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Monday March 20, 2006 - 11:16:01 GMT
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UK Chancellor Brown has little room for manoeuvre in the 2006 Budget

Economics Weekly: UK Chancellor Brown has little room for manoeuvre in the 2006 Budget

A Budget of little net consequence?
This week sees what could be the final budget from Gordon Brown as Chancellor. After an economic slowdown last year that saw him having to raise taxes on business, once again, in order to avoid breaching his own fiscal rules what is likely to be in the 2006 Budget? That is the subject of this week’s economic briefing.

/b>Little change to economic forecasts expected…
In terms of economic policy, we do not expect any material changes compared with the Pre Budget Report (PBR) released in December 2005. Then, the chancellor severely lowered his forecasts for economic growth to 2-2.5%, a rate that is getting more likely by the day, but this was 1 percentage points below his previous range. For 2007, the growth forecast was cut, to 2.75 - 3.25%; a range that we think is possible but is currently at the top end of financial market expectations. Overall, the risks to the official economic forecasts are still probably to the downside, with investment and consumer spending key to these risks crystallising. The danger is that growth does not accelerate as the Treasury predicts, upsetting fiscal plans as tax revenue undershoots projections. As chart a shows, the growth of current receipts has fallen below that of spending since 2003, as annual spending growth rose strongly to the 8-9% range. Any further slowdown in the economy would surely hit current receipts relative to spending, so widening the fiscal deficit. After all, this is the fifth year in succession that the Chancellor has had to alter his fiscal plans between March and December.

...but little room for manoeuvre on taxation and spending plans
A rise in taxation is unlikely after December’s £5bn increase, as that could result in weaker economic growth than last year and so reduce tax revenue even further, thus worsening the fiscal deficit. But a net giveaway is unlikely also, not least because any spending increase will only worsen an already large fiscal deficit, likely to be some 3% or so of gdp in 2005/6. The result is that we are likely to be left with a budget with many small measures that do not add up to very much. In other words, a neutral budget – one that does not diverge much from previous plans (in this case, the December ones). But this is what one should expect from a mid-term budget in any event – any giveaway will be nearer the next general election and any tax increases just after the results. It does not always work out to be this way, of course, but that is the pattern that most government's would like to adopt.

The government’s new borrowing totals, of £37bn in the current financial year, 2005/6, and £34bn in 2006/7 have been made much more likely by the increase in taxation of North Sea oil companies and by the £5bn lifting of government net debt. The forecasts in the March Budget are unlikely to be much different from those presented in December. The real challenge lies next year, with the start of the three year Comprehensive Spending Review. The reason for this is that the plans in the current budget imply that spending, seen in chart a, will fall by 0.7% of national income in nominal terms over the period from 2008/9 to 2010/11. That would be roughly £8 1/2bn at 2005 prices. But if planned spending on health and education are taken into account, the squeeze on other departments mean spending cuts and so some very tough choices would have to be made.

Will the government meet its fiscal rules?
The government’s fiscal plans suggest that the golden rule, borrowing only to invest over the economic cycle, will be met comfortably, with a surplus of £12.8bn. But this is based on a cut in spending of £8.5bn by the end of the next three year spending review due to start in the 2008/9 fiscal year, with real spending rising by just 0.8% a year after inflation (that compares with 1.9% a year from now to 2008/9 and by 3.8% a year over the history of spending reviews). That is difficult to see and could mean a rise in taxation if spending does not fall. Using more pessimistic economic growth assumptions and so less optimistic assumptions about revenue growth suggest that the golden rule will be close to being breached.

/b>What will the Chancellor find to talk about in the Budget?
One issue that will figure in the Budget is the funding of government debt. Although we believe that total government borrowing will continue to drift upward as a share of national income, potentially weakening the productivity of the UK economy, this does not mean bond yields will rise. That is more dependent on price inflation pressure than the supply of gilts. Companies should therefore think about issuing more bonds and buying back equity (increase gearing), rather than buying expensive government long dated gilts to fund pension liabilities. But, for the DMO, there should be more issuance of long dated official paper as this will
keep down government funding costs.

Other issues likely to be aired in the Budget
There are issues, about government efforts to improve productivity, R&D incentives, and the high level of UK corporation tax in an international context of falling tax rates, that leave the Chancellor with plenty of room to say some perhaps interesting things in the Budget on Wednesday. Look out for mention of inheritance tax, which is increasingly hitting lower middle income families, tax avoidance, which is now expected to bring in £4.5bn a year to the exchequer and tax credits, which have been widely criticised. But any new measures are unlikely to alter the fiscal path set out in the December PBR.

Trevor Williams, Chief Economist
[email protected]
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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