Budget day: Politics not economics

March 17, 2014

–Sam Hill is Senior UK economist at RBC. The opinions expressed are his own.–

The headlines generated by the forthcoming UK budget are likely to be political rather than economic; the general election is next year. Despite a faster than expected fall in unemployment and inflation, macroeconomic developments since the December autumn statement present limited scope for forecast revisions to government borrowing. But come the post-budget analysis, some of the seemingly esoteric revised economic assumptions may have important consequences for how the budget is perceived politically.

The modest changes we do expect to the economic forecasts would be seen as positive in essence. Small upgrades to the growth outlook should translate into borrowing reductions of  between £3 billion and £6 billion per year throughout the five-year horizon. That would leave the underlying measure of borrowing at £332 billion for the six years to 2018-19, down from £358 billion in the existing forecast from December, which itself represented a significant improvement on last year’s budget.

In these terms the presentation of the budget maths looks, on the face of it, to be a good news story for the government. It can claim deficit reduction is getting back on track. The complication comes though in the assessment that is made by the Office for Budget Responsibility (OBR) about the responsible way to approach tackling the rest of the deficit from here.

The risk for the government is that the OBR’s updated outlook leads to the conclusion that further tax hikes or spending cuts are needed – despite those falls in the overall borrowing forecast. Whether or not this happens depends on how much below its capacity size the OBR thinks the economy is operating, both now and in future. The further below full potential the economy is judged to be, the more of the deficit it is safe to assume will disappear naturally as the economy grows. Conversely, if the OBR say there is no spare capacity, the entire remaining deficit from that point must be dealt with by announcing further policy tightening. This portion of the deficit is the structural deficit.

In December’s Autumn Statement the OBR judged the economy to be operating 2.1% below capacity with the gap closing over five years. Since then, the strong performance in the labour market means that they are likely to have to revise that to a smaller gap. Furthermore, the Bank of England has said spare capacity is smaller at 1%-1.5% and that it will be eroded over just 2-3 years.

So there is a risk the economy will be operating at full capacity sooner than the OBR thought making a larger proportion of the deficit deemed to be structural, despite faster economic growth. RBC research has shown that it wouldn’t be unreasonable for a further £10 billion of tax hikes or spending cuts to be needed by 2016-17 to prevent the structural deficit increasing using the BoE assessment of spare capacity. And it is the structural deficit that the government set as its fiscal rule.

So just over a year before an election, the government will be sensitive about announcing new taxes or cuts, but the other side of the coin is that they will probably want to make a virtue of their fiscal discipline. Watch out then for how much the structural deficit is affected by the judgement on spare capacity in the economy. If it increases significantly, the government will have a tough choice; questions over commitment to cutting the deficit or further tightening pre-election.

 

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