Economics Weekly By Lloyds TSB

With UK economic growth slowing and the housing market weakening, the call for government action is rising. In the US, they have cut taxation by nearly 2% and slashed interest rates by 3.25 percentage points to 2%.

How bad can the UK’s fiscal position get?

 

Calls for a looser UK fiscal stance are rising…

 

With UK economic growth slowing and the housing market weakening, the call for government action is rising. In the US, they have cut taxation by nearly 2% and slashed interest rates by 3.25 percentage points to 2%. But the UK economy is
in a different position, for one thing its budget deficit as a share of gdp is slightly larger and for another it is not clear whether a relaxation of fiscal policy would be met by a response from the Monetary Policy Committee (MPC) in the form of higher interest rates. Further, the weakening of annual UK economic growth from an above trend
pace last year of 3% to a below trend pace this year of about 1.8% has resulted in a widening of the fiscal deficit, to its worst position since the 1990s. But how bad can it get and why does it matter?

 

…but there is no scope to cut taxes or increase public spending in the UK…

 

Chart a shows that the UK’s budget deficit is turning out to be bigger than expected and more than last year, as growth in the economy weakens to a sub 2% annual rate. Indeed, it is on course to be about £50bn in 2008/9, well above the official projection of £43bn. Why is this happening so quickly? The answer is shown in chart b: slowing economic growth hits tax revenues at a time that expenditure is pushed up by falling unemployment and more claims on government spending, as it acts as an ‘automatic stabiliser’. In the case of revenue, we are already seeing lower stamp duty from falling house sales and a weaker equity market, but there will also be an impact in due
course from lower corporate tax receipts and lower income tax as unemployment rises, albeit modestly.

 

…as the budget deficit is already high…

 

What chart b highlights is that, since 2001, UK government tax revenue growth has been buoyant but spending growth has been even faster. Although the chart implies that the difference between the two growth rates is small, that gap represents the difference between two very large numbers. General government expenditure in 2007/8 was £618bn and revenue was £575bn. Hence, a small percentage change, with receipts falling and expenditure rising, will lead to a big shift in the gap between the two, which is the net borrowing requirement. This is happening now and has occurred in past cycles, as shown in chart c, where it is clear that government borrowing as a share of the economy can be even more volatile than the economic cycle. As an example of this, at 2008 prices, tax receipts in the 1990s recession fell by £30bn a year and, in 2001/2 to 2002/3 when the UK economy narrowly managed to avoid recession, tax revenues still fell by £10bn.

 

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