1 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010

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1 1 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Office of the Chief Economic Adviser Outlook for Scottish Government Expenditure July 2010 Outlook for Scottish Government Expenditure June 2010 Emergency Budget Update Dr Andrew Goudie Chief Economic Adviser July 2010 Introduction This report provides an update to research by the Office of the Chief Economic Adviser on the outlook for future expenditure by the Scottish Government, following the June 2010 Emergency UK Budget. It passes no judgement on the wisdom or otherwise of the UK Government s plans. Rather it details the implications for Departmental Expenditure Limits and in particular the Scottish budget. In April 2010, an initial assessment of the outlook for Scottish Government expenditure was undertaken based upon the information available at that time. The projections showed that public spending in Scotland was likely to be subject to a significant period of consolidation and that it would take a number of years before public spending returned to 2009/10 levels in real terms. The June 2010 Emergency Budget set out the new UK Government s plans for fiscal consolidation. While exact implications for public spending will not be known until 20 th October 2010, following the completion of the Comprehensive Spending Review, it is clear that public spending will be subject to a period of significant constraint in the years ahead. Scottish Government expenditure will not be immune from these pressures. This report, produced by the Office of the Chief Economic Adviser, uses the updated information provided in the June 2010 Emergency Budget and a range of assumptions where necessary, to provide an outlook for Scottish Government expenditure beyond 2010/11.

2 2 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Preface This report provides an update to research on the outlook for future expenditure by the Scottish Government following the UK June 2010 Emergency Budget. The new Office for Budget Responsibility (OBR) estimates that the UK s structural deficit will be 7.4% of GDP in 2010/11. It is projected that this will be the highest such deficit in the OECD 1. To address this, the new UK Government set out in their June 2010 Emergency Budget plans for a period of significant fiscal consolidation. While the process of consolidation began under the previous UK Government, the measures being introduced by the new administration are both faster and deeper than those set out in the March 2010 Budget. The greatest contribution to this consolidation is scheduled to come from public spending reductions, though there are also noticeable tax increases such as the rise in VAT from 17.5% to 20.0%. By 2015/16, the UK Government plans to have implemented discretionary tightening worth 128 billion, of which 99 billion (77%) will come from spending cuts and 29 billion (23%) will come from tax increases 2. Almost two thirds of the fiscal tightening scheduled to take place was set out in the plans of the previous UK Government. The new UK Chancellor of the Exchequer has announced that a full Comprehensive Spending Review will report on 20 th October Until then, detailed spending programmes for individual departments beyond the current financial year are not available at either the Scottish or UK level. However, the Chancellor has announced that given commitments to protect spending on Health and Overseas Aid, nonprotected Whitehall Departments will be in line for spending reductions worth an average of 25% in real terms over the next four years. In the light of the information contained within the June 2010 Emergency Budget and the Chancellor s Statement to the House of Commons, it is possible to project the general outlook for future expenditure by the Scottish Government over the next spending review period and beyond. The analysis takes the current funding framework, and in particular the operation of the Barnett formula, as given. 1 Source: OECD Economic Outlook, Number 87, May Source: June Emergency Budget Table 1.1, page 15 (HM Treasury)

3 3 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Given the lack of detail that currently exists, a range of assumptions and estimation techniques are applied. This necessarily generates a degree of variability within the results and they should be viewed accordingly. A full discussion of the methodologies used in the report is provided in the accompanying annexes. The development of this research is an ongoing process and feedback is welcome. Please address any comments to Office of the Chief Economic Adviser, St Andrew s House, Regent Road, Edinburgh, EH1 3DG

4 4 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 June 2010 Emergency Budget: Summary of Results UK Spending Outlook The new UK Government set out in their June 2010 Emergency Budget, plans for a period of significant fiscal consolidation. While the process of consolidation began under the previous UK Government, the measures being introduced by the new administration are both faster and deeper than those set out in the March 2010 Budget. The path of consolidation is governed by a Fiscal Mandate set out by the Chancellor in his Emergency Budget Statement. This requires the UK Government to achieve 3 : A cyclically adjusted current balance by the end of the rolling, five-year forecast period. The end of the current forecasting period will be 2015/16. Public sector net debt as a percentage of GDP to be falling by 2015/16. In total, the planned consolidation is expected to reach 113 billion in 2014/15 and 128 billion in 2015/16 4. Almost two thirds of the fiscal tightening scheduled to take place was set out in the plans of the previous UK Government Table 1. Of the total 83 billion of spending cuts now scheduled to take effect by 2014/15, 52 billion (62.7%) had been planned by the previous UK Government. Therefore, approximation 2/3 of future spending cuts can be traced back to the plans underpinning the March 2010 Budget. 3 HM Treasury (2010 June 2010 UK Budget 4 The planned consolidation is measured as the sum of the revenues raised from all discretionary tax increases plus the spending saved from all expenditure cuts relative to what would have been the case with no action.

5 5 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Table 1: Total Fiscal Consolidation over Forecast Period ( billion) 2010/ / / / / /16 Discretionary policy A n/a announced at June Budget of which spending of which taxation Policy plans of previous UK n/a Government of which spending of which taxation Total Discretionary Consolidation of which spending of which taxation Notes: A: includes additional efficiency savings in 2010/11 announced in May 2010 Source: June 2010 Emergency Budget: HM Treasury, Table 1.1, Pg 15 Chart 1 shows the planned period of consolidation as measured by the cyclically adjusted current budget balance, which illustrates the underlying fiscal position after removing temporary cyclical effects. As the chart highlights, the cyclically-adjusted or structural current deficit is now forecast by the OBR to be eliminated by 2014/15, a year earlier than required by the Chancellor s Fiscal Mandate. The OBR s forecasts suggest that the UK will achieve a cyclically adjusted current budget surplus worth 0.3% of GDP in 2014/15. In comparison, the March 2010 Budget forecast that the UK would run a cyclically adjusted current budget deficit worth 1.3% of GDP in 2014/15. The forecasts in the March 2010 Budget suggested that the cyclically adjusted current budget would not return to surplus until 2016/17, whilst the December 2009 Pre-Budget Report (PBR) assumed that the UK would not return to surplus until 2017/18. Chart 1: UK Cyclically Adjusted Current Budget Balance (% of GDP) % of GDP Fiscal consolidation now completed by 2014/ / / / / / / / / /16 June Budget March Budget Source: HM Treasury (2010) March 2010 Budget, June 2010 Budget

6 6 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 The accelerated pace of fiscal consolidation planned by the new UK Government means that public sector net debt is now forecast to peak at 70.3% of GDP in 2013/14 before falling from 2014/15 onwards. The forecasts in the March 2010 Budget assumed net debt would peak in 2014/15 at 74.9% of GDP. Chart 2: UK Public Sector Net Debt (% of GDP) % of GDP / / / / / / / / /16 June Budget March Budget Source: HM Treasury (2010) March 2010 Budget, June 2010 Budget Within the adjustment process planned by the new UK Government, departmental spending is forecast to bear a significant burden of adjustment at the UK level. The OBR forecast that over the period of the next spending review 2011/12 to 2014/15 total UK Departmental Expenditure Limit (DEL) spending will fall by an average 3.5% a year in real terms. Table 2: Real Annual Change in UK Public Expenditure OBR June 2010 Emergency Budget Forecasts Average Real Growth 2010/ / / / /15 11/12 to 14/15 Total Managed Expenditure 1.2% -1.4% -0.7% -1.0% -0.5% -0.9% Departmental Expenditure Limits -2.3% -4.4% -3.2% -3.3% -3.1% -3.5% Annually Managed Expenditure 5.7% 2.1% 2.1% 1.3% 2.1% 1.9% Source: Scottish Government calculations based on OBR forecasts from June 2010 Emergency Budget Between 2010/11 and 2014/15, total UK DEL is expected to fall by 50.4 billion or 13.3% in real terms. The distribution of these cuts by department is not yet known. However, the Chancellor has indicated that he intends to protect health spending in

7 7 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 real terms and increase expenditure on overseas development in real terms. Given such commitments, the Chancellor announced that unprotected departments could see average real terms cuts in their DEL budgets of approximately 25% over the four years to 2014/15. The Chancellor also announced that there would be no further reductions to capital expenditure above those announced by the previous UK Government in the March 2010 Budget. As a result, based on the latest GDP deflators and the UK Government s plans for capital Annually Managed Expenditure (AME), UK capital DEL is expected to fall by an average of 9.1% a year in real terms between 2011/12 and 2014/15. Scottish Government Spending Outlook Exact implications for UK departmental budgets and the Devolved Administrations will not be known until the 20 th October 2010 following the results of the Comprehensive Spending Review. However, using the overall plans set out above for UK spending, it is possible to provide an updated outlook for future expenditure by the Scottish Government. Clearly a variety of factors will determine the eventual allocations to fund Scottish DEL spending, not least the performance of the economy, the strength of the public finances and the priorities and choices for expenditure. At this stage however, it is useful to obtain an overall understanding of the scale of the challenge, even if the actual specific outcome was to differ from the examples set out below. It is easiest to highlight the scale of the challenge with an example based on a particular set of scenarios 5. The projections below take as a starting point the outlook for public spending set out in the Chancellor s Statement and forecasts for future economic growth and the public finances provided by the OBR 6. This is referred to as the June 2010 Emergency Budget scenario. As a result of the June 2010 Emergency Budget, the principal changes to the March 2010 Budget scenario presented in the April 2010 Outlook for Scottish Government Expenditure report are revised UK Government plans for UK DEL expenditure over the period 2010/11 to 2015/16; 5 There is no central or preferred scenario in this report: it seeks only to set out the range of outcomes that might arise and the key considerations. 6 Source: Annex C

8 8 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 a commitment to protect health spending in real terms over the period of the next Spending Review and to increase overseas aid to 0.7% of GNI by 2013/14; and, revised forecasts for economic growth, and in particular for long-term trend growth, now provided by the Office for Budget Responsibility. The next Spending Review will cover the period 2011/12 to 2014/15. Over this period, the analysis, based upon the key parameters set out in the June 2010 Emergency Budget and a range of additional assumptions, suggests that Scottish Government DEL expenditure could fall on average by 3.3% a year in real terms over this four year period. This could result in a cumulative real terms fall of 12.5% in real terms by 2014/15 compared to 2010/11. Chart 3: Estimated Annual Real Growth in Scottish Government DEL Expenditure June 2010 Budget Results 10% 8% 6% % Real Annual Change 4% 2% 0% -2% 2000/ / / / / / / / / / /11 6 years of real decline 2011/ / / / /16-4% -6% -8% Source: Scottish Government calculations. The June 2010 Emergency Budget also included forecasts for public spending in 2015/16. Over the five year period 2011/12 to 2015/16, it is estimated that Scottish Government DEL expenditure could fall by approximately 3.0% a year on average in real terms - marginally lower than the comparable decline in total UK DEL. From the 2009/10 peak, this would imply a 6 year real terms contraction in Scottish Government DEL expenditure of 2.9% per annum - a cumulative fall of 16.1%. As a result, Scottish Government DEL expenditure could be 4.8 billion below its 2009/10 peak in real terms by 2015/16 chart 4.

9 9 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Chart 4 - Estimated Scottish Government DEL Expenditure June 2010 Budget Results (2010/11 Prices) 35,000 30,000 Millions (2010/11 Prices) 25,000 20,000 15,000 10,000 5, / /01 Source: Scottish Government calculations. 2001/ / / / / / / / / / / / / / /16 As the charts illustrate, and based upon this analysis, by 2012/13 the Scottish Government DEL would be broadly comparable with that in 2005/06 in real terms, whilst by 2015/16 it would be comparable to that in 2004/05. Consistent with the forecasts for the UK, Scottish Government capital DEL would incur a proportionately greater cut, with spending falling by 1.6 billion (40.1%) in real terms between 2009/10 and 2015/16. Current DEL is assumed to fall by 3.2 billion (12.3%), in real terms, over this same period. From 2016/17, with the fiscal tightening complete, if aggregate UK public spending was to grow in line with UK GDP, Scottish Government DEL would be projected to grow by approximately 1.8% per annum in real terms. Under this scenario, whilst Scottish DEL spending is projected to start growing again in 2016/17, it is important to recognise that the level of public spending in Scotland would continue to remain below the 2009/10 peak for a considerable period of time.

10 10 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Chart 5 - Estimated Scottish Government DEL Expenditure June 2010 Budget Results (2010/11 Prices) 32, years , billion Millions ( Prices) 28,000 26,000 24,000 22,000 20, / / / / / / / / / / / / / / / / / /27 Source: Scottish Government calculations As Chart 5 highlights, assuming a consolidation period and subsequent return to spending growth in line with the wider economy, the analysis suggests that it may take until 2025/26 for the Scottish Government Budget to return to 2009/10 levels. This is a total adjustment period of 16 years. In total, the cumulative loss foregone, compared to a scenario where the Scottish Government Budget remained at its 2009/10 level in real terms, is estimated to be approximately 42 billion. The results in Chart 5 suggest a significantly deeper contraction in Scottish DEL expenditure, followed by a more protracted recovery, than the assessment published in the April 2010 Outlook for Scottish Government Expenditure report. The projections based on the March 2010 Budget estimated that Scottish DEL spending would reach a trough in 2014/15, with expenditure 12.7% below its 2009/10 peak in real terms 7. As a result of the new UK Government s plans for fiscal consolidation, Scottish DEL expenditure is now expected to fall in each of the next five years in real terms, reaching a trough in 2015/16. By this point Scottish DEL expenditure is forecast to be 16.1% below its 2009/10 peak in real terms. The total adjustment period until Scottish DEL expenditure is forecast to return to its 2009/10 peak has also increased from 13 years to 16 years as a result of the measures announced in the June 2010 Emergency Budget, and the accompanying forecasts for the UK economy set out by the OBR. Consequently, the cumulative 7 Note: These estimates have been updated to reflect minor technical changes in the reporting of UK DEL Budgets. A full discussion of this issue is set out in Section 2.

11 11 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 loss foregone, compared to a scenario where the Scottish Government Budget remained at its 2009/10 level in real terms, is estimated to have increased from 26 billion to 42 billion. There are two reasons for this change in the outlook. Firstly, approximately two thirds of this increase is attributable to the plans for departmental spending and the additional fiscal consolidation planned by the new UK Government. Secondly, the remainder is attributable to the OBR s new lower forecasts for long term trend UK GDP growth which acts to slow the recovery in spending post consolidation. It should be noted that this additional effect is not the result of a policy announcement by the UK Government but a technical reassessment of the future strength of the UK economy and its ability to generate revenues to fund increases in public services. Alternative Scenarios As noted earlier, the analysis summarised above takes the UK June 2010 Emergency Budget as a starting point to help inform the outlook for future Scottish Government DEL expenditure. There are however, a number of important assumptions embedded in this scenario and if these were to change, the outlook for Scottish spending would also be subject to change. Variations in the economic growth assumptions, the extent to which any additional fiscal tightening is focussed on expenditure cuts as opposed to increased taxation and the decision of whether or not to protect particular areas of expenditure all lead to results which range from the June 2010 Emergency Budget scenario. However as the report demonstrates, whilst adjusting these assumptions alters the estimated year on year changes in Scottish Government DEL expenditure, it does little to change the key messages that arise from the analysis.

12 12 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Section 1: June 2010 Emergency Budget: Plans for Fiscal Consolidation Background As set out in the initial Scottish Government report Outlook for Scottish Government Expenditure published in April , the financial crisis and subsequent recession created a significant hole in the UK public finances. In May 2010, the International Monetary Fund (IMF) forecast that public sector borrowing in the UK would be higher than in any other G20 country this year, and that the structural deficit is on course to be the highest in the OECD 9, 10. To address this, a period of significant fiscal consolidation is now planned. This process began under the previous UK Government through the establishment of the Fiscal Responsibility Act. While this established the broad parameters governing the path to restoring net borrowing and net debt to more sustainable levels, the detailed implications for taxation and public spending were not set out. At the heart of the Fiscal Responsibility Act are fiscal rules which require: 11 Public sector borrowing in each financial year between 2010/11 and 2015/16 is lower than the previous year, measured as a percentage of GDP; Public sector borrowing in 2013/14 is no more than half its 2009/10 level. A draft statutory instrument made under the Bill also requires borrowing to be no more than 5.5% of GDP in 2013/14; Public sector debt is lower in 2015/16 than in 2014/15, measured as a percentage of GDP Source: IMF Fiscal Monitor, May Source: OECD Economic Outlook, Number 87, May Fiscal Responsibility Bill 2009/10 -

13 13 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 The new UK Government has chosen to establish an even more ambitious Fiscal Mandate. The new Mandate requires the UK Government to achieve 12 : A cyclically-adjusted current balance by the end of the rolling, five-year forecast period. The end of the current forecasting period will be 2015/16. Public sector net debt as a percentage of GDP to be falling by 2015/16. The new Office for Budget Responsibility (OBR) has been tasked with judging whether or not the fiscal policy decisions taken by the UK Government are consistent with a greater than 50% chance of achieving this Fiscal Mandate. It will deliver its judgement at each Budget and Pre-Budget Report (PBR). Acceleration in Fiscal Consolidation In an effort to achieve their Fiscal Mandate, the new UK Government has set out the broad parameters which underpin the plans for fiscal consolidation. Table 3 summarises the tax and spending decisions over the next five years. In total, the consolidation planned by the UK Government is expected to reach 113 billion a year in 2014/15 and 128 billion by 2015/16. By 2015/16, approximately 77% of the planned consolidation will stem from reductions in public spending. Almost two thirds of the fiscal tightening scheduled to take place was set out in the plans of the previous UK Government. Table 3: Total Fiscal Consolidation over Forecast Period ( billion) 2010/ / / / / /16 Discretionary policy A n/a announced at June Budget of which spending of which taxation Policy plans of previous UK n/a Government of which spending of which taxation Total Discretionary Consolidation of which spending of which taxation Notes: A: includes additional efficiency savings in 2010/11 announced in May 2010 Source: June 2010 Emergency Budget: HM Treasury 12 HM Treasury (2010 June 2010 UK Budget

14 14 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 As Table 3 highlights, the new UK Government intends to increase the size and speed of consolidation. New measures worth approximately 40 billion are now scheduled to take effect by 2014/15, with 32 billion in the form of further spending cuts and 8 billion in tax increases. The plan to increase the pace of fiscal consolidation centres on the aim of eliminating the structural current budget deficit more quickly than the previous UK Government intended. This task was made more difficult by the revised forecast from the OBR of the UK structural deficit published one week in advance of the June 2010 Emergency Budget. In this re-assessment of the forecasts made in the March 2010 Budget, the OBR forecast that, while net borrowing in 2009/10 was 11.8 billion lower than forecast in the March 2010 Budget, the structural current budget deficit was 0.5% of GDP higher than previously estimated. The chart below shows the planned path of consolidation as measured by the cyclically adjusted current budget balance. As the chart highlights, the cyclicallyadjusted or structural current deficit is now forecast by the OBR to be eliminated by 2014/15 one year earlier than required by the Fiscal Mandate. This is also two years earlier than had been planned in the March 2010 Budget, and three years earlier than forecast in the December 2009 Pre-Budget Report (PBR). This is despite starting from a larger structural deficit in 2009/10 than previously estimated. Chart 6: UK Cyclically Adjusted Current Budget Balance (% of GDP) % of GDP Fiscal consolidation now completed by 2014/ / / / / / / / / /16 June Budget March Budget Source: HM Treasury (2010) March 2010 Budget, June 2010 Budget

15 15 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 The accelerated pace of fiscal consolidation planned by the new UK Government means that public sector net debt and net borrowing are both projected to be lower in the coming years than forecast in the March 2010 Budget. Public sector net debt is now expected to peak at 70.3% of GDP in 2013/14 before starting to fall from 2014/15 onwards. This is one year earlier than the Fiscal Mandate requires. The forecasts in the March Budget assumed net debt would peak in 2014/15 at 74.9% of GDP. Public sector net borrowing is also forecast to be lower than previously projected in each year from 2010/11 to 2015/16. Over the period 2010/11 to 2014/15 as a whole, the OBR s projections suggest that borrowing will now be 116 billion lower than forecast in the March 2010 UK Budget. Chart 7: UK Public Sector Net Debt (% of GDP) Chart 8: UK Public Sector Net Borrowing (% of GDP) % of GDP % of GDP / / / / / / / / / / / / / / / / / /16 June Budget March Budget June Budget March Budget Source: HM Treasury (2010) March 2010 Budget, June 2010 Budget Source: HM Treasury (2010) March 2010 Budget, June 2010 Budget UK Public Spending As a result of the adjustment path set out in the Fiscal Mandate, the economic and fiscal projections in the June 2010 Emergency Budget and the balance of taxation and spending set out in Table 3, the UK Government s plans for fiscal consolidation suggest that there will be significant reductions in departmental spending at the UK level. The OBR forecast that over the period of the next spending review 2011/12 to 2014/15 total UK Departmental Expenditure Limit (DEL) spending will fall by an average 3.5% a year in real terms, as summarised in Table 4.

16 16 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Table 4: Real Annual Change in UK Public Expenditure OBR June 2010 Emergency Budget Forecasts Real Growth 2010/ / / / /15 Total Managed Expenditure Departmental Expenditure Limits Annually Managed Expenditure Average 11/12 to 14/15 1.2% -1.4% -0.7% -1.0% -0.5% -0.9% -2.3% -4.4% -3.2% -3.3% -3.1% -3.5% 5.7% 2.1% 2.1% 1.3% 2.1% 1.9% Source: Scottish Government calculations based on OBR forecasts from June 2010 Emergency Budget Between 2010/11 and 2014/15, DEL expenditure is expected to fall by 50.4 billion or 13.3% in real terms. The distribution of these cuts by department is not yet known. However, the Chancellor has indicated that he intends to protect health spending in real terms and increase expenditure on overseas development in real terms. Given such commitments, the Chancellor announced that unprotected departments could see average real terms cuts in their DEL budgets of approximately 25% over the four years to 2014/15. Economic Growth As highlighted in the initial Outlook for Scottish Government Expenditure report published in April, projections for the fiscal consolidation and therefore future public spending depend critically on the outlook for economic growth. The OBR has made substantial downward revisions to future GDP growth relative to the forecasts in the March 2010 Budget. Chart 9 highlights the forecasts for future GDP growth up to 2015/16 which underpin the public finance projections in the March and June 2010 Budgets. While some of these revisions reflect the policy choices in the June 2010 Emergency Budget, the vast majority stem from a less optimistic outlook for economic recovery than the previous UK Government predicted in the March 2010 Budget.

17 17 Outlook for Scottish Government Expenditure: Emergency Budget Update July % 3.0% 2.0% Chart 9: UK Economic Growth Forecasts Real GDP Growth 1.0% 0.0% -1.0% -2.0% N/A -3.0% -4.0% -5.0% 2008/ / / / / / / /16 June Budget March Budget Source: HM Treasury (2010) March 2010 Budget, June 2010 Budget. Economic growth assumptions are those underpinning the June 2010 Emergency Budget fiscal projections In an equally important development, the OBR have revised down the long-run trend growth rate of the UK economy. In the March 2010 Budget, the long-term growth rate of the UK economy was forecast to be 2.75% per annum, with a cautious forecast of 2.5% per annum used for assessing the outlook for the public finances. Whilst acknowledging the significant uncertainty around forecasting future trend growth, the OBR now predict that the long-term growth rate of the UK economy will be 2.1% from 2014 onwards 13. This downward revision has been driven by revised forecasts for net migration and trend productivity growth. This reduction in long-term growth forecasts has important implications for public spending from 2016/17 onwards. As growth is expected to be lower in future years, it implies that public spending will also grow more slowly in the long run, unless it was to increase as a share of the economy. To the extent that the actual growth path of the economy was to diverge from these forecasts, then the projections for borrowing, and hence any assessment of the prospects for achieving the Fiscal Mandate, would be subject to change. If the economy were to recover more slowly, cyclical borrowing would be expected to be higher, while if there were a further loss in the productive capacity of the economy, structural borrowing may also rise. In both cases, in order to continue meeting the Fiscal Mandate, a greater consolidation than is currently planned would have to be undertaken. Of course, if the outlook for the economy were to be more positive than currently forecast, then there would be greater scope to fund more generous public spending settlements or to reduce the tax burden. 13 OBR (2010) Pre-Budget Forecasts -

18 18 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Section 2: June 2010 Emergency Budget: Outlook for Public Spending in Scotland Summary As highlighted above, the UK Government plans for almost 80% of the scheduled fiscal consolidation to come from reductions in public spending. Exact implications for departmental budgets will not be known until the 20 th October 2010 following the results of the Comprehensive Spending Review. However, the June 2010 Emergency Budget did contain projections for the total spending envelope that will be available and an initial distribution of spending broken down into Departmental Expenditure Limits (DEL) and Annually Managed Expenditure (AME) at the UK level 14. Using these plans, and the forecasts for the UK economy contained in the June 2010 Emergency Budget, it is possible to provide an updated outlook for future expenditure by the Scottish Government. This analysis takes the current funding arrangements as given. A full discussion of this mechanism and how changes in UK spending feed through to future Scottish budgets, is set out in the April Outlook for Scottish Government Expenditure report. 14 The June 2010 Emergency Budget also provides estimates of the breakdown of total DEL and AME into their current and capital components

19 19 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Clearly a variety of factors will determine the eventual allocations to fund Scottish DEL spending, not least the performance of the UK economy, the strength of the public finances and the priorities and choices for expenditure. It is easiest to highlight the scale of the challenge with an example based on a particular set of scenarios 15. Section 2 presents results from the June 2010 Emergency Budget scenario. Section 3 sets out some alternative scenarios and discusses the sensitivity of the analysis to different assumptions. The projections take as a starting point the outlook for public spending set out in the Chancellor s Statement and forecasts for future economic growth provided by Office for Budget Responsibility (OBR). As a result of the June 2010 Emergency Budget, the principal changes to the baseline March 2010 Budget scenario presented in the April outlook are revised UK Government plans for UK DEL expenditure over the period 2010/11 to 2015/16; the Chancellor s commitment to protect health spending in England in real terms over the period of the next Spending Review and to increase overseas aid to 0.7% of GNI by 2013/14; and, revised forecasts for long-term trend growth published by the Office for Budget Responsibility. Before presenting the new results, it is worth summarising the results in the April publication (March 2010 Budget) and to highlight a number of technical budgeting changes that have been implemented since then. These changes ensure that direct comparisons can be made between the results presented in that report and the updated June 2010 Emergency Budget results presented below. They have no significant impact on the results. However, when comparing the analysis of April 2010 with the new scenario set out below, only this revised analysis should be used for direct comparisons. 15 There is no central or preferred scenario in this report: it seeks only to set out the range of outcomes that might arise and the key considerations.

20 20 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 March 2010 Budget Update The charts below provide an update of the March 2010 Budget scenario presented in the April publication Outlook for Scottish Government Expenditure. These estimates differ slightly from those presented at that time for two reasons 1. Firstly, consistent with the new presentation of DEL budgets in the June 2010 Emergency Budget, they remove non-cash transactions from UK and Scottish DEL figures Secondly, the 100 million over-allocation, which was included in the 2010/11 Scottish Budget has been removed to reflect actual spend and ensure consistency with the reporting of departmental budgets in the Red Book. It should be noted that these changes reflect minor technical changes and are simply to allow for direct comparisons with the results based on the June 2010 Emergency Budget presented in this report. They do not lead to a material difference in the results. Any direct comparisons between the April projections and those based on the June 2010 Emergency Budget should only use the analysis presented in Chart 10 below. A full discussion of the methodology underpinning the analysis is provided in Annex A of the April report. Chart 10 Scottish Government DEL Expenditure Updated April 2010 Publication Results (2010/11 Prices) 32, years , billion Millions ( Prices) 28,000 26,000 24,000 22,000 20, / / / / / / / / / / / / / / /24 Source: Scottish Government calculations 16 These changes are part of the UK Government s Alignment project and have the effect of reducing reported DEL budgets in all years. The changes have no effect on the purchasing power of departments. More information on the project is available at

21 21 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 The March 2010 Budget forecasts suggested that it would have taken until 2022/23 for the Scottish Government Budget to return to 2009/10 levels. This is a total adjustment period of 13 years. Ultimately, the cumulative loss foregone, compared to a scenario where the Scottish Government Budget was assumed to remain at its 2009/10 level in real terms, is estimated to be approximately 26 billion. For reference, the April publication predicted a total adjustment of 25 billion over 13 years.

22 22 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 June 2010 Emergency Budget Short-term Outlook for Scottish Government Expenditure Chart 11: Estimated Annual Real Growth in Scottish Government DEL Expenditure June 2010 Budget Results 10% 8% 6% % Real Annual Change 4% 2% 0% -2% 2000/ / / / / / / / / / /11 6 years of real decline 2011/ / / / /16-4% -6% -8% Source: Scottish Government calculations. June 2010 Emergency Budget: Short-term outlook The exact impact of changes in total UK DEL on Scottish Government DEL depends upon how any aggregate UK spending adjustment is allocated across Whitehall departments, and the resulting consequentials allocated via the Barnett Formula. The Chancellor announced in his Emergency Budget Statement a commitment to protect health spending in England in real terms and to increase UK overseas aid over the period of the next Spending Review. Further details on implications for other Departments are not yet known. In the analysis that follows, it is assumed that the remaining Whitehall departments receive the same nominal percentage changes in their current and capital budgets and that the Scottish Government receives the resulting consequentials through the Barnett Formula. The methodology applied in this section is set out in Annexes A and B. A later section of the report discusses the potential impact from an alternative allocation of spending across Whitehall departments and the potential impact on the Scottish Budget.

23 23 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 The next Spending Review will cover the period 2011/12 to 2014/15. Over this four year period, the analysis suggests that Scottish Government DEL expenditure will fall on average by 3.3% a year in real terms. This would result in a cumulative real terms fall of 12.5% by 2014/15 compared to 2010/11. Chart 11 shows that the Scottish DEL budget is expected to fall by almost 6% in real terms between 2010/11 and 2011/12. This reflects the front loading of the UK Government s deficit reduction programme, the Scottish Government s decision to defer its share of the UK Government s 6.2 billion in spending cuts implemented in 2010/11 into 2011/12, the reduction in the 2011/12 baseline as a consequence of these UK cuts, and the assumption that no End Year Flexibility (EYF) is drawn down in 2011/12. In 2012/13, the Scottish DEL budget is forecast to fall by a further 1.7% in real terms. The June 2010 Emergency Budget also included forecasts for public spending in 2015/16. For this year, it is forecast that Scottish Government spending will fall by a further 1.8% in real terms. Over the five year period 2011/12 to 2015/16, it is estimated that Scottish Government DEL expenditure could fall by approximately 3.0% a year in real terms - marginally lower than the comparable decline in total UK DEL. From the 2009/10 peak, this would imply a 6 year real terms contraction in Scottish Government DEL expenditure of 2.9% per annum - a cumulative fall of 16.1%. As a result, Scottish Government DEL expenditure could be 4.8 billion below its 2009/10 peak in real terms by 2015/16 as illustrated in chart 12. Chart 12 - Estimated Scottish Government DEL Expenditure June 2010 Budget Results (2010/11 Prices) 35,000 30,000 Millions (2010/11 Prices) 25,000 20,000 15,000 10,000 5, / /01 Source: Scottish Government calculations. 2001/ / / / / / / / / / / / / / /16

24 24 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Chart 12 presents revised projections for the Scottish DEL budget over the period 2009/10 to 2015/16 following the June 2010 Emergency Budget. As the chart illustrates, by 2012/13 the Scottish Government DEL would be broadly comparable with that in 2005/06, whilst by 2015/16 it would be comparable to that in 2004/05. Consistent with the forecasts for the UK, Scottish Government capital DEL would incur a proportionately greater cut, with spending falling by 1.6 billion (40.1%) in real terms between 2009/10 and 2015/16. Current DEL is assumed to fall by 3.2 billion (12.3%) in real terms over this same period.

25 25 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Medium-term Outlook for Scottish Government Expenditure Chart 13 Scottish Government DEL Expenditure June 2010 Budget Results (2010/11 Prices) 32, years , billion Millions ( Prices) 28,000 26,000 24,000 22,000 20, / / / / / / / / / / / / / / / / / /27 Source: Scottish Government calculations Scottish Government Expenditure: Medium-term Outlook From 2016/17, with the fiscal tightening complete, and public spending growing in line with UK GDP, Scottish Government DEL is projected to grow by approximately 1.8% each year in real terms. Whilst Scottish DEL spending is projected to start growing again in 2016/17, it is important to recognise that the level of public spending in Scotland would continue to remain below the 2009/10 peak for a considerable period of time. As chart 13 highlights, assuming a consolidation period and subsequent return to spending growth consistent with the wider economy, the analysis suggests that it may take until 2025/26 for the Scottish Government Budget to return to 2009/10 levels in real terms. This is a total adjustment period of 16 years. In total, the cumulative loss foregone, compared to a scenario where the Scottish Government Budget is assumed to remain at its 2009/10 level in real terms, is estimated to be approximately 42 billion.

26 26 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Comparison with the April 2010 Forecast Chart 14 Estimated Scottish Government DEL Expenditure June 2010 and March 2010 Budget Results (2010/11 Prices) 31,000 30,000 29,000 Millions (2010/11 Prices) 28,000 27,000 26,000 25,000 24,000 23,000 22, / / / / / / /16 June Budget 2010 Assumptions March Budget 2010 Assumptions Source: Scottish Government calculations. Note, the difference in the reported expenditure for 2009/10 between the March and June Budgets reflects revisions to the Treasury s GDP deflators published in the June Budget. The cash value of Scottish DEL expenditure in this year is the same under both scenarios. Scottish Government Expenditure: Comparison with the April 2010 Forecasts The fiscal consolidation planned by the UK Government suggests that the reductions in Scottish Government DEL expenditure will be deeper than previously forecast, and will result in a larger share of the tightening being implemented in 2011/12. Chart 14 compares the updated forecasts presented in Chart 13 with the initial March 2010 Budget forecasts presented in Chart 10. Scottish DEL expenditure is now forecast to fall by 1.7 billion (5.9%) in real terms between 2010/11 and 2011/12. This compares to a reduction of 1 billion (3.4%) based on the assumptions in the March 2010 Budget. The projections in the June 2010 Emergency Budget also suggest that Scottish DEL expenditure could fall in real terms in each of the next five years. Consequently, by 2015/16, Scottish DEL expenditure is forecast to be 16.1% below its 2009/10 peak in real terms. In comparison, the March 2010 Budget results implied that Scottish DEL expenditure would reach a trough in 2014/15, with expenditure 12.7% below its 2009/10 peak in real terms. By 2015/16, the projections in the June 2010 Emergency Budget imply that Scottish Government DEL expenditure will be approximately 1 billion lower than suggested by April s analysis of the March 2010 Budget.

27 27 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Scottish Government DEL Expenditure to 2026/27 (June Budget and March Budget) 34,000 Chart 15 - Estimated Scottish Government DEL Expenditure June 2010 and March 2010 Budget Results (2010/11 Prices) 32,000 30,000 Millions (10/11 Prices) 28,000 26,000 24,000 22,000 20, / / / / / / / / / / / / / / / / / /27 Source: Scottish Government Calculations June 2010 Budget Assumptions March 2010 Budget Assumptions As a result of the measures announced in the June 2010 Emergency Budget, and the accompanying forecasts by the OBR, the total adjustment period until Scottish DEL expenditure is forecast to return to its 2009/10 peak has increased from 13 years, under the assumptions in the March 2010 UK Budget, to 16 years. Consequently, the cumulative loss foregone, compared to a scenario where the Scottish Government Budget remained at its 2009/10 level in real terms, is estimated to have increased from 26 billion to 42 billion. The increase in the size of the estimated cumulative loss is driven by two factors. Firstly, the accelerated pace of fiscal consolidation announced by the Chancellor, results in the Scottish Government Budget falling more sharply over the period 2011/12 to 2015/16 than previously forecast. In the March 2010 Budget, the fiscal consolidation was forecast to be completed by 2016/17. In contrast, the Chancellor now plans to complete the process of consolidation in 2015/16, with public spending forecast to bear a greater burden of the additional adjustment.

28 28 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Total UK DEL is forecast to be cut by an average 3.5% in real terms per annum over the four year period 2011/12 and 2014/15 compared to the earlier estimates based on the projections in the March 2010 Budget of a 3.0% average annual real terms cut. In addition, the Chancellor has introduced an AME margin into the total UK DEL spending figures to cover possible increases in annually managed spending. This margin is forecast to reach 5 billion by 2014/15 and means that there will be a corresponding reduction in the resources available for departmental budgets. Secondly, the Office for Budget Responsibility has revised the trend rate of economic growth in the UK which underpins the public finances projections from 2.5% per annum to 2.1% per annum from 2014 onwards. As future spending postconsolidation is assumed to grow in line with trend growth in the economy, this lower forecast limits the annual increase in UK public spending, and therefore via the Barnett Formula, Scottish Government spending, over the medium term. This accounts for approximately 6 billion of the 16 billion increase in the cumulative loss foregone in Scottish DEL expenditure.

29 29 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Section 3: Alternative Scenarios Alternative Scenario 1: Changing the Departmental Allocation of adjustment As noted earlier, the analysis summarised above takes the UK June 2010 Emergency Budget as a starting point to inform the outlook for future Scottish Government DEL expenditure. There are however, a number of important assumptions embedded in this scenario and we highlight the impact of alternative assumptions on the key results. As stated above, there is no central or preferred scenario in this report: it seeks only to set out the range of outcomes that might arise and the key considerations. Under the current financial arrangements, changes in total Scottish Government DEL expenditure are determined by increases or decreases in spending in Whitehall departments. The consequentials that Scotland receives depends critically on the extent to which the relevant Whitehall departmental programme is comparable with the services carried out in Scotland. The Chancellor announced in the June 2010 Emergency Budget that he plans to protect health spending and to increase spending on overseas aid, implying a greater relative burden on other departments. The Chancellor has requested that departments consider plans for cuts of up to 40% in a worst case scenario, though the average is forecast to be 25%. The IFS estimate that cuts of 10% to defence and education would mean that all other departments faced average real terms cuts of up to one third to maintain a 25% average in non-health and overseas aid budgets.

30 30 Outlook for Scottish Government Expenditure: Emergency Budget Update July 2010 Such uncertainty over the balance of future spending cuts makes forecasting future Scottish Budgets difficult. To illustrate the impact of potential changes in the allocation of spending, an additional scenario is considered below. This additional scenario examines the straightforward case of each Whitehall department receiving the same nominal percentage changes in their current and capital budgets, with Scotland receiving the resulting consequentials. All other assumptions, including the composition, size and speed of consolidation, and the future growth rate of the economy, are as that outlined above in the June 2010 Emergency Budget scenario. The next Spending Review will cover the period 2011/12 to 2014/15. Under this alternative scenario, the analysis suggests that Scottish Government DEL expenditure could fall on average by 3.7% a year in real terms over this four year period. This could result in a cumulative real terms fall of 14.2% in real terms by 2014/15 compared to 2010/11. As health is not protected in this scenario, the cuts to the Scottish Budget are proportionately larger than under the June 2010 Emergency Budget Scenario. Over the five year period 2011/12 to 2015/16, it is estimated that Scottish Government DEL expenditure could fall by approximately 3.3% a year in real terms under this scenario. From the 2009/10 peak, this would imply a 6 year real terms contraction in Scottish Government DEL expenditure of 3.2% per annum - a cumulative fall of 17.6%. As a result, Scottish Government DEL expenditure could be 5.3 billion below its 2009/10 peak in real terms by 2015/16. Chart 16 - Estimated Scottish Government DEL Expenditure June 2010 Budget Results (2010/11 Prices) (Cuts Shared Equally across Whitehall) 32, years , billion Millions ( Prices) 28,000 26,000 24,000 22,000 20, / / / / / / / / / / / / / / / / / / /28 Source: Scottish Government calculations

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