Pre-Budget report 2005: growth down and borrowing up

As widely predicted, the chancellor has had substantially to downgrade his growth forecast for 2005 to just 1.75% - around half the level Gordon Brown predicted at the time of his March 2005 Budget. As a result, government borrowing will be higher than anticipated.

While perhaps not exactly dreading his appearance at the Dispatch Box, Gordon Brown could hardly have relished the prospect of delivering his 2005 pre-Budget report to the House of Commons in December last year¹. The principal cause of his discomfort was the announcement that the UK economy would grow by 1.75% for 2005, and by between 2% and 2.5% in 2006. While these figures allowed the chancellor to boast that UK gross domestic product (GDP) had grown for 53 consecutive quarters, the longest unbroken expansion since records were first kept, the difficulty was that the growth figure for 2005 was far below that he confidently predicted at the time of his last Budget, presented only a few months before (See Budget 2005: a question of 'vote now, pay later'? ). While Gordon Brown has become accustomed to commentators questioning the Treasury's optimistic growth forecasts, he has taken great delight when subsequent events have proved them wrong. On this occasion at least, the doubters have been shown to be right.

Statistical revisions and global factors to blame, says Brown

As one would expect, the chancellor was able to tell his detractors exactly why the UK economy had under-performed. Since the 2005 Budget, he said, there have been "extensive revisions" to the UK national accounts "that have altered the path of output relative to previous estimates. In particular, there have been significant revisions to the profile of quarterly growth in 2004, which by reducing the level of output at the end of 2004 reduced 2005 growth by almost half of 1%."

At the same time, the government says, UK economic activity has been adversely affected by two key external influences:

If this was not bad enough, the chancellor also pointed to a weakness in domestically generated demand. In particular, average earnings growth has been slower than expected, which has further reduced spending power. Therefore, overall GDP growth is now estimated to have remained below its trend rate of 2.75% over the first three-quarters of 2005 and was expected to increase by 1.75% for the year as a whole, compared with between 3% and 3.5% forecast at the time of the March 2005 Budget. Growth for 2006 is predicted to be pitched at between 2% and 2.5%, again below trend and below the March 2005 Budget's forecast. Thereafter, output growth is expected to strengthen, rising to between 2.75% and 3.25% in both 2007 and 2008.

Inflation on the government's preferred measure - the consumer prices index (CPI) - is expected to remain a little above 2% in the short term, mostly in response to higher fuel and import prices. However, it is predicted to edge down during the course of this year, ending 2006 a little below target. Thereafter, it will rise to hit 2% in 2007.

Higher borrowing, but the "golden rule" remains unbroken

Weaker output growth has resulted in both a bigger Budget deficit for 2004/05 than forecast and higher net borrowing. The documentation accompanying the 2005 pre-Budget report shows that the deficit on the current account for 2004/05 was almost £20 billion, with net borrowing standing at £38.8 billion. This latter figure is around £4.4 billion more than was projected at the time of the 2005 Budget.

For the 2005/06 financial year, the pre-Budget report estimates that the deficit will fall to £10.6 billion. Although this is £9.25 billion lower than in 2004/05, it is still around twice the level predicted by the chancellor at the time of the 2005 Budget. Borrowing for 2005/06 will be £37 billion, against the £31.9 billion forecast in March 2005.

Despite these revisions, Gordon Brown is still on target to meet his "golden rule" - this states that, over the economic cycle, the government will only borrow to invest, and not to fund current spending. The latest Treasury projections suggest that the average surplus on the current account over this economic cycle, forecast to now end in 2008/09, will be just 0.1% of GDP.

Thereafter, the average surplus over the period between 2008/09 and 2010/11 is forecast to be a far healthier 0.75% of GDP. "At this early stage, and based on cautious assumptions, the government is therefore on course to meet the golden rule after the end of this economic cycle," the Treasury says.

Commentators distinctly underwhelmed

The fact that the chancellor has had to move the goalposts in relation to the end of the economic cycle to ensure that he meets his golden rule, and that by doing so he still only meets it by the slimmest of slim margins has led many commentators to suggest that Gordon Brown's reputation for sound macroeconomic management is somewhat tarnished, and he may have to raise taxes to keep borrowing levels in check.

This is certainly the view of Roger Bootle, economic adviser to Deloitte, the audit, tax, consultancy and corporate finance group: "Were it not for the various adjustments already made," he said, "the chancellor would be on course to break his own golden rule comprehensively. But whether or not the rule is broken, the big picture remains one of a very dramatic deterioration in the state of the public finances over recent years. Even his own, optimistic, forecasts [predict] public borrowing of some £26 billion in 2008/09, providing little scope for the economy to continue to disappoint.

"Accordingly, I continue to believe that policy action, probably in the form of tax increases, will eventually be required to get government borrowing back down to acceptable levels. The fact that the economic cycle is now not expected to end until 2009 means that Mr Brown can avoid raising taxes while the economy remains so weak, but he cannot put off the inevitable forever."

The CBI described the pre-Budget report as a "missed opportunity", notably because the government had "failed to ease back on growth in public sector spending, and relied instead on yet more ... borrowing and more tax on business". In addition, said Sir Digby Jones, CBI director-general, "the chancellor's predictions are totally dependent on strong growth in the economy generally, yet he has failed to provide any significant and immediate productivity incentives to ensure that this growth is delivered."

Press reaction was hardly kinder. The Financial Times editorial of 6 December 2005 noted that: "As in recent years, Mr Brown's forecasts rely on a level of tax buoyancy that few independent observers believe in. The Treasury acknowledges that current receipts have been revised down since the [2005] Budget by £3.5 billion. If receipts continue to fall short, he will have to either cut spending or raise taxes to keep within the golden rule."

Stephen King, commenting on the pre-Budget report for the Independent, noted that Gordon Brown "is facing economic and financial challenges that are making life at Number 11 rather uncomfortable. This is a chancellor whose iron grip on the controls of the economy is showing the first signs of corrosion." Over at the Guardian, Larry Elliot concluded that "this year's slowdown has exposed weaknesses that have remained unrectified under Labour. Productivity is weak (especially in the public sector), and little advantage has been taken of the booming global economy. It has been far from a vintage year, and yesterday was hardly a vintage performance from the chancellor either."

Boosting employment ...

In previous years, the government has stated that its "long-term goal is employment opportunity for all - the modern definition of full employment". To achieve this, it has stated that everyone "should be provided with the support they need to participate in a successful labour market". Boasting that UK unemployment has fallen to 4.7%, the second lowest of the Group of Seven major world economies and the lowest rate for some 30 years, the chancellor announced a package of measures that he hopes will further strengthen the labour market and will "extend support to the inactive and those who face particular barriers to work". These include:

... and productivity

According to the government, productivity growth, alongside high and stable employment levels, is a vital component of strong, long-term, economic performance. One of the central problems, acknowledged in the pre-Budget report, is that historically the UK has experienced comparatively low rates of productivity in relation to other major economies such as the United States, France and Germany. In recent years this "productivity gap" has closed somewhat. From 1997 to 2005 actual trend productivity grew at 2.35% a year, compared with 2.03% over the previous cycle.

Despite this improvement, the government maintains that the UK cannot rest on its laurels, pointing out that new challenges are constantly emerging as the intensity of global competition increases. Building on the reforms and initiatives that have already been introduced, the pre-Budget report sets out a number of measures designed to further close the productivity gap by achieving a faster rate of growth than that of the UK's main competitors. These include the publication of a strategy to tackle the long-term lack of supply in the housing market, which unnecessarily restricts the movement of labour around the UK.

An interim report on the UK's existing skills profile is also to be published². This research reveals that, while the government maintains that the skills profile of the UK's workforce has improved, there is still much to be done. More than one-third of British adults do not have a basic school-leaving qualification, double the proportion in Canada and Germany. In addition, 5 million adults have no qualifications at all. One in six adults does not possess the literacy skills expected of an 1 1-year-old, and half of adults surveyed do not have this level of functional numeracy.

Public sector faces squeeze

One of the government's key objectives, as set out in the 2004 spending review, is to ensure it gets "value for money", and it has set itself the target of achieving £21 billion worth of efficiency savings by 2007/08. The 2004 spending review also set out government plans for an overall cut of 84,000 civil service posts by 2007/08. In the 2005 Budget, the chancellor reported that a reduction of more than 12,500 jobs would be achieved by the end of March last year, and a further 12,800 posts were removed by the end of September. According to the government, an additional 5,700 civil servants had been "reallocated to frontline services". The government maintains that these staffing reductions are being achieved through natural wastage, with compulsory redundancies "being avoided wherever possible".

Not only are public sector job losses likely to continue for the foreseeable future, those still in employment are likely to find their pay being squeezed. The pre-Budget report notes that wages account for around 25% of all public spending, and so "controlling pay is essential to delivering value for money, and keeping inflationary pressures in check." Gordon Brown has already written to the pay review bodies, which recommend increases for around 2 million public sector workers, including NHS staff, teachers, police officers and the armed forces, stating that "it will be important to ensure that public sector pay settlements do not contribute to inflationary pressure in the economy. To do so would risk converting a temporary increase in inflation into a permanent increase. The pay review bodies should therefore base their pay settlements on the achievement of the [CPI] inflation target of 2%, rather than on the recent, temporary, rise in the rate of inflation."

In addition, and in an attempt to achieve what the chancellor says is a "more coordinated approach to pay across the public sector", the pre-Budget report announces that the government is to establish a new "single gateway" for major pay decisions. Reporting to the Chief Secretary to the Treasury, this gateway will set common objectives for pay across government, "extending and strengthening existing arrangements for considering the structure of new pay deals". The aim is to ensure that "all new pay structures are evidence-based, represent value for money, and are financially sustainable over the long term - including taking account of the pension implications of new pay decisions."

Unions express concern

As one would expect, these strictures received something of a frosty reception from the public sector trade unions. While welcoming the chancellor's commitment to continuing investment in public services, Unison general secretary, Dave Prentis, added that "artificial pay restraint would jeopardise all the positive initiatives to improve recruitment and retention problems ... and could undermine morale." The reaction of Mark Serwotka, general secretary of PCS, which has nearly 325,000 members working in government departments, agencies, public bodies and in a number of private companies, notably in information technology, was somewhat sharper: "The chancellor talks about extending the New Deal and putting skills at the heart of economy, yet in the same breath boasts about cutting the very staff who will deliver this. Rather than championing crude job cuts, which are leading to a meltdown in essential services such as benefits and job broking, the chancellor should be stepping back and looking at the damage being wrought by job cuts on services [that] some of the most vulnerable in society rely on."

Table 1: Economic growth and net borrowing, 2005/06-2008/09

Source: HM Treasury.

¹ "Britain meeting the global challenge: Enterprise, fairness and responsibility", Pre-Budget report, December 2005, Cm 6701, available from HM Treasury, tel: 020 7270 4558, price £45. Also available, free of charge, at www.hm-treasury.gov.uk .

² "Skills in the UK: the long-term challenge", Leitch Review, 5 December 2005, available from www.hm-treasury.gov.uk , free of charge.