The current budget balance

22. The Treasury's forecast of the current budget deficit for 2007-08 in the 2007 Pre-Budget Report was £8 billion, compared to a forecast deficit of £4 billion for that year in the 2007 Budget and a forecast deficit of £1 billion for that year in the 2006 Pre-Budget Report. In the 2007 Pre-Budget Report, the Treasury also revised its forecast of the current budget balance for the financial year 2008-09, from a forecast surplus of £3 billion in the 2007 Budget, to a forecast deficit of £4 billion. Since 2001, the Treasury's forecasts of the current budget balance for one year ahead have been consistently over-optimistic.[55] We discussed this issue previously in our Report on the 2005 Pre-Budget Report and concluded that it was "important that official forecasts for tax receipts avoid any systemic bias either to exaggerate or underestimate revenue".[56] Referring to the fiscal forecasts in evidence to us, Mr Macpherson said:

The fiscal aspect is a challenge. Forecasting revenues in a global economy is difficult. We seek to learn from our experience and we are confident that these forecasts are realistic. [57]

23. The weaker budget balances now forecast for 2007-08 and 2008-09 in part reflect the expected impact of recent financial market turbulence on broader economic growth and, therefore, receipts. The expected rebound in the budget balance from 2008-09 onwards is partly dependent upon a timely recovery in the financial sector such that economic growth quickly returns to trend. Discussing the vulnerability of the public finances to uncertainty surrounding the GDP forecasts, Dr Weale said:

If … the current revenue weakness persists and real GDP growth in 2009 is slower than the Treasury hopes, then the current budget will probably not move back into surplus until 2010 or 2011. This does not in any sense imply that the current proposals are unsustainable or that the country faces a fiscal crisis. But at a time of economic boom with output above trend, as the Treasury recognises, one would expect a current surplus rather than a current deficit …[58]

24. Table 1 demonstrates that 2006-07 is the first financial year for five years where the outturn for the current budget balance is better than forecast in the preceding Budget.

25. As we noted in our Report on the 2007 Budget, forecast errors tend to be correlated with the economic cycle.[59] Treasury officials commented on our earlier conclusions:

As the Committee has highlighted before, there seems to be a pro-cyclicality in our forecasting record, so during the late 1990s when the economy was growing very strongly our receipts forecasts were consistently over-pessimistic. Table 2 in the Committee's Report on the 2007 Budget draws this out very well. We had very big positive errors up until 2001-02 and then went through five years when, as your account describes, we had errors in our borrowing forecasts driven largely by errors on receipts.[60]

26. The apparent correlation between forecast errors and the economic cycle suggests that, as the economy approaches trend, a reduction in forecast errors can be expected. While the recent reduction in the size of forecast errors is welcome, it is not clear whether this reduction reflects improvements in the forecasting process or the current stage of the economic cycle. We expect the Treasury to continue to exercise vigilance in addressing errors in its forecasts of the public finances.

Revenue receipts

27. The turbulence in financial markets since August 2007 is likely to have a negative impact on the public finances, particularly on corporation and income tax receipts, reducing the forecast level of receipts and increasing the degree of uncertainty surrounding the forecast. The 2007 Pre-Budget Report explained how developments in financial markets would impact on the public finances:

The performance of the financial sector also impacts on the public finances, most directly through financial company corporation tax and income tax and NICs[61] on bonuses, where receipts from the sector are significant. While the effect on the public finances of current global financial market disruption is uncertain, the projections for the public finances in this Pre-Budget Report allow for an impact on receipts from corporation tax and income tax and NICs, along with other factors. [62]

Table 2 shows revisions to estimates of corporation and income tax receipts since the 2007 Budget for 2007-08 and 2008-09.

Source: Pre-Budget Report and Comprehensive Spending Review 2007, table B.8, p 168
* Gross of tax credits
** National Accounts measure: gross of enhanced and payable tax credits.

28. The 2007 Pre-Budget Report explained that the forecast for non-North Sea corporation tax receipts assumed that "the financial sector recovers, consistent with the sector maintaining its international competitiveness and capacity for innovation".[63] However, Mr Chote questioned the Treasury's expectation that revenues would rebound as quickly as it hoped, drawing parallels with the last bout of instability in the financial sector, where the shock to revenues had been greater than the Treasury had expected.[64] We note that the risk of a downturn in the financial sector that is deeper and more prolonged than expected poses a consequential downside risk to tax revenues in 2007-08 and 2008-09. We will continue to monitor this situation.

The golden rule

29. Since 1997, the Government has sought to adhere to a new fiscal policy framework set out in the Code for Fiscal Stability. The Code requires the Government to state the rules through which fiscal policy will be operated. There are currently two fiscal rules—the sustainable investment rule, which is discussed further below, and the golden rule. The golden rule states that, over the economic cycle, the Government will borrow only to invest and not to fund current spending. Compliance with the golden rule is evaluated by calculating the average of the Government's annual current budget balances as a percentage of GDP over the economic cycle. The current budget balance represents the difference between current receipts and current expenditure, including depreciation. The 2007 Pre-Budget Report assessed compliance with the golden rule in the following terms:

The economy appears to have passed through trend [that is, the output gap moved from negative to positive] in the final quarter of 2006. On this basis, and on the basis of cautious assumptions, the Government would have met the golden rule with a margin of £18 billion, higher than estimated at Budget 2007 … With the economy appearing to have passed through trend in the final quarter of 2006, Pre-Budget Report projections show that the current budget moves into surplus in 2009-10, with the surplus rising to 1.1 per cent of GDP by 2012-13. At this early stage, and based on cautious assumptions, the Government is therefore on course to meet the golden rule in the next economic cycle.[65]

30. According to the 2007 Pre-Budget Report, the economic cycle that began in 1997-98 ended in the fourth quarter of 2006, slightly sooner than the forecast of early 2007 made in the 2007 Budget. However, the Treasury stated that it is "too soon to assess whether or not the economic cycle has ended".[66] The complexity of dating the cycle was explained by Dr Weale:

The difficulty that the Treasury is having is that the 2004 peak at the moment is possibly slightly higher than the 2007 peak. If the 2004 peak is raised further by a revision then it would be difficult to avoid the conclusion that the cycle had ended in 2004-05, which would, of course, mean that in the current cycle the golden rule has not been met. Data revisions can move cycles around and this is well known. There has been substantial academic literature on this. They can move cycles around for quite long periods, so my response to that is that it demonstrates why the current policy structure is not usable as a way of assessing the Government's fiscal performance.[67]

31. As a result of the difficulty in dating the economic cycle, it is difficult to tell for some years after the event whether the Government has been successful in meeting the golden rule. We reiterate the recommendation, made in our Report on the 2007 Budget, that the Government review the golden rule such that it becomes more forward-looking and less dependent upon the dating of the economic cycle.

The sustainable investment rule

32. The objective of the sustainable investment rule is to ensure that the Government maintains sound public finances in the medium term. In order to meet the sustainable investment rule in the current economic cycle, the Government aims to maintain net debt below 40% of GDP in each and every year of the economic cycle.[68] In the 2007 Pre-Budget Report, the Treasury forecast that the sustainable investment rule would be met over the current and new economic cycle, peaking at 38.9% of GDP in 2010-11 before falling back in subsequent years. In the 2007 Budget, the Treasury forecast that net debt would stabilise at 38.8% of GDP in 2009-10 before falling in 2011-12.

33. In our Report on the 2007 Budget, we recommended that the Government "give an account of the circumstances in which it would change its current interpretation of the sustainable investment rule for the next economic cycle".[69] In its response to our Report, the Government stated that it would "set out in the normal way the details of the fiscal position under the framework over the next cycle when it provides its view on the end of the current cycle".[70] We recommend that, in its response to this Report, the Government sets out details of when it intends to provide its view on the end of the current economic cycle.

56   Treasury Committee, Second Report of Session 2005-06, The 2005 Pre-Budget Report, HC 739, para 61 Back

57   Q 133 Back

58   Ev 51 Back

59   Treasury Committee, Fifth Report of Session 2006-07, The 2007 Budget, HC 389-I, para 22 Back

60   Q 131 Back

61   National insurance contributions. Back

62   Pre-Budget Report and Comprehensive Spending Review 2007, Box 2.3, p 23 Back

63   Pre-Budget Report and Comprehensive Spending Review 2007, para B.42, p 169 Back

64   Q 4 Back

65   Pre-Budget Report and Comprehensive Spending Review 2007, paras 2.35-2.36, p 27 Back

66   Ibid., para B.6, p 158 Back

67   Q 31 Back

68   Pre-Budget Report and Comprehensive Spending Review 2007, para 2.13, p 20 Back

69   HC (2006-07) 389-I, para 33 Back

70   Treasury Committee, Fifth Special Report of Session 2006-07, The 2007 Budget: Government Response to the Committee's Fifth Report of Session 2006-07, HC 696, p 6 Back