SMF Autumn Statement Briefing

Social Market Foundation | Autumn Statement: Implications for public spending and growth

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Autumn Statement:

Implications for public spending and growth

Overview

The stakes for George Osborne as he prepares to deliver his third Autumn Statement this week couldn’t be higher. With

growth faltering, public borrowing above target, and the Chancellor’s economic plan under attack from all sides, the Office

for Budget Responsibility’s (OBR’s) verdict on the public finances will be a crucial determinant of future Government

economic policy.

The SMF’s recent work speaks to a number of the questions likely to be raised by the Autumn Statement. Our study Fiscal

Fallout uses the OBR’s own models to estimate the size of the output gap, on which much of the OBR’s advice is based. Our

earlier publication, Osborne’s Choice, outlines how the Chancellor can create a potent growth strategy within the existing

deficit reduction plan by changing the composition of cuts.

Based on the analysis in these two studies, this short briefing explores:

• What the OBR may say about the size of the structural deficit;

• the consequences for the public finances of the OBR’s likely assessment;

• how the OBR’s main model for judging the state of the public finances differs from those of other forecasters and

what the consequences of this are; and

• how the Chancellor can use fiscal policy to boost growth while sticking to his deficit reduction plan.

1. What will the OBR say about the size of the structural deficit?

At last year’s Autumn Statement, higher borrowing figures and the poor performance of the UK economy led the OBR to

conclude that the output gap had shrunk. In response the Government pencilled in a further £15bn of cuts to current

spending or tax rises in 2015-17 to meet its mandate to eliminate the structural deficit within five years. This £15bn was on

top of the extra money that will need to be found to accommodate the natural growth in social security expenditure by

2016-17, bringing the additional cuts needed after 2014-15 to £26bn.

Economically, this year has been something of a repeat performance, for two reasons: government borrowing is well above

target and more of the deficit now looks permanent.

• The latest official figures on the public finances show that borrowing is just over 10% higher than it was this time

last year, once one-off effects like the Royal Mail pension fund assets are excluded. On its current trajectory, then,

borrowing will overshoot the OBR’s March 2012 forecast by more than £12bn. That’s bad news, but how bad

depends on the OBR’s assessment of how much government borrowing will melt away once the economy

returns to its full potential.




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• A core part of the OBR’s forecast is its estimate of the amount of spare capacity in the economy, known as the

output gap. How big the output gap is determines how much of the deficit is structural (i.e. will persist even

when the economy returns to its potential level). In March 2012, the OBR estimated that the output gap would be

-2.7% of potential output in 2012-13. But, just eight months later, it looks likely that the OBR will further revise

down its estimate . Using OBR modelling, updated with the latest survey data, the SMF anticipates that the

watchdog will calculate the output gap at just -1.8% of potential output for 2012-13, if it follows its models in the

way that it has in the past. The economy therefore has less room to bounce back than previously expected.

Consequently it appears that a higher proportion of the deficit will remain when the economy returns to its

potential level.

Higher borrowing and a smaller output gap spell very bad news. It seems likely that the OBR will find that the structural

deficit is 1.3% of GDP larger this year than previously expected. The OBR is therefore likely to require the Government to set

out a further round of spending cuts at the autumn statement in order to meet its fiscal mandate.

2. What further cuts will be needed to eliminate the deficit?

Assuming the OBR puts weight on the same model it has traditionally used to calculate the output gap (see below), it is

likely to find that the structural deficit in 2012–13 is 1.3 percentage points of GDP higher than its March 2012 forecast. This

means that further fiscal tightening will be required in 2017-18. But the Chancellor has some room for manoeuvre on the

size of the extra consolidation he could announce, since the March 2012 Budget planned more consolidation than

necessary to eliminate the structural deficit.

• If the Chancellor wants to get the public finances back to where they would have been in 2017-18, had the

economy evolved as expected at the time of the last Budget, he would need to identify £19bn of extra

tightening. This would leave the cyclically adjusted current budget in surplus to the tune of 0.8% of GDP in 2017-

18.

• If the Chancellor chooses to extend the current pace of spending cuts (-0.9% in real terms) for a further year – into

2017-18 – he would need to identify a further £7bn of fiscal tightening. This move would represent a loosening

of current plans, but would achieve the mandate with a small margin, putting the cyclically adjusted current

budget into a surplus of 0.3% in 2017-18.

• If the Chancellor wants to scrape home on the fiscal mandate by bringing the current budget just to balance in

2017-18, he would need to identify around £3bn of extra tightening. This would represent a substantial

loosening of fiscal policy compared to existing plans, leaving no margin for error on the fiscal mandate.

Why the implied cuts will in fact be significantly larger

Whichever of the above the Chancellor chooses to do, the scale of necessary cuts looks set to be substantial. However, the

above figures represent real terms cuts to current spending and are, unfortunately, only part of the story. In the absence of

any policy action, Annual Managed Expenditure (AME) spending (primarily social security) rises in real terms year-on-year.

For this reason, even holding current spending constant in real terms would require cuts to be made elsewhere to

accommodate the rising social security bill. This phenomenon was evident last year, when the £15bn of extra tightening set

out by the Treasury was actually in addition to a further £11bn of cuts needed to accommodate the rise in social security

spending. In 2017-18, this is likely to add a further £7bn to the needed cuts.




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The chart below shows the combined tightening necessary - accommodating rising AME and additional necessary cuts or

tax rises – to achieve the fiscal mandate on the three scenarios set out above. To get the public finances back on track with

where they were planned to be at the Budget (scenario 1), fully £26bn of spending cuts or tax rises may be necessary.

Chart: Additional tightening required for three scenarios

What does all this mean for the next spending review?

As described above, last year’s Autumn Statement identified form £26bn of fiscal tightening as necessary by 2016-17. If a

further £26bn is advised this time, a total of £52bn of cuts will be meted out at the next spending review, due next autumn,

to take effect in 2015 to 2018.

3. Is the OBR right about the output gap?

The OBR’s assessment of the structural deficit, and hence the scale of necessary consolidation, is dependent on its analysis

of the size of the output gap. As the Government’s fiscal policy stance is determined by the OBR’s assessment, this has real

consequences for the future of public spending in the UK, as well as significant political implications.

But there is huge variation in estimates of the output gap among independent forecasters, and the OBR’s models appear to

make it among the most pessimistic about the economy’s potential of the 13 forecasters shown in the chart below. In

March 2012, by contrast, the OBR’s estimate was roughly in line with the average of other independent forecasters. But in

Fiscal Fallout we concluded that the OBR’s models would take it away from the consensus. The chart below shows the

results of our replication of the OBR’s models in comparison with 13 independent forecasters.

7 7 7

19

7

3

Scenario 1: Getting deficit reduction

back on track

Scenario 2: Extending the pace of

cuts

Scenario 3: Scraping home on the

fiscal mandate

Cuts necessitated by growth in Annual Managed Expenditure Additional tightening required

26 bn

14bn

10 bn




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Chart: Output gap forecasts for 2012

Source: HM Treasury, Forecasts for the UK Economy (London: HMSO, November 2012), SMF calculations

On average, independent forecasters have revised their output gap estimates for 2012 up, from -2.6% to -2.7% between

March 2012 and October 2012, suggesting that there is slightly more room for the economy to bounce back. But the OBR

models appear to have been moving in the opposite direction.

The OBR models rely on responses to surveys asking businesses how close they think they are to capacity. But in some

cases, firms may be reporting immediately available capacity rather than their long-run capacity. Historical data suggests

that business survey measures of capacity tend to move with actual output rather than potential output. If this is

happening, the OBR models could be underestimating the size of the output gap. This theory is backed up by the fact that

firms have been running large surpluses, suggesting that they may have the ability to expand capacity relatively quickly if

demand returns.

What are the consequences if the OBR’s output gap assessment is wrong?

If the OBR decides to stick to the results from the model it has drawn on in the past but independent forecasters turn out to

be right the Government could end up making substantial unnecessary cuts, or imposing large unnecessary tax increases.

The huge variation in independent output gap forecasts leaves the Government with a serious and complex question: does

it want to risk substantial cuts to welfare and public services, or tax rises, that may turn out to be unnecessary, or does it

want to risk missing its fiscal target?

-7.0%

-6.0%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

2012 estimate

Average of independent forecasts




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4. Growth: Plan A, Plan B, or something else?

A core part of the OBR’s EFO is its growth forecast. At the March 2012 Budget the OBR predicted growth of 0.8% for 2012,

but since then the economy has performed poorly and independent forecasters now think the economy will contract by

0.2% this year. The Chancellor looks set to miss his supplementary target to have debt as a proportion of GDP falling in 2015

-16, with or without the effect of last month’s quantitative easing coupon manoeuvre (the effects of which, on debt in 2015

-16, appear ambiguous). However it seems hugely unlikely that the Chancellor will seek to step up the pace of cuts in order

to get back on track – an implicit admission that withdrawing fiscal support for the economy now would be a very bad

idea.

Indeed, because the prospects for imminent recovery appear so weak, he will face growing calls to move in the other

direction and use fiscal policy action to stimulate output. But the Chancellor has already indicated that a u-turn on the

deficit reduction plan is not on the cards.

In our publication, Osborne’s Choice, the SMF outlines how the Chancellor can stick to his deficit reduction plan and achieve

a potent fiscal stimulus, by taking full advantage of the cuts he has to make at the next spending review.

By altering the composition of spending and taxation, and making it much more supportive of growth, the Chancellor can

act now to axe measures that have little impact on output. The SMF plan recommends that he identify future necessary

cuts or tax rises from areas with a low impact on output, implement them immediately, and recycle the saved (or raised)

money into infrastructure investment that can boost GDP directly, creating jobs and increasing the long-term potential of

the economy. Capital spending could then be phased out over the next four years, leaving the public finances where they

need to be by the end of the forecast period.

The Social Market Foundation estimates that bringing forward £15bn of the necessary cuts and recycling the saved money

into infrastructure could boost output by £10bn, or 0.7 per cent of GDP per year for three years. This represents a fiscal

stimulus substantially bigger than that offered by a 2.5% VAT cut, without adding a penny to the deficit.

The idea for a funded stimulus has also been endorsed by the International Monetary Fund, who stated in May that “there is

scope within the current overall fiscal stance to improve the quality of fiscal adjustment to support growth.”

Pre-autumn statement speculation indicates that that Government may be moving in this direction, with funding

being released from cuts to current spending and redirected to fund capital investment.

Possible Autumn Statement measures that have been discussed in the press recently include cutting benefits in real

terms and reducing the annual pensions contribution limit to raise money from the better-off. These policies provide a

very interesting case study into the kind of measures that will and will not support growth. Cutting tax incentives for the

better-off to engage in long-term savings would do nothing to weaken aggregate demand or damage economic output.

Indeed, if those affected then chose to spend more rather than save it, the impact would be to support the economy.

Benefits, on the other hand, are spending that gets straight into the economy since the poor have a high marginal

propensity to spend (they spend everything they have). Cutting benefits (albeit in real terms) would therefore act as a

further drag on the economy if implemented. None of this involves making any value judgement about the redistributive

effects of any such policy package, nor does it imply that benefit reductions should not be part of the final fiscal

consolidation package. The question is one of timing.

Documents

SMF Autumn Statement Briefing