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Economics Weekly

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How bad can the UK's fiscal position get?

Mon, Jul 28 2008, 11:10 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Calls for a looser UK fiscal stance are rising...
With UK economic growth slowing and the housing market weakening, the call for government action is rising. In the US, they have cut taxation by nearly 2% and slashed interest rates by 3.25 percentage points to 2%. But the UK economy is in a different position, for one thing its budget deficit as a share of gdp is slightly larger and for another it is not clear whether a relaxation of fiscal policy would be met by a response from the Monetary Policy Committee (MPC) in the form of higher interest rates. Further, the weakening of annual UK economic growth from an above trend pace last year of 3% to a below trend pace this year of about 1.8% has resulted in a widening of the fiscal deficit, to its worst position since the 1990s. But how bad can it get and why does it matter?

...but there is no scope to cut taxes or increase public spending in the UK...
Chart a shows that the UK’s budget deficit is turning out to be bigger than expected and more than last year, as growth in the economy weakens to a sub 2% annual rate. Indeed, it is on course to be about £50bn in 2008/9, well above the official projection of £43bn. Why is this happening so quickly? The answer is shown in chart b: slowing economic growth hits tax revenues at a time that expenditure is pushed up by falling unemployment and more claims on government spending, as it acts as an ‘automatic stabiliser’. In the case of revenue, we are already seeing lower stamp duty from falling house sales and a weaker equity market, but there will also be an impact in due course from lower corporate tax receipts and lower income tax as unemployment rises, albeit modestly.

...as the budget deficit is already high...
What chart b highlights is that, since 2001, UK government tax revenue growth has been buoyant but spending growth has been even faster. Although the chart implies that the difference between the two growth rates is small, that gap represents the difference between two very large numbers. General government expenditure in 2007/8 was £618bn and revenue was £575bn. Hence, a small percentage change, with receipts falling and expenditure rising, will lead to a big shift in the gap between the two, which is the net borrowing requirement. This is happening now and has occurred in past cycles, as shown in chart c, where it is clear that government borrowing as a share of the economy can be even more volatile than the economic cycle. As an example of this, at 2008 prices, tax receipts in the 1990s recession fell by £30bn a year and, in 2001/2 to 2002/3 when the UK economy narrowly managed to avoid recession, tax revenues still fell by £10bn.

Analysis by the Institute of Fiscal Studies suggests that the biggest errors in computing the UK’s budget deficit have been in predicting tax revenues and government spending for a given level of national income.

...potentially putting pressure on interest rates and the economy
With this in mind, one major issue has to be how bad can it get? The answer is that it could get very bad or it could turn out to be surprisingly good. Using the Treasury’s past errors in projecting public sector net borrowing shows that it can on average be 1% above or below the central projection in the year ahead and by 1.5% two years ahead. Moreover, it is as likely to be worse as it is to be better. Under current circumstances, of course, one could argue that it will be worse but we show both outcomes in chart d. It highlights that in just two years, at the extreme end of the range of possible outcomes, government net borrowing could be as high as £94bn, some 6% of gdp, or as low as a repayment of £20bn, or 1.3% of gdp.

Why does this matter? The answer is that it could mean higher long term interest rates and so weaker economic growth than otherwise and a weaker exchange rate, implying higher than otherwise inflation and higher short term interest rates. Part of the reason for the latter could also be that inflation expectations are higher when government debt is high because of a fear that price inflation will be the consequence of loose fiscal policy.

The fiscal deficit has been worsening for some time, and now requires action to prevent it becoming an even more serious issue in the future
But this potential deterioration in the UK’s fiscal position did not happen overnight. Using the OECD’s estimate of structural budget deficits, which attempts to strip out the effects of the economic cycle on the peaks and troughs in government revenue and expenditure and only leave the underlying position of the deficit, shows that it has been deteriorating for some time, see chart e. Further, the UK’s structural budget deficit is amongst the worst of any major economy, after being one of the best between 1997 and 2002, and is now even higher than the euro area average. This is not good news for the future ability of the UK government to borrow, but the saving grace is shown in chart f, which is that the UK’s outstanding debt to gdp ratio is still lower than the industrial country average. This means that it has time to adjust its budget deficit without facing a serious funding problem that would mean even higher future long and short term interest rates. However, the rate at which the outstanding debt position deteriorates will depend on just how bad the budget deficit is from year to year. The challenge will be to prevent it from deteriorating too rapidly and potentially destabilise the UK economy.

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Published on  Mon, Jul 28 2008, 11:23 GMT