Britain’s public financesRobert Chote

Chairman

Royal Economic Society Public LectureLondon and Birmingham

14 and 15 December 2011

Outline

• Why do governments tax, spend, lend and borrow?

• The public finances today: a snapshot

• The crisis and the repair job

• Some historical and international perspective

• The policy debate: Plan A versus Plan B

Why do governments tax, spend and lend?

• Providing ‘public goods’

– Defence, criminal justice

• Replacing ‘missing markets’

– Unemployment and incapacity insurance, higher education

• Influencing behaviour: paternalism and spillovers

– Schools, pensions, libraries, tobacco duties, green taxes

• Redistributing resources

– Taxes, cash benefits and benefits in kind

Why do governments borrow?• Revenue and spending forecast errors

– It is hard to ensure revenues equal spending even if you try

• Inter-generational fairness

– Wars, capital spending, training doctors and teachers

• Stabilizing tax rates

– Using the deficit as a shock absorber helps avoid costly tax rate changes

• Macroeconomic management

– Automatic and discretionary changes help stabilise total spending

• Political expedience

– Voters like having money spent on them more than paying taxes

The public finances today: a snapshot

Public spending in 2011-12

• We estimate that the public sector will spend £703 billion this year

– Equivalent to £26,000 per family or 46.2% of national income

Social protection29%

Health and care services

22%

Education13%

Defence6%

Debt interest7%

Other23%

Public sector receipts in 2011-12

• We estimate that the public sector will raise £576 billion this year from taxes and other receipts

– Equivalent to £21,300 per family or 37.8% of national income

Income tax and NICs44%

VAT16%

Corporation tax7%

Council tax and business rates

9%

Fuel and excise duties8%

Capital taxes3%

Other13%

Public sector borrowing in 2011-12

Public sector spending £703bn 46.2% of GDPPublic sector receipts £576bn 37.8% of GDP

Public sector borrowing £127bn 8.4% of GDP

• Deficit down from post-war peak of 11.2% in 2009-10

• Government still borrowing £1 for every £5 it spends

Public sector net debt in March 2011Gross Debtof which: gilts £919bn 62% of GDP

: treasury bills £63bn 4% of GDP : national savings £99bn 7% of GDP

less liquid assetsof which: forex reserves £53bn 4% of GDP

Public sector net debt £905bn 60% of GDP

• Debt highest share of GDP since 1968

But is this the whole story?

• PSND often criticised as a measure of the public sector’s financial health, as it fails to take account of future debts that will arise because of past government action

• Some prefer to look at the public sector’s balance sheet in the same way you would look at a private sector one

• Now possible thanks to ‘Whole of Government Accounts’

• Built up from accounts of 1500 constituent public bodies

• WGA includes physical and illiquid financial assets, plus present value of some future cash flows

WGA public sector assets 2009-10

Land, buildings and dwelling £354bnPhysical infrastructure £233bnTaxes due £105bnLoans and deposits £68bn Shareholdings in banks £65bnTreasury loans to financial institutions £58bnMilitary equipment £36bnStudent loans £28bnOverseas government bonds £24bnOther £237bn

Total £1208bn 86% of GDP

WGA public sector liabilities 2009-10

Public service pension liabilities £1132bnGilts, treasury bills and National Savings £966bnProvisions (mostly nuclear decommissioning) £102bn Amounts payable under PFI contracts £27bnOther £192bn

Total £2419bn 173% of GDP

• Does not include contingent liabilities where the chance of having to pay is <50% – mostly guarantees for the financial sector

So is the public sector insolvent?

WGA liabilities £2419bn 173% of GDPWGA assets £1208bn 86% of GDP

WGA net liabilities £1212bn 86% of GDP

• No. Its greatest asset is not included in the WGA – the right to levy future taxes

• Judging fiscal sustainability therefore requires analysis of long-term prospects for spending and revenues, taking into account demographics, health care etc

Assumptions: demography

• Ageing population – past rises in life expectancy and falls in fertility plus baby boom ‘bulge’

• ONS population projections

• Our central projection assumes:– 65+ proportion rises from 17% in

2011 to 26% in 2061– Net inward migration averages

roughly half recent levels

• We also show sensitivity to older and younger age structures and higher net migration

Figures refer to annual growth rates

0

10

20

30

40

50

60

70

80

90

100

2011 2061

Per c

ent o

f UK

popu

latio

n

0-15 16-54 55-64 65-84 85+

2.7%

0.9%

0.2%

0.1%

0.2%

Results: non-interest spending

2010-11 2015-16 2020-21 2030-31 2040-41 2050-51 2060-61

Health 8.2 7.4 7.7 8.5 9.1 9.5 9.8

Long-term care 1.3 1.2 1.3 1.5 1.8 1.9 2.0

Education 6.3 5.0 5.1 5.2 5.0 5.0 5.0

State pensions 5.7 5.5 5.2 6.1 6.8 6.9 7.9

Pensioner benefits 1.2 1.0 1.0 1.2 1.2 1.2 1.2

Public service pensions 2.0 2.0 1.9 1.8 1.6 1.5 1.4

Total age-related spending 24.6 22.0 22.1 24.3 25.6 26.0 27.3

Other social benefits 6.2 4.9 5.1 5.1 5.0 5.0 5.0

Other spending 13.3 9.4 9.4 9.4 9.4 9.4 9.4

Spending 44.2 36.3 36.6 38.8 40.0 40.4 41.7

Per cent of GDP

FSR ProjectionEstimate

Results: non-interest revenues

2010-112015-162020-212030-312040-412050-512060-61Income tax 10.3 10.7 10.8 10.8 10.9 10.8 10.9

NICs 6.5 6.6 6.6 6.5 6.5 6.4 6.4

Corporation tax 2.9 2.9 2.9 2.8 2.8 2.8 2.8

VAT 5.8 6.1 6.2 6.3 6.4 6.3 6.4

Capital taxes 1.0 1.2 1.3 1.4 1.5 1.6 1.7

Other taxes 10.4 10.1 10.2 10.3 10.4 10.4 10.4

Revenue 37.0 37.6 37.9 38.2 38.4 38.2 38.5

Per cent of GDP

Estimate FSR projection

Long term revenue and spending projections

30

34

38

42

46

50

2010-11 2020-21 2030-31 2040-41 2050-51 2060-61

Per ce

nt o

f GD

P

Non-interest spending Non-interest revenue

FSR 2011 projectionsMarch EFO

forecast

Public sector net debt

-50

0

50

100

150

200

250

2010-11 2020-21 2030-31 2040-41 2050-51 2060-61

Per

cent of G

DP

Central Constant primary balance

EFO forecast

FSR projection

The crisis and the repair job

Public sector net borrowing-4

-2

0

2

4

6

8

10

12

1996-97 2000-01 2004-05 2008-09 2012-13 2016-17

Per ce

nt o

f GD

P

Total public spending and receipts

30

34

38

42

46

50

1996-97 2000-01 2004-05 2008-09 2012-13 2016-17

Per

cent

of G

DP

Spending Receipts

Nominal GDP: total cash size of economy

90

110

130

150

170

190

210

230

2003 2005 2007 2009 2011 2013 2015 2017

Inde

x 10

0 =

200

3Q1

15%

Total public spending and revenues

30

34

38

42

46

50

1996-97 2000-01 2004-05 2008-09 2012-13 2016-17

Per ce

nt o

f GD

P

Spending ReceiptsSpending excl. measures Receipts excl. measuresSource: OBR, IFS

Policy measures from autumn 2008

0

2

4

6

8

10

2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17

Per

cent

of G

DP

Tax Benefits Debt interest Other spendingSource: IFS

80%

20%

Bigger squeeze on public services spending

-8

-4

0

4

8

12

195

0-51

195

3-54

195

6-57

195

9-60

196

2-63

196

5-66

196

8-69

197

1-72

197

4-75

197

7-78

198

0-81

198

3-84

198

6-87

198

9-90

199

2-93

199

5-96

199

8-99

200

1-02

200

4-05

200

7-08

201

0-11

201

3-14

201

6-17

Ann

ual p

erce

ntag

e re

al in

crea

se

Source: IFS

Some historical and international perspective

Net borrowing as a share of GDP-6

-3

0

3

6

9

12 194

8-49

195

1-52

195

4-55

195

7-58

196

0-61

196

3-64

196

6-67

196

9-70

197

2-73

197

5-76

197

8-79

198

1-82

198

4-85

198

7-88

199

0-91

199

3-94

199

6-97

199

9-00

200

2-03

200

5-06

200

8-09

201

1-12

201

4-15

Per ce

nt o

f GD

P

National debt since 1700

0

50

100

150

200

250

300

1700 1730 1760 1790 1820 1850 1880 1910 1940 1970 2000

Per ce

nt o

f nat

iona

l inc

ome

War

of s

pani

sh s

ucce

ssio

n

Aus

trian

suc

cess

ion

Seve

n Ye

ars

War

Am

eric

an W

ar o

f In

depe

nden

ce

Revo

lutio

nary

and

N

apol

eoni

c W

ars

Boer

War

Wor

ld W

ar I W

orld

War

II

Introduction of income tax

Expansion of national insurance

Forecast

Selected OECD budget deficitsGovernment net lending/net borrowing in 2011

-15 -10 -5 0 5 10 15

Ireland

United States

United Kingdom

Greece

Japan

OECD-Total

Spain

Portugal

France

Italy

Germany

Sweden

Switzerland

Norway

Per cent of GDPSource: OECD

Selected OECD debt ratiosGovernment gross financial liabilities in 2011

0 50 100 150 200 250

Switzerland

Sweden

Norway

Spain

Germany

United Kingdom

United States

France

OECD-Total

Portugal

Ireland

Italy

Greece

Japan

Per cent of GDPSource: OECD

The policy debate: Plan A versus Plan B

The backdrop: weak economic growth

-5

-4

-3

-2

-1

0

1

2

3

4

5

1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

Perc

enta

ge c

hang

e on

pre

viou

s ye

ar

The backdrop: economy has spare capacity

-5

-4

-3

-2

-1

0

1

2

3

Q12007

Q3 Q12008

Q3 Q12009

Q3 Q12010

Q3 Q12011

Q3

Per ce

nt

"Aggregate composite" estimates"Principal components analysis" estimates (previous approach)"Principal components analysis" estimates (updated approach)

Output gap c. 2.5% in Q3

The backdrop: govt can borrow cheaply

5 year bond yields

0

1

2

3

4

5

6

7

8

Mar-11 Apr-11 May-11 Jul-11 Aug-11 Sep-11 Nov-11

Per

cent

0

10

20

30

40

50

60

Per

cent

UK Germany Italy Greece (RHS)

Plan A versus Plan B

• Is there a temporary tax cut or spending increase large enough to give a material boost to the economy, but small enough not to push up the Government’s borrowing costs in a self-defeating way?

• The Government says borrowing costs are low because it has a credible fiscal consolidation plan. A fiscal loosening would undermine confidence, push up debt interest costs and soon require even greater fiscal tightening

• The Opposition says borrowing costs are low more because we are outside the eurozone and because people are pessimistic about long term growth. Slowing the consolidation would boost growth and help cut the deficit

• Who’s right? It’s not for us to say!

The role of the OBR

• “to examine and report on the sustainability of the public finances” (Budget Responsibility and National Audit Act 2010)

• Overcome mistrust of ministerial analysis. Four main tasks:

– Produce two five-year forecasts for economy and public finances– Judge progress towards the government’s fiscal targets– Scrutinise Treasury costing of tax and spending measures– Assess long-term sustainability and public sector balance sheet

• Demonstrating our political independence is key

– Various legal safeguards– But transparency is key