Tag: Office for Budget Responsibility

Since 2019, UK personal taxes (income tax and national insurance) have been increasing as a proportion of incomes and total tax revenues have been increasing as a proportion of GDP. However, in his Autumn Statement of 22 November, the Chancellor, Jeremy Hunt, announced a 2 percentage point cut in the national insurance rate for employees from 12% to 10%. The government hailed this as a significant tax cut. But, despite this, taxes are set to continue increasing. According to the Office for Budget Responsibility (OBR), from 2019/20 to 2028/29, taxes will have increased by 4.5 per cent of GDP (see chart below), raising an extra £44.6 billion per year by 2028/29. One third of this is the result of ‘fiscal drag’ from the freezing of tax thresholds.

According to the OBR

Fiscal drag is the process by which faster growth in earnings than in income tax thresholds results in more people being subject to income tax and more of their income being subject to higher tax rates, both of which raise the average tax rate on total incomes.

Income tax thresholds have been unchanged for the past three years and the current plan is that they will remain frozen until at least 2027/28. This is illustrated in the following table.

If there were no inflation, fiscal drag would still apply if real incomes rose. In other words, people would be paying a higher average rate of tax. Part of the reason is that some people on low incomes would be dragged into paying tax for the first time and more people would be paying taxes at higher rates. Even in the case of people whose income rise did not pull them into a higher tax bracket (i.e. they were paying the same marginal rate of tax), they would still be paying a higher average rate of tax as the personal allowance would account for a smaller proportion of their income.

Inflation compounds this effect. Tax bands are in nominal not real terms. Assume that real incomes stay the same and that tax bands are frozen. Nominal incomes will rise by the rate of inflation and thus fiscal drag will occur: the real value of the personal allowance will fall and a higher proportion of incomes will be paid at higher rates. Since 2021, some 2.2 million workers, who previously paid no income taxes as their incomes were below the personal allowance, are now paying tax on some of their wages at the 20% rate. A further 1.6 million workers have moved to the higher tax bracket with a marginal rate of 40%.

The net effect is that, although national insurance rates have been cut by 2 percentage points, the tax burden will continue rising. The OBR estimates that by 2027/28, tax revenues will be 37.4% of GDP; they were 33.1% in 2019/20. This is illustrated in the chart (click here for a PowerPoint).

Much of this rise will be the result of fiscal drag. According to the OBR, fiscal drag from freezing personal allowances, even after the cut in national insurance rates, will raise an extra £42.9 billion per year by 2027/28. This would be equivalent of the amount raised by a rise in national insurance rates of 10 percentage points. By comparison, the total cost to the government of the furlough scheme during the pandemic was £70 billion. For further analysis by the OBR of the magnitude of fiscal drag, see Box 3.1 (p 69) in the November 2023 edition of its Economic and fiscal outlook.

Political choices

Support measures during the pandemic and its aftermath and subsidies for energy bills have led to a rise in government debt. This has put a burden on public finances, compounded by sluggish growth and higher interest rates increasing the cost of servicing government debt. This leaves the government (and future governments) in a dilemma. It must either allow fiscal drag to take place by not raising allowances or even raise tax rates, cut government expenditure or increase borrowing; or it must try to stimulate economic growth to provide a larger tax base; or it must do some combination of all of these. These are not easy choices. Higher economic growth would be the best solution for the government, but it is difficult for governments to achieve. Spending on infrastructure, which would support growth, is planned to be cut in an attempt to reduce borrowing. According to the OBR, under current government plans, public-sector net investment is set to decline from 2.6% of GDP in 2023/24 to 1.8% by 2028/29.

The government is attempting to achieve growth by market-orientated supply-side measures, such as making permanent the current 100% corporation tax allowance for investment. Other measures include streamlining the planning system for commercial projects, a business rates support package for small businesses and targeted government support for specific sectors, such as digital technology. Critics argue that this will not be sufficient to offset the decline in public investment and renew crumbling infrastructure.

To support public finances, the government is using a combination of higher taxation, largely through fiscal drag, and cuts in government expenditure (from 44.8% of GDP in 2023/24 to a planned 42.7% by 2028/29). If the government succeeds in doing this, the OBR forecasts that public-sector net borrowing will fall from 4.5% of GDP in 2023/24 to 1.1% by 2028/29. But higher taxes and squeezed public expenditure will make many people feel worse off, especially those that rely on public services.

Videos

  • Fiscal drag
  • Sky News Politics Hub on X, Sophy Ridge (22/11/23)

  • Fiscal drag
  • Sky News Politics Hub on X, Beth Rigby (22/11/23)

Articles

Report and data from the OBR

Questions

  1. Would fiscal drag occur with frozen nominal tax bands if there were zero real growth in incomes? Explain.
  2. Examine the arguments for continuing to borrow to fund a Budget deficit over a number of years.
  3. When interest rates rise, how much does this affect the cost of servicing public-sector debt? Why is the effect likely to be greater in the long run than in the short run?
  4. If the government decides that it wishes to increase tax revenues as a proportion of GDP (for example, to fund increased government expenditure on infrastructure and socially desirable projects and benefits), examine the arguments for increasing personal allowances and tax bands in line with inflation but raising the rates of income tax in order to raise sufficient revenue?
  5. Distinguish between market-orientated and interventionist supply-side policies? Why do political parties differ in their approaches to supply-side policy?

On 23 September, the new Chancellor of the Exchequer, Kwasi Kwarteng, announced his mini-Budget. It revealed big tax-cutting plans with the aim of stimulating economic growth. See the blog From Reaganomics to Trussonomics for details. However, the announcement triggered a crisis of confidence in the markets. The government says the measures will kickstart economic growth, but with the tax cuts funded through extra government borrowing, markets have raised alarm over the plans, sending the pound plunging.

On Monday 26 September, traders in the UK awoke to see that the pound had fallen to the new lowest level on record against the dollar of $1.03. Although it came at a time when the markets expected the pound to weaken, the announcement pushed a fall in the pound beyond previous expectations. Concerns about where the extra money would come from to pay for the tax cuts were reflected in market movements. A weaker currency suggests investors’ faith in a country’s economic prospects is wavering.

What does a falling pound mean?

The pound’s value affects everyone – from shoppers to business owners and investors. The main impacts of the falling pound include:

  • Higher prices. A fall in the value of the pound will increase the price of goods and services imported into the UK from overseas. When the pound is weak against the dollar, it costs more for companies in the UK to buy things such as food, raw materials or parts from abroad. Firms are likely then to pass on some or all those higher costs to their customers.
  • Higher mortgage repayments. By increasing inflation, a falling pound is likely to push the Bank of England to raise interest rates to counter this. With two million people in the UK on a tracker or variable rate mortgage, monthly costs could increase substantially. Lenders are also likely to increase the rates charged on credit cards, bank loans or car loans.
  • Further pressure on energy costs. The price of all of the gas that the UK uses is based on the dollar – even if the gas is produced in the UK. As oil prices are based on the dollar, petrol and diesel could also be more expensive for UK drivers as it costs more to be imported by fuel companies. Although the dollar price of oil has been falling in recent weeks, consumers are not likely to see the benefit at the pump due to the slide in the value of the pound.
  • Stronger sales for UK firms who sell goods abroad. Some businesses in the UK could get a boost from a fall in the value of the pound. A cheaper pound makes it less expensive for people from around the globe to buy goods and services from British firms, making them more competitive.
  • More expensive trips abroad. The plunge in the pound means that people’s holiday money won’t stretch as far, particularly for anyone planning a trip to the USA. The depreciation of the pound could also see airlines face sharply increased costs, with fuel and aircraft leases often denominated in dollars.

Threat to confidence

The Bank of England said a weaker outlook for the UK economy as well as a stronger dollar were putting pressure on sterling. However, market responses were clear that Kwarteng’s mini-Budget was threatening to undermine confidence in the UK. The pound plunged to its lowest since Britain went decimal in 1971, as belief in the UK’s economic management and assets evaporated.

By Tuesday 27 September, there were expectations that the Bank of England would have to raise interest rates to counter the extra spending in the mini-Budget. Economists from the City suggested the slump in the pound would not just force the Bank of England into raising rates at the next MPC announcement in November, but to intervene now by announcing an emergency interest rate rise to support the currency. This sent mortgage activity into a frenzy as brokers worked around the clock to help clients secure deals before lenders pulled their products or replaced them with more expensive ones. By the end of the week there were 40% fewer products available than before the mini-Budget.

The Bank of England

In August, the Bank predicted that the UK would go into recession, lasting some 15 months. It did so as it raised interest rates by the highest margin in 27 years (0.5 percentage points) in a bid to keep soaring prices under control. Higher interest rates can make borrowing more expensive, meaning people have less money to spend and prices will stop rising as quickly. The Bank of England is expected to raise interest rates by an even larger amount to combat the inflationary impact of the mini-Budget, as a weakening pound drives up costs of imports. The money markets are pricing a doubling of UK interest rates to more than 5% by next summer.

On Thursday 29 September the cost of government borrowing was rising to levels many economists thought were concerning. After the mini-Budget, the UK Debt Management Office, which borrows on behalf of the government by issuing new government bonds (‘gilts’), plans to raise an additional £72bn before next April, raising the financing remit in 2022/23 to £234bn. The investors in bonds are mainly large institutions, such as pension funds.

New bonds are issued at a fixed payment per annum based on the face value. If interest rates rise, then new bonds must pay a higher amount per annum to attract purchasers. Old bonds with a relatively low payment per year will fall in value. For example, if a £100 bond issued a while back paid £2 per annum (a nominal 2%) and interest rates on equivalent assets rose to 4%, the market price of the bond would fall to £50, as £2 per annum is 4% of £50. This percentage of the market price (as opposed to the face value) is known as the ‘yield’. With worries about the rise in government borrowing, bond prices fell and yields correspondingly rose. Investors were demanding much higher interest rates to lend to the UK government.

The Investment Director at JM Finn compared investing in government bonds to sloths, they’re low risk and typically don’t move. This is because lending to the UK is usually considered as an ultra-safe bet. However, some bonds fell in price by 20% in two days (26–28 September).

There was concern that the mini-Budget threatened the financial health of Britain’s biggest pensions and insurance companies, which together manage trillions of pounds of people’s cash. These companies hold large amounts of UK government bonds and the fall in their price was significantly reducing the value of their assets.

The Bank of England thus announced that it would step in to calm markets, warning that continued volatility would be a ‘material risk to UK financial stability’. The Bank would start buying government bonds at an ‘urgent pace’ to help push their price back up and restore orderly market conditions. It would set aside £65bn to buy bonds over 13 working days. It is hoped that the Bank’s action will now ease the pressure on pension funds and insurance companies.

But the purchase of bonds increases money supply. This was the process by which money supply was increased during periods of quantitative easing (QE). Increasing money supply, while helping to dampen the rise in interest rates and stabilise the financial markets, is likely to lead to higher inflation. The Bank of England had previously planned to do the opposite: to engage in quantitative tightening (QT), which involves selling some of the stock of (old) bonds which the Bank had accumulated during the various rounds of QE.

Despite the Bank of England’s action which helped to curb the fall in the sterling exchange rate, some analysts warned it could fall further and could even reach parity with the dollar. There are concerns that the Bank is simply firefighting, rather than being able to solve the wider problems. There is now growing pressure on the government to make clear the financial cost of its tax cuts and spending plans.

Criticism from the IMF

There has been widespread criticism of the government’s plan, with the International Monetary Fund warning on Tuesday 27 September that the measures were likely to fuel the cost-of-living crisis and increase inequality. The stinging rebuke from the IMF arrived at the worst moment for the UK government. The IMF works to stabilise the global economy and one of its key roles is to act as an early economic warning system. It said it understood the package aimed to boost growth, but it warned that the cuts could speed up the pace of price rises, which the UK’s central bank is trying to bring down. In an unusually outspoken statement, the IMF said the proposal was likely to increase inequality and add to pressures pushing up prices.

Mark Carney, the former Governor of the Bank of England also criticised the government, accusing them of ‘undercutting’ the UK’s key economic institutions. Mr Carney said that while the government was right to want to boost economic growth, ‘There is a lag between today and when that growth might come.’ He also criticised the government for undercutting various institutions that underpin the overall approach, including not having an OBR forecast.

What is next for the economy?

Before the announcement, the Bank had expected the economy to shrink in the last three months of 2022 and keep shrinking until the end of 2023. However, some economists believe the UK could already be in recession. The impacts of the mini-Budget have so far not alleviated fears of the UK diving into recession. However, the Governor of the Bank of England, Andrew Bailey, also warned that little could be done to stop the UK falling into a recession this year as the war in Ukraine continued. He added that it would ‘overwhelmingly be caused by the actions of Russia and the impact on energy prices’.

Despite the external pressures on the economy, it is clear that recent market activity has damaged confidence. The Bank has already said it will ‘not hesitate’ to hike interest rates to try to protect the pound and stem surging prices. Some economists have predicted the Bank of England will raise the interest rate from the current 2.25% to 5.75% by next spring.

The Bank’s action of emergency bond purchases helped provide Kwarteng with some respite from the financial markets after three days of turmoil, which included strong criticism of the mini-Budget from the International Monetary Fund, about 1000 mortgage products pulled and interest rates on UK government bonds hitting their highest level since 2008.

On 3 October, at the start of the Conservative Party annual conference, Kwarteng announced that the planned cut in the top rate of income tax from 45% to 40% would not go ahead. This showed that the government would change course if pressure was strong enough. That day, the sterling exchange rate against the dollar appreciated by around 0.5% to around $1.12.

But this was not enough. The pressure was still on the government. There were urgent calls from the House of Commons Treasury Select Committee to bring forward the government’s financial statement, which was not due until 23 November, by at least a month. The government was urged to publish growth forecasts as soon as possible to help calm the markets. In response, on 4 October the government agreed to bring the financial statement forward to late October along with the forecasts of its impacts from the OBR.

However, Truss and Kwarteng have so far resisted this pressure to bring analysis of their tax plans forward. They have refused independent analysis of their plans until more than six weeks after receiving them, despite more calls from Tory MPs for Downing Street to reassure the markets. The Prime Minister and Chancellor said they would only publish the independent forecasts on 23 November alongside a fiscal statement, despite them being ready on 7 October.

Longer term impacts

Amongst all the activity in the week following the mini-Budget, there are real concerns of the longer-term impacts the budget will have on the economy. Some experts predict that the lasting effects of the ‘mini’ Budget will be felt far beyond the trading floors. Large tax cuts the government claimed would boost growth have instead convinced markets the UK’s entire macroeconomic framework is under threat. Although this turmoil has been the short-term result, it’s important to step back and think about how the effects of this abrupt shift in economic policy will be felt far beyond the trading floors.

Sterling’s partial recovery a few days after the mini-Budget reflects an increased confidence that there will be a large interest rate rise coming on November 3. However, the bleak economic outlook has removed any fiscal headroom the government may have had. The largest tax cuts in five decades need funding, while spooking the markets means another £12.5bn a year added to the debt interest bill. However, Kwarteng remains committed to debt falling eventually.

It is estimated that there needs to be a fiscal tightening of around £37–£47bn by 2026/27. Even more could be required to ensure that tax revenues cover day-to-day spending or for even a small margin for error. Many have therefore called for a U-turn on the measures announced in the mini-Budget beyond abolishing the cut to the top rate of income tax. Performing a U-turn on some of the tax cuts would make the fiscal tightening much more achievable. However, it could be politically detrimental. Much lower taxes will mean less public spending. Some suggest that this trade-off was ignored when those tax cuts were announced, but market pressure has now put it centre stage.

The Prime Minister has since admitted that mistakes were made in the controversial ‘mini’ Budget that sparked market turmoil in the last week of September. However, a day before reversing the cut in the top rate of income tax, she said she would not retreat on her plan to deliver £45bn of unfunded tax cuts, insisting it would help deliver growth, but admitted: ‘We should have laid the ground better and I have learned from that.’

Articles

Questions

  1. Explain how the announced tax cut will stimulate economic growth.
  2. What is the impact of the weakened pound on UK households and businesses?
  3. Draw a diagram illustrating the way in which the $/£ exchange rate is determined.
  4. How is UK inflation likely to be affected by a depreciation of sterling?
  5. Are there any advantages of having a lower pound?

In various blogs, we’ve looked at the UK’s low productivity growth, both relative to other countries and relative to the pre-1998 financial crisis (see, for example, The UK productivity puzzle and Productivity should we be optimistic?). Productivity is what drives long-term economic growth as it determines potential GDP. If long-term growth is seen as desirable, then a fall in productivity represents a serious economic problem.

Recent data suggest that the problem, if anything, is worse than previously thought and does not seem to be getting better. Productivity is now some 21% below what it would have been had productivity growth continued at the rate experienced in the years before the financial crisis (see second chart below).

In its latest productivity statistics, the ONS reports that labour productivity (in terms of output per hour worked) fell by 0.1% in the second quarter of 2017. This follows a fall of 0.5% in quarter 1. Over the whole year to 2017 Q2, productivity fell by 0.3%.

Most other major developed countries have much higher productivity than the UK. In 2016, Italy’s productivity was 9.9% higher than the UK’s; the USA’s was 27.9%, France’s was 28.7% and Germany’s was 34.5% higher. What is more, their productivity has grown faster (see chart).

But what of the future? The Office for Budget responsibility publishes forecasts for productivity growth, but has consistently overestimated it. After predicting several times in the past that UK productivity growth would rise towards its pre-financial crisis trend of around 2% per year, in its October 2017 Forecast evaluation Report it recognises that this was too optimisitic and revises downwards its forecasts for productivity growth for 2017 and beyond.

As the period of historically weak productivity growth lengthens, it seems less plausible to assume that potential and actual productivity growth will recover over the medium term to the extent assumed in our most recent forecasts. Over the past five years, growth in output per hour has averaged 0.2 per cent. This looks set to be a better guide to productivity growth in 2017 than our March forecast of 1.6 per cent.

Looking further ahead, it no longer seems central to assume that productivity growth will recover to the 1.8 per cent we assumed in March 2017 within five years.

But why has productivity growth not returned to pre-crisis levels? There are five possible explanations.

The first is that there has been labour hoarding. But with companies hiring more workers, this is unlikely still to be true for most employers.

The second is that very low interest rates have allowed some low-productivity companies to survive, which might otherwise have been driven out of business.

The third is a reluctance of banks to lend for investment. After the financial crisis this was driven by the need for them to repair their balance sheets. Today, it may simply be greater risk aversion than before the financial crisis, especially with the uncertainties surrounding Brexit.

The fourth is a fall in firms’ desire to invest. Although investment has recovered somewhat from the years directly following the financial crisis, it is still lower than might be expected in an economy that is no longer is recession. Indeed, there has been a much slower investment recovery than occurred after previous recessions.

The fifth is greater flexibility in the labour market, which has subdued wages and has allowed firms to respond to higher demand by taking on more relatively low-productivity workers rather than having to invest in human capital or technology.

Whatever the explanation, the solution is for more investment in both technology and in physical and human capital, whether by the private or the public sector. The question is how to stimulate such investment.

Articles

UK productivity lagging well behind G7 peers – ONS Financial Times, Katie Martin (6/10/17)
UK productivity sees further fall BBC News (6/10/17)
UK resigned to endless productivity gloom The Telegraph, Tim Wallace (10/10/17)
UK productivity estimates must be ‘significantly’ lowered, admits OBR The Guardian, Richard Partington and Phillip Inman (10/10/17)
UK productivity growth to remain sluggish, says OBR BBC News (10/10/17)
Official Treasury forecaster slashes UK productivity growth forecast, signalling hole in public finances for November Budget Independent, Ben Chu (10/10/17)
The Guardian view on Britain’s productive forces: they are not working The Guardian, Editorial (10/10/17)
Mind the productivity gap: the story behind sluggish earnings The Telegraph, Anna Isaac (26/10/17)

Data and statistical analysis

Labour productivity: April to June 2017 ONS Statistical Bulletin (6/10/17)
International comparisons of productivity ONS Dataset (6/10/17)
Forecast evaluation report OBR (October 2017)

Questions

  1. Explain the relationship between labour productivity and potential GDP.
  2. What is the relationship between actual growth in GDP and labour productivity?
  3. Why does the UK lag France and Germany more in output per hour than in output per worker, but the USA more in output per worker than in output per hour?
  4. Is there anything about the UK system of financing investment that results in lower investment than in other developed countries?
  5. Why are firms reluctant to invest?
  6. In what ways could public investment increase productivity?
  7. What measures would you recommend to encourage greater investment and why?
  8. How do expectations affect the growth in labour productivity?

During the 1970s, commentators often referred to the ‘political business cycle’. As William Nordhaus stated in a 1989 paper. “The theory of the political business cycle, which analyzes the interaction of political and economic systems, arose from the obvious facts of life that voters care about the economy while politicians care about power.”

In the past, politicians would use fiscal, and sometimes monetary, policies to manipulate aggregate demand so that the economy was growing strongly at the time of the next election. This often meant doing unpopular things in the first couple of years of office to allow for popular things, such as tax cuts and increased government transfers, as the next election approached. This tended to align the business cycle with the election cycle. The economy would slow in the early years of a parliament and expand rapidly towards the end.

To some extent, this has been the approach since 2010 of first the Coalition and now the Conservative governments. Cuts to government expenditure were made ‘in order to clear up the mess left by the previous government’. At the time it was hoped that, by the next election, the economy would be growing strongly again.

But in adopting a fiscal mandate, the current government could be doing the reverse of previous governments. George Osborne has set the target of a budget surplus by the final year of this parliament (2019–20) and has staked his reputation on achieving it.

The problem, as we saw in the blog, Hitting – or missing – the government’s self-imposed fiscal targets is that growth in the economy has slowed and this makes it more difficult to achieve the target of a budget surplus by 2019–20. Given that achieving this target is seen to be more important for his reputation for ‘sound management’ of the public finances than that the economy should be rapidly growing, it is likely that the Chancellor will be dampening aggregate demand in the run-up to the next election. Indeed, in the latest Budget, he announced that specific measures would be taken in 2019–20 to meet the target, including a further £3.5 billion of savings from departmental spending in 2019–20. In the meantime, however, taxes would be cut (such as increasing personal allowances and cutting business rates) and government spending in certain areas would be increased. As the OBR states:

Despite a weaker outlook for the economy and tax revenues, the Chancellor has announced a net tax cut and new spending commitments. But he remains on course for a £10 billion surplus in 2019–20, by rescheduling capital investment, promising other cuts in public services spending and shifting a one-off boost to corporation tax receipts into that year.

But many commentators have doubted that this will be enough to bring a surplus. Indeed Paul Johnson, Director of the Institute for Fiscal Studies, stated on BBC Radio 4’s Today Programme said that “there’s only about a 50:50 shot that he’s going to get there. If things change again, if the OBR downgrades its forecasts again, I don’t think he will be able to get away with anything like this. I think he will be forced to put some proper tax increases in or possibly find yet further proper spending cuts”.

If that is the case, he will be further dampening the economy as the next election approaches. In other words, the government may be doing the reverse of what governments did in the past. Instead of boosting the economy to increase growth at election time, the government may feel forced to make further cuts in government expenditure and/or to raise taxes to meet the fiscal target of a budget surplus.

Articles

Budget 2016: George Osborne hits back at deficit critics BBC News (17/3/16)
George Osborne will have to break his own rules to win the next election Business Insider, Ben Moshinsky (17/3/16)
Osborne Accused of Accounting Tricks to Meet Budget Surplus Goal Bloomberg, Svenja O’Donnell and Robert Hutton (16/3/16)
George Osborne warns more cuts may be needed to hit surplus target Financial Times, Jim Pickard (17/3/16)
6 charts that explain why George Osborne is about to make austerity even worse Independent, Hazel Sheffield (16/3/16)
Budget 2016: Osborne ‘has only 50-50 chance’ of hitting surplus target The Guardian, Heather Stewart and Larry Elliott (17/3/16)
How will Chancellor George Osborne reach his surplus? BBC News, Howard Mustoe (16/3/16)
Osborne’s fiscal illusion exposed as a house of credit cards The Guardian, Larry Elliott (17/3/16)
The Budget’s bottom line: taxes will rise and rise again The Telegraph, Allister Heath (17/3/16)

Reports, analysis and documents
Economic and fiscal outlook – March 2016 Office for Budget Responsibility (16/3/16)
Budget 2016: documents HM Treasury (16/3/16)
Budget 2016 Institute for Fiscal Studies (17/3/16)

Questions

  1. Explain the fiscal mandate of the Conservative government.
  2. Does sticking to targets for public-sector deficits and debt necessarily involve dampening aggregate demand as an election approaches? Explain.
  3. For what reasons may the Chancellor not hit his target of a public-sector surplus by 2019–20?
  4. Compare the advantages and disadvantages of a rules-based fiscal policy and one based on discretion.

In the second part of this blog, we look at an interview with the Guardian given by Robert Chote, Chair of the UK’s Office of Budget Responsibility. Like Mervyn King’s, that we looked at in Part 1, Robert Chote’s predictions are also gloomy.

In particular, he argues that if Greece leaves the euro, the effects on the UK economy could be significant, not just in the short term, but in the long term too.

The concern is that you end up with an outcome in the eurozone that creates the same sort of structural difficulties in the financial system and in the economy that we saw in the past recession, and that that has consequences both for hitting economic activity in the economy, but also its underlying potential. And it’s the latter which has particular difficulties for the fiscal position, because it means not just that the economy weakens and then strengthens again – ie, it goes into a hole and comes out – but that you go down and you never quite get back up to where you started. And that has more lingering, long-term consequences for the public finances.

The interview looked not just at the effects of the current crisis in the eurozone on the eurozone, British and world economies, but also at a number of other issues, including: the reliability of forecasts and those of the OBR in particular; relations between the OBR and the Treasury; allowing the OBR to cost opposition policies; the economic effect of cutting the 50p top rate of income tax; the sustainability of public-sector pensions; and tax increases or spending cuts in the long term.

In Part 3 we look at attempts by the G8 countries to find a solution to the mounting crisis.

Articles
Robert Chote interview: ‘I would not say in the past there’s been rigging’ Guardian, Andrew Sparrow (18/5/12)
UK ‘may never fully recover’ if Greece exits euro Guardian, Andrew Sparrow, Helena Smith and Larry Elliott (18/5/12)
British economy may ‘never quite recover’ from a severe Euro collapse The Telegraph, Rowena Mason (18/5/12)

OBR report
Economic and fiscal outlook Office for Budget Responsibility (March 2012)

Questions

  1. Why is it very difficult to forecast the effects of a Greek withdrawal from the euro?
  2. Why may Greek withdrawal have an effect on long-term potential output in the UK and the rest of Europe?
  3. Why are economic forecasts in general so unreliable? Does this mean that we should abandon economic forecasting?
  4. Why are public finances “likely to come under pressure over the longer term”?
  5. Why might the cut in the top rate of income tax from 50% to 45% have little impact on economic growth? Distinguish between income and substitution effects of the tax cut.