Autumn Statement – financial analysis

Autumn Statement – financial analysis

Despite expectations to the contrary, the Chancellor, George Osborne, was able to present an Autumn Statement with a budget deficit that continued to fall, even though he had only achieved half of what he’d expected back in 2010.

With the economic recovery now well established and a general election due in May he was keen therefore to emphasise that his “long term economic plan” was working, that it would deliver a budget surplus by the end of the next parliament and so should not be jeopardised by a change in government.

But weaknesses soon emerged in the scenario he presented. The level of spending cuts assumed for the next five years is so large as to threaten not only the bounds of credibility but also the consensus between the coalition partners. And the forecasts of the budget finances emerged as very sensitive to two crucial assumptions: that wages will rise significantly to bolster tax returns, and interest rates will remain low to reduce the cost of debt repayments. Neither of these are in any way certain.

The economy is robust…

The Office of Budget Responsibility (OBR) now expects the economy to come in at 3% growth in 2014, up from their 2.7% forecast at the March Budget. Expectations of growth in 2015 are also up a notch, from 2.3% to 2.4%. Overall it is the pick-up in business investment that is driving the recovery, and a strong service sector, with the difference since March due to slightly higher spending from both households and government than previously anticipated. A weaker-than-expected eurozone, however, means the growth contribution from net trade has fallen.

However, as in previous years, the OBR has not altered its estimates of the supply side potential of the economy significantly such that increased growth in 2014 and 2015 is compensated for by reduced growth in the years that follow: their story is simply one of the slack in the economy being used up faster than was previously thought.

GDP Growth

…with unemployment continuing to surprise…

A key feature of recent years has been the surprisingly strong performance of the labour market. It continues to outperform expectations with a million more people in work now than had been presumed only 18 months ago, although some of the increase recorded in 2014 is due to the Office of National Statistics (ONS) revising up its estimates of the size of the working population. In the next parliament, the OBR expects employment to rise by a further million jobs overall – despite the continuation of deep cuts in public sector employment. The economic conundrum is why this strong performance has not – yet – translated into higher income tax receipts, exposing the Chancellor to accusations from the Labour Party that the jobs created are low quality. Indeed where the OBR was expecting a 2.4% increase in private average earnings in the last year, the actual out-turn was 1.1%. Having said that, real wages are now beginning to enter positive territory with the official forecasts expecting average earnings to start rising strongly from 2016.

Employment forecasts

…and inflation due to under-shoot the Bank of England target.

A key change since the March budget is a downwards revision to the inflation forecast. In line with Bank of England projections, the headline Consumer Price Index (CPI) measure of inflation is expected to fall below 1% early next year, which will prompt the Governor of the Bank of England to write a letter to the Chancellor explaining why.

His reasons will include the recent rise in sterling which has pushed import prices down, falls in oil and other global commodity prices and the weakness in wages. The OBR suggests that inflation will not rise back to the target level of 2% until 2017. This is good news for the government finances as it will put downward pressure on key parts of the welfare bill that are linked to inflation, reversing the situation of recent years where a spike in inflation had an unwelcome effect on the cost of benefits and tax credits to the public purse.

Inflation forecasts

This has allowed the deficit to keep falling (depending on your definition)…

The government in 2010 set itself a target to eliminate the structural current budget deficit over a rolling five-year period. It remains on track to do so, anticipating a surplus to be recorded in the year 2017-18 as expected in March. However the path to this consolidation will now initially be slower, indeed the structural deficit as a proportion of GDP actually rises slightly, from 2.6 per cent to 2.7 per cent of GDP over the next year – a fact that Mr Osborne neglected to mention in his statement to parliament.

Cyclically adjusted surplus on budget forecasts

Putting the structural elements to one side, the overall size of the budget deficit is now expected to fall from 10.2% of GDP in 2009-10 to a surplus of 0.2% of GDP in 2018-19, around half of which has currently been completed. Although in both periods, the bulk of the cuts are expected to come from a reduction in Whitehall spending, the next five years will also see a greater contribution from welfare cuts and increased tax receipts, offset by a slowing in the pace of cuts to capital expenditure.

…and debt levels to peak…

There have been numerous changes to the net debt forecast since March, the overall effect of which has been to cause the amount of outstanding government debt to rise in each of the forecast years, but the date at which it is expected peak, as a proportion of GDP, remains the same: 2015-16.

Two technical changes have taken place – a reclassification of all public sector finances to the ESA10 standard, the main effect of which is to include Network Rail for the first time, and the inclusion of Asset Purchase Facility transfers – the combined effect of which is to increase overall borrowing in the near term and reduce it in the medium term.

On top of this, forecasts of government income have been revised down substantially – by £25bn annually at the end of the forecast period – driven by lower-than-expected income tax receipts. However, and perhaps luckily for the Chancellor, spending is also expected to fall.

This lowering of the spending forecast comes primarily from the fall in debt service payments which in turn arise from the lower long term interest rate expectations seen in recent weeks, but is also affected by new Treasury assumptions of the (large) size of cuts that would occur at the end of the forecast period which were provided to the OBR by the government late in the process and after the usual deadline. Cynics might presume they were provided simply to make the books balance; the Liberal Democrat Business Secretary, Vince Cable, was quick to distance himself from them.

Public sector net debt (%of GDP)

On top of these technical and forecast changes, the effect of policy measures announced in the budget are to reduce borrowing a little further across the whole of the forecast period by an average of £0.2bn, allowing the Chancellor to claim that the budget as a whole represented a fiscal tightening.

Policy announcements were designed to trap Labour…

The main winners from the specific policy announcements in the Autumn Statement are home buyers who will benefit from the abolition of the previous ‘slab’ rate of stamp duty taxation and its replacement by a progressive new marginal rate. With a positive impact on 98% of sales, this is a giveaway to homeowners of £400m next year, doubling in the years that follow. And its highly progressive yet one-off nature is a challenge to Labour’s annual mansion tax proposal for homes worth over £2m, which has attracted criticism from, amongst others, the party’s potential mayoral candidates as being unpopular with cash-poor people living in large houses.

A further challenge for Labour comes in the proposed extension and review of business rates relief; the Opposition had already sought to distinguish itself by favouring reductions in business rates over corporation tax rates. And by re-emphasising earlier announcements to invest in the road and rail networks, more money for the NHS, a sovereign wealth fund to invest in the North of England from shale gas revenues, support for oil and gas, apprenticeships and energy efficiency, and an appetite for greater city-level devolution, the government demonstrated its sensitivity to issues that are important to many Labour MPs.

At the same time a small but significant increase in the personal allowance – up to £10,600 by 2015 with corresponding increases to the higher rate – will over-achieve a key Liberal Democrat promise while having broad and simple appeal to all working people bar the super-rich.

…despite evident risks to financing….

These giveaways are financed through three main sources: limits to the ability of banks to spread losses in one year against future income streams, a continuation of general anti-avoidance schemes and an attack on multinationals’ ability to avoid taxation by taking profits offshore – the so-called “Google tax”. Yet of the 17 separate policy announcements designed to achieve these aims, 12 of them are deemed by the OBR to have either ‘medium-high’, ‘high’ or ‘very high’ risks that they won’t raise the amounts required, with the remaining 5 having ‘medium’ risks that they will not yield the expected amount.

…as ducks are lined up for the general election shoot-out.

Labour’s response was to start a line of attack designed to undermine the government’s lead on issues of economic credibility. They emphasised that the budget deficit had only been halved, when the government had said it would be eliminated, and accused them of performing a U-turn by introducing steeply progressive property taxation when they had opposed Labour’s mansion tax. They also used the lower-than-expected income tax receipts as proof of the ‘cost of living crisis’ experienced by many people.

The Liberal Democrats are beginning an attempt to distance themselves from the severity of implied departmental cuts in the next parliament, exposing the Conservatives to such an extent that the Chancellor was forced the morning after the Autumn statement to describe such claims as “hyperbolic” even though the OBR’s analysis is that the scale of departmental cuts to meet the overall spending assumptions is unprecedented.

For the Conservatives, however, there remains an advantage to pinning their colours to drastic levels of austerity: if they can provoke Labour into opposing it then a question will be opened up during the imminent general election campaign as to how the Opposition’s more lenient approach would be funded.

Points to watch

In the next week the government will introduce a new fiscal framework requiring a parliamentary vote in the new year. This will flush out whether Labour is prepared to sign up to the level of austerity that the government is proposing or whether there is a wedge between them that will be filled by tax rises.

If real wages rise as currently forecast, Labour’s attack on grounds of cost of living may look weaker. Conversely, if productivity – and real wages – do not pick up, the assumptions behind the fiscal forecasts will begin to look very uncertain.

If growth rates consistently come in higher than the OBR is forecasting without upward pressure on inflation, they may consider revisiting their estimates of the supply side potential of the economy that will alter any consideration of whether the government’s current fiscal rules have been met.

The total welfare bill for in-work benefits also needs watching. If it starts to rise – for example if the number of people in low paid work who are eligible for tax credits continues to go up and/or the expected savings from a reassessment of health-related payments are slow to appear – then the welfare cap may be deemed to be breached requiring compensatory policy measures.

Any increase in interest rate or inflation expectations will also have a negative effect on forecasts of the government finances, particularly if it isn’t driven by a strong UK economy and so is not offset by a rise in income tax receipts.

However with Budget 2015 no more than a few months away, to be followed rapidly by the dissolution of parliament prior to the general election, it seems likely that most of these issues could be problems for the next government, not this one.

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