The most startling part of the UK Budget and the economic forecasts it is premised on is the significant downgrade to growth and people’s incomes. Britons will be no better off in 2022 than they were in 2008; in fact, they’ll be worse off since real (after taking into account inflation) average pay will be £800 lower. The Office for Budget Responsibility (OBR) forecasts that real cumulative per capita GDP growth will be the slowest in the UK among G7 countries. It means that even by 2022, a decade and a half after the banking crash, people will still, on average, be worse off than they were before the crisis. That’s the stark consequence of slow economic growth due to a slump in productivity.
The OBR had been expecting productivity to pick up, but decided to forecast along the lines of what the Bank of England has done, which is to downgrade the potential growth rate of the economy due to slow productivity growth. Output per worker has been flat since the crash and the OBR had expected it to return to the previous growth rate of 2% per annum. As it hasn’t picked up nearly a decade later, the OBR has now downgraded the GDP growth rate of the British economy to around 1.5% (dipping as low at 1.3% for a couple of years before picking up to 1.6%) for the next five years. The UK used to grow at between 2-2.5%. To work out what that means for the size of the economy and national income, a rule of thumb is to divide the number 70 by the growth rate. So, at 2%, the UK economy would double in 35 years. But at closer to 1% would mean that our average income would double in 70 years. That’s why the growth downgrade is so troubling for standards of living. This worrying downgrade of what the economy is capable of growing at is why the Chancellor decided to “loosen” fiscal policy to try and raise productivity to change this “new normal” growth rate. Of the additional spending of £25 billion announced in the Budget, £10 billion is earmarked for quick expenditure to try and improve these forecasts. Even though it is a global issue in that productivity growth has slowed across major economies, Britain’s challenge is worsened by a dramatic cut in investment since the crash and having had low rates of investment before. The Chancellor is aiming to raise public investment as a share of GDP to a sustained 2.4%. That’s still lower than most of the G7 who have averaged 3.5% of GDP for two decades. Private investment has also been the lowest in the G7 since 1997, according to the OECD. Therefore, the fiscal stimulus in this Budget is divided between productivity-enhancing investment, including in housing and electric vehicles, and other spending needed to address urgent issues such as the NHS and preparing for Brexit. Focussing on the productivity-related measures, the government is increasing the size of the National Productivity Investment Fund to £31 billion and has extended its life to 2022. About two-thirds is geared at housing and transport infrastructure which leaves about a third on digital infrastructure and R&D. For instance, in 2017-18, the Fund will allocate £25 million to digital communication and £425 million R&D funding out of a total spend of £1.5 billion. There are also other measures such as increasing the R&D tax credit by 1 percentage point to 12% and £406 million allocated to improve STEM education to help produce skilled workers/researchers. Of course, better hard (transport) and digital or soft infrastructure would also raise productivity. But, focussing on the crucial component of R&D, these measures go toward realising the government’s aim to raise the UK’s investment in research & development to 2.4% of GDP in a decade in 2027. That is an improvement, but it would still be lower than other major economies. Still, the technology-focus in the Budget is a welcome shift. The challenge will be whether these measures are sufficient to turn around a decade-low productivity slump. It takes time for investment to generate returns and for R&D to produce technological innovations that raise the productivity of the economy. It would also be hard to differentiate between whether a lack of productivity improvement is due to the length of time it takes to innovate or upgrade capital or due instead to insufficient investment by the government and private sector. In other words, although the Budget is mildly stimulative, the spending measures are modest because the Chancellor still aims to hit the government’s fiscal target of bringing the structural (non-cyclical) deficit down to 2% of GDP by 2020-21. He is able to do so in this Budget partly because of what the OBR calls “fiscal illusions.” In other words, by selling shares in the largely state-owned bank RBS and re-classifying housing associations as private, the balance sheet looks a bit better. But, the OBR warns it’s illusory and can mask risks in the underlying health of the economy. Even with these “fiscal illusions,” the OBR judges the government has missed one of its fiscal targets which is to bring the budget into balance by the mid-2020s. Instead, it looks like the Budget won’t be in balance until 2030, which would mean three decades since the UK’s budget had last been balanced. Given that the deficit target was hit due to the above measures and the fiscal objective of a balanced budget was missed, it’s arguable that the government’s fiscal rules are not as reassuring as intended. In which case, perhaps the government might consider a more straightforward change to its fiscal rules to allow for greater investment to try and turn around the productivity trend. By separating capital from current spending, so investment is not considered similarly to the day-to-day running of government, there would be greater scope to invest. By accounting for these categories separately, it would be transparent to financial markets to consider whether the government is acting prudently since the fiscal rules are intended to reassure investors and creditors of Britain. That may be something to consider if productivity doesn’t pick up and slow growth worsens the budget deficit. After all, even after considering these new government policies, the OBR has forecasted that by 2022, the end of this Parliament, the productivity trend won’t have significantly improved and thus average incomes for Brits will not have surpassed 2008 levels. By doing more, there might be a greater chance of changing the current path of the British economy. Not by a huge amount, but the 2017 Budget shifts course to promote economic growth. As declared by the British PM and the Chancellor, this was a “balanced” budget to meet the government’s fiscal target of reducing the structural deficit to 2% of GDP by 2021 while at the same time spending a bit more on productivity-enhancing measures such as supporting technological innovation as well as helping the national health service (NHS), preparing for Brexit ,and increasing house-building. In other words, it was a departure from previous years when the Chancellor would announce “fiscally neutral” Budgets that meant that any additional spending would be funded by a tax rise/spending cut elsewhere so that the UK could reduce its fiscal deficit that was 10% of GDP in 2009-10 to the Maastricht Treaty level of 3%. The European Commission today declared the UK met that target as the deficit was 2.3% this fiscal year, so it comes off of the Excessive Deficits list (two EU nations remain on it).
Irrespective of the EU-wide target, the government has been aiming to hit its own structural (underlying) budget deficit target that is not due to the business cycle. On current projections, it looks like it will do so as the structural deficit will fall to 1.3% in 2021. But the government has decided against hitting it sooner because it has chosen to spend the minimal fiscal room it has on boosting economic growth. In other words, the government had been expected to run a £10 billion surplus in 2019-20 but that will now be a deficit of £35 billion instead. In 2022-23, there will still be a deficit of some £26 billion. Running a budget surplus has been abandoned and the reason was apparent from the start of the Chancellor’s speech. It’s due to a worrying growth picture. The UK’s economic growth forecasts were severely downgraded due to slow productivity growth. Instead of growing at 2% per year as it was before the crisis, productivity growth has been flat. This has led the Office for Budget Responsibility to cut GDP growth to around 1.5% for the next 5 years of this Parliament. Growth is expected to be 1.5% this year and then slow to 1.3% in 2019 and 2020 before picking up a bit to 1.6% in 2022. This is in line with the recent assessment of the Bank of England that the potential rate of growth for Britain is now just 1.5% instead of around 2%. So, the Chancellor has chosen to try and raise economic growth by spending what fiscal space is available to address the productivity challenge that has led to slow growth. Increasing support for R&D and investment in a range of technological sectors, including electrical vehicles, was part of the refrain heard during the Chancellor’s speech that stressed a post-Brexit, tech-oriented future. As faster economic growth usually means more tax revenues, this slight fiscal loosening to raise growth may help the government’s fiscal position in the coming years. This somewhat looser fiscal position is more necessary because the Bank of England has begun to tighten monetary policy by raising interest rates and higher rates make borrowing and investment more costly. Given the scale of Britain’s productivity challenge, if the measures announced today do not raise economic growth as expected or the government faces a worsening fiscal deficit because slower growth becomes a bigger drag on tax revenues, then there may be those who wonder whether more should have been done. |