Chancellor Gordon Brown has finally halved his growth forecasts to a more realistic level for this year and next, but risks repeating the same mistake in 2007 and 2008. As a result we expect his sustainable investment rule to be broken in 2009.
The Economic Outlook
Gordon Brown has revised down his economic growth forecast to 1 % for 2005 from his previous forecast of between 3% and 3%.
This is finally in line with most commentators, although at cebr we expect that once statistical revisions and internet retailing have been included, growth could be just above 2%.
Try 6 free issues of MoneyWeek today
Get unparalleled financial insight, analysis and expert opinion you can profit from.
Sign up for MoneyWeek’s free twice-daily newsletter.
Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
Clearly, we do not buy the Chancellor's stated reasons for why he got his forecasts wrong. Since he only made his previous forecasts nine months ago, it is difficult to see how even he could believe that his excuses of oil price and domestic inflation are credible. Moreover, since the UK is roughly self sufficient in oil, the impact of rising oil prices on the UK should be less than for most other countries. As we have pointed out and others have since quoted us on the subject UK economic growth in the first 3 quarters of this year puts us 19th out of the EU's 25 member states.
The Chancellor would have been on a much safer footing to point where the UK is in the economic cycle. This owes a lot to the Chancellor's decision at the beginning of his Chancellorship to put interest rate policy on autopilot under the MPC rather than allowing himself to take the decisions. The UK reacted well to the end of the dotcom bubble, slowing by less than could have been expected in the 2001 to 2003 period, with growth averaging 2.1 %, buoyed by continuing strong consumer spending growth and rapid rises in government spending. The reason for the weakness now is that the consumer is slowing down and the unproductive growth in government is affecting confidence.
For next year the Chancellor now forecasts between 2 % -2.5 % as the economy recovers following its toughest year'. We agree with the Chancellor, as continuing world growth and flat oil price inflation should give the UK a leg up.
However by expecting growth of between 2% and 3% in 2007 and 2008, we believe the Chancellor remains overoptimistic on future economic growth. This is for a number of reasons:
1) The world economy has held up well this year and is likely to remain strong next year. But the world economy should slow in 2007 on higher interest rates and an unfavourable cycle.
2) UK interest rates are likely to remain high so that consumer confidence is not likely to get a boost. With consumers still borrowing strongly, they are likely to remain subdued for longer. The same applies for the housing market.
3) Tax rises are likely in the next financial year as we explain later in this commentary. This has already affected the mood of businesses and consumers, while the actual measures will actually feed through in 2007.
4) Finally we continue to disagree with the Treasury's long term growth assumption. We estimate that UK trend growth is 2.3 % and not 2.75 %, as previously thought by the Chancellor. The Chancellor has revised down his assumption about trend productivity (output per hour by 0.2% per annum, bring him closer to us) but he only expects trend GDP growth to fall to 2.5% by late 2006 (which makes his forecast of above trend GDP growth for 2007 and 2008 a bit surprising). Indeed it is possible that with such a high proportion of employment growth in the public sector that future productivity growth could fall further.
Looking at the details of the forecast, we think that the Chancellor is over-optimistic about business investment in 2006 whilst growth of 3% is likely this year, growth of 4 % next year seems high given the slowdown in economic growth and inflation.
We also think that he remains over-optimistic about exports growth. He continues to forecast a sharp acceleration from 0% in 2003 and 2% in 2004 to 5% this year and next. He is counting on strong export growth to Europe, but fails to recognise the uncompetitive pound against the dollar, the loss in competitiveness due to the loss of productivity from North Sea oil and the ballooning competitive strength of Asian competitors.
So the Treasury still fails to recognise that the UK's economy cannot grow as fast as it would like it to. The consequence is likely to be slower growth from 2006 onwards, leading to weaker government revenues and hence greater problems with the public finances.
Public Borrowing
The Chancellor's numbers for borrowing follow the same pattern as those for growth. He raised his forecast for the deficit on the current budget in 2005-06 to £19 billion from £6 billion nine months ago. In the next financial year he expects a deficit of £10 billion, down from a surplus of £1 billion.
After getting a big corporation and income tax boost in October 2005, the forecast for this year now seems attainable. However the forecasts for the following years are, once again, overoptimistic unless there are further tax rises announced next Spring. This despite him announcing a modest fiscal tightening of £2 billion per year by 2007-2008. Although he has extended his economic cycle by two years, we still see the delivery of his golden rule as improbable even for the last cycle and he has little chance of achieving it in the next cycle.
On the revenue side, he cannot continue to rely on corporation taxes because although company profits have been strong, they will soon feel the pinch of the consumer slowdown. And raising the North Sea tax from 10 % to 20 % can only contribute a limited amount (see below).
Once again, we got a list of draconian so-called anti-avoidance measures (see below). And as we commented one year ago, we believe that the Chancellor still misses the point that excessive tax levels eventually hit tax receipts as people and businesses gradually adjust to legal ways of arranging their affairs to avoid tax. Public sector net borrowing, which includes investment and current expenditure, is unlikely to fall below £30 billion before 2009 the Chancellor expects it to be £23 billion in 2008-09.
The Chancellor talked in great detail about his second budget rule the sustainable investment rule. He plans to raise investment on health, education, and transport (the latter two are more welcome than the former for the economic benefits they provide). Despite an expected rise in total investment from £26 billion this fiscal year to £35 billion in 2009-2010, he expects government debt to remain just below his top limit of 40 % of GDP at 38.2% in 2009. Our figures show the sustainable investment rule broken in 2009 and beyond without policy changes.
The Chancellor could fairly point to the higher level of debt in other developed countries, and we would add that debt servicing is low since interest rates are low (although will they remain so as the OPEC surpluses are used up, the Asian investors move their assets into commodities and equities rather than bonds, and UK pension funds move back closer to solvency?) But the problem is that because he set his second rule rather arbitrarily he is now fighting a useless war to defend it and his reputation.
Finally, unfortunately the Chancellor pushed aside the suggestion to cut spending. We do not buy his argument that cutting spending will undermine the economy. In fact we think that the opposite is true and that at present in the UK the government has become too big to let the economy reach its potential. The latest forecasts show the ratio of government receipts to GDP (mainly tax) rising from 38.1% in fiscal 2004/05 to 40.7% in 2009/10.
Individual measures
The Pre-Budget Report included the usual Brownian smattering of tax wheezes for favoured business sectors, help for the elderly in the shape of further extension of the winter fuel allowance, and clampdowns on tax avoidance.
However the dominant announcement is the increase in the supplementary charge from 10% to 20% for North Sea oil companies. This is forecast to raise £2 billion in the 2006-07 financial year, and a little more than that in years after that.
This is a tax attack on one particularly profitable corner of UK business the big oil companies, currently raking in billions in profits on the back of a record crude price.
The Chancellor added a sop to the oil majors by promising that "there will be no further increases in North Sea oil taxation during the lifetime of this parliament", but the danger of this tax rise is that it may prompt some oil firms to drill new fields elsewhere rather than in UK waters. If so, that would damage UK economic growth and the balance of payments. The jury must remain out for the moment on whether this will happen.
Other business sectors are not out of the woods yet. At cebr, we have warned that the Chancellor could be tempted to announce a windfall tax on bank profits in his spring 2006 Budget not a measure, incidentally, that we would support. The banks are likely to be nervous for several months yet and have already apparently been strongarmed into providing finance for two of Mr Brown's pet schemes shared equity for house purchase and handing over funds from orphan accounts to local authorities to fund the building of youth facilities. This latter is surely challengeable in the courts.
Among the other individual measures, the Chancellor froze fuel excise duties, to placate the restive hauliers, farmers and motorists. This will be at a cost to the Treasury of some £610 million in the next financial year.
Bizarrely, this concession is included in the Pre-Budget Report under the heading "protecting the environment". There might be some good arguments for not increasing fuel duty at a time of very high oil prices, but protecting the environment is not one of them.
A little nasty one for small businesses is included in the Pre-Budget Report under the anodyne title of "tackling tax motivated incorporation". This is effectively an abolition of the zero corporation tax rate for companies making profits of between zero and £10,000, and will produce more than £500 million extra revenue for the Treasury by 2008-09. Moreover this is a measure that Mr Brown himself introduced.
This is only partly offset by an extension of capital allowances on company investment. Overall, we judge that this move will be very unpopular with start-up companies, giving them a disincentive to build up retained profits. It will therefore be bad for UK enterprise.
A final measure of note is the new local planning gains supplement. This is a new wheeze to enable local authorities to scoop up some of the windfall gains when developers get planning permission on a piece of land.
There will now be consultation on this proposal, but the strong probability is that it will go ahead and lead to a new revenue source for the public purse. However it is likely to be a slippery target, with developers using every trick in the book to avoid giving up any of their gains. Moreover, similar taxes in the past have caused revenues to go down as developers have held off supplying land for development.
Not mentioned by the Chancellor in the statement but hidden away in the small print are proposals to stop investors putting their SIPPs into residential housing or fine wines and the announcement of the implementation of the Cave report which taken at face value means a tax on wireless communications which the BBC's own submission for the licence review indicated would be equivalent to a £9 a year levy on TV licences.
The Chancellor's raft of housing measures looks at first glance like a damp squib. The key features are Real Estate Investment Trusts, but these will only be allowed if they are revenue neutral which looks unlikely; shared equity housing loans to help first time buyers (but these are unlikely to affect more than 5% of first time buyers and will add to housing demand and hence costs for the rest); and the possibility of planning gains supplement post 2008, allegedly in return for curtailing local authorities' Section 106 privileges. Given that the Barker report indicated a shortfall of 120,000 addition houses each year, compared with a current rate of new build of below 200,000, these are woefully inadequate for a statement that had been trumpeted by the spin doctors as helping 1st time buyers.
Implications for the markets
The initial reaction to the Pre-Budget Report saw sterling weaken a little against the euro and the dollar, on the lowered growth forecasts. We would expect to see more of this trend, with investors focussing on the fact that the measures in the Pre-Budget Report are aimed at tightening fiscal policy by a net £1.1 billion in 2006-07 and a net £2 billion in 2007-08.
The stock market took the Report in its stride. There is little to disturb the equanimity of large quoted companies, but the fact that the Chancellor has targeted the oil companies here ought to make other profitable sectors a little uneasy ahead of the Budget next spring.
The gilts market had discounted virtually everything in today's statement. The fact that the Chancellor was relatively cautious with his growth forecasts for this year and next may encourage the bulls a little however. The fact that he has, in our view, been over-optimistic with his predictions for the public finances from 2007-08 onwards may be a headache for the gilts market on another day, further down the line.
Conclusion
In conclusion we can only repeat what we concluded on the Pre-Budget report last year
This looks like a Pre-Budget Report from someone who does not expect to be Chancellor in a year's time. The numbers look overoptimistic. As recent data has shown, statistical revisions can boost the GDP growth numbers but do nothing to help the Chancellor whoever he (or she) is with the national public finances.
There must be a sporting chance that the problems with the public finances that the Chancellor is trying to paper over unravel in an embarrassing fashion before the next election. But even if he can juggle the balls up in the air until the election, it is likely that whoever is Chancellor by the time of the 2006 Budget will be forced to cut spending or raise taxes.'
Looks like we were right
By the Centre for Economics and Business Research Macro Team: Angus McCrone, Douglas McWillliams and Jonathan Said
To contact the Centre for Economic and Business Research, email: feye@cebr.com
Join more than 165,000 subscribers and keep yourself informed with the latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
MoneyWeek is written by a team of experienced and award-winning journalists, plus expert columnists. As well as daily digital news and features, MoneyWeek also publishes a weekly magazine, covering investing and personal finance. From share tips, pensions, gold to practical investment tips - we provide a round-up to help you make money and keep it.