United Kingdom: Selected Issues
Author: International Monetary Fund
Publication Date:
26 Jan 1998
eISBN:
9781451814071
Language:
English
Keywords:
ISCR; CR; minimum wage; GDP; GDP growth; GDP data; employment effect; GDP figures; inflation targeting period; Inflation targeting; Minimum wages; Labor markets; Employment; Unemployment; Europe; Australia and New Zealand; Global; forecast VAT receipt; GDP deflator; VAT receipts; July budget; excl. privatization; Budget planning and preparation; Income and capital gains taxes; Privatization; Income tax systems
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13. The new Labour government has set out a fiscal framework in which the primary focus is on fiscal sustainability and sound public finances, backed up by determined efforts to control spending and taxation. This represents a fundamental shift away from the emphasis on demand management that prevailed at the time of the previous Labour government in the 1970s. To a large extent, the new government has endorsed the sweeping changes in the approach to economic policy during the intervening years—as reflected in government involvement in the economy, as measured by the shares of public expenditure and revenue in GDP, that is now rather low by European standards.13

Abstract

13. The new Labour government has set out a fiscal framework in which the primary focus is on fiscal sustainability and sound public finances, backed up by determined efforts to control spending and taxation. This represents a fundamental shift away from the emphasis on demand management that prevailed at the time of the previous Labour government in the 1970s. To a large extent, the new government has endorsed the sweeping changes in the approach to economic policy during the intervening years—as reflected in government involvement in the economy, as measured by the shares of public expenditure and revenue in GDP, that is now rather low by European standards.13

II. FISCAL POLICY: DEVELOPMENTS AND PROSPECTS12

A. Introduction

13. The new Labour government has set out a fiscal framework in which the primary focus is on fiscal sustainability and sound public finances, backed up by determined efforts to control spending and taxation. This represents a fundamental shift away from the emphasis on demand management that prevailed at the time of the previous Labour government in the 1970s. To a large extent, the new government has endorsed the sweeping changes in the approach to economic policy during the intervening years—as reflected in government involvement in the economy, as measured by the shares of public expenditure and revenue in GDP, that is now rather low by European standards.13

14. The fiscal deficit, however, has been sizable in recent years, and, although significantly lower than in 1993, is still large given the cyclical position. In structural terms, the fiscal balance at 2¾ percent of GDP in 1996/97 is among the highest in major industrial countries. The medium-term path set in the previous government’s 1995 budget, which envisaged fiscal tightening to balance the budget before the end of the century, went off track following revenue shortfalls during 1995/96, and in the 1996 budget, the achievement of medium-term balance was postponed by a year. This slippage was largely offset by a better-than- budgeted performance in 1996/97: the fiscal deficit (Public Sector Borrowing Requirement (PSBR), excluding privatization proceeds) at 3½ percent of GDP was ½ percent of GDP lower than the 1996 budget, mainly reflecting better-than-expected revenues (Table 1).

Table 1.

United Kingdom: General Government Finances 1/

(In percent of GDP)

article image
Sources: KM. Treasury; and staff estimates.

Cash basis, except for GGFD.

Staff estimates.

15. The new government used its first budget, delivered on July 2, 1997, to stress its commitment to fiscal discipline and enhance the credibility of its pledge to sound public finances. The announced measures were intended to improve the public finances, support demand restraint, and reduce macroeconomic imbalances caused by pressures on the interest rate and sterling. The government announced tax measures amounting to ½ percent of GDP in each of the 1997/98 and 1998/99 fiscal years. These measures, together with those already in place—in particular, the previous government’s tight nominal spending targets, which have been reaffirmed, in the face of a higher GDP deflator—are projected to improve the general government’s structural balance by 2¼ percent of GDP in 1997/98. The PSBR data so far in 1997/98 do not suggest that this projection is overly optimistic.

B. Historical Background

16. Although the shares of public expenditure and revenue in GDP are not any lower than in 1978 when Labour was last in office, they are now among the lowest in Europe—albeit still larger than the G-7 average—largely because the United Kingdom has been more successful than other European countries in containing spending growth (Figure 1).

FIGURE 1.
FIGURE 1.

UNITED KINGDOM: INTERNATIONAL COMPARISONS: PUBLIC FINANCE

Citation: IMF Staff Country Reports 1998, 004; 10.5089/9781451814071.002.A002

Sources: Office for National Statistics; IMF, World Economic Outlook.1/ General government basis.

17. Throughout much of the 1970s, fiscal policy had been used largely to smooth out cyclical variations in output and employment. This broadly Keynesian demand-management approach to policy was severely restricted following the Labour government’s acceptance of the IMF’s conditions for assistance after the exchange rate crisis of 1977, and was further limited following the election of a Conservative government in 1979. The Conservatives embarked on a program of introducing significant changes in the running of the public sector.14

18. On the spending side, a number of changes have contributed to slower growth of expenditure in the United Kingdom than elsewhere in Europe. First, on social security, in the mid-1980s a switch was made from indexing pensions and benefits to average wage, in favor of indexing to prices. This has generally reduced growth in spending on social security by 1-2 percentage points a year. Other social security changes that have tended to reduce expenditure include converting the pensions schemes of a large part of public sector employees into occupational or personal schemes, legislation to make certain benefits taxable, and tightening up of eligibility rules for claiming unemployment benefits. Despite these efforts, the share of expenditure on social security, health, and education has risen from 50 percent of total expenditure in 1979 to 60 percent in 1997, reflecting the difficulty of controlling expenditure in this area, the relatively high income elasticities of demand for such services, demographic factors, and changes in medical technology. Second, a sharp reduction in spending has occurred as the interventionist policies of the earlier period were abandoned, state enterprises were privatized, and as a result government subsidies fell, and the share of public investment declined.15 Third, public sector pay awards have been stringently controlled during most of the period since 1980, contributing significantly to slower growth in public spending. Finally, changes in local government finance have acted to reduce central government expenditure on transfers to local authorities and to increase local spending financed by local taxes (although the failure of the Poll Tax partly reversed this process) and, more recently, by enforcing caps to control local spending.

19. On the revenue side, the major change has been the attempt to move away from direct to indirect taxes, in order to enhance the efficiency of the tax system and reduce distortions. Income tax rates have been successively reduced at all levels of income while VAT rates and coverage have increased: the share of income taxes has fallen from 29 percent of total receipt to 24 percent, while that of VAT has increased from 7.8 percent to 16.9 percent. The corporate tax rate has also fallen significantly over the period, while tax allowances have been reduced. As a result of these changes the United Kingdom is now a low-tax country by European standards.

20. Despite these reforms, the fiscal deficit over the past two decades has been in surplus only for a short period of time during the strong recovery of the late 1980s. The deficit deteriorated particularly sharply during the recession of 1990-92, and successive budgets have since attempted to bring the PSBR back toward balance in the medium term. The fiscal deficit at 3½ percent of GDP, however, although significantly reduced since 1993, is still large given the current cyclical position.

C. The November 1996 Budget

21. The November 1996 budget implied a small tightening of fiscal policy relative to the Treasury’s Summer Forecast but did not go as far as putting the fiscal position back on the medium-term track envisaged in the 1994 and 1995 budgets. This largely resulted from a shortfall in revenues that was largely noncyclical and thought to reflect factors, such as increased VAT avoidance by companies. Relative to the 1995 budget, there were shortfalls in corporation tax of £1.2 billion, in income tax of £0.8 billion, and in VAT receipts of £0.7 billion, continuing a trend that had started earlier. 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.

22. The 1996 budget projected that the PSBR would fall to 2.7 percent of GDP in 1997/98, down from 3.2 percent of GDP in the Treasury’s 1996 Summer Forecast but up from 2.2 percent of GDP in the 1995 budget, and be close to balance by 1999/00 (see Table 1). New measures, which featured cuts in spending and direct taxes, partly offset by increases in indirect taxes, were equivalent to roughly V4 percent of GDP. The improvement over the 1996 Summer Forecast also reflected an upward revision to growth projections and projected savings from a clampdown on tax and benefit fraud. The 1996 budget projected that the Maastricht fiscal criterion would be met in 1997.

23. On the spending side, the budget planned to cut public spending by 2¼ percent relative to the previous budget over the coming three years, reducing it to 40 percent of GDP by 1997/98. Central government running costs were projected to fall by 7 percent by the end of 1999, while expenditure on health and education would increase. Benefits for single parents would be aligned with those for couples with children, and increases in social security would be held to 1.5 percent a year in real terms. The budget proposed to save nearly 1 percent of GDP over three years by targeting tax and benefit fraud. Spending on police and prisons would rise but defense expenditure would be cut.

24. On the revenue side, the budget included a variety of measures intended to cut direct taxes and to raise indirect taxes. The basic rate of income tax was lowered to 23 percent from 24 percent and various income tax allowances were increased in real terms, while special tax relief on profit-related pay would be phased out over 1998-2000. On corporate taxation, business rates on small properties were lowered, and the rate of corporate taxation on small companies was cut to 23 percent from 24 percent. Special measures would be undertaken to counter VAT avoidance by eliminating loopholes. National insurance contributions were lowered for employers, while upper and lower thresholds were increased for both employers and employees. Various indirect taxes were also adjusted—with increases in the rate of insurance tax, air passenger duty, and excise duties on tobacco, cars, and petrol and diesel, changes in alcohol excises, and a cut in road fuel tax—with the overall effect of increasing revenues.

25. Although the budget was tighter than expected by the market, there were doubts over the quality of some of the measures. In particular, the budget projected that savings from intensified enforcement to reduce tax evasion and avoidance (the “spend to save” initiative) would be over£½ billion in 1997/98, and much larger in later years. However, clearly revenues from such a broad measure would be highly uncertain. The treatment of some spending components in the budget were also criticized. The sale of the Student Loan Company’s loan book and that of the Ministry of Defence housing (totaling £1.7 billion) were both counted as negative expenditure under the control total and not as privatization proceeds. These concerns, among others, led the new Labour government to look into the assumptions underlying the Treasury’s fiscal projections. The National Audit Office was assigned the task of scrutinizing the forecasts by reviewing the assumptions (see below).

D. The Outturn for 1996/97

26. The outturn for 1996/97 was better than projected in the budget. The PSBR, excluding privatization, was £27.1 billion (3.6 percent of GDP), lower by £3.8 billion (0.5 percent of GDP) than the budget. This overperformance reflected an overshoot of £5.4 billion in government receipts, partly offset by £0.4 billion in extra general government expenditure—despite lower central government expenditure—and a £1.2 billion overshoot in public corporations borrowing (Table 2). On the revenue side, income and corporation taxes were higher than budgeted by £L3 billion and £1.6 billion, respectively, but VAT receipts were lower by £0.6 billion. On the expenditure side, spending ceilings by departments were not violated, with control total spending marginally lower than in the budget, but other (cyclical) general government spending and net borrowing by public corporations were somewhat above the budget.

Table 2.

United Kingdom: General Government Receipts and Expenditure in 1996/97

(In billions of pounds except when indicated)

article image
Sources: Financial Statement and Budget Report 1997-98, HMT, Tables 4A.1-4A.5; and Office for National Statistics.

27. The overshoot in revenues contrasts with revenue shortfalls during 1994/95 and 1995/96 fiscal years. The recovery in income and corporate taxes suggests that transitory albeit noncyclical factors may have been responsible for shortfalls in earlier years. The continuation of below forecast VAT receipts, on the other hand, is evidence that factors behind VAT shortfalls have not disappeared and may be of a more structural nature. Increasing VAT avoidance by companies has been suggested as a major cause of the latter shortfalls.

E. Background to the July 1997 Budget

28. At the time of the July budget, the new government faced a fiscal situation that required corrective actions on fiscal grounds, as well as on macroeconomic and political grounds. First, despite better-than-budgeted performance in 1996/97, fiscal deficits were large, in particular given the cyclical position of the economy. Second, given the modest additional fiscal consolidation in the November 1996 budget, buoyant activity and expectations of higher interest rates had pushed sterling up to a point where further appreciation would have been undesirable. Thus, fiscal consolidation was required to support demand restraint and reduce macroeconomic imbalances caused by pressures on the interest rate and sterling. Third, the consolidation plans that the new government inherited were back-loaded: of the 2 percentage point reduction in the structural balance over the three-year horizon, about half were to come into effect during the last year. And finally, the credibility of the new government’s pledge to establish sound public finances, as perceived by the market, hinged on taking convincing measures in the budget.

29. Prior to forming a government, the Labour Party had committed itself to several parameters of fiscal policy. These included: (i) respecting the spending targets set by the previous government for at least two years; (ii) leaving income tax rates unchanged; (iii) lowering VAT on domestic fuel (basically household heating bills); (iv) imposing a one-off windfall tax on the excess profits of privatized utilities with the proceeds to be used to finance a “Welfare-to-Work” program to counter unemployment (see Chapter IV below); and (v) observing over the medium term the “Golden Rule” of borrowing (over the course of the economic cycle) only to finance public investment and to stabilize the debt/GDP ratio at a sensible level on average.

30. Once in office, the new government introduced new, more conservative budgetary assumptions: (i) expected receipts from privatization would be included in the budget only if tied to specific assets publicly identified for sale; (ii) the estimate of savings generated by the previous government’s “spend to save” (anti-tax evasion and avoidance) program would be limited to the direct effects of the measures; (iii) the estimated rate of potential output growth was revised downward to 2¼ percent a year from 2½ percent; (iv) the number of people claiming unemployment benefit was assumed constant over the projection period (and thus, for example, not counting on any of the anticipated benefits from active labor market policies); and (v) the interest rate assumption would be made on the basis of market expectations. These changes would remove a cumulative £20 billion (3 percent of GDP) from the previous government’s net revenue projections over the medium term.

31. The revised assumptions were intended to improve the quality of the forecasts and to increase transparency in the forecasting procedure. Among the changes, the downward revision to potential growth was unexpected: it had been raised to 2½ percent from 2¼ percent only two years earlier. The authorities seem to consider both estimates as being within the acceptable range, but now prefer to be on the side of caution.16 The National Audit Office was asked to scrutinize these assumptions, judging them to be prudent, but not the only prudent assumptions.

F. The July 1997 Budget and the New Government’s Fiscal Plans

32. Chancellor Brown’s first budget, announced on July 2, featured significant fiscal tightening. Citing the policy mix, the unbalanced recovery, and the need to address exporters’ concerns at the high level of sterling, the chancellor tightened the fiscal stance by about 0.4 percent of GDP17 in 1997/98, rising to 0.5 percent in 1998/99. Adhering to the previous government’s nominal spending targets in the face of an upward revision in the GDP deflator led to further significant tightening. As a result, the general government’s financial deficit is now set to improve in structural terms by 2.3 percent of GDP in 1997/98 and a further 1 percent in 1998/99 (see Table 1).

33. As promised, the chancellor retained existing spending ceilings for 1997/98 and 1998/99, announced a windfall tax on privatized companies to be used largely to fund his Welfare-to-Work initiatives, reduced VAT on domestic fuels, and confirmed his medium-term goal of observing the “Golden Rule.”

34. Moreover, he announced a reduction (from 1998/99) in the rate of mortgage interest relief; an increase stamp duty on property transfers; phased abolition of Advanced Corporation Tax (ACT) credits for shareholders in respect of tax paid on dividends by companies; and increases in excises on road fuels and tobacco by 6 percent and 5 percent per annum, respectively, in real terms (compared with the previous government’s commitments to 5 percent and 3 percent). These were partly offset by a 2 percent rate reduction in the corporate tax rate that was the one genuine surprise in the budget, and a temporary doubling of investment allowances for small and medium enterprises.

35. The new government justified the windfall tax, a one-off levy on privatized utilities, on the grounds that these companies were sold off too cheaply at the initial privatization; that the regulatory regime had been too lax over the period since privatization; and that the companies had been able to exploit a degree of monopoly power, The tax would apply to companies privatized by floatation, and be assessed as a proportion of the difference between the value placed on the company at the time of sale and a valuation figure based on post-tax profits during the four years following the privatization. The tax is to be paid in two installments on December 1, 1997, and December 1, 1998, for a projected total of £5.2 billion.

36. A number of issues have been raised in relation to this tax and its use to finance Welfare-to-Work. In particular, the tax is unlikely to ensure fairness, in the sense of targeting the individuals who actually received the “excess profit.”18 Moreover, it uses a one-off tax to finance what could become permanently higher expenditure on training, job subsidization, and other programs to reduce unemployment. Finally, retroactive measures are generally undesirable, as they create a climate of uncertainty. In principle, a windfall tax that is levied only once should not affect the economic behavior of the firms taxed, assuming that it will genuinely be “one-off.” Retroactive tax measures, such as the windfall tax, however, potentially face a time-inconsistency problem; they may be resorted to again despite promises to the contrary, and, as a result, could have real effects. To alleviate such fears, the authorities have stressed that this is a genuine one-off arrangement, not to be resorted to again.

37. The budget initiated an overhaul of corporate taxation. It lowered the corporate tax rate from 33 percent to 31 percent and introduced a phased abolition of ACT credits. The former is projected to lower revenues by £3½ billion, while the latter would add £12 billion to revenues over three years. Payments of tax credits to pension funds and United Kingdom companies (other than charitable companies) was abolished with immediate effect; for other shareholders with no tax liabilities, it would come into effect on April 6, 1999. On the same day, the rate of tax credit would also halve to 10 percent. Transitional relief for charities would be available from April 1999 over a five-year period.

38. The combination of lower corporate taxes and a phased abolition of ACT credits was intended not only to improve the fiscal position and reduce demand pressures, but also, and more importantly, to encourage investment both through lower taxes and through a reduction in the bias in favor of retention of profits. Before 1973, the United Kingdom had operated a system where distributed profits were taxed twice, once as part of corporate taxation and then as dividends. Since 1973, in order to prevent this double taxation, an imputation system had been used which allowed a tax credit against personal income tax. However, since the credit also accrued to nontaxpaying shareholders such as pension funds, there had been a bias in favor of dividend payments. In effect, the system raised the cost of capital for investment financed from retained profits because it introduced a tax advantage in using debt finance as opposed to finance from retained profits. One estimate suggests that the bias in the tax system added 1-2 percentage points to the overall cost of capital, lowering investment by up to 5 percent.19

39. Phasing out the credits is, therefore, likely to encourage firms to retain more profits for investment purposes. In the short term, the measure could have the opposite effect to the extent that companies would have to use internal funds to compensate for lower returns on invested pensions. Over the long term, however, the burden of lower credits for pensions funds is likely to be largely borne by households in the form of lower pensions benefits or higher contributions.

40. Cutting the rate of VAT on domestic fuel from 8 percent to 5 percent, the lowest level permitted under the EU’s indirect tax harmonization rules, is projected to cost about £1 billion in lost revenues. Moreover, the measure runs against the objective of broadening the VAT and the desirability of tax on fuel from an environmental point of view. The argument used by the authorities to support the measure is a distributional one: since spending on domestic energy accounts for a large part of spending by the poor and the elderly, VAT on fuel is a regressive measure.

41. The reduction in mortgage interest tax relief from 15 percent to 10 percent and the increase in stamp duty are projected to deliver an extra £2 billion in revenues over three years, with only a small part of it during the first year. These measures would also likely remove some pressure from the housing market, where prices have been rising at a rate well above the rate of inflation—although, this effect is likely to be minor since the measures had already been largely expected.

42. On taxation of savings, the budget announced the introduction, effective April 1999, of “individual savings accounts”; these accounts will be available for holders of the existing tax-exempt savings vehicles (TESSA and PEPs)20 as well as other individual shareholders and savers. The budget’s projections for tax credits after 1999 allow for tax relief to continue through the use of individual savings accounts when they are introduced in 1999.

43. On the expenditure side, the central component of the budget was its commitment to nominal departmental expenditure ceilings (control totals) for 1997/98 and 1998/99 set in the November 1996 budget by the previous government. These nominal ceilings were already restrictive and, with an upward revision in the GDP deflator—lowering deficits by about 1 percent of GDP over two years—this commitment translated into a significant fall in the projected deficit (see below). Including outlays financed by the windfall tax, control total spending is projected to fall in real terms by ½ percent between 1996/97 and 1998/99.

44. The budget, however, introduced two spending items outside of the control total: spending financed by the windfall tax, amounting to £5.2 billion spread over five years, with ⅔ to be spent on Welfare-to-Work, and the rest on schools and lone parents; and additional capital spending by local councils, amounting to £0.9 billion spread over two years, financed by the release of part of the blocked receipts of proceeds of earlier housing privatizations. In addition, the budget allocated, with unchanged control total, £2.5 billion out of the contingency reserve for 1998/99 to health and education.

45. The new government has initiated a comprehensive expenditure review. Unlike the previous fundamental expenditure review, which concentrated on 3-4 departments at a time, the new plan is intended to cover all government departments in a centralized manner. It will concentrate on defining objectives and priorities based on cross-departmental reviews, rather than expenditure cuts per se.

46. The budget sets to observe the “Golden Rule” over the medium term: that public borrowing should be used to finance investment rather than current spending over the course of the cycle. In addition, it specifies that public debt should be maintained stable at a “prudent and sensible level” over the cycle. With concrete expenditure plans awaiting the outcome of the comprehensive spending review, the budget does not contain well-defined medium-term expenditure targets. Instead, it presents three medium-term fiscal scenarios based on different expenditure growth assumptions. Even on the most expansionary of these (with expenditure growing at the same rate as trend output), the budget plans overperform on the “Golden Rule” objective, with the general government in balance by 1999/2000 and in modest surplus thereafter. The debt-to-GDP ratio would decline over the next five years from the present level of 54 percent to 45 percent of GDP.

47. Notwithstanding the budgetary plans’ substantial overperformance relative to the “Golden Rule,” which leaves the status of this rule unclear in the medium-term plans, the rule itself is subject to well-known shortcomings as a medium-term objective of fiscal policy. In particular, since most of the returns from public investment do not accrue as government revenue, following this rule would not necessarily assure sustainable public finances. This is implicitly acknowledged by complementing the rule with the objective of stabilizing debt at a prudent and sensible level. The need for medium-term plans to ensure sustainability is especially important in light of the new government’s announced aim of increasing public expenditure in priority areas.

48. The new government has pledged to start a program of public-private partnership in place of the previous Private Finance Initiative (PFI). Under the new system, every potential partnership project will be subject to an appraisal at the outset, with the focus on achieving results and cutting costs. The Private Finance Panel will be strengthened to streamline procedures, develop standard forms of contract, and cut red tape. In particular, there will be new forms of public-private partnership in the National Health Service in order to overcome the problems that have plagued the PFI. The reforms also include dropping the requirement that every investment project first be considered for the PFI and prioritizing projects already in procurement.

49. The new government has initiated reviews of the tax and benefit and pensions systems. A taskforce, made up of senior civil servants and headed by a leading businessman, is considering options for modernizing the tax and benefit system to improve work incentives and reduce welfare dependency. The government is also looking into developing a long-term strategy for pensions, in particular, the possibility of making it compulsory for employers and employees to make sizeable pension contributions into private funds.

G. The Impact of the July Budget

50. Macroeconomic circumstances at the time of the budget had put pressure on the new chancellor to include measures that would significantly restrain demand and reduce upward pressure on the interest rate and exchange rate. The market’s initial reaction was that the budget did not do enough toward that aim: interest rates’ futures rose in the expectations that the Bank of England would need to raise interest rates by as much as 1 percentage point in the following months; and sterling rose further to new five-year record highs, and later that month surpassed the DM 3 level.

51. A closer examination, however, reveals that, contrary to the market’s initial view, the budget’s impact on demand is likely to be significant. Table 3 reports estimates for structural expenditure, revenue, and fiscal balances for the periods 1996/99—1990/2000, both on a cash basis for the public sector (PSBR, excluding privatization proceeds) and on an accrual (Maastricht) basis for the general government (GGFD). On a cash basis, the structural balance improves by 1.5 percent of GDP in 1997/98. The fiscal impulse is larger when the more economically meaningful accruals-based GGFD measure is used:21 structural GGFD improves by about 2.3 percent of GDP, reflecting in part the larger increase in revenues on an accruals basis than a cash basis. The projections show that the Maastricht criterion will easily be met in 1997 and that the budget will be close to balance in 1998/99.

Table 3.

United Kingdom: Structural Fiscal Balances

(In percent of GDP)

article image
Sources: H.M. Treasury; and staff estimates.

52. While the implied fiscal impulse, as measured by projected improvement in the structural balance, is hefty, the question arises as to whether the projected cuts in real spending constitute credible and genuine fiscal tightening, and whether the near-term impact of revenue measures on consumer demand would be sufficient to mitigate pressures on monetary policy.

53. Credibility is unlikely to be a problem in relation to the 1997/98 spending plans but it could with regards to the 1998/99 plans. Departmental spending in 1996/97 were within the limits set in the budget, and will likely remain so in the current fiscal year: most public sector pay settlements are already in place, with wage increases below those in the private sector; departmental bids for allocations from the reserve are running at lower levels than in the preceding two financial years; and departments seem to be learning to live within tight budget constraints. PSBR data for the first five months of 1997/98 support this favorable picture. By next year, however, upward pressures in public sector pay could build up as above-trend growth continues, and pressures to reverse the continuing fall in the provision of public services relative to GDP could increase.

54. About a quarter of the projected tightening in 1997/98 reflects an upward revision in the GDP deflator. Some analysts have argued that this should not be treated as true fiscal tightening, unless it also implies a rise in the public consumption deflator: otherwise, it amounts to a change in relative prices, affecting wages and consumer expenditure, rather than a cut in real expenditure. However, although it is true that an upward revision in the GDP deflator relative to the public consumption deflator is a change in relative prices, it is clearly the GDP deflator that is relevant in measuring the fiscal impulse.22

55. Finally, the fiscal impulse remains relatively large even when one excludes measures that might take time to affect consumer demand. It has been argued that, while the ultimate burden of the revenue measures is likely to fall on households, in the short term the measures will impact the company sector more strongly. Therefore, in view of the strength of consumption, the short-term burden on households should have been made larger—for example, by bringing forward the reduction in mortgage interest relief or abolishing the relief altogether. While this argument merits serious consideration, the new government’s options were somewhat restricted by its manifesto commitments regarding VAT and personal income taxes. In any event, the effect of the budget remains large even after removing the tax measures that may not affect consumer demand immediately. Removing the windfall tax and the associated spending, for example, reduces the fiscal impact to 2.0 percent of GDP in 1997/98; removing further the immediate impact of reduction in ACT credits would still give a fiscal impulse of 1.7 percent of GDP (see Table 3).

H. Medium-Term Projections

56. Table 4 reports the staffs medium-term projections. These suggest that the fiscal position will turn into surplus, in actual and structural terms, by the end of the decade. The projections assume GDP to grow at a rate of 3.2 percent in 1997/98 and 2,6 percent in 1998/99, before eventually settling down at the potential rate of growth of 2½ percent. The output gap is assumed to remain close to zero throughout. On the revenue side, the projections assume that for the period 1997/98-1998/99 the revenue measures announced in the July 1997 budget are implemented and that the revenue overshoot in 1996/97 carries through to the medium term. On the spending side, the control total is assumed to evolve as in the July budget during the two-year budget horizon, and to grow at the same real rate as potential output thereafter.

Table 4.

United Kingdom: Staff Medium-Term Projections

(In billions of pounds except when indicated)

article image
Source: Staff estimates.
12

Prepared by Hossein Samiei.

13

The shares of expenditure and revenue in GDP are not lower than in 1978, but are now low relative to other European countries, largely because the United Kingdom has been able to control growth in public spending more than elsewhere in Europe.

14

For an analysis of developments during this period, see N. Rajah and S. Smith, “Fiscal Developments in the United Kingdom since 1980,” European Economy, Towards Greater Fiscal Discipline, No. 3, 1994.

15

As emphasized in Chapter III of last year’s Recent Economic Developments, SM/96/254 (10/9/96), the United Kingdom experience shows that reducing public expenditure mainly through cutting capital expenditure is not sustainable.

16

The staff continues to assume 2½ percent potential growth.

17

Excluding the temporary effect on the fiscal balance of the lag between receipts of the windfall tax and the associated spending.

18

Alternative measures of excess profits such as total returns on shareholders minus return on an aggregate index, would also have suffered from similar problems; see IFS Election Briefing, The Institute for Fiscal Studies, April 1997.

19

See S. R. Bond, M. P. Devereux, and M. J. Gammie, “Tax Reform to Promote Investment,” Oxford Review of Economic Policy, Vol. 12, No. 2, 1996.

20

TESSAs are tax-exempt savings accounts; PEPs are personal equity plans.

21

Structural GGFD is estimated based on the judgement that accrual adjustments to cash balances are of a noncyclical nature. These adjustments (reported in Table 4 A. 5 of the July Red Book) result from, among other things, changes to the timing of 1996/97 VAT payments in the 1995 budget, changes in income taxes and the introduction of gilt strips in 1996/97, the buoyancy of national insurance contributions and local business tax cash receipts in 1996/97, the sale of student loans, and the redemption of index-linked gilts in 1996/97.

22

One could perhaps argue that a rise in the GDP deflator relative to public sector wages would have a smaller impact on aggregate demand than a reduction in spending on goods and services—analogous to the reasoning underlying the balanced-budget multiplier. This appears to be a second-order consideration, however.

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Cover IMF Staff Country Reports
United Kingdom: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 1998: Issue 004
Publisher:
International Monetary Fund
ISBN:
9781451814071
ISSN:
1934-7685
Pages:
116
DOI:
https://doi.org/10.5089/9781451814071.002

UNITED KINGDOM: INTERNATIONAL COMPARISONS: PUBLIC FINANCE