Budget: OBR underestimates fiscal tightening – ITEM Club
ERNST & Young’s influential ITEM Club said the Office for Budget Responsibility had underestimated the impact of today’s significant fiscal tightening.
Peter Spencer, chief economic advisor to the ITEM Club, comments:
“Today’s budget had to demonstrate that the new government could meet its twin goals of deficit reduction and economic recovery, whilst seeming to be fair and avoiding the fault lines within the coalition. That was never going to be easy.
We certainly saw an ambitious fiscal target: the elimination of the structural current deficit over the next five years. Although there were no big surprises, the overall package was much tighter than most had envisaged, probably as much as the Chancellor could expect the public to swallow. That should satisfy the financial markets, at least until they see the detail of the Spending Review in October.
Short-term impact on GDP staggeringly small
However, the worry is that the extra £40bn of fiscal tightening that this involves could undermine the recovery and thus delay the recovery in the headline borrowing figures. With the OBR’s ‘before and after’ forecasts, we have – for the first time – the opportunity to see an estimate of the impact of a government’s package on the wider economy. But where this should have brought clarity, it has instead muddied the waters.
The boost to growth in later years from lower borrowing does not look unreasonable, but the short-term effects are staggeringly small. For example, in 2011, with VAT rising to 20% and current spending around £10bn lower than the pre-Budget forecast, GDP growth is estimated to be just 0.3 percentage points lower. It seems that the OBR is underestimating the impact of this significant fiscal tightening.
OBR relies on consumers cutting back on savings
In particular, the OBR appears to have assumed that consumers will react to having lower incomes by simply saving less, rather than making any significant adjustments to their spending, an assumption which looks highly questionable.
Well constructed package
Having said that, the measures that were announced add up to a well constructed package that should reduce the risk to the recovery. Delaying the increase in VAT until January will help maintain spending over the Christmas period and delay the impact on the CPI which is critical to the outlook for interest rates. The two-year pay freeze in the public sector will mean that the reduction in spending will come in gradually rather than kicking in immediately, and will help to maintain the level of services available as expenditure is cut.
Bank levy thin end of wedge
Lower paid workers will be exempt from the pay squeeze. This will help defuse the criticism that public sector workers are paying for the mistakes of the banking industry, as will the new bank levy and the consultation on the Financial Activities Tax. The bank levy may look a little thin, raising only an estimated £2bns initially, but is likely to prove to be the thin end of a very fat wedge, especially with Germany and France moving in a similar direction, reducing the effects of fiscal and regulatory migration. The increase in Capital Gains Tax to 28% on those paying higher rates of income tax will also help to balance the effect of the budget across the income scale. This rate while less than expected, represents a relative compromise between the coalition partners. It allows the CGT system to remain simple while reducing the loss of income tax revenue.
Business friendly budget
The package was also remarkably business friendly, particularly for small businesses opening up in the regions where the public spending axe will fall the hardest.
Hopefully, the uncertainty that has been holding back business spending will be resolved. It is going to be tough but at least we all know where we stand. Ultimately if the economy is to grow out of this situation much of the growth has to come from business spending and entrepreneurial activity. Without that response, the task of retrenchment and recovery will prove much harder.
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