IFS Green Budget (Feb 2011)

Released on 2 February as part of its preparations for the 2011 Budget, the Institute of Financial Studies' Green Budget included the following observations and predictions about the economy's behaviour this year, with accompanying suggestions for the Chancellor. There are extracts from the economic overview:

Tax rises and spending cuts will hurt, but little room for Budget easing

The IFS Green Budget forecast is that the government will need to borrow slightly less in 2010–11 (£2.9 billion) than the Office for Budget Responsibility (OBR) forecasts. But this is in the context of a deficit which we expect to be at £145.6 billion this year. Having set out his fiscal consolidation plan, it is important that Chancellor George Osborne resist the temptation to engage in any significant net giveaway in the Budget.

If the economy evolves as the OBR expects over the next few years, and if the government adheres to its tight spending plans, then we expect borrowing to continue to be slightly below the OBR’s forecast. We forecast that borrowing will be 0.2% of national income lower than the OBR forecast in 2015–16, a very small difference relative to the large planned fiscal consolidation.

But there are considerable risks to this forecast, in particular on the downside. Any forecast improvement in the public finances should be banked to give additional headroom against these risks. In particular, two risks that might materialise are:

First, the economy might not grow as quickly as the OBR expects, and even if it does the public finances might not bounce back as strongly as it forecasts.

Michael Dicks of Barclays Wealth and Simon Hayes of Barclays Capital expect the economy to grow at a similar rate to that forecast by the OBR in 2011, but with the risks skewed to the downside. Over the medium term, they forecast less growth than the OBR forecasts. This is based on estimates that show the future potential output of the UK economy to be lower than the OBR expects, and that show that this potential will take longer to reach. If the economy were to evolve along the Barclays central scenario, we forecast that the public finances would not strengthen as much as the OBR expects. Under this forecast for the economy, we project a deficit on the cyclically-adjusted current budget of 0.4% of national income in 2015–16, which would mean that current policy would not be consistent with the Chancellor’s fiscal mandate.

Under the Barclays ‘optimistic’ scenario, the public finances would evolve in a similar way to that expected by the OBR (and the fiscal mandate would be met), but the outlook is much worse under the Barclays ‘pessimistic’ scenario, under which we forecast public sector net debt would still be rising in 2015–16.

Second, the planned spending cuts might prove formidably hard to deliver.

The last time the UK government attempted to implement real cuts to spending on public services (in the 1990s), it was successful at sticking to its cash plans, but lower-than-expected inflation meant that the planned real cuts were not delivered as quickly as intended. The current government’s planned cuts to public spending are far greater than those attempted in the 1990s, and achieving these more ambitious spending cuts will be more difficult. In some parts of the public sector – such as in the Home Office and the Ministry of Justice – a combination of the depth of the spending cuts and low labour turnover means that a downsizing of the workforce on the scale implied by the Spending Review will be difficult to achieve cost-effectively on the proposed timescale.

Overall, with such large downside risks to the public finances, having alternative plans to hand could prove useful.

Effect of tax changes planned for April 2011:
Households will be hit by an average £200 a year loss from tax increases and benefit cuts due in April. The changes hit high-income households hardest, but those dependent on means-tested benefits will be hit by the decision to raise benefits in line with the consumer price index (3.1%) rather than the higher retail price index or Rossi index (4.6% and 4.8% respectively). There will also be big changes in marginal tax rates for some, with 500,000 people being taken out of income tax altogether by the rise in the tax allowance, but around 750,000 more people becoming higher-rate taxpayers as a result of a reduction in the level of income at which the higher rate starts to bite. A further 850,000 would be brought into the higher-rate bracket by 2015–16.

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