Beware Budget 2016

Photo credit -  Which magazine

Photo credit -  Which magazine

"What the sofa gives, the sofa can easily take away" - Robert Chote, speech to the Scottish Parliament Finance Committee, Edinburgh, January 6 2016


With the budget just a couple of months away – it will be on 16th March – we can make at least one prediction: it will be a lot tougher than the Chancellor hoped, and many believed, back just a few weeks ago.  And it seems likely we will all pay the price.

In his Autumn Statement speech on 27th November 2015, the Chancellor said:

“The OBR expects tax receipts to be stronger. A sign that our economy is healthier than thought....[D]ebt interest payments are expected to be lower – reflecting the further fall in the rates we pay to our creditors.

Combine the effects of better tax receipts and lower debt interest, and overall the OBR calculate it means a £27 billion improvement in our public finances over the forecast period, compared to where we were at the Budget…

First, we will borrow £8 billion less than we forecast – making faster progress towards eliminating the deficit and paying down our debt. Fixing the roof when the sun is shining.

Second, we will spend £12 billion more on capital investments - making faster progress to building the infrastructure our country needs. 

And third, the improved public finances allow us to reach the same goal of a surplus while cutting less in the early years. We can smooth the path to the same destination.”

The turbulent economic start to 2016 has already made this speech sound hubristic – and Mr Osborne has sought to get his defence in first, blaming foreigners for the likely slowdown with their "dangerous cocktail of new threats".  But he tells us, this year is “mission critical” in his resolve to make “the biggest reduction in government consumption outside demobilisation in over 100 years.”

In November, the Chancellor escaped from a nasty politico-economic trap around his earlier plan to drastically cut the incomes of those on working tax credit, thanks in large part to a series of small shifts in their future economic estimates by the Office for Budget Responsibility (OBR).

In his speech to the Scottish Parliament Finance Committee on 6th January, Robert Chote (OBR Director) sought to defend the OBR against charges that – in their Economic and Fiscal Outlook of late November – they had been, let us say, over-responsive to the shorter-term political needs of the Chancellor:

Lots of people latched onto the £27 billion that we had apparently found down the back of the sofa over the next five years. The biggest contributors to this aggregate improvement in the budget balance were a fall in the Government’s prospective debt interest payments, the recent strength of some tax receipts and changes to the way we forecast VAT and National Insurance Contributions.

He quite fairly points out that

…£27 billion is not as much as it sounds. Over five years it corresponds to an average downward revision to the budget deficit of one quarter of one per cent of GDP. This is pretty small beer in an economy where the public sector is spending around 40 per cent of GDP and raising about 36 per cent of GDP in revenue - and where the average error forecasting the budget deficit just over the rest of the fiscal year at an Autumn Statement is around ½ per cent of GDP.

But what matters most is what Mr Chote does not say – that the (in themselves) relatively small changes in the near-term almost all fell on the side of optimism, evidently helpful to a Chancellor in a tight political spot, at a time when the economic and fiscal data were giving the opposite message, that the economy was in fact slowing.  

Thus, on 27th November - just two days after the OBR’s Outlook, but surely shared between them – the ONS published its second estimate of GDP for Q3 2015, which already showed that the economy was decelerating quarter by quarter.

According to this estimate, constant volume (“real”) GDP had increased at an annual rate per quarter of  

Q4 2014 3%,  Q1 2015 2.7%, Q2 2.4%, Q3 2.3%.  

Nominal (current price) GDP over the same period slackened from an annualised rate of 4.2% (Q4 2104) to 3.7% then 3.4% and (Q3) 3.4%.  

Yet despite this evident slowdown the OBR  (while leaving real “growth” for 2015 unchanged at 2.4%) decided to increase its estimate of GDP for 2016 and 2017 by a little nudge, from 2.3% to 2.4% for 2016, and from 2.4% to 2.5% for 2017.  

This small change, added to others, had the effect of slightly improving (lowering) the headline figures for public debt and deficit (as % of GDP), which gave the Chancellor more political space in the shorter term.  With one small leap, he was free of the self-imposed fiscal need to cut working tax credits (the task still ultimately being achieved by cuts to Universal Credit).

The OBR continues to assume (see its very helpful database) that nominal GDP for the year 2015/6 will increase at the annual rate of 4%, next year (2016/7) by 4% and the year after by 4.3%.  

Given the continuing fall in commodity prices, and the deflation/disinflation that has become more embedded, these assumptions also seem highly questionable.  Yet they are relevant to the OBR and government assumptions about public finances, since tax receipts are paid in current pounds, not “constant volume” pounds.  Thus (to simplify) if you spend £120 in a shop in each of two years, but in the second year get 50% more stuff in volume due to deflation, real GDP rises but nominal GDP remains unchanged.  And the government gets VAT income of just £20 in each year, i.e. a zero increase.

But the OBR’s forecasts took another, more serious, knock just before Christmas, when the 3rd estimate of GDP for Q3 2015 was published by ONS.  In this, the annual rate of GDP increase per Quarter was reduced by ONS for each of the last 4 Quarters.  More remarkably, the ONS’s estimates for nominal GDP were reduced much further – but in reality coming more in line with what one would anticipate with near-zero inflation.  Here are the ONS's old (Nov) and new (Dec) annual percentage assumptions for the last 4 Quarters:

Thus, the estimate for Q3 is that nominal GDP rose by no more than “real” GDP – an exceptionally rare occurrence in post-war history.  And this is far below the OBR assumption that nominal GDP will increase by 4% this financial year and next.  The OBR database gives their assumption for nominal GDP per financial (not calendar) year as follows:

Taking 2015/16, if we assume Q on Q increase of 0.5% per Q in real GDP for Q4 2015 and Q1 2016, then real GDP for the financial year would be 2.1% above 2014/15, or 0.3% below the OBR assumption.

And for nominal GDP for the fiscal year 2015/16, assuming a Q on Q increase of 0.6% per quarter for the rest of the year, total GDP for the year would be up just 2.6%.  This is around £26 billion below the OBR’s estimate (about 1.4% of GDP).  

And if in 2016/17 nominal GDP rose by 3% instead of 4%, the shortfall for the year would be £47bn (a further 2.5% of GDP).  Public debt as a percentage of nominal GDP would indeed be significantly higher than foreseen.

The effect of the decelerating GDP increase will for other reasons be likely to impact on the debt and deficit figures, expressed as percentages of GDP.  The November public finance figures – also published just before Christmas – were not good, with public sector net borrowing up by £1.3 billion (to £14.2 billion) in November 2015 compared with November 2014.  The OBR has posted on its home page a statement that “temporary factors push borrowing up in November” and “we continue to expect year-on-year falls in the deficit to be bigger over the final months of 2015-16.”  Well, we shall see – but we do note that in November, VAT receipts were only marginally higher than a year before. 

Moreover,  other recent economic data have been on the gloomy side – the most recent industrial production figures for November show an annual rate of increase of just 0.9%, and that increase is due significantly to an increase in North Sea oil and gas volume output (though surely not much increase at current prices!).  And November construction data show a small year on year fall.  

It seems reasonable therefore to assume at this point that the Q on Q increase for Q4 will not exceed 0.5%, in which case real GDP will be up by just 2.1% for the calendar year, and with a less than stellar outlook for the final quarter of the current financial year.

One thing we can already be almost sure of – the OBR will need (if they have any wish to retain or salvage credibility) - to be more cautious in their estimates for 2016 and 2017 at least.  While interest rates are likely to stay low, future tax receipts must be more questionable, and the debt and deficit to GDP ratios will also be adversely affected.  

Faced with more pessimistic assumptions from the OBR, the Chancellor will have two roads to choose from – and alas, we can already judge which he will take.

The high road would be to increase public investment further by a significant margin, in part by borrowing at current almost negligible interest rates.  This investment in our future – which is likely to be in higher-paid, higher-skilled jobs – will be in infrastructure and (even if counted technically as “consumption”) in our people – in their education, training, and health.  And higher paid jobs means higher tax receipts, increased labour productivity, and a lower overall level of in-work benefits for the lower paid.

The low road - to which the Chancellor seems ideologically committed - is the tried-and-failed austerity trail, aiming to cut back spending on key public services and support to those in difficulties still further, in the vain hope that thereby, the deficit will (“this time is different”) magically disappear.  But it won’t.  It is high employment rates with decent pay that produce decent tax receipts and in due course eliminate deficits.  Going for a budget surplus merely worsens the situation by withdrawing yet more purchasing power from private and public sectors together. 

As Robert Chote said on 6th January,

The lesson is that what the sofa gives, the sofa can easily take away. And the sums lost or gained have often been much larger than they were last November.

In November, it is now clear that the sofa made a short term, interest-free loan to the Chancellor, rather than a permanent gift.  In March, the sofa will seek to reclaim what it lent.  But in reality, what the sofa lent was political rather than monetary support.

And in March, the Chancellor will face a choice.  He can make a U-turn, and dump his long-promised fiscal surplus and slow down the deficit reduction.  Alternatively, he can dig the austerity hole deeper, and make the most savage and unpopular further cuts yet  - in line with his aim to reduce government spending by the largest amount in over a century. 

Footnote: The 2nd table, 1st column was corrected on 28th January 2016, as the reference to what should have been the years 2016/17 and 2017/18 had in error been referred to as 2017/18 and 2018/19 respectively. The unchanged data in columns 2 and 3 are therefore now ascribed to the correct year.  Apologies for this.