U.K. Chancellor Unveils £20-bil. Fiscal Stimulus Package in Bid to Limit Recession

Chancellor Alistair Darling yesterday announced a fiscal stimulus package valued at £20 billion (US$30.2 billion) in his pre-budget report (PBR) for fiscal year (FY) 2009/10. Some of these measures will take effect before the next fiscal year (which starts in April 2009) as the chancellor seeks to limit the length and depth of the recession that the U.K. economy is now undeniably in. This includes the centrepiece measure, the temporary reduction of value-added tax (VAT) from 17.5% to 15.0%, effective from 1 December 2008.

Desperate times call for desperate measures. Ordinarily, with the public finances in the very poor state that they are, the government would be looking to tighten fiscal policy rather than relax it. Indeed, data released in mid-November showed that the current budget deficit more than doubled to £23.3 billion in the first seven months of FY 2008/09 (April-October) from £9.5 billion in the corresponding period of FY 2007/08. Current government receipts were up just 1.9% year-on-year (y/y) in April-October, which was well below target and reflected a deteriorating tax take. In contrast, current government expenditure was up 6.0% y/y. Meanwhile, the Public Sector Net Borrowing Requirement (PSNBR) surged to £37.0 billion in April-October from £20.1 billion a year earlier.

At this rate of deterioration, the PSNBR was on course to hit £67.5 billion in FY 2008/09, compared with the chancellor's target of £43.0 billion in last March's budget—without taking into account the immediate stimulus actions that were enacted in today's PBR. Consequently, the chancellor was forced to admit that the PSNBR is likely to reach £78.0 billion in FY 2008/09. Indeed, in normal times, there would be much more focus on how the public finances have got to be in such a poor state after GDP growth averaged 2.9% a year over the period 1997 (when the Labour Party came to power) through to 2007.

However, these are a long way from ordinary times and the key issue now is trying to ensure that a potentially long and deep recession does not develop into something even nastier. And the very real risk of this happening warranted serious fiscal stimulus measures being enacted at this stage in addition to the monetary stimulus now increasingly coming from the Bank of England.

Measures Aimed at Providing Near-Term Boost to Economy

The fiscal measures that the chancellor has announced are primarily orientated at having an effect as soon as possible and boosting spending. This is evident in both the centrepiece cut in VAT from 17.5% to 15% from this December until the end of 2009, as well as in a number of measures to help the lowest paid and least well-off, who have a higher propensity to consume. For example, this year's temporary rise in the income tax personal allowance is to be made permanent and raised from £120 to £145 from April 2009. The problem for the government is that there is a clear risk that the VAT cut will have only a very limited impact in stimulating spending, particularly as the effect may be partly lost in the major price cuts, promotions, and discounts that shops are currently enacting. It may also be that some people regard the reduction in prices from the VAT cut as insufficient to boost their spending, particularly given their heightened concerns over the economic outlook and jobs. Moreover, other people may just save the money from any reduced shopping bills, again due to concerns over jobs and the economy.

There are some welcome measures to help small and medium-sized businesses. These include allowing firms to spread all their business tax payments for "as long as they need" to help their cash flow. In addition, the chancellor is deferring the increase from 21% to 22% in small companies' rate of corporation tax that was planned for April 2009.

Meanwhile, £3 billion of capital spending is being brought forward from 2010/11, mainly aimed at schools, social housing, the motorway network, and energy efficiency.

Recovery Forecasts Look Optimistic, While Borrowing Will Surge

IHS Global Insight suspects that the bounce back in growth that the chancellor has pencilled in is too early and too optimistic. Specifically, the chancellor is expecting the economy to contract throughout the first half of 2009, before starting to recover. Consequently, Darling is forecasting the economy to contract by 0.75-1.25% in 2009 and then grow by 1.50-2.00% in 2010. Even allowing for the chancellor's stimulative measures, it is still hard to see any growth before 2010. We think that the economy is likely to contract by 1.5% in 2009, and we suspect that growth in 2010 will be limited to 0.8%. The main impact of the chancellor's measures has been to stop us from downgrading our GDP forecasts further, which we had been considering. We see the fiscal package as limiting and reducing the downside risks to the economy, rather than substantially boosting growth prospects.

The fact that the economy may well recover later and more slowly than the chancellor expects means that there are considerable upside risks to the already eye-wateringly near-term large fiscal deficits that he has projected. Specifically, Darling expects the PSNBR to rise from £77.6 billion in FY 2008/09 to £118 billion (8% of GDP) in FY 2009/10 before falling back to £105 billion in FY 2010/11, £87 billion in FY 2011/12, and £54 billion in FY 2013/14. The deficit on the current budget is expected to rise from £41.2 billion in FY 2008/09 to £78 billion in FY 2009/10 before retreating to £73 billion in FY 2010/11, £54 billion in FY 2011/12, and £37 billion in FY 2012/13.

The planned path for the government finances means that the government has had to suspend its "golden rule". Under the "golden rule", the current budget (when expressed as a percentage of GDP) must be balanced during the economic cycle, with borrowing only allowed to finance capital investment; it is not allowed to fund current expenditures. In addition, public debt must not exceed 40% of GDP (it is now forecast by the government at 41.2% of GDP in FY 2008/09, rising to a peak of 57.1% of GDP in FY 2012/13).

Consequently, the government has introduced a "temporary operating rule". This requires the government to "set policies to improve the cyclically-adjusted current budget each year, once the economy emerged from the downturn, so it reaches balance and debt is falling as a proportion of GDP once the global shocks have worked their way through the economy in full". Specifically, the government is aiming for a reduction in the cyclically adjusted current balance of over 0.5% a year from FY 2010/11. And in an attempt to boost confidence in its commitment to do this, Darling indicated that the National Audit Office will audit the Treasury's analysis of the cyclical fiscal position.

The chancellor has announced some concrete measures to bring the public deficits down over the medium term and is aiming to return the current budget to balance in FY 2015/16. It was vitally important that  Darling put some meat on the new fiscal framework bones, and he has partly done that through announcing that employers' and employees' national insurance contributions will rise by 0.5 percentage point from April 2011; that a new 45p top rate of income tax rate will be introduced after the next general election (due by mid-2010) on earnings over £150,000 a year; that a further £5 billion will be found in efficiency savings in FY 2010/11; and that public spending growth will be limited to a real 1.2% a year from FY 2011/12.

Outlook and Implications

Although the chancellor had to address rebalancing the budget, the majority of the meat on the fiscal framework will be introduced after the next general election, due to take place before May 2010. As a result, the chancellor has been accused of "budgeting for the next election" by postponing all of the tax rises in order to boost Labour's resurging popularity. However, by significantly increasing the top rate of income tax, Darling has associated the PBR with a redistributive budget in line with Labour's populist roots. Furthermore, the chancellor has been criticised for introducing semi-stealth tax increases on alcohol, tobacco, and gasoline (petrol) duty in order to cancel out the effect of the VAT reduction, leading to claims that the PBR will actually help a much smaller demographic than initially envisaged.