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Economics Weekly: UK 2007 pre-Budget report: Weaker growth leads to increased borrowing and higher taxation; Weekly economic data preview: Economic data to guide interest rate expectations
Economics Weekly 15 October 2007
UK 2007 pre-Budget report: Weaker growth leads to increased borrowing and higher taxation
Summary - a political pre-Budget report?
Political calculations for a possible snap election in the autumn were evident in the 2007 pre- Budget report, notably in proposals to raise the threshold of inheritance tax and to tax non-domiciled residents which were suggested by the conservative party at its conference two weeks earlier. So this was a pre-Budget report that will be long remembered for its political considerations. But there was a lot of economic and fiscal news in it as well. The pre-Budget report saw a downward revision in economic growth to 2.0%-2.5% for 2008 and a rise in government borrowing both this year and next compared with plans in the 2007 Budget. But the economic background has worsened, leaving little room to raise spending. The net spending increase was small, Â£0.4bn, for 2008/09 and in fact fiscal policy starts to tighten, with a net tax increase of Â£1.4bn from 2009/10 onwards.
Economic growth revised lower â€“ but only to the consensus
In the last few years, the Treasury has forecast stronger economic growth than the consensus and has been proved correct to do so. 2007 turned out to be no exception, with the Treasury forecast of 3% growth proving nearer to what now seems the most likely outcome than the consensus of 2.6%. But the new Chancellor has chosen to stay in line with the consensus for 2008, with a projected growth range of 2 to 2.5% for gdp in 2008, leaving the mid point almost bang in line with the consensus at 2.25%, see chart a.
Price inflation is expected to remain on target over the next two years, (see chart b), implying that interest rates will fall from current levels if economic growth slows in 2008. Our central view is that UK interest rates could fall back to 5% in November 2008, if economic growth slows to 2.3%, but there will be no rate cuts in 2007 as the economy is currently growing too quickly.
The Treasury expects the UK current account deficit to remain wide, and investment spending growth to slow after strong increases this year. This means that gdp growth remains driven by consumer spending and it is an expected slowdown in this also that causes the overall rate of annual average economic growth to fall back quite sharply next year, from an expected 3% this year to 2.3%. The US sub- prime crisis was blamed by the UK Chancellor for the coming slowdown in growth, but the real reason is the rise in UK interest rates from 4.5% a year ago to the current level of 5.75%. However, the credit squeeze has exacerbated its effects, particularly through widening interbank spreads relative to base rates. As a result of weaker growth, government spending is also set to slow, and this was more clearly seen in the Comprehensive Spending Review (CSR), which saw real spending growth kept roughly below gdp growth of 2.3%, at 2.1% expected in the next three years, almost half the increase in real terms of 4% over the period 1998-2008.
Pre-Budget report reveals further rises in government borrowing and increased taxation
What of the fiscal arithmetic? The net impact was quite small, just a cut in tax of Â£0.3bn, despite the spending measures announced. However, net debt as a share of UK gdp will rise from 36.7% in 2006/7 to 38.4% by 2009/10. Whilst this meets the governmentâ€™s own fiscal rules of borrowing only to invest over the economic cycle and of sustainable investment, it is still a rise in net borrowing over the next three years. Government net borrowing over the current tax year (2007/8), will be Â£4bn higher at Â£38bn rather than Â£34bn as in the March 2007 Budget, see chart c. This rise carried over into 2008/9, with an additional Â£2bn, taking the total of net borrowing that year to Â£36bn rather than Â£30bn in the March Budget. Changes to capital gains tax are expected to raise Â£900m by 2010/11; inheritance tax cuts will cost Â£1.4bn by 2010/11 while changes to non-domiciled taxation is estimated to raise Â£800m by 2009/10.
The main reason for higher borrowing is not increased spending but a shortfall in revenue due to weaker economic growth (see chart d). Slower growth in average earnings has hit income tax receipts this year and slower economic growth in 2008 will hit VAT receipts. This also means that the tax share of gdp will rise as well (see chart e), as the revenue lost from slower growth is partly met from allowing wage inflation to drag more people into higher tax bands.
The long term trend is for further deterioration in the UK public sector financial balance
Continued borrowing at this stage of the economic cycle is bad news for the stability of the public finances in the medium term. After 15 years of sustained economic growth, the UKâ€™s public sector balance should be in surplus. The risk is if the economy slows unexpectedly sharply - this could force government borrowing up to unsustainable levels. However, short term risks from a financial market perspective seem small. UK debt outstanding at 37% of gdp is well below the EU average. The implication of this pre-Budget report is neutral for the financial markets because the net giveaway was small and fiscal policy is expected to become tighter from 2009/10 onwards as higher capital gains tax receipts kick in. Gilts were little moved following the report, because the net issuance is unchanged. Inflation is expected to remain on target and capital spending increases are large, boosting equities and construction firms in particular.
Trevor Williams, Chief Economist
Weekly economic data preview
Economic data to guide interest rate expectations
This week, the key message will be that inflation in the major economies may have stabilised for now, but there continues to be an upside risk, which may encourage some central banks to raise rates and deter others, possibly the US Fed, from cutting them. Also, optimism about economic growth in the major economies could strengthen. The first estimate of UK Q3 GDP could show little if any let up in the pace of economic growth, while the slump in the US housing market may ease. All this will add to the growing market perception that interest rates in the US, the UK and the Eurozone will stay on hold this year, while central banks digest data to conclude whether or not the credit squeeze has slowed economic growth. This slow shift towards a view that the global economy may emerge relatively unscathed from the credit squeeze is adding to the appeal of equity markets over bonds. The G7 meeting on Friday/ Saturday could trigger market unease.
â€¢ This is the most important week in the month for UK economic data releases. Overall, the data will show that growth is strong, with some signs of weakness and inflation muted. On Monday, October's Rightmove house price data will show growth slower than September's 9.6%, but prices are clearly still at high level. Official house prices (DCLG) for August are also published and are expected to grow at a slower rate than 12.4% in July. On Tuesday, September's CPI inflation rate may increase back to the Bank of England's 2% target, from 1.8% in August. While RPI, the benchmark for wage negotiations is likely to decline a touch from 4.1% to 3.9%. Headline 3-month average wages growth may remain at 3.5% on Wednesday, one percentage below the 4.5% preferred limit. We are looking for a twelfth consecutive monthly fall in unemployment claims, underpinning robust economic growth. On Thursday, retail sales may have grown strongly by 5.6% pa in September, up from 4.9% in August, after the British Retail Consortium same-store-sales grew at the fastest rate in 3 months. M4, money supply growth, sterling lending and public finances for September, should also support the view that UK GDP growth has held up well. Friday's key data is UK Q3 GDP first estimate; we expect 0.7% on the quarter and 3.2% on the year, hardly supporting a rate cut.
â€¢ The minutes of the Bank of England's Monetary Policy Meeting of 3/4 October are published on Wednesday, and will outline the members' reasons for holding rates at 5.75%. Lower CPI inflation and average earnings growth, as well as fears of higher borrowing costs, may have prompted some members to vote for a cut. On balance, it would be unlikely to have been a unanimous decision to hold rates. Mervyn King hinted last week that the BoE is not gearing itself up for a cut and would not 'insulate the banking system from the repricing of risk'.
â€¢ CPI inflation and housing market data are key releases on the US calendar, both due Wednesday. Although headline CPI inflation may be up 2.8% compared with 2.0% in August, core inflation is likely to have remained at 2.1%. US housing starts and building permits may have fallen in September, but the scale of descent may be slowing. On Tuesday, Treasury International Capital Data for August may show stronger portfolio inflows of $60bn compared with $19.2bn in July, allaying concerns that appetite for funding US Treasuries is waning. A plethora of speeches by Fed members, including Chairman Bernanke, will reiterate the view that the Fed is in no hurry to cut interest rates, but will continue to closely monitor incoming data for signs of serious weakness in economic growth as well as upward inflation pressures. The Fed's Beige book is published on Wednesday, offering clues about economic developments in the US states.
â€¢ There is little new information released from the Eurozone this week, apart from a possible improvement in ZEW investor sentiment index and confirmation of 2.1% EU-13 CPI growth, both published Tuesday. Attention will turn to discussions of the â‚¬/ $ exchange rate and possible intervention to stem its rise at the G7 meeting at the weekend.
Nichola James, Senior Economist
Economic Research,10 Gresham Street,
Lloyds TSB Corporate
London EC2V 7AE,
0207 626 - 1500
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