Audit of Assumptions for the March 2001 Budget. REPORT BY THE COMPTROLLER AND AUDITOR GENERAL HC 304 Session : 7 March 2001

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1 Audit of Assumptios for the March 2001 Budget REPORT BY THE COMPTROLLER AND AUDITOR GENERAL HC 304 Sessio : 7 March 2001

2 Audit of Assumptios for the March 2001 Budget REPORT BY THE COMPTROLLER AND AUDITOR GENERAL HC 304 Sessio : 7 March 2001 LONDON: The Statioery Office 0.00 Ordered by the House of Commos to be prited o 7 March 2001

3 This report has bee prepared for presetatio to the House of Commos uder Sectios 156 ad 157 of the Fiace Act Joh Bour Natioal Audit Office Comptroller ad Auditor Geeral 1 March 2001 The Comptroller ad Auditor Geeral is the head of the Natioal Audit Office employig some 750 staff. He, ad the Natioal Audit Office, are totally idepedet of Govermet. He certifies the accouts of all Govermet departmets ad a wide rage of other public sector bodies; ad he has statutory authority to report to Parliamet o the ecoomy, efficiecy ad effectiveess with which departmets ad other bodies have used their resources. For further iformatio about the Natioal Audit Office please cotact: Natioal Audit Office Press Office Buckigham Palace Road Victoria Lodo SW1W 9SP Tel: Website address:

4 Report Report by the Comptroller ad Auditor Geeral to the House of Commos I this report Statemet of resposibilities 1 Basis of report 1 Factor icome shares 2 Debt Iterest 4 Coclusios 5 Statemet of Resposibilities 1 Sectios 156 ad 157 of the Fiace Act 1998 provide for me to examie ad report o ay covetios ad assumptios uderlyig the Treasury's fiscal projectios that are submitted to me by the Treasury for examiatio. 2 The Chacellor of the Exchequer has cofirmed that there are o ew assumptios he wishes me to examie. I uderstad that oe of the assumptios I have examied i previous reports 1 are to be chaged. This report therefore covers assumptios fallig withi the scope of the three year rollig review arragemets aouced by the Chacellor at the time of the last Budget. As before, the Treasury remais resposible for makig projectios of future public expediture ad reveue o the basis of these assumptios. 3 The purpose of the rollig review is to provide a check both that the relevat assumptios remai reasoable ad cautious, ad to see whether they have ideed resulted i reasoable ad cautious projectios i the three year period sice they were first audited. 4 Assumptios covered i this report are those first examied for the March 1998 Budget: for the purposes of fiscal projectios i the medium term, whe the ecoomy is assumed to be o its tred path, the shares of labour icome ad of profits i domestic icome are broadly costat; ad the fudig assumptios used to project cetral govermet debt iterest are cosistet with the forecast level of govermet borrowig ad with the curret fiacig policy as set out i the Debt Maagemet Report. Basis of Report 5 As i my previous reports o assumptios uderlyig the fiscal projectios, I have cosidered the available evidece i udertakig the rollig review. Evidece was obtaied from relevat papers ad discussios with officials i the Treasury. 1 Cm 3693; HC 361, Sessio ; HC 616, Sessio ; HC 294, Sessio ; HC 873, Sessio ; HC 348, Sessio ; ad HC 959, Sessio

5 Report Factor icome shares 6 The Treasury assumes for the purposes of makig their medium term fiscal projectios that output i the ecoomy is aroud its tred level ad so grows at the same rate as tred or potetial output. This reflects the fact that it is ot possible to forecast uforesee shocks to the ecoomy, which would ted to move the ecoomy off its tred path i the medium term. At the tred level ad rate of growth, a further assumptio made by Treasury is that the shares i domestic icome of labour icome ad icome from capital profits are broadly costat. 7 This factor share assumptio is importat for projectios of equity prices, which I re-examied i my Report for the 2000 Pre-Budget Report, (HC 959, Sessio ). It also has a direct bearig o the public fiaces, sice labour icome ad profits are taxed at differet rates. Labour icomes at the margi are more highly taxed tha compay profits. The basic rate of icome tax is 22 per cet ad takig accout of both employee ad employer Natioal Isurace cotributios, the margial tax rate at average earigs for cotracted out employees is about 40 per cet. The stadard rate of corporatio tax is 30 per cet. 8 A shift betwee labour icome ad profit shares i domestic icome will therefore affect the level of tax reveues. While the precise effects will deped o a rage of assumptios (especially for average earigs ad employmet), Treasury estimates suggest that, if o secod roud effects o the real ecoomy or o prices are take ito accout, a permaet shift of oe percetage poit i GDP from profits to labour icome could raise the total level of tax receipts by up to 1 billio after oe year. 9 Maistream ecoomic theory gives grouds for thikig that the shares of labour icome ad profits i domestic icome will ted to be costat, though this predictio depeds o a umber of assumptios, particularly about the ature of techology i the ecoomy ad the existece of competitive markets. I have examied the empirical evidece for the assumptio that the shares of labour icome ad profits are broadly costat whe the ecoomy is o tred. 10 There have bee major chages i the methodology for compilig the Natioal Accouts sice my previous audit of the factor share assumptio i March This follows the adoptio of a ew atioal accoutig stadard withi the Europea System of Accouts. 11 The factor share data have bee affected by these chages largely through a reclassificatio of part of self-employmet icomes (the icome of parterships) to profits. The remaider of self-employed icome, largely the icome of sole traders, is ow defied as 'mixed icome', which with compesatio for employees, defies 'labour icome'. Capital icome is defied as gross tradig profits et of stock appreciatio. For the purposes of fiscal projectios, labour ad capital icomes together costitute domestic icome Retal icome ad a imputed charge for geeral govermet o-tradig capital cosumptio are excluded whe calculatig shares of labour icome ad profits i domestic icome; the former o the basis that it icludes a large imputed elemet attributed to households, ad the latter because profits are defied o the basis of tradig activities. 2 2 Domestic icome = icome from employmet + gross tradig profits Icome from employmet = compesatio of employees + mixed icome Gross tradig profits = gross operatig surplus excludig stock appreciatio - retal icome icludig a imputed charge for o-tradig capital cosumptio

6 13 Figure 1 shows the patter of the shares of labour icome ad profits for the period from 1959 owards. The shares have teded to be costat though with fluctuatios aroud a average level of 78.2 per cet for labour icomes, ragig from about 75 per cet to 84 per cet over the period. 1 Factor shares i domestic icome et of stock appreciatio ad retal icome, Capital share 0 percetage of domestic icome Labour share percetage of domestic icome Source: HM Treasury 14 Data are ot yet available for the last year of the three year rollig review period, but the labour share of domestic icome i 1998 was 76.7 per cet, risig to 78.4 per cet i This is withi the rage of fluctuatio over the log term for which data exist. The two mai possible explaatios for why the shares were ot precisely costat are structural ad cyclical factors. 15 Structural factors produce a shift i the way the ecoomy fuctios ad hece may affect factor shares. For example, sigificat icreases i labour supply due, say, to tax ad beefit system reform, which traslate ito higher employmet ad output may temporarily ivolve real wage growth fallig short of productivity growth. This will alter factor shares for a period. Chages i the real exchage rate will ted to have fairly log draw out cosequeces for profit margis ad real wages, agai affectig factor shares. O the basis of two years data for the rollig review period, Figure 1 suggests there is o clear evidece of structural chages sigificatly shiftig factor shares i that period. 16 Cyclical factors ca also lead to chages i icome shares if ecoomic growth falls below or rises above tred. Figure 2 examies how factor shares ad the ecoomic cycle are related i more detail. It shows the relatioship betwee profits as a percetage of domestic icome ad the "output gap". The output gap is calculated by the Treasury as a estimate of the amout (i percetage terms) by which actual output is above or below log ru potetial output. The output gap caot be measured with complete certaity, as potetial output is hard to estimate. The Treasury forms a view of the output gap based o a rage of ecoomic idicators icludig measures of capacity utilisatio from the Cofederatio of British Idustry survey of maufacturig, the British Chambers of Commerce survey of services, ad the Buildig Employers' Cofederatio survey of costructio. 3

7 2 Profit share ad output gap 26 6 percetage of domestic icome output gap (per cet) 16 Profit share (LHS) Output gap (RHS) Source: Note: HM Treasury The output gap is defied as: actual output - potetial output potetial output x Figure 2 shows that the profit share teds to move cyclically with the output gap. As actual output falls relative to potetial, the profit share teds to fall ad vice versa. The evidece over the rollig review period is ot icosistet with this relatioship. This suggests that some part of the observed chages i factor shares over the period may have bee cyclical, ad therefore that the use of the assumptio over the rollig review period was reasoable. 18 For the future, I observe above that there is a theoretical basis for assumig factor shares are costat, ad there is also supportig empirical evidece provided allowace is made for the effects of structural shifts ad cycles i the ecoomy. The Treasury's medium term projectios abstract from both these iflueces, ad a assumptio that factor shares are broadly costat whe the ecoomy is assumed to be o its tred path i the medium term remais reasoable as a basis for fiscal projectios. Debt Iterest 19 I have examied the cosistecy of the assumptios used i projectig cetral govermet debt iterest with the forecast of govermet borrowig ad with fiacig policy as set out i the Debt Maagemet Reports, from this Budget re-titled the Debt ad Reserves Maagemet Report, DRMR. 20 These checks are ecessary to esure that the data iput to the Treasury's ecoomic forecastig system are cosistet with the detailed forecast of debt iterest over the year ahead, which is separately prepared ad is based o kow ad plaed debt redemptio ad issuace trasactios. 21 A further elemet of esurig cosistecy is that both fiacig requiremet forecasts ad debt iterest calculatios reflect policy itetios relatig to debt maagemet. These policy itetios iclude: 4 maitaiig a costat level of official et reserves of gold ad foreig exchage. I lie with the policy ot to itervee i foreig exchage markets to achieve a give level of sterlig, the policy is that there should be o et borrowig (ad hece o impact o et debt iterest paymets), for example to icrease the level of the reserves;

8 fully fiacig through the issue of gilts the cetral govermet et fiacig requiremet, the repaymet of maturig debt ad ay uplaed chages i the official reserves. This impacts o the stock of outstadig govermet debt ad hece debt iterest paymets; a policy decisio about the extet to which Natioal Savigs will make a cotributio to the cetral govermet et fiacig requiremet. This affects debt iterest paymets to the extet that iterest rates paid o Natioal Savigs products differ from those o other debt istrumets; ad policy decisios regardig the mix of fiacig through covetioal ad idex-liked gilts. This agai affects the level of debt iterest payable as the returs o the two securities differ. 22 These policies uderlie a particular patter of debt issuace, as set out previously i Debt Maagemet Reports ad ow i the DRMR. For cosistecy this patter must be used i the calculatios of debt iterest paymets. 23 For the three year period of the rollig review sice March 1998, I examied the relevat workig papers relatig to the 1999 ad 2000 Budgets ad the 1998, 1999 ad 2000 Pre-Budget Reports. I cofirm that the figures for govermet borrowig used to calculate debt iterest paymets were cosistet with the forecast of govermet borrowig, ad that they reflected the policy assumptios i the relevat Debt Maagemet Report. I cofirmed also that the Treasury has used the audited methodology for projectig iterest rates, (my Report for the November 2000 Pre-Budget Report, HC 959 Sessio ), ad has applied the outcome i its calculatios of debt iterest paymets, icludig for this Budget. 24 For this Budget, my examiatio of the relevat papers cofirms that the data iput to the Treasury's ecoomic forecastig system is cosistet with the detailed forecast of debt iterest over the year ahead. 25 The govermet's curret statemet of fiacig policy is set out i the Debt ad Reserves Maagemet Report published today. I additio to the debt maagemet policies set out above, the DRMR idicates that there will be a ru dow of the govermet's curret et short term cash positio. This has arise due to buoyat public fiaces ad uexpectedly large cash receipts from the auctio of radio spectrum liceses for third geeratio mobile phoes. Cosistet with the policy commitmet give i the November 2000 Pre-Budget Report, the ru dow i the short term cash positio will take place over the ext three years. This will i tur reduce the scale of ew gilts issuace, ad hece the total outstadig stock of debt ad debt iterest payable, compared to what it would have bee. 26 For , I have cofirmed that the patter of gilt issuace adopted i the DRMR has bee used i the calculatio of the debt iterest forecast. For subsequet years, the DRMR makes o explicit assumptio about the patter of gilt issuace. However, the Treasury forecastig system assumes that the patter remais uchaged. I have cofirmed that this assumptio has bee applied i makig forecasts of debt iterest for future years. Coclusios 27 I coclude that the assumptio of broadly costat factor shares was a reasoable oe to use over the rollig review period of the last three years, ad that it curretly remais a reasoable oe to adopt for the future. I am satisfied that the calculatios of debt iterest paymets were cosistet with forecasts for cetral govermet's et fiacig requiremet ad with curret fiacig policy at the time of each forecast made sice the March 1998 Budget, ad are for this Budget. 5

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