This paper reviews economic developments in the United Kingdom during 1991–96. The paper examines two sets of possible reasons why the United Kingdom's savings and investment rates are lower than elsewhere. The first consists of factors leading to lower optimal rates of savings and investment: these include demographics, economic structure and technology, a liberalized financial environment, and so on. The second consists of distortions leading to lower-than-optimal savings and investment rates. The paper also presents new estimates for the potential growth rate, the output gap, and the natural rate of unemployment.


This paper reviews economic developments in the United Kingdom during 1991–96. The paper examines two sets of possible reasons why the United Kingdom's savings and investment rates are lower than elsewhere. The first consists of factors leading to lower optimal rates of savings and investment: these include demographics, economic structure and technology, a liberalized financial environment, and so on. The second consists of distortions leading to lower-than-optimal savings and investment rates. The paper also presents new estimates for the potential growth rate, the output gap, and the natural rate of unemployment.


A. Introduction

82. Following a sharp deterioration in the United Kingdom’s fiscal balance during the recession of 1990–92, successive budgets have aimed at consolidating the fiscal position by controlling spending growth and raising tax revenues. According to the November 1995 budget, the objective of fiscal policy is to bring the Public Sector Borrowing Requirement (PSBR) back toward balance in the medium term, and in particular to ensure that when the economy is on trend the public sector borrows no more than is required to finance its net capital spending. On the spending side, the objective has been to reduce the share of public spending in national income over the medium term by setting cash limits on departmental expenditures. In the 1995 budget, expenditure was projected to fall below 40 percent of national income by the fiscal year 1997/98.30 On the revenue side, the budgets have aimed at reforming the tax system in order to raise revenue in ways that are least distortionary, for example by shifting the balance from taxes on income to taxes on spending. Phased tax increases announced in the two 1993 budgets contributed significantly to reducing the fiscal imbalances.

83. Despite a significant reduction in the PSBR since 1993, the overall performance has not matched the objectives set in the budgets. Under present policies, the 1997 Maastricht fiscal deficit criterion is unlikely to be met. Fiscal slippages largely reflect lower-than-budgeted revenues, only a small part of which is due to cyclical factors. Non-cyclical causes of the revenue shortfalls include a combination of forecasting optimism and structural factors, such as increasingly skillful tax avoidance by corporations.

84. Although revenue shortfalls explain most of the slippages, the government’s inability to significantly reduce fiscal deficits also reflects the fact that, over long periods, the main elements of public consumption tend to preserve their share of GDP. Indeed, the marginal decrease in the overall expenditure-to-GDP ratio since 1993 has been achieved through a significant reduction in the share of capital expenditure; the current expenditure-to-GDP ratio has in fact risen slightly since 1992.

B. The 1995 Budget and the Outturn for 1995/96

85. The November 1995 budget had a neutral impact on the fiscal balance, reducing both revenue and expenditure for 1996/97 by over £3 billion (about 0.5 percent of GDP) relative to previous plans (Table 1). As such, it did not offset the worse projected outcome for 1995/96 resulting mainly from lower-than-expected nominal GDP and a shortfall in tax receipts relative to GDP. The forecast for the 1995/96 PSBR (excluding privatization proceeds) was revised to £32 billion, or 4.5 percent of GDP, compared with 3.4 percent of GDP in the 1994 budget. The PSBR was projected to decline to 3.5 percent in 1996/97, and to be eliminated by 1999/2000, a year later than projected in the 1994 budget. According to the projections the Maastricht fiscal criteria would be satisfied in 1997, with the general government balance (defined on a national accounts basis, and excluding privatization proceeds and public corporations’ financial surpluses) falling well below 3 percent and the debt-to-GDP ratio remaining comfortably below 60 percent (Table 2).

Table 1.

Summary of the 1995 Budget Projections

(In billions of pounds except when indicated)

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Source: Financial Statement and Budget Report 1996-97, HMT, Tables 4.4 and 4.5.
Table 2.

General Government Balance and Debt Ratio

(In percent of GDP)

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Source: Financial Statement and Budget Report 1996/97, HMT, and staff estimates.

86. On the revenue side, cuts in personal income tax rates accounted for over 70 percent of the total reduction in revenues (Table 3). The measures included reductions in both the standard income tax rate and the investment income tax rate from 25 percent to 24 percent, wider tax bands, and higher allowances. Other measures included a higher threshold for estate tax liability, lower tax rates for small-scale enterprises, and lower employer national insurance contributions. Indirect taxes on tobacco, gasoline, and car registration were increased while those on liquor and natural gas were reduced.

Table 3.

1995 Budget: Main Revenue Measures

(In millions of pounds: changes from indexed base)

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Source: Financial Statement and Budget Report 1996/97, pp. 106-107.

Includes vehicle excise duties.

87. On the expenditure side, increases in projected spending on health, education, and the police were offset by further planned cuts in the cost of public administration (12 percent in real terms over the next three years), implementation of results of fundamental reviews of departmental spending (including steps to limit real growth of social security spending to 1½ percent per annum), and further cuts in public investment—facilitated by increasing the scope of the Private Finance Initiative (PFI).31

88. The PSBR outturn for 1995/96 exceeded the 1995 budget by over £3.2 billion (½ percent of GDP) and the 1994 budget by around £10 billion (1½ percent of GDP). The overshoot relative to the 1995 budget was due to a shortfall of £2.4 billion in central government revenues, a shortfall of £0.6 billion in privatization proceeds, and an excess of £0.8 billion in central government expenditures, offset by an improvement of £0.8 billion in local authority net borrowing (Table 4). Relative to the 1994 budget, the shortfall in general government revenues was £7.9 billion, together with a shortfall of £0.6 billion in privatization proceeds, and an overshoot of £1.2 billion in expenditures. (The reasons for revenue shortfalls are discussed below.)

Table 4.

Central Government Receipts and Expenditure in 1995/96

(In billions of pounds except when indicated)

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Source: Financial Statement and Budget Report 1996-97. HMT, Tables 4A.1-4A.5.


89. In view of the actual outturn for 1995/96, the Treasury Summer 1996 Forecast revised downward the revenue projections for 1996/97 and 1997/98 relative to the 1995 budget by £4.5 billion and £5.4 billion, respectively. Relative to the 1994 budget the revisions are around £17 billion in each year (over 2 percent of GDP). As a result the general government deficit on a Maastricht definition is now officially projected to be 3.9 percent of GDP in 1996/97 and 2.9 percent of GDP in 1997/98.

C. Staff Medium-Term Projections

90. Staff fiscal projections assume that GDP growth picks up from 2.4 percent in 1996/97 to 3.0 percent in 1997/98 and then stays around 2.8 percent until the end of the decade, when by assumption the output gap would be closed. On the revenue side, the 1995/96 revenue shortfall is assumed to be carried through. On the spending side, the control total is assumed to evolve as in the November 1995 budget until 1998/99 (which remains unchanged in the 1996 Treasury Summer Forecast), but to grow at the same real rate as potential output (2.4 percent) thereafter. Future privatization proceeds correspond to official projections. On this basis, the PSBR (excluding privatization proceeds) is projected to fall from 4.9 percent of GDP in 1995–96 to 1.5 percent of GDP by the end of the decade (Table 5).

Table 5.

Staff Medium-Term Projections

(In billions of pounds except when indicated)

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Source: Staff estimates

91. According to the staff projections, the Maastricht deficit criterion will not be met in 1997. The general government deficit is projected to be 3.3 percent of GDP in 1997 (see Table 2). Moreover, unlike in the November 1995 budget projections, a surplus would not be achieved even by the end of the decade.

92. Table 6 presents estimates of the structural and cyclical factors in the fiscal balance.32 Cyclical contributions to the deficit decline as output moves back on trend. The structural component of the PSBR remains positive at 1.7 percent of GDP at the end of the decade, but excluding central government debt interest payments (structural primary) it becomes negative during 1996/97 and rises in magnitude as the decade closes.

Table 6.

Estimates of Cyclical and Structural PSBR (excl. privatization)

(In percent of actual GDP)

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Source: Staff estimates.

D. Expenditure Performance and Prospects

93. The authorities’ objective has been to reduce the share of public spending in national income over the medium term. According to the 1995 budget, expenditure was projected to fall below 40 percent of national income by 1997/98. This section briefly reviews the progress in cutting expenditure over the past few years and suggests that despite major progress in this area, in the absence of major reforms, in particular in social security spending, significant and sustainable cuts in expenditures will continue to be difficult to achieve.

94. The concept of control total has been central to the recent spending measures. It comprises the non-cyclical, non-interest component of public expenditure, and comprises about 85 percent of government spending. Spending plans are based on imposing cash limits on control total spending by departments. This decentralized approach to expenditure restraint attempts to discipline overall spending, without imposing restrictions on the composition of spending, including between current and capital spending.

95. Fundamental expenditure reviews were initiated with the aim of identifying areas of public spending which could be made more cost-efficient or eliminated. Attempts to cut down on spending have included: a) containing growth in social security spending through reforms in invalidity, unemployment, and housing benefits, and clamping down on fraud; b) cuts in running costs, and, in particular, requiring public sector pay increases to be offset by increased efficiencies and economies; c) spending increases on priority programs, including education, health, and the police, to be funded from savings elsewhere; and, d) directly controlling (“capping”) local authority spending.33 In addition, the private sector has been encouraged to undertake capital expenditure for public facilities under the Private Finance Initiative (PFI) in exchange for future payments.

96. The government has been relatively successful in keeping departmental spending within the established nominal control totals, although the path of expenditure has been somewhat higher than planned in real terms on account of lower-than-expected inflation.34 Moreover, overshoot of about £1 billion in total spending for 1995/96 relative to the 1994 and 1995 budgets has been largely due to higher interest payments on government debt.

97. However, the performance has not been impressive in absolute terms. Government expenditure excluding privatization has fallen by only 1 percent of GDP since 1992–1993 to 43.3 percent in 1995–1996, and remains higher than in the late 1980s when it fell below 40 percent of GDP. Moreover, the small reduction in expenditure that did occur has been entirely at the expense of capital expenditure, the share of which in GDP has fallen significantly in recent years.35 The share of current expenditure in GDP has in fact risen slightly since 1993. The 1995 budget planned to cut public sector capital expenditure by 12 percent in nominal terms (over 20 percent in real terms) between 1995/96 and 1998/99, while keeping total publicly- sponsored capital expenditure roughly unchanged in nominal terms by increasing capital expenditure under the PFI. As it turned out, total public investment fell by 12 percent in real terms in 1995, significantly more than predicted in the 1995 Treasury Summer Forecast (1.5 percent) or in the November Budget (6 percent).

98. The largest spending areas are social security, health, education, and defence, led by social security, accounting for 30 percent of total expenditure (Table 7). Over the past two decades social security spending has almost doubled in real terms, largely because the number of claimants has increased due to population aging and a rising number of lone parents entitled to receive benefits (among other factors). Housing benefits have also increased substantially. The recent budgets have attempted to cut back spending in these areas; reforms in invalidity, unemployment, and housing benefits, and enhanced measures to combat fraud are projected to reduce growth in social security spending to below that of GDP.

Table 7.

Major Spending Areas

(In billions of pounds, unless otherwise indicated)

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Source: Public Expenditure, Statistical Analyses 1996–97, HM Treasury, March 1996.

99. Expenditure on health and education have proven difficult to cut further, in part because of the authorities’ stated commitments and pressure from the public. For education, moreover, spending depends on both the national and local levels: local authorities choose their expenditure on education within the limits set by caps on their overall expenditure By contrast the share of defense in total expenditure has declined by 3 percentage points since 1990.

100. Finally, the government may seek to cut back on the costs of running the government through efficiency gains and some have argued that this could generate significant savings. However, the current plans for departments’ running costs are already relatively tight: central government employment has been cut and the running cost of civil departments has remained relatively flat in nominal terms. The costs, according to the 1995 budget are projected to be lower by 12 percent in real terms in 1998/99.

101. The running cost of the central government departments (excluding the Ministry of Defence) amounted to around £15 billion in 1995/96 (Table 8), or around 5 percent of total expenditure, out of which an estimated £11.5 billion was spent on funding the civil service pay bill. The department with the largest running cost was the Department of Social Security with a running cost that exceeded £3.0 billion in 1995/96. This Department, the Home Office and the Inland revenue together account for almost half of the central government’s running costs.

Table 8.

Central Government’s Running Costs

(In billions of pounds)

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Source: FSBR 1995/96 and 1996/97.

E. Revenue Shortfalls

102. The authorities’ medium-term objective has been to reform the tax system in order to raise revenue in ways that are least distortionary, for example by shifting the balance from taxes on income to taxes on spending. Under the authorities’ 1993 consolidation plans, revenues were projected to rise above 40 percent of GDP in the medium term through measures including broadening the tax base, reducing tax reliefs, and raising taxes on tobacco and fuel.

103. Revenues, however, have fallen significantly short of projections and at 38 percent of GDP are only one percentage point above their 1992/93 value. The lower-than-expected revenues in 1995/96, relative to the 1995 budget, were caused by shortfalls in corporation tax of £1.2 billion, in income tax of £0.8 billion, and in VAT receipts of £0.7 billion. Relative to the 1994 budget, on the other hand, corporation tax was lower by £4.6 billion, income tax by £2.0 billion, and VAT receipts by £4.8 billion. The causes of the recent slippages are not yet fully understood except that, with nominal GDP having deviated only modestly from its forecast path, they are largely non-cyclical. The rest of this section examines the role of specific factors that have contributed to the shortfalls and argues that forecasting optimism may also have reinforced the problem.

104. Increasing VAT avoidance by companies has been suggested as a major cause of the revenue shortfalls. Opportunities for avoidance and efficient tax planning have increased with the growing complexity of corporate structures and cross-border business. This has been helped by the increased lack of uniformity in the system associated with the large share of zero-rated and exempt items, and the rise in the standard VAT rate in recent years.36 These combined with a general move toward cost-cutting and improved efficiency, have led to efforts to minimize tax liabilities. At present VAT is levied on about 60 percent of consumer expenditure. Some goods and services such as food and children clothing are zero-rated, and some, such as rents and health services, are exempt.37 As a result schemes to exploit the threshold below which small businesses are VAT-exempt and to shift transactions into categories that are exempt or zero-rated have become increasingly prevalent.38

105. On the income tax side, a variety of tax exemptions and preferences have been introduced over the years to encourage (for example) profit-related pay, savings, and equity investment by individuals. Many of these schemes have turned out to be much more expensive than initially anticipated. Examples include tax-exempt special savings accounts (TESSAs), introduced in 1991, which allow taxpayers to receive tax-free interest on certain bank and building society deposit accounts; and personal equity plans (PEPs) introduced in 1987, which allow tax relief on dividends and other income earned on shares and unit trusts held in a plan.

106. On corporate taxes, the shortfalls seem to have been largely the consequence of an upward bias introduced into the forecasts following the high October 1994 receipts which, as transpired later, had resulted from the introduction of the policy “pay-now-assess-later” requiring payments before full assessment has been made.

107. On excise taxes, the high rates of duties in the United Kingdom relative to other EU countries may have contributed to revenue shortfalls.39 Since January 1993, there have been no limits to the amount of alcohol and tobacco that may be brought into the country, duty paid, provided they are for personal consumption. Combined with the duty differentials, as well as lower pre-tax prices in many EU countries, this has increased incentives for cross-border shopping. This is likely to have harmed domestic sales and tax revenue, but the magnitude is probably small. HM Customs and Excise estimates suggest that about half of the legitimately imported alcohol of around £800 million a year is new consumption. On this assumption, given that excise taxes are on average about half the final price, lost revenue (inclusive of VAT) would be at most around £200 million a year, or 0.03 percent of GDP. On top of this, Customs estimate that about £80 million in excise duty and VAT revenue is lost on legitimate cross border shopping of tobacco. As for smuggling, a recent survey by Customs estimates that total revenue evaded on alcoholic drinks and tobacco smuggled from other EU member states could amount to £770 million a year. This is substantial, but nevertheless represents less than 5 percent of annual excise duty and VAT collected from alcoholic drinks and tobacco. The actual loss of revenue would be less than these figures, because some smuggling is likely to represent additional consumption rather than substituting for similar goods bought in the United Kingdom.

108. Although the specific factors enumerated have clearly contributed to the revenue shortfalls, the fact that the shortfalls have been broad based and not concentrated in any particular category, together with the Treasury’s recent forecasting performance suggest that part of the problem was a tendency toward excessive optimism. The revenue forecasts in the November 1994 budget over predicted the outturn for 1994/95 by £2.6 billion, or 0.3 percent of GDP, and the outturn for 1995/96 by around £10 billion, over 1 percent of GDP (Table 1). The Summer 1995 Forecast revised the earlier projections for 1995/96, but nevertheless exceeded the outturn by £8 billion. Finally, the projections in the November 1995 Budget exceeded the outturn for 1995/96 by £3 billion.

109. Moreover, despite the revenue shortfalls, in 1995 tax revenues in the main categories, as ratios to GDP, were either above—VAT and income tax—or equal—corporate tax—to their 1985–1994 averages (Table 9).40 This suggests that tax revenues have not been out of line with recent experiences, although, because of the changes in tax rates, it does not in itself provide evidence that the forecasts have been overly optimistic

Table 9.

Tax Revenues

(In percent of GDP)

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Source: Office for National Statistics

110. One may examine whether the forecasts have been too optimistic by comparing actual outturns with forecasts based on estimated equations using data for the earlier period, although because of the changing structure of the tax system such an analysis can only be illustrative. In specifying the equations, the analysis presented below is broadly based on previous work in this area in the Treasury41, but it also incorporates specific factors such as the consumption-to-GDP ratio and profitability. Equations are estimated for VAT, corporate tax (tc), and income tax (ti), as ratios to GDP, as linear functions of seasonal factors, a time trend (t), up to four lags of the dependent variable, GDP growth (g), the output gap, and up to four lags of these variables. Moreover, the consumption/GDP ratio (c) is included in the case of VAT, and total company profits/GDP ratio (pr) in the case of corporate tax. The equations are estimated for the 1982Q1–1993Q4 period, and are then used to forecast for the period 1994Q1–1996Q1. The preferred specifications reported below are arrived at after dropping the insignificant variables from an initial set of estimated equations that included all the regressors.

Value Added Tax


111. VAT/GDP had a rising trend over the period as indicated by a significant positive coefficient on the time trend. Growth and the output GAP have negative impacts on VAT in the long run. The coefficient on consumption is 0.084, which seems to be consistent with the fact that 60 percent of consumer expenditure is taxed at a rate of 17.5 percent. If, as has been suggested, there was a structural change in VAT payment then one would presumably observe a break in the estimated relationship after 1993q4. A test for structural break, however, rejects this hypothesis; the model in fact seems to perform quite well in forecasting out of sample (Chart 1). Moreover, estimating the equation recursively suggests that the estimated coefficient of consumption is remarkably stable over recent years, providing further evidence that the elasticity has not changed.



(In percent of GDP, 4–quarter moving average)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A003

Sources: Office for National Statistics: and staff estimates.1/ See text for the description of the forecasting procedure.

Corporate Tax


112. The share of corporate tax in GDP has followed a downward trend; the output gap seems to positively affect the share, and the profit share has an elasticity of 0.36. Again a test of structural break in the relationship after 1994ql is rejected by the data, although the actual outcome is somewhat better than the model’s forecast (see Chart 1). Moreover, recursive estimation of the model suggests that the elasticity with respect to profitability, if anything, increased since the late 1980s.

Income Tax


113. The share of income tax in GDP has also had a downward trend; a change in the output gap positively affects the share once the dynamics have worked through. Although, as in the case of VAT and corporate tax, a test for structural break after 1994ql is rejected by the data, the actual outcome seems to be considerably better than the forecast (see Chart 1).

114. In summary, a large part of the revenue shortfalls seem to have non-cyclical causes. A number of specific factors such as VAT avoidance by companies, a change in the composition of expenditure, tax exemptions and preferences, and cross-border shopping have all played a role. There is also some evidence that a tendency toward excessive optimism has exacerbated the problem, although the changing structure of the tax system makes it difficult to examine this issue fully. The causes of such optimism are obvious only in case of corporate taxes, where the introduction of pay-now-assess-later policy introduced some upward bias in the forecasts in the 1994 budget.

F. Concluding Remarks

115. Despite significant progress on the fiscal front since 1993, the fiscal deficit remains large and the goal of balance remains elusive. Recent slippages have moved the United Kingdom off its medium-term fiscal track and substantial efforts are required to make up for the slippage in the upcoming budgets.

116. On the expenditure side, while the control total framework has been successful in disciplining overall spending, total spending to GDP ratio has not fallen significantly and adjustment has come disproportionately from public investment. Although this has partly resulted from the decentralized approach to expenditure restraint, it is nevertheless in line with historical experience which suggests that the expenditure-to-GDP ratio has a tendency to remain relatively stable over time and that periods of restraints in public spending have been associated with significant (and often unsustainable) cuts in capital spending.42 Thus, it appears that despite major progress in this area, significant and sustainable cuts in expenditures will continue to be difficult to achieve. It would be hard to achieve significant savings without profound restructuring of the system, for example with the government gradually relinquishing some of its responsibility in the social security area.

117. On the receipts side, strengthening the revenue-generating capability of the tax system remains a priority. The slippages, which in part have resulted from the loopholes generated by the proliferation of exemptions and preferences, and the increased lack of uniformity in the tax system, illustrate the need for tax reforms. Tax reforms, in particular in relation to VAT, would also improve economic efficiency. The case for broadening the VAT base is based on the potential efficiency gains resulting from a uniform indirect tax system. To impose an indirect tax on items such as food, however, would require redistribution toward poorer household by other means in order to take account of equity considerations, and ensure that the tax and benefit system as a whole remains progressive.43


Prepared by Hossein Samiei.


The fiscal year begins in April.


The PFI entails the private provision of public facilities—not only their construction but also their design and operation. This initiative is discussed in Chapter IV.


The estimation of these factors followed the same procedure outlined in SM/94/257, pp. 48-53.


The benefits of lower fiscal deficits, especially through cutting current expenditure, are well known, see for example Alesina and Alberto Perrotti, “Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects” International Monetary Fund Working Paper, WP/96/70 (July 1996). Simulations using the Oxford Economic Forecasting model suggest that a cut in current expenditure equivalent to ¼ percent of GDP relative to the baseline (as suggested by the staff for 1997/98) would lower short term interest rates by about 0.5 percentage points two years ahead, long-term rates by 0.25 percentage points, and inflation by 0.4 percentage points. Moreover, over the medium term fiscal balances would improve by more than the initial reduction in expenditure, as tax revenues rise because of higher consumer expenditure resulting from lower interest rates.


Control total spending in 1995/96 was higher in real terms by about ¼ percent than the 1994 and 1995 budgets.


This has, in part, resulted from the replacement of some public investment by private investment through the Private Finance Initiative scheme. The authorities have also argued that cuts in public investment were also intended to bring capital spending back to the more normal levels of the 1980s.


By European standards the current standard rate of VAT levied in the United Kingdom is still relatively low (see, for example, Options for 1996: The Green Budget, Institute for Fiscal Studies, Commentary No. 50, October 1995).


The list of goods that are zero-rated are determined primarily by distributional considerations. For example an indirect tax on food would be regressive because food’s share in total expenditure falls as income rises. The list of exempted goods and services, on the other hand, is determined largely by practical considerations relating to measuring value added.


A zero rating implies that not only is the finished product VAT exempt but the producer also receives a VAT refund for the inputs. The United Kingdom is one of only two EU countries—the other being Ireland—making extensive use of the zero rating.


See the discussion in Options for 1996: The Green Budget, Institute for Fiscal Studies, Commentary No. 50, October 1995.


The ratio of VAT to private consumption, 9.6 percent in 1996, is also higher than its average of the past 10 years.


This specification is in line with the work reported in Public Finances and the Cycle, Treasury Occasional Paper No. 4, HM Treasury, September 1995.


See, for example, Stephen Hall, John O’Sullivan and Andre Sentance, “U.K. Fiscal Policy Over the Medium Term”, Center for Economic Forecasting, Discussion Paper No DP. 09-96, (May 1996).


Estimates suggest that the revenue lost due to zero rating and exemption could be up to £23 billion a year. See Options for 1996: The Green Budget, Institute for Fiscal Studies, Commentary No. 50, October 1995.

United Kingdom: Recent Economic Developments
Author: International Monetary Fund