Uncertain productivity makes a forecast less sweet

Uncertain productivity makes a forecast less sweet

Most inconveniently for the Chancellor, the independent Office of Budget Responsibility revised down its growth forecasts for the UK economy at Wednesday’s Budget, causing him to miss his target that debt should fall this year.

This downgrading of the growth forecast has also required him to make further changes to ensure his aim of a budget surplus by 2019-20 is met, which he achieves mainly through postponing planned savings from a re-phasing of corporation tax payments so that they land in the final year of the parliament.

Perhaps unsurprisingly Mr Osborne’s rhetoric skated over these short-term difficulties and focussed instead on the long-term nature of his economic plan, as well as highlighting the recent difficulties in the global financial markets and the further risk to the UK economy from Brexit.

There was much in the budget that appealed to his core constituency: the ending of local authority control over schools, a backtrack on plans to scrap higher-rate pension tax relief, more generous ISA allowances and raising the higher-rate income tax threshold.

He also continued his highly successful political tactic of peppering his Budget with regional transport and devolution announcements: highlights this year include reducing tolls on the Severn Bridge, more funding for schools in Northern England, and pressing ahead with the next phases of Crossrail in London and the new High Speed 3 train line between Manchester and Leeds.

Lower earners and the self-employed were also supported through a further increase in the personal tax allowance, the freezing of fuel duty (despite the fall in petrol prices) and the abolition of self-employed NICs. Online eBay traders and Airbnb enthusiasts were also helped through a new tax-free allowance from profits obtained through “sharing economy” activities.

The picture for business was more complex. Although the Chancellor cut the headline rate of corporation tax, to 17% at the end of the parliament, he also restricted corporation tax relief on debt interest payments bringing in substantial revenues two years beforehand. The onslaught on the pensions industry continued with the introduction of a new Lifetime ISA designed to help the under-40s save for a home or a pension, and rises to insurance premium tax to fund flood defences.

But the papers the next day focussed instead on the announcement of a new levy on sugary drinks, the proceeds from which will go towards supporting more sport in schools, with many papers describing this as a spoonful of sugar designed to help us swallow the medicine of more cuts.


Growth is revised down…

Although the Chancellor was keen to emphasise the uncertain global environment, the Office of Budget Responsibility made only “relatively small” downward revisions to forecasts for world GDP and world trade. Instead, it is their decision substantially to downgrade forecasts of potential productivity growth within the UK that drives their growth forecasts down.

GDP growth now looks as if it was a little lower at the end of last year than previously thought, but employment grew faster than expected, as did the average number of hours worked. It is therefore arithmetically true that productivity, measured in terms of output per hour worked, was also lower.

As a result, the OBR argues, it is appropriate to reduce estimates of the potential rate of productivity growth for the entire forecast period which brings down all their growth forecasts. In 2016 economic growth is now expected to be 2%, down from the 2.4% predicted in November, before settling at 2.1% towards the end of the forecast period, down from 2.3%, as chart 1 below shows.


Chart 1: GDP growth forecasts

GDP growth forecasts


Whether the projected weakening of potential productivity growth into the future follows naturally from the lower-than-expected productivity growth of the last few months is a matter of debate; the OBR themselves accept that it is “the most important uncertainty in our (and most people’s) economic forecast”.

Indeed there are clues that the Treasury themselves privately expect the forecasts to be revised back up again: departmental spending cuts designed to partially fill the fiscal hole that arises from lower GDP forecasts will only be outlined following a review scheduled to report in 2018, by which time things could look very different.

…even before any implications of Brexit are considered…

The OBR is required to make its forecasts based on government policy, and since the official policy is that Britain should remain in the European Union, this means that their forecasts are based on an assumption that the referendum to be held on the UK’s EU membership on June 23rd will return a vote in favour of remaining in.

This gave the Chancellor the opportunity to emphasise the further risks that would come from voting to leave, over and above the already-lower forecasts, citing the OBR’s statement that a vote to leave would have “negative implications for activity via business and consumer confidence”.

…causing debt and deficit projections to weaken.

Since the standard way of monitoring the stock of government debt, and the annual budget deficit, is to express it as a proportion of GDP, it follows that the downgrade to the GDP forecasts has caused a corresponding increase in the debt and deficit forecasts. There is also a further pressure on the government finances from the fact that low inflation throughout the economy is expected to reduce tax receipts in nominal terms.

These factors combined have reduced the expected pace at which the stock of government debt will start to fall, causing the government to miss its target that debt will fall in each year of this parliament, as shown by the March 2016 forecast line rising in the current year on chart 2 below, before finally starting its long-awaited fall.


Chart 2: Public sector net debt forecasts

Public sector net debt forecasts

Given that it is too late to affect outcomes for a fiscal year that is about to finish, the Chancellor instead focussed his attention on the knock-on effect to his main target of eliminating the budget deficit by the end of the parliament, making a series of policy changes designed to ensure that the projected surplus for 2019-20 remained of a similar size to that anticipated in the Autumn Statement, as Chart 3 below shows: 


Chart 3: Budget deficit forecasts

Budget deficit forecasts

These changes include:

  • Pushing back the planned changes to the timing of corporation tax payments so that the one-off gain to the Treasury falls in the last year of the parliament
  • A new efficiency review of departmental spending designed to identify further cuts in the 2019-20 year. This will report in 2018.
  • A reduction in spending on overseas aid and also EU contributions, as these are both linked to GDP which is now lower.
  • A decision not to compensate departments for anticipated increases in employer pension contributions, scored in the public accounts as a cut.
  • Bringing forward planned capital spending, so that the spend in 2019-20 is lower

It is notable that the bulk of these decisions are about phasing, suggesting perhaps that the Treasury considers there to be little need for further structural change in the direction of fiscal policy.


Meanwhile employment remains strong…

The number of people in work continues to outperform expectations (chart 4), as it has done consistently since the OBR’s first forecast in 2010. The unemployment rate is now expected to reach a low of 5% in 2016, down from the 5.2% expected in November. After this, the labour market is finally expected to start tightening with increases to productivity and wages, albeit not as fast as previously thought.


Chart 4: Employment forecasts

Employment forecasts

…and inflation low.

The outlook for inflation is also benign, with inflationary expectations falling a little since the last forecast, although the zero rate of inflation recorded in 2015 is not expected to persist into 2016. This, combined with lower GDP forecasts and the New Year instability in the global financial markets has again ensured that expectations of interest rate rises recede further into the future, taking some of the pressure off a government with high debt servicing obligations.


Chart 5: Inflation forecasts

Inflation forecasts

Main policy changes

Budget 2016 saw a large package of changes to business and personal taxation, as well as a continuation of efforts to clamp down on tax avoidance and evasion.

The main changes announced at the budget in terms of size are listed below (with illustrative cost/savings in 2020-21):

  • An increase in the personal allowance to £11,500 and the higher rate threshold to £45,000 in April 2017 (costs £2.5bn)
  • Raising the ISA limit to £20,000 and introducing a new Lifetime ISA (cost £850m)
  • New sugar levy on the soft drinks industry (raises £455m)
  • More generous small business rates (costs 1.5bn)
  • Reduce corporation tax to 17% from April 2020 (costs £945m)
  • Reduce tax relief on interest payments (raises £885m)
  • Other changes to corporation tax (raises £1bn)
  • Reforms to stamp duty land tax for non-residential property (raises £590m)
  • Reduce capital gains tax excluding residential property and carried interest (costs £735m)
  • Abolish class 2 NICs for self-employed (costs £360m)
  • Tax free allowance for “sharing economy” income (costs £200m)
  • Abolish Petroleum Revenue Tax and reduce Oil and Gas Supplementary Charge (costs £200m)
  • Various tax avoidance and evasion measures (raise £2bn)
  • Fuel duty freeze in April 2016 (costs £450m)


Looking across the whole the five year period from 2016-17 to 2020-21, the policy decisions taken in Budget 2016 raise an additional £6.3bn for the Treasury.

However in the fourth year, 2019-20, the net effect is to raise around £8bn, supporting the policy requirement achieve a budget surplus in that year.


Points to watch

The OBR’s forecast does not factor in a short-term economic effect on the UK economy in the months running up to the EU referendum on 23rd June. It is possible that the surprisingly low GDP figures at the end of 2015 were affected by the forthcoming referendum, for example through a postponement of business investment. Presuming the UK remains in the EU, this might be expected to lead to a re-bound effect in the second half of the year that could cause growth forecasts to be revised up again if not by the time of the Autumn Statement then certainly by Budget 2017.

Conversely were the UK to vote to leave the EU, there would be significant knock-on effects to business and consumer confidence, not to mention turbulence in financial markets, which could cause a substantial revision to the economic forecasts.

Notwithstanding the economic effects of the Brexit vote, the forecasts are heavily dependent on assumptions around the pace of productivity growth which are notoriously uncertain. By the time of the Autumn Statement there should be more data to ascertain whether the assumptions that were made in this forecast are borne out in practice.

In the meantime, were the US Fed to decide to continue raising interest rates following their first foray into this arena just before Christmas, this would be a strong indicator that they are confident that the economic outlook is strong, which would have a positive effect on confidence.

The inflation forecasts are also dependent on whether OPEC decides to continue its recent intervention to support oil prices.

Overall, therefore, given that the OBR’s next forecast is not expected for a further eight months, during which time many of these issues will be resolved, perhaps the only thing that can be said for certain is that it is likely to change.

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