Budget 2010: Mind the gap...you can’t depend on growth

The forecast for the development of public finances in the Budget are based
on the assumption that the growth rate of real GDP will be above 3% in 2011 and
thereafter.

These growth assumptions are consistent with the government’s predictions in
the pre-Budget Report from last December. But they are significantly higher than
those expected by independent forecasters, which are roughly 2% for 2010 and
2011.

The growth assumptions used in projecting the deficit are important.

This is partly because the forecast for the deficit is typically expressed as
a proportion of GDP. So, other things being equal, a higher growth rate will
raise GDP, and lower the deficit-to-GDP ratio.

But also, tax revenues tend to rise in line with GDP, while expenditures can
rise more slowly.

So how do these growth assumptions affect the forecast for the deficit
reduction?

Based on their optimistic assumptions, the government expects that by 2014
the public sector deficit will be halved, and that the stock of public debt will
reach a maximum of less than 80% of GDP, before declining.

At the Centre for Business Taxation, we have simulated the development of the
public finances until 2020 under the assumption that GDP growth will be as
predicted by the average of independent forecasts until 2011 and that it will
remain at this level afterwards. (These independent forecasts are available to
view on the HM Treasury website).

Our simulations suggest that, under these independent growth assumptions, the
government will fail to achieve its objectives for the deficit reduction. The
deficit would decline much more slowly. The stock of debt would increase to
approximately 100% of GDP by 2018, which would be the highest level since the
early 1960s.

So how should we respond to this information? Not by advocating much sharper
and more immediate cuts in public spending. In fact, as a proportion of GDP, the
cuts proposed by the government after 2011 are already as deep as anything
achieved by Mrs Thatcher in the 1980s.

And in any case, there is still considerable uncertainty about the future of
the economy.

More information about the state of the economy will be revealed over time.
And as it is revealed, it should become easier to identify whether greater
spending cuts or further tax rises will be needed.

Professor Michael Devereux is director at the Centre for Business Taxation,
University of Oxford.