
2.45 These risks highlight the importance of the Government's forward-looking policy framework. While house price inflation and activity is likely to remain robust in the near-term, pressures should ease later in 2000 and into 2001 as higher purchase prices, mortgage rates and some easing in real income growth act to curtail housing demand. The removal of MIRAS from April 2000 and increased stamp duty will also contribute to greater sustainability in housing and consumer demand. Policy will need to remain alert to the risks.
2.46 There is also an upside risk to the investment outlook. Incentives to invest are strong, not least because future growth will depend increasingly on securing an improved productivity performance. Although company borrowing has recently risen to high levels, firms' balance sheets remain healthy. This suggests that a return to much stronger rates of growth in capital spending is quite possible.
2.47 Moreover, in the global economy there is also clear evidence, following instabilities over the past two years, that growth is strengthening. Global pressures, including rising oil prices, mean that policymakers must remain vigilant and act decisively when necessary.
2.48 The downside risks mainly reflect imbalances in the world's two largest economies, the USA and Japan. In the US growth remains above trend, and the current account deficit has reached record levels. By contrast in Japan growth remains weak with the economy slipping back into recession in the second half of last year. A gradual rebalancing of global growth to a more sustainable pattern is expected this year as policy is tightened in the US and the recovery becomes more established in Japan. However, the risk remains of a sharp slowdown in the US and continued weakness in Japan with adverse effects on UK prospects.
2.49 Against this background, continued vigilance will be necessary if the MPC's successful track record is to be maintained. Responsible wage bargaining and price setting is key, as unsustainable wage and price rises would result in higher interest rates, with undesirable consequences for economic growth and unemployment. Continued fiscal prudence is also needed if stability is to be maintained. Low inflation and sound public finances are the best contribution the Government can make to securing a stable and competitive exchange rate over the medium term.
2.50 Potential for stronger sustainable output and productivity growth exists. The Government has taken significant steps to begin to close the productivity gap with its main competitors, described in Chapter 3. The share of business investment in GDP has already risen sharply, and within that growth in Information and Communications Technology (ICT) spending appears to have been particularly strong. Growth in e-commerce is also likely to provide an increasing spur to competition and productive efficiency. However, the Government is determined to adopt a prudent approach, erring on the side of caution where uncertainties exist. The upside possibilities are therefore illustrated by the upper ends of the GDP forecast ranges, based on 23/4 per cent trend output growth, and incorporating some modest improvement in underlying productivity performance not banked in the neutral case.
Fiscal outlook
2.51 Following a significant improvement in the public finances in 1999-2000, which is projected to persist, the large surpluses expected on the current budget would imply a fiscal tightening well in excess of that anticipated in Budget 99. While the golden rule helps ensure over time that current taxpayers pay for current goods and services it is also prudent to plan adequately to cover possible adverse shocks and ensure that the fiscal rules are met. It is against this background that the Budget decisions have been taken.
2.52 The economic forecast is based on a neutral estimate of 21/2 per cent a year trend growth. However, for the purposes of the public finance projections, a more cautious assumption of 21/4 per cent has been adopted. This assumption has been re-audited by the National Audit Office (NAO) as part of the rolling review of existing assumptions the Chancellor has asked the NAO to undertake4. For each of the three audited assumptions from the July 1997 Budget which were reviewed, the NAO concluded that they have "provided a reasonable basis for the elements of the fiscal projections to which they relate, and that they should continue to do so for future projections". In addition to the rolling review, the NAO has audited the methodology for forecasting tobacco revenues. The NAO concluded that the approach adopted is reasonably cautious.
BUDGET DECISIONS
Framework
2.53 The Budget represents a definitive statement of the Government's desired fiscal policy settings. As well as introducing new measures, this Budget sets the firm overall spending limits for the three year period covered by the 2000 Spending Review (2001-02 to 2003-04).
2.54 With the economy above trend and continuing to show momentum, it is vital that a clear distinction is made between the cyclical and structural strength of the economy. This approach helps to ensure that the Government remains on track to meet the fiscal rules over the economic cycle and takes account of the lessons of the past. It is also important that Budget decisions enable fiscal policy to continue supporting monetary policy. For these reasons, it is more important than ever that a cautious, forward-looking approach is taken towards fiscal policy settings.
2.55 Two key issues are considered before decisions are made about changes to the aggregate fiscal policy settings:
-
the outcomes required to ensure that, over the economic cycle, the Government meets its fiscal rules and its broader medium-term fiscal objectives, including the need to maintain fairness between generations; and
-
the path for the key fiscal aggregates that best ensures, over the economic cycle, fiscal policy supports monetary policy.
Decisions
2.56 The Government has taken both considerations into account in making its Budget decisions. In the face of substantially improved projections, the Government has been able to lock in the fiscal tightening over the next two years to an even greater extent than expected in Budget 99, while releasing substantial extra resources to its key public service priorities.
2.57 The Government is:
-
implementing a Budget package to promote enterprise and work and release extra resources to tackle child and pensioner poverty; and
-
setting firm overall limits for public spending for the period of the 2000 Spending Review, allowing:
-
current spending to increase by 21/2 per cent a year in real terms in the three years to 2003-04, in line with the Government's neutral view of the economy's trend rate of growth; and
-
a more than doubling in net investment, rising to 1.8 per cent of GDP by 2003-04. This makes a significant further contribution to tackling the legacy of underfunding of Britain's public infrastructure while remaining consistent with the sustainable investment rule, with the debt to GDP ratio remaining well below 40 per cent in the medium term.
2.58 In implementing these measures, the Government remains well on track to meet the fiscal rules, including under the cautious case (see below). Maintaining a cautious approach is essential given the inherent uncertainties surrounding public finance projections.
2.59 Social security spending in 1999-2000 has been £2 billion lower than expected in Budget 99, and in 2000-01 is projected to be £2 billion lower than expected. The Government has decided that, in the light of the significantly improved fiscal position and its commitment to meeting the fiscal rules, it is able to allocate a further £4 billion to DEL in 2000-01, including the £1 billion DEL underspend, while locking in the fiscal tightening to a greater extent than projected in Budget 99. This provides:
-
an additional £3 billion of current spending; and
-
an additional £1 billion of capital spending for renewing public infrastructure.
This additional spending is being targeted at the Government's key public service priorities - education, health, law and order and transport. Further details of the allocations are given in Chapter 5.
2.60 A full explanation of the addition to DEL in 2000-01 and the firm spending limits for 2001-02 to 2003-04 within which the 2000 Spending Review will be completed is given in Chapter 5. These decisions allow spending on key public services to be sustained and increased, while at the same time ensuring that the Government's strict fiscal rules and objectives continue to be achieved. The Budget measures are set out in Chapter A.
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Box 2.2: The 2000 Spending Review
The Government is currently conducting a Spending Review, to be completed by July 2000.
The aim of the Review is to determine how best departments' programmes can contribute to the achievement of the Government's objectives, in particular its aims of:
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opportunity for everyone to fulfil their potential through education and employment;
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a fair and inclusive society in which communities are healthy and secure; and
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higher productivity, sustainable economic growth and effective co-operation with our European and international partners.
The Review will roll forward the three-year planning cycle for public expenditure introduced in the 1998 Comprehensive Spending Review (CSR). The third year of the CSR plans (2001-02) will become the first year of the new three-year planning period. The Review will set new departmental spending plans for 2002-03 and 2003-04, with the firm overall limits for public spending announced in this Budget.
Besides setting new spending plans the Review will agree new Public Service Agreements with departments. These Agreements show Parliament and the public what they can expect to get for their money. They will set out the specific, measurable targets for service improvements which departments must deliver in return for investment.
The Review is taking a rigorous look at the effectiveness of existing programmes in considering the future path of spending in each area. For the first time the Review is being conducted on a resource budgeting basis, taking account of all the resources departments employ in delivering an objective, not just cash consumed.
One of the major innovations in the 2000 Review will be the inclusion of fifteen cross-departmental reviews. These will focus on key issues from crime reduction and intervention in deprived areas to science and research and the knowledge economy. The reviews will identify the best ways of improving inter-departmental co-operation and co-ordination.
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MEDIUM-TERM FISCAL PROJECTIONS
2.61 Table 2.4 compares the revised medium-term projections for the current budget and public sector net borrowing with those published in Budget 99 and the Pre-Budget Report. Changes are decomposed into those explained by policy measures, and those due to forecasting and other changes.
Table 2.4: Changes in the surplus on current budget and net borrowing since Budget 991
| £ billion |
| Outturn3 | Estimate | Projections |
|
1998-99 |
1999-00 |
2000-01 |
2001-02 |
2002-03 |
2003-04 |
2004-05 |
| Surplus on current budget1,2 |
| Budget 99 | 4.1 | 2 | 4 | 8 | 9 | 11 | - |
| Effect of revision/forecasting changes | 3.1 | 7 | 8 | 6 | 4 | 1 | - |
| Effect of policy measures | - | - | -1 | -1 | -1 | -1 | - |
| PBR 99 | 7.2 | 9.5 | 11 | 13 | 13 | 12 | 11 |
| Effect of revision/forecasting changes | 0.3 | 7.5 | 6 | 11 | 10 | 8 | 9 |
| Effect of policy measures | - | - | -3 | -9 | -10 | -11 | -12 |
| Budget 2000 | 7.5 | 17.1 | 14 | 16 | 13 | 8 | 8 |
| Net borrowing1,2 |
| Budget 99 | -1.0 | 3 | 3 | 1 | 3 | 4 | - |
| Effect of revision/forecasting changes | -1.5 | -6 | -7 | -5 | -3 | 0 | - |
| Effect of policy measures | - | - | 1 | 1 | 1 | 1 | - |
| PBR 99 | -2.5 | -3.5 | -3 | -3 | 1 | 4 | 6 |
| Effect of revision/forecasting changes | -0.3 | -8.4 | -6 | -11 | -10 | -8 | -9 |
| Effect of policy measures | - | - | 4 | 11 | 13 | 16 | 15 |
| Budget 2000 | -2.8 | -11.9 | -6 | -5 | 3 | 11 | 13 |
1 Excluding windfall tax receipts and associated spending.
2 Figures may not sum due to rounding
3 The 1998-99 figures were estimates in Budget 99.
Fiscal stance
2.62 Table 2.5 compares the latest fiscal projections, including Budget decisions, with those presented in Budget 99. It shows that the fiscal stance, defined as cyclically-adjusted PSNB, is projected to be tighter over the next two years than in Budget 99. Thus the tightening in the fiscal stance has been locked in further, as compared with Budget 99, with fiscal policy doing more over this period to support monetary policy while the economy is above trend.
Table 2.5: Fiscal balances comparison with Budget 991
| Outturn2 | Estimate | Projections |
|
1998-99 |
1999-00 |
2000-01 |
2001-02 |
2002-03 |
2003-04 |
2004-05 |
| Fiscal balances (£ billion) |
| Surplus on current budget - Budget 99 | 4.1 | 2 | 4 | 8 | 9 | 11 | - |
| Surplus on current budget - Budget 2000 | 7.5 | 17.1 | 14 | 16 | 13 | 8 | 8 |
| Net borrowing - Budget 99 | -1.0 | 3 | 3 | 1 | 3 | 4 | - |
| Net borrowing - Budget 2000 | -2.8 | -11.9 | -6 | -5 | 3 | 11 | 13 |
| Cyclically-adjusted budget balances (per cent of GDP) |
| Surplus on current budget - Budget 99 | 0.2 | 0.6 | 1.0 | 1.1 | 0.9 | 1.0 | - |
| Surplus on current budget - Budget 2000 | 0.6 | 1.8 | 1.3 | 1.3 | 1.0 | 0.7 | 0.7 |
| Net borrowing - Budget 99 | 0.1 | 0.0 | -0.2 | -0.1 | 0.3 | 0.4 | - |
| Net borrowing - Budget 2000 | -0.1 | -1.2 | -0.5 | -0.3 | 0.5 | 1.1 | 1.1 |
1 Excluding windfall tax receipts and associated spending.
2 The 1998-99 figures were estimates in Budget 99.
Adhering to key fiscal principles
2.63 Table 2.6 presents a summary of the key fiscal aggregates focused around five key themes: fairness and prudence, sustainability, economic impact, financing and meeting European commitments5.
Table 2.6: Summary of public sector finances1
| Per cent of GDP |
| Outturn | Estimate | Projections |
|
1998-99 |
1999-00 |
2000-01 |
2001-02 |
2002-03 |
2003-04 |
2004-05 |
| Fairness and prudence |
| Surplus on current budget | 0.9 | 1.9 | 1.5 | 1.6 | 1.2 | 0.8 | 0.7 |
| Cyclically-adjusted surplus on current budget | 0.6 | 1.8 | 1.3 | 1.3 | 1.0 | 0.7 | 0.7 |
| Average surplus since 1999-2000 | - | 1.9 | 1.7 | 1.7 | 1.5 | 1.4 | 1.3 |
| Long-term sustainability |
| Public sector net debt2 | 39.7 | 37.1 | 35.1 | 33.6 | 32.7 | 32.6 | 32.6 |
| Net worth2 | 13.6 | 15.4 | 17.1 | 18.2 | 18.7 | 18.8 | 18.8 |
| Primary balance | 3.3 | 3.8 | 3.2 | 2.8 | 1.9 | 1.0 | 0.9 |
| Economic impact |
| Net investment | 0.6 | 0.6 | 0.9 | 1.2 | 1.5 | 1.8 | 1.8 |
| Public sector net borrowing (PSNB) | -0.3 | -1.3 | -0.7 | -0.5 | 0.3 | 1.0 | 1.1 |
| Cyclically-adjusted PSNB | -0.1 | -1.2 | -0.5 | -0.3 | 0.5 | 1.1 | 1.1 |
| Financing |
| Central government net cash requirement2 | -0.5 | -0.6 | -0.5 | 0.0 | 0.5 | 1.5 | 1.4 |
| European commitments |
| Maastricht deficit3 | -0.6 | -1.3 | -0.6 | -0.3 | 0.3 | 1.1 | 1.2 |
| Maastricht debt ratio4 | 47.0 | 44.1 | 42.0 | 40.2 | 39.1 | 38.9 | 38.7 |
| Memo: Output gap | 0.2 | 0.1 | 0.4 | 0.3 | 0.2 | 0.1 | 0.0 |
1 Excluding windfall tax receipts and associated spending.
2 Including windfall tax receipts and associated spending.
3 General government net borrowing on an ESA95 basis. The Maastricht definition includes windfall tax receipts and associated spending.
4 General government gross debt.
Fairness and prudence
2.64 The golden rule is designed to achieve fairness between generations ensuring that, as far as possible, those generations who benefit from public spending meet the costs of the services they consume.
2.65 Since 1996-97, the Government has delivered a substantial improvement in the current budget, which has moved from a deficit of 3 per cent of GDP to an estimated surplus of 1.9 per cent in 1999-2000. Estimates of the cyclically-adjusted current budget suggest that much of this improvement has been structural.
2.66 The average current budget over the period 1997-98 to 1999-2000, which early indications suggest may constitute a complete economic cycle, is estimated to have been
0.7 per cent of GDP, indicating that the Government met the golden rule over the period.
2.67 Over the projection period, the surplus on the current budget is projected to fall gradually to 0.7 per cent of GDP by 2004-05. Consistent with the need to maintain a cautious approach, this profile shows that the Government is well on track to meet its golden rule over the projection period, with the average surplus on the current budget from 1999-2000 falling from 1.7 per cent GDP in 2000-01 to 1.3 per cent GDP in 2004-05.
2.68 It is also important to take into account the cyclical component of the surplus. The Government has maintained a prudent approach in its Budget decisions, and the cyclically-adjusted current budget remains comfortably positive throughout the projection period.
Long-term sustainability
2.69 Net debt has declined continuously as a proportion of GDP since 1996-97, when it stood at 44 per cent of GDP. By the end of March 2000, it is projected to be 37.1 per cent of GDP. This is consistent with meeting the sustainable investment rule. The Budget 2000 projections show a decline in net debt, stabilising at 32.6 per cent of GDP by 2004-05 reflecting the sustained improvement in the position of the public finances. This is consistent with the projected more than doubling of net investment over the same period.
2.70 Net worth and the primary balance are alternative indicators of the sustainability of the public finances. Net worth, which is the difference between the total assets and liabilities of the Government, is projected to be 15.4 per cent of GDP by the end of 1999-2000, rising to almost 19 per cent of GDP by 2002-03. The primary balance, which is PSNB excluding debt interest payments, is forecast to be 3.8 per cent of GDP in 1999-2000, falling to 0.9 per cent of GDP in 2004-05.
Chart 2.3: Public sector net debt and net worth
Economic impact
2.71 While the primary objective of fiscal policy is to ensure the medium-term sustainability of the public finances, fiscal policy also plays a role in supporting monetary policy6.
2.72 The key indicator for assessing the overall fiscal impact is the change in PSNB. PSNB differs from the current budget because it includes net investment. Government investment will have an impact on economic activity and should therefore be included when assessing the economic impact of fiscal policy.
2.73 The overall fiscal impact is made up of changes in:
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the fiscal stance - that part of PSNB resulting from changes in cyclically-adjusted PSNB; and
-
the automatic stabilisers - that part of PSNB resulting from cyclical movements in the economy.
2.74 The fiscal stance can change as a result of:
-
a discretionary Budget measure to achieve the desired change in the fiscal stance; and
-
a Budget decision to accommodate or offset the impact of non-discretionary factors (non-cyclical or structural changes to tax receipts or public spending) that are expected to affect the fiscal stance.
2.75 Table 2.7 explains how these concepts relate to the projections presented in this Budget. It shows the change in both the fiscal stance and the overall fiscal impact relative to the projections in Budget 99.
Table 2.7: The overall fiscal impact - change from Budget 99 projections
| Percentage points of GDP |
| Estimate | Projections |
| 1999-00 | 2000-01 | 2001-02 | 2002-03 | 2003-04 |
| discretionary policy measures1 | - | 0.5 | 1.2 | 1.4 | 1.6 |
| + |
| non-discretionary factors | -1.2 | -0.8 | -1.4 | -1.2 | -0.9 |
| = |
| CHANGE IN FISCAL STANCE | -1.2 | -0.3 | -0.2 | 0.2 | 0.7 |
| + |
| automatic stabilisers | -0.4 | -0.8 | -0.4 | -0.2 | -0.1 |
| = |
| OVERALL FISCAL IMPACT | -1.6 | -1.1 | -0.6 | 0.0 | 0.6 |
1 Includes measures announced in November 1999 Pre-Budget Report and Budget 2000.
2.76 In 1999-2000, there was a significant tightening of the fiscal stance, of 1.2 per cent of GDP relative to that anticipated at the time of Budget 99. This has occurred primarily through a more favourable composition of GDP, and lower than projected current expenditure. In addition to this large tightening of the fiscal stance, growth above that anticipated at the time of Budget 99 has meant that the automatic stabilisers have operated to a greater extent than anticipated (0.4 per cent of GDP). Taken together, the overall fiscal impact has supported monetary policy more than anticipated at Budget time, by 1.6 per cent of GDP.
2.77 Over the next two years the non-discretionary tightening of the fiscal stance is projected largely to persist. The package of measures announced in Budget 2000 partially offsets this. Overall, however, the fiscal stance is anticipated to be 0.3 percentage points of GDP tighter in 2000-01, and 0.2 percentage points of GDP tighter in 2001-02, than expected in Budget 99. The automatic stabilisers will also operate to a greater extent than previously allowed for, reflecting the stronger evolution of the economy now expected. The overall fiscal impact is therefore projected to support monetary policy more than anticipated in Budget 99, by 1.1 per cent of GDP in 2000-01, and by 0.6 per cent of GDP in 2001-02.
Financing
2.78 The financing requirement is primarily determined by two variables:
-
refinancing redemptions of gilts, which are expected to be fairly stable over the projection period. From £19 billion in 2000-01 they are projected to fluctuate between £16 billion and £22 billion over the 2001-02 to 2004-05 period; and
-
the central government net cash requirement, consistent with the rest of the fiscal projections, is forecast to rise over the period from minus £5 billion in 2000-01, to balance in 2001-02, and to £16 billion in 2003-04 and 2004-05.
2.79 The Debt Management Report7, published at the time of the Budget, reviews developments in debt management over the past financial year, and sets out the details of the UK Government's borrowing programme for the forthcoming financial year.
European commitments
2.80 The Maastricht Treaty and Stability and Growth Pact provide reference values for general government net borrowing (3 per cent of GDP) and general government gross debt (60 per cent of GDP). The Budget 2000 projections show general government net borrowing (the Maastricht Deficit) at -1.3 per cent of GDP i.e. net lending, and general government gross debt at 44.1 per cent of GDP in 1999-2000. Both measures meet the reference values comfortably.
Dealing with uncertainty
2.81 Forecasting the public finances involves a high degree of uncertainty. For this reason the public finance projections are based on cautious assumptions audited by the NAO. The projections build in an additional surplus on the current budget over the economic cycle, providing a safety margin over what would be strictly necessary to meet the golden rule.
2.82 Chart 2.4 illustrates a more cautious case in which trend output is assumed to be 1 per cent lower than in the projection used for the medium-term public finance projections in Table 2.6. This scenario would imply that a greater degree of the projected surplus on the current budget is due to the cyclical strength of the economy. Even on this more cautious case the golden rule would be met, with the cyclically-adjusted current budget projected to be in surplus or balance over the forecast horizon.
LONG-TERM FISCAL PROJECTIONS
2.83 In setting fiscal policy it is important that the Government ensures that its short-term decisions are consistent with a sustainable long-term framework. In line with this, the illustrative long-term fiscal projections for the UK (see Annex at the end of the EFSR) show a broadly sustainable fiscal position. Improvements in labour force participation or productivity would further strengthen this position.
2.84 The projections also show that if net investment is sustained at around 13/4 per cent of GDP, the debt ratio will stabilise at slightly below 40 per cent of GDP in the long-term, consistent with meeting the sustainable investment rule. The considerable uncertainty surrounding the long-term analysis of fiscal trends means that, despite the sound overall position, there is no scope for complacency.
2.85 In addition to the long-term sustainability of the public finances, the Government is focusing on how its wider economic, social and environmental policies impact on quality of life - both now and for future generations. The Government's strategy for sustainable development is summarised in Box 6.1.
1See The New Monetary Policy Framework, HM Treasury, October 1999, for a more detailed assessment.[back]
2The Treasury's methodology for cyclical adjustment is set out in Fiscal Policy: Public Finances and the Cycle, HM Treasury, March 1999.[back]
3See Trend Growth - Prospects and Implications for Policy, HM Treasury, November 1999.[back]
4See Audit of Assumptions for the March 2000 Budget, March 2000 (HC348).[back]
5Based on the formulation introduced in Analysing UK Fiscal Policy, HM Treasury, November 1999.[back]
6For a more detailed explanation of the Government's approach see Analysing UK Fiscal Policy, HM Treasury, November 1999.[back]
7See Debt Management Report, HM Treasury, March 2000.[back]
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