United Kingdom: Staff Report for the 2010 Article IV Consultation—Supplementary Information

The U.K. economy is on the mend, but crisis-related scars still need healing. The challenge ahead will be to ensure sustainable recovery and balance sheet repair while remaining flexible to respond to shocks. A highly accommodative monetary stance is required to offset the contractionary impulse from fiscal policy and keep inflation close to target. Risks to this scenario are substantial, and policies will need to adapt if they materialize. The government should continue to fortify fiscal institutions. Efforts should continue to strengthen financial sector health.

Abstract

The U.K. economy is on the mend, but crisis-related scars still need healing. The challenge ahead will be to ensure sustainable recovery and balance sheet repair while remaining flexible to respond to shocks. A highly accommodative monetary stance is required to offset the contractionary impulse from fiscal policy and keep inflation close to target. Risks to this scenario are substantial, and policies will need to adapt if they materialize. The government should continue to fortify fiscal institutions. Efforts should continue to strengthen financial sector health.

Third quarter GDP release

1. Third quarter GDP growth came in at a relatively strong 3.2 percent (q-o-q, saar). This preliminary estimate was much higher than the consensus forecast and moderately above staff’s projection (text table). Construction growth was especially strong (up 17 percent); services and manufacturing also expanded at a solid pace (both up 2.4 percent).1 Nonetheless, staff still expects GDP growth to moderate to about 2 percent in 2011, reflecting headwinds from accelerating fiscal consolidation and near-term indicators that suggest some cooling of construction growth.

Real GDP Growth, Q3 2010

(Percent)

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Sources: Bank of England (BoE), Consensus Forecast, ONS, and IMF staff projections.

Annualization is an IMF staff calculation.

The Bank of England publishes only 4-quarter growth rate forecasts and hence the annualization is an IMF staff calculation of the mode forecast at market interest rates.

Spending Review

2. The government recently announced the results of its 2010 Spending Review, which specifies plans to reduce public expenditure at an even nominal pace over the next four years. The total consolidation, however, remains frontloaded due to frontloaded tax measures. Notable elements of the Spending Review include the following:

Fiscal Consolidation Plan

(Cumulative £ billion, unless otherwise indicated)

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Sources: HM Treasury and IMF staff calculations.
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Departmental Expenditure Limits

(Real percent change between 2010/11-2014/15)

Citation: IMF Staff Country Reports 2010, 338; 10.5089/9781455208456.002.A003

Sources: HM Treasury, and IMF staff calculations.
  • Relative to previous announcements, by FY 2014/15 annual spending on social benefits will be reduced by an additional £7 billion (0.4 percent of GDP). Of these savings, £2.5 billion come from the elimination of the child benefit for higher-income taxpayers (this benefit is currently universal), starting in 2013.2 Another £2.0 billion in savings comes from placing a one-year time limit on certain benefits available to those who have a disability but are deemed able to work.3

  • The additional reduction in social benefits lessens the required retrenchment of other government functions: excluding the protected areas of health and foreign aid, departmental spending will be reduced by 19 percent in real terms by 2014/15—less than the 25 percent real cuts announced in the June budget.

  • Within departmental spending, transfers to local governments and public security face some of the largest spending reductions (text chart).

  • The government plans to accelerate the increase in the state pension age (state pensions are the universal scheme for both private and public employees). Proposed legislation would equalize the pension age for women with that of men at 65 by 2018 (instead of 2020 as under current law) and raise it to 66 for both men and women by 2020 (instead of 2026 as under current law).

  • Public employee pension contributions will rise by 3 percentage points on average, yielding 0.1 percent of GDP by 2014/15. The ongoing review of pensions for public sector employees (due by the time of the FY 2011/12 budget) is likely to yield additional long-run savings in this area.

  • The total spending envelope remains very close to previous announcements. One modest adjustment is a slight increase (by 0.1 percent of GDP by FY 2014/15) in the allocation for capital expenditure, easing the real reduction in this category (relative to FY 2010/11) from 33 percent to 29 percent. Although this increase in capital expenditure is not offset by new savings elsewhere, the change does not affect achievement of the government’s fiscal mandate, which aims to balance the cyclically adjusted current budget.

3. Several of the announced policies go in the direction recommended by staff. Specifically, the government’s plans have (i) restricted some universal benefits—notably the child benefit—to lower-income families in order to improve targeting; (ii) reduced somewhat the reliance on capital expenditure cuts; (iii) lowered public sector compensation premia (in the context of reforming public employee pensions); and (iv) modestly accelerated increases in the state pension age. However, scope for reform, especially in the latter two areas, is not yet exhausted. In this regard, the outcome of ongoing studies on public employee pension reform and the further acceleration of increases in the state pension age will have important effects on longer-run fiscal sustainability.

4. Implementation of expenditure reductions remains a risk. Cuts of this magnitude will be challenging to implement and may strain public service delivery in some areas. However, the roughly even distribution of spending reductions across the next four years should help ease adjustment costs. The effect of spending reductions on vulnerable segments of society will need to be monitored closely.

Upgrade of ratings outlook

5. Standard & Poor’s revised its outlook for the UK’s AAA rating from Negative to Stable on October 26. S&P cited the Spending Review as a key factor behind the upgraded outlook, noting that the Review had reduced uncertainty regarding the political resolve to tackle the deficit. The rating agency’s decision reversed an earlier outlook revision from May 2009.

Draft legislation for the Office for Budget Responsibility (OBR)

6. Draft legislation to establish the OBR on a permanent basis has been presented to parliament. The draft legislation includes a number of safeguards to protect the OBR’s independence, including fixed terms for members of the OBR’s executive committee, a statutory veto for the Treasury Select Committee over their appointment and dismissal, and an explicit statement that the OBR has discretion in performing its required duties, including in determining its own work program beyond its statutory tasks. The draft law also gives the OBR full access rights to information required to discharge its duties. To help safeguard the OBR’s financial independence, Treasury has agreed to provide the OBR with a multi-year budget for the period of the Spending Review.

1

Details on the expenditure side will not be released until November 24.

2

The full elimination of this benefit once a certain income threshold is reached implies very high effective marginal tax rates right at the threshold. However, the government views the simplicity of the reformed scheme as a higher priority than avoiding such “cliff effects.”

3

With the new reductions, changes to social benefits now account for 25 percent of the reduction in total primary expenditure, up from 15 percent in the June budget. The costing of savings from reductions in social benefits was vetted by the newly established independent Office for Budget Responsibility. The OBR will also take into account the effect of the revised spending plans on its economic growth projections when it next updates its forecasts. However, staff does not expect the Spending Review to result in large growth revisions, as it was largely in line with expectations.

United Kingdom: 2010 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the United Kingdom.
Author: International Monetary Fund