What Explanations Can You offer for Suggestions That the Budget Is Likely to Move Into Substantial Deficit over the Coming Years?

Economic Environment.

What explanations can you offer for suggestions that the budget is likely to move into substantial deficit over the coming years?

The UK national budget is based on so-called economic cycles. Which in theory mirrors the 5-year term of a Government. In the event of a shorter government term then the 5-year cycle would need to be shortened accordingly.

The article in the Times of October 25th 2002 refers to the growing belief that the model for the economic cycle 2002 - 2007 based upon predictions formed during the 1997 - 2001 economic cycle are no longer likely to be realised, thus plunging the hitherto projected budget into deficit.

The current government committed its self to manage the economy according to the Maastricht criteria for fiscal convergence; also in 1998 it adopted two more important fiscal rules:

1. 'The Golden Rule' - over the economic cycle the government will only borrow to invest and will not borrow to fund current expenditure.

2. The 'Public Debt Rule' - the ratio of public debt to national income will be held over the economic cycle at a 'stable and prudent' level.

Taking both rules together we have a scenario that effectively means that, as an average over the economic cycle the ratio of PSBR to national income cannot exceed the ratio of investment to national income.

During the first part of the 1997 - 2001 economic cycle the economy grew strongly to the extent that by 2001 the budget was showing a surplus of £50 billion. The start of the 2002 - 2007 economic cycle was based on the Treasury forecasts that the economy would grow by 2 - 2.5% in 2002 and 3 - 3.5% in 2003, rates that are no longer considered sustainable and are currently predicted at around 1.4% for 2002 and 2.5% for 2003.

Such a growth shortfall would create a short-term public sector borrowing shortfall of around £3 billion higher than the budget prediction. If the income shortfall continued along the same rates for 2002/3 to 2006 then the budget shortfall would be around £20 billion as a maximum, if the government continued to meet all it's spending commitments.

Income levels derived from personal taxation, company taxation and the cost of borrowing determine the state of the government finances. The current predictions for reduced economic growth are based on predictions that UK manufacturing out put would be 4% lower in 2002 than in 2001 and even lower in 2004 than in 2001. Although this will be partially offset by a projected increase in consumer spending, which is believed to be sourced by manufacturers reducing their inventory levels, rather than manufacturing more.

At the same time subdued growth in the world economy and falling equity markets has led to a raising of the cost of equity capital resulting in lower business investment, which will subsequently result in lower output levels, leading to a further reduction of taxed income to the government.

This situation is predicted to be further adversely affected by a reduction of 'household' tax revenue as people are either forced or choose to save more to reflect the changing pensions situation.

What would be the effect of a £20billion tax rise on the levels of output and employment in the economy?

To prevent a £20billion deficit the Government has three options - tax more, spend less or increase borrowing. Whatever decision the Chancellor makes it is likely to have as impact on the wealth of the person in the street.

Taxing more and spending less would take money out of the economy and could lead to unemployment and a crisis in the housing market - the buoyancy of which is a key to consumer confidence. As for borrowing more, its first seems the least painful option but if the Government was to get its sums wrong it could then lead to higher interest rates which could push the economy into recession. For the Government spending less is not an option given its election pledge to improve public services.

For the short term it seems that borrowing is the way the Chancellor plans to go, as he is relatively free to increase borrowing. The Government has paid back more than £50billion of its debt over recent years and it is easy to build it up again without any difficulties.

However if money markets believe that Britain is heading into debt then it is likely that the government will have to pay more for its borrowings, which as a result could lead to rising interest rates across the economy, causing the housing market to take a fall, bringing recession closer which in turn will hit tax revenue.

If you split the economy into four parts - investment, exports, consumer spending and government spending, it's the first two components that have failed to meet expectations. Businesses