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The UK economy.

The UK economy entered 1992 having experienced one of the largest falls in the volume of domestically produced output during a single calendar year in the post-war period, with output likely to have fallen by close to 2-5 per cent in 1991. However the pace of the decline has begun to moderate in recent months, with activity in the second half of the year around 2 per cent lower than a year earlier. With oil production having recovered since the summer, it seems likely that onshore activity declined for the sixth successive quarter in the final three months of 1991.

As yet there is little tangible evidence of any recovery in activity in the early weeks of this year, with consumer and business sentiment remaining depressed. The latest provisional estimate of the longer leading cyclical indicator published by the CSO exhibits a small downturn, with housing starts failing back in the last quarter of 1991 and a decline in business optimism in the latest CBI Industrial Trends Survey.

The balance of respondents who became less optimistic in the CBI survey was close to that recorded in the survey of last July, reversing the apparent improvement in the business outlook recorded in the October survey. However, as with the October Survey, it remains true that over half the firms questioned did not report any change in optimism, even though demand expectations proved over-optimistic for the seventh successive quarter at the end of 1991. In contrast to the turnaround in general optimism there was little change in expectations of new orders or the volume of output. It seems quite possible that optimism may have been adversely affected by the survey being undertaken at a time when sterling was under pressure within the ERM and there was considerable speculation about an upward move in base rates.

Recent indicators suggest that consumers' expenditure failed to recover over Christmas, with retail sales volumes being little changed in the fourth quarter of the year. Overall consumption may have fallen by around 2 per cent over 1991 as a whole, with the personal sector savings ratio rising to close to 10-5 per cent. As in our previous forecasts we are currently anticipating that consumption will remain subdued throughout 1992, with growth being around 1 per cent and the savings ratio remaining close to its present level. The profile of the savings ratio is shown in Chart 1.

We have argued for some time that the slowdown in consumption can be viewed as a counterpart to a desired adjustment in the financial position of the personal sector. The scale of this adjustment is apparent from the rise in the savings ratio and the slowdown in consumer borrowing. The net new flow of consumer credit is lower in real terms than at any time since the mid-1970s with a net repayment being made in the last quarter of 1991.

The factors behind this adjustment reflect developments on both sides of the personal sector balance sheet. The 1980s saw the total financial debt held by the personal sector rise rapidly from 56 per cent of disposable income in 1980 to 113 per cent by 1990, with financial deregulation helping to ease previously binding credit constraints. For most of the period the appreciation in the value of the assets held as collateral for the debt was just as rapid, and net wealth therefore continued to rise in nominal terms. Charts 2 and 3 show the ratio of total personal sector debt to both financial assets and a broader measure including the value of the housing stock. The broader definition provides a better picture of the overall state of the personal sector balance sheet as debts include mortgage liabilities secured on housing assets.

The ratio of debt to total assets has risen quite sharply since 1988, reflecting the relative stagnation of house prices and the continued growth of personal sector debt in line with income. Similar trends are apparent in earlier recessions. It is probable that much of the upward jump in this ratio over the last two years was unanticipated at the time the debts were incurred, with asset prices failing to appreciate as much as expected.

Although the ratio of debt to total assets remains below 20 per cent, many borrowers are presently experiencing considerable difficulties in meeting the required level of interest payments on existing debt. Indeed with house prices falling in the last quarter of 1991 by around 2 per cent, the real cost of mortgage debt is presently around 12-13 per cent. The response to the unexpectedly high level of debt servicing costs and the decline in total net wealth has been a cutback in discretionary expenditure, particularly on consumer durables, and attempts to repay existing debt.

It is unlikely that the weak housing market is responsible for all of the rise in the savings ratio, with additional effects arising from the continuing uncertainty about job prospects, with unemployment having risen by some 900,000 since the middle of 1990. it is unlikely that any recovery that begins this year will gain sufficient momentum to prevent further rises in unemployment.

Many of the problems facing the personal sector also bedevil the corporate sector, although as the note on corporate debt elsewhere in the Review shows the current levels of corporate debt are not unprecedented when related to the value of the capital stock. It appears that the uncertainty about future demand prospects is currently constraining corporate expenditure and many firms are continuing to experience financial difficulties. The number of corporate liquidations in England and Wales is estimated to have risen by 45 per cent in 1991, although the number of insolvencies did fall in the fourth quarter as Chart 4 shows. There is little sign of any end to the spate of individual insolvencies which rose by 83 per cent over the last 12 months.

The strength of the recession has led to considerable downward pressure on domestic prices, especially in the more open sectors of the economy. Domestic price expectations as recorded in the CBI Survey have been weak for some time, with the balance of firms expecting to raise prices in the latter half of last year being lower than at any time since 1967. Although there was a small upturn in the balance intending to raise prices in the most recent survey, the rise was much smaller than the normal seasonal rise due to firms revising their list prices at the start of the year. Signs of price moderation are beginning to emerge in the data for producer output prices, with the rate of increase over the year to january being 3-1 per cent, helped by negligible price movements in the latter half of last year.

However it is not yet clear that inflation elsewhere in the economy has declined to the levels required to sustain competitiveness within the European market. The rate of change in retail prices excluding mortgage interest payments was 5.6 per cent over the year to january, a rate little changed from the average level over the last half of 1991.

Policy assumptions

At the beginning of the year sterling came under considerable pressure within the ERM and twice approached the effective lower limit within the wide band. The volatility of the sterling effective exchange rate has been less pronounced, with the weakness against the deutschmark being offset by an appreciation against the dollar. The temporary operational advantages afforded by membership of the wider band allowed the authorities to maintain the existing level of interest rates in the aftermath of the half point rise in German official rates in mid December, although there is little doubt that the present high level of German rates has constrained the government's ability to lower domestic interest rates. However, as we argued in November, it is probable that the outlook for growth will help to ease inflationary pressures in the main European economies and create scope for some reduction in rates around the middle of the year. The path of German and UK three month rates is shown in Chart 5, with UK rates falling to 9-5 per cent by the end of 1992, close to the forecast level of French interest rates.

The persistence of the recession means that the finances of the public sector have continued to deteriorate rate since our last forecast, with the PSBR for 1991/92 likely to be around L 11.7 billion, some 2 per cent of GDP. In contrast to November we now assume that the Budget judgement will be highly political, with a 1 penny reduction in the basic rate of income tax, worth some L1.9 billion according to the Ready Reckoner figures published in the Autumn Statement. It appears unlikely that the personal sector will be neglected as the government has done nothing to stem the recent build up of expectations.

With the cut in taxation coming on top of the extra expenditure announced in the Autumn Statement and the recent pay awards averaging 6-5 per cent for many public sector employees, we now expect the PSBR to be around L22.2 and L21.6 billion in the coming two financial years, close to 3-5 per cent of money GDP. It seems likely on the basis of our medium term forecast (detailed in Table 12 below) that the borrowing requirement will remain high for much of the 1990s, although it is unlikely to fall outside the proposed Maastricht guidelines.

We continue to make the conventional presentation of the main forecast on the basis of an unchanged administration. However there is considerable uncertainty about the future course of fiscal policy at the present time, with the likelihood being that the Labour party would make a quite different Budget judgement should it win the forthcoming election. Part 3 of this chapter accordingly presents a detailed short-term analysis of the likely changes in taxation and expenditure that a Labour administration could be expected to announce in its first two budgets. This analysis serves as a complement to the earlier study published in the Review in November 1990 which concentrated on the medium term impact of Labour's supply side policies.

Summary of the forecast

In common with a number of other forecasters we have revised down the projected rate of growth in GDP over 1992, with our current forecast now showing growth of 1-3 per cent, some -75 per cent lower than in our November forecast. However, in contrast to others, our consumption forecast is little changed, with the main differences resulting from a moderation in the projected turnaround in stockbuilding and a more subdued level of activity in foreign markets. This time we also show the forecast for 1993 in greater detail than before. Growth is forecast to be just above 2-5 per cent, close to its long term trend, with the full year impact of the assumed income tax cut helping to boost consumer spending. Details of the composition of expenditure are given in Table 1.

For 1992, we expect consumption to grow by around 1 per cent, close to the growth in disposable income. As yet there is little sign of the further improvements in consumer confidence about future economic prospects that are a prerequisite for any substantive recovery in expenditure. Recent monthly surveys have shown little improvement in confidence since the autumn of last year, although it remains at a level above the low point experienced in 1990. In the absence of any firm evidence of a revival in either the housing market or demand for credit, we expect the savings ratio to remain close to its present level for some time.

Over the course of the year the main stimuli to growth are likely to be the feed-through of the additional public expenditure announced in the Autumn Statement and a modest turnaround in the stock cycle. The forecast upturn in stockbuilding is less marked than that projected in November, accounting for much of the difference between our present growth forecast and that made in November. In part this reflects recent revisions to the national accounts, with destocking in the first three quarters of 1991 now some L2 billion lower than previously thought. In addition, with demand expectations proving over optimistic in the last part of 1991, both on our part and that of the company sector, it is probable that many firms will wish to make further reductions in their present stock holdings.

Fixed investment continued to decline throughout 1991, with investment in manufacturing projected to have fallen by some 14 per cent. The outlook for investment over the coming months is constrained by the uncertainty as to the timing of the recovery. For the year as a whole, investment volumes may fall further by around 1.5 per cent, although some recovery may be observed in the second half of the year and in 1993, with service industries continuing to invest in information technology. New manufacturing investment may be checked by the current high levels of spare capacity in many companies. Our estimates based on the CBI Survey suggest that capacity utilisation in the manufacturing sector is presently some 18 per cent below the peak reached in the last quarter of 1988. Much of this turnaround reflects subsequent additions to capacity rather than the decline in output.

Overall the present position of the company sector suggests that much of the initial upturn in demand will be met by running down existing stocks and a gradual rise in utilisation rates. This implies a delayed recovery in investment levels and a slow restoration of profit margins.

With margins remaining depressed, there are likely to be further falls in inflation, with retail and consumer price inflation falling below 3.5 per cent by the end of 1992, and remaining around this level for much of 1993. The latest data for producer output prices suggests that relatively few firms chose to raise their list prices significantly in january and we expect the rate of increase in prices (excluding food, drink and tobacco) to average around 2-5 per cent over 1992 as a whole, and just over 3 per cent in 1993.

The pressure on profit margins together with the present poor trading conditions will put further downward pressure on unit costs. We expect the underlying rate of average earnings growth to fall to just over 6 per cent in the second half of 1992 as the high settlements reached in the early part of last year drop out of the figures. The moderation in pay will not prevent further rises in unemployment, although the rate of growth in the total numbers unemployed may well diminish over the course of the year. The profile of unemployment is shown in Chart 6, with unemployment rising to around 2.9 million during 1993. Some cutbacks in employment will be experienced in all sectors, with the shakeout being greatest in the manufacturing and construction industries.

The downward pressure on manufacturing prices is likely to feed through into export prices, and we are currently forecasting that the recent falls in manufacturers' export prices will continue into the early months of this year. With sterling forecast to depreciate against the dollar in line with the interest differential between the two currencies, the moderation in export price inflation may help to improve competitiveness and offset some of the impact of the present difficult trading conditions in overseas markets. Over 1992 as a whole we expect the volume of manufactured exports to rise by around 4 per cent, close to the growth in UK-weighted world trade. Exports of services may rise by somewhat less, in part due to heavy overseas insurance claims on Lloyds of London. Import volumes are likely to pick up in the latter part of

the year and the early part of 1993. Much of this is accounted for by non-manufactures due to an anticipated recovery in material stocks typical of the early stages of a recovery. Growth in manufactured imports may well accelerate in 1993, as the full year impact of the assumed tax cut boosts consumption.

Overall these projections imply a current account deficit around L8 billion in 1992 and L9.5 billion in 1993. Much of the deterioration from the 1991 outturn of L5.7 billion is accounted for by a rise in net transfers abroad by the public sector as the contributions by foreign governments to the cost of the Gulf War decline.

Medium-term projections

The medium-term projections contained in Table 12 below provide an indication of the underlying state of the UK economy under the assumption that present policies remain unchanged. We show the economy growing at around 2.5 per cent on average, close to its long term trend. The projections are consistent with a gradual convergence between the UK and the other European economies, although this rests on the dual assumptions that the government signals that it is serious about the commitment to eventual monetary union and that wage bargainers and price setters realize that any cost or price escalation is unlikely to be validated by a depreciation in the nominal exchange rate.

As we have argued in previous Reviews the commitment to eventual monetary union requires that the domestic inflation rate fall below the European average for some time to ensure a sustainable relationship between the respective price levels. Our projections show the real effective exchange rate depreciating by around 0.75 per cent per annum over the mid-1990s. The adjustment process serves to limit the scope for future fiscal maneouvre and means that unemployment could well remain above 2 million throughout the decade.

In spite of the slow improvement in competitiveness it seems likely that the structural imbalance in UK trade will persist into the 1990s. The trend in the non-oil visible trade balance over the last two decades is shown in Chart 7 and suggests that the trade problems are longstanding with a deficit being experienced in every calendar year over the last two decades. The recent improvement in the trade balance due to the recession appears greater than in 1980/81, but smaller than in the aftermath of the 1974 recession.

Even with the recent improvement in the trade performance of manufactured exports, the visible trade deficit remains in the early 1990s, with the constraints imposed by ERM membership leading to continued pressure on export profit margins and the revival in consumption stimulating further growth in imports of consumer goods.

Part Two. The Forecast in Detail

Our forecasts of growth in consumer spending in 1992 have been below the consensus forecasts for some time. Our current forecast is for growth of 0.9 per cent, some 0.3 per cent below that in the November Review. With real personal disposable income rising by just over 1 per cent, there is little change in the savings ratio. We have also revised our estimate for 1991 downwards, with the latest National Accounts statistics showing a substantial downward revision of over L1 billion to the level of expenditure in the second quarter of last year and activity being more depressed than we had previously anticipated. Indeed without the expenditure switching induced by the rise in VAT in last year's Budget it is likely that expenditure would have shown a fall in each quarter since mid-1990.

As we explain in the introduction to this section, the rise in the savings ratio can be viewed as the counterpart of an attempt by the personal sector to restore its balance sheet towards more normal levels. As yet there is little sign that this adjustment process is coming to an end. Both the number of mortgage approvals and net new mortgage loans fell in the fourth quarter of 1991 and December saw the biggest monthly net repayment of consumer credit debt

since 1976. The balance of respondents in the December survey of financial services by the CBI and Coopers Deloitte expected business with private individuals to fall in the first quarter of this year.

It is likely that the housing market will show a limited recovery in the forthcoming months, helped by the temporary suspension of stamp duty until the middle of August and attempts on the part of lenders to stimulate activity by means of mortgage rate cuts. However with a large overhang of unsold and repossessed properties, prices at the end of 1992 may be little changed from those at the end of 1991.

The profile of the gross and net acquisitions of financial assets by the personal sector are shown in Chart 8. Whilst gross financial saving remained fairly constant over the 1980s, net saving fell due to an increase in the level of borrowing. The personal sector has recently moved back into a net financial surplus, which at around 4 percent of GDP is close to the levels of the early 1980s. Our forecast implies that the financial surplus will amount to some 3.7 per cent of GDP in 1992 and 3.3 per cent in 1993.

Overall the projected rise in disposable income over 1992 is little different from that in our November forecast. Although growth may be lower than previously anticipated, the decline in labour income is offset by the effects of the assumed cut in the basic rate of income tax. Net property income may rise by around 3-3.5 per cent over 1992, with a boost in the early part of the year from the annual review of mortgage payments by many building societies. However the overall boost may be lower than widely anticipated as some of the decline in mortgage rates has already been passed on to borrowers (for example, the Halifax building society changed the rates for all borrowers last August). Investment income may also decline with financial institutions having widened the spread between their loan and deposit rates.

Investment and Stockbuilding (Table 3 and 4)

The latest National Accounts figures show that investment has continued to decline, although the pace of the decline has begun to moderate a little. Overall we expect a fall of 11-12 per cent in the volume of investment in 1991, with a further small fall of 1.3 per cent in 1992. The decline has occurred across all sectors with the exception of energy and water supply, where the combination of new drilling activity and environmental investment has raised the volume of investment in 1991.

Investment in manufacturing is estimated to have fallen by some 14-15 per cent over 1991, with the prospect of a further fall of around 5 per cent over this year. Our model equation has continued to track the downturn in investment with the weak liquidity position of the company sector and the rise in potential capacity utilisation acting as key influences. The forecast fall in 1992 is in contrast to the 2 per cent rise predicted in the latest CSO Investment Intentions Survey. This was conducted last October and it is likely that intentions have been revised downwards since then, with demand at the end of the year being weaker than previously expected. With 71 per cent of firms in the latest CBI Survey working below capacity, it is likely that any initial recovery in demand will simply be met by raising utilisation rates of existing equipment.

Construction investment has been particularly badly hit by the recession, with the current weakness of the property market sufficient to cause the total investment deflator in the National Accounts to show a small fall in the year to 1991Q3. The volume of new housing orders obtained by contractors in the three months to November was some 5 per cent lower than the previous three month period and some 6 per cent lower than in the comparable period of 1990. Falls of a similar magnitude are apparent in private commercial orders. We do not anticipate any substantial pick-up in housing investment for some time, in part due to the overhang of unsold properties.

Some possible contrary evidence on investment is provided by the trade statistics which show that imports of capital goods rose consistently over the last nine months of 1991. However this coincided with a continual decline in the level of domestic production of investment goods, with production in the three months to November being some 3 per cent lower than in the previous three months. One possible explanation for these different statistics is that the recession has caused a number of domestic firms to cease trading.

Stockbuilding remains an area of considerable uncertainty, with recent revisions to the National Accounts suggesting that the destocking in the first half of last year was much less severe than previously thought. Indeed the data suggest that there were some small positive additions to stocks in the third quarter of the year. These revisions account for much of the difference between the current forecast for 1992 and that in November as there is now less scope for any substantial rebound in stockbuilding, although the stock cycle should still make a modest contribution to growth in 1992 as the pace of destocking moderates.

Stock output ratios for manufacturing, distribution and the rest of the private sector are shown in Chart 9. The downward trend in manufacturing stock levels was interrupted in 1990/91 with the unexpected downturn in demand. We expect the previous trend to resume over time, reflecting continued improvements to stock control techniques. There is less evidence of any underlying improvement in the distributive sector, possibly suggesting that manufacturers have simply pushed stocks onto retailers.

Stocks in the remainder of the private sector have actually been on an upward trend relative to output. This is largely due to a build up of construction stocks, with unsold commercial property and private housing. Energy stocks have also risen during 1991, with stocks of crude oil at the end of November some 7.5 per cent higher than a year earlier when they were run down in the aftermath of the sharp rise in oil prices following the Iraqi invasion of Kuwait. It is likely that some destocking will be observed in the second half of 1992, as housing stocks begin to fall and energy stocks reach their desired level.

Elsewhere we expect some continued destocking in manufacturing in 1992, with the latest CBI Industrial Trends Survey showing that stocks remain higher than desired, although firms were reasonably successful in running down stocks in the fourth quarter of last year in spite of the shortfall in demand.

The provisional estimate for the current account deficit in 1991 is some L5.7 billion, around 1 per cent of GDP. Over the course of the year net trade has made a positive contribution to GDP, with the volume of imports falling in line with domestic demand and UK exporters continuing to improve their share of trade in the main export markets. Indeed the last quarter of the year saw a record level for the volume of exported goods, primarily due to an 11 per cent rise in food, drink and tobacco exports over the quarter. In contrast the volume of manufactured exports fell in the final quarter, as did the value of total exports of goods, with exporters being forced to cut prices in order to retain market share.

We expect the volume of manufactures to rise by close to 4 per cent over the coming year, with trade in the main export markets rising by a similar magnitude. This is a somewhat smaller rise than in the November forecast as we are now expecting world activity to be somewhat more subdued in the coming months. Indeed exports to the United States fell by 1 1 per cent in the final quarter of 1991. Net trade may again make a positive contribution to the volume of output over 1992, as we do not expect imports of manufactures to grow by more than 1.5 per cent, with consumer spending remaining subdued. The overall growth in imports of goods may be somewhat greater, with higher imports of raw materials likely if the recovery begins to gain momentum. In 1993 we expect imports of manufactures to rise by over 5 per cent, with the rebound in consumption boosting the domestic demand for manufactures.

We do not expect any immediate changes in the overall balance of trade in services over the coming months, with a decline in export earnings due to heavy overseas insurance claims on Lloyds of London being offset by a decline in UK residents' travel overseas. Overall the current account may deteriorate by around L2.5 billion in 1992, although the visible trade balance may be little changed from its current level. Most of the deterioration over the coming months is accounted for by a decline in foreign contributions towards the cost of the Gulf War. Such contributions amounted to some E2 billion in 1991.

The net overseas assets held by the UK fell sharply over the course of 1990 to a level around L30 billion by the year end. This continued the long term decline in the real value of overseas assets as shown in Chart 10. Our estimates suggest that some of the recent losses will have been recouped over 1991, with the end year level of assets being around 7-5 per cent of money GDP. We anticipate little change in the underlying level over the course of 1992, with the adverse impact of the continued current account deficit being offset by the depreciation of sterling against the dollar.

The basic balance, defined as the current account plus net flows of direct and portfolio investment, is likely to have been close to overall balance during 1991, with outward flows of direct investment falling in recent months as part of the process by which companies have adjusted their liquidity position. We expect foreign direct investment in the UK to fall back from its present levels in 1992 as trading conditions become more difficult worldwide.

In the medium term it is possible that there may be a continued net inflow of portfolio investments, with overseas institutions being heavy buyers of the forthcoming gilt sales to finance the sustained rise in public sector borrowing. With aging population structures and the maturing of many pension funds it is likely that the demand for capital certain assets will begin to rise in coming years. Membership of the ERM not only helps to improve the confidence of foreign investors concerned to avoid foreign currency losses on sterling investments, but also limits outward investment from the UK by reducing the likelihood of gains from continual sterling depreciation.

Sectoral output and the labour market (Tables 7 and 8) The recession has permeated all sectors of the economy, and, with the exception of oil, all sectors of output are likely to show a decline in 1991. Among the hardest hit were the construction and manufacturing industries, with falls of around 8 and 5 per cent respectively. The profiles of manufacturing, construction and services output the latter defined as a weighted aggregate of distribution and business services) are shown in Chart 11. In contrast to the early-1980s, the falls in output in the present recession have been more widely spread amongst the different sectors.

Manufacturing fell sharply in the last quarter of the year having earlier appeared to stabilise close to its level in the middle of the year. It is probable that this fall was in part a reflection of continued destocking, with respondents to the CBI Survey indicating that they had run down stocks further during the quarter in spite of the shortfall in demand. We anticipate a limited recovery in output levels over the course of this year, although the year-on-year rise may be no more than -5 per cent. Prospects for 1993 are somewhat brighter with the stimulus to both domestic demand and world activity possibly boosting output by over 3 per cent.

In contrast we expect the decline in construction to continue into the first half of this year, with the stock of unsold properties delaying any expansion in housebuilding. Around two thirds of the respondents in the latest survey by the Building Employers' Federation expected output to fall over the coming year.

Overall the output of the production industries remained fairly stable throughout 1991, with the decline in manufacturing being offset by the recovery in North Sea production in the second half of the year to levels some 10 per cent higher than a year earlier. We expect the current level of oil production to be maintained, with a gradual rise to the mid-point of the possible range indicated in the Brown Book in the medium term.

Output in the distributive sector fell in the early part of 1991, but has since stabilised, and we expect to see little change over the last quarter of 1991 and the early months of 1992, with consumption remaining flat and the January CBI Distributive Trades Survey pointing to a disappointing Christmas for retailers.

Employment has continued to fall rapidly over the course of 1991, with around 1 million jobs having been lost since the middle of 1990. This slightly exceeds the rise in claimant unemployment over this period, suggesting that some employees have left the labour market completely. A similar pattern was observed at the time of the last recession. The decline in employment has been widespread, with our estimates suggesting that some 400,000 jobs have disappeared in the manufacturing sector since mid 1990, with a further 375,000 jobs being lost in distribution and business services. Our forecast implies that the recovery is unlikely to gain sufficient momentum to prevent a further rise in unemployment in 1992 to around 2-8 million by the year end.

As we argued in the August Review, the severity of the labour shakeout is likely to stem from the continued over-optimism of output expectations well into 1990, with firms retaining employees in the belief that skilled labour shortages would persist. With employment falling faster than output over the last year, some limited improvements in productivity were made in the second half of the year. We expect these to continue into this year, with whole economy productivity possibly rising by around 3 per cent over the year as a whole.

Average earnings (Table 2)

Average earnings growth has continued to fall from a peak of 10-25 per cent in the middle of 1990 to 7-5 per cent in November of last year, with a decline in both settlement levels and wage drift. The latest figures from the CBI Pay Databank suggest that manufacturing settlements averaged 4-1 in the last quarter of 1991, implying a small rise in real pre-tax wages over the course of 1992. The fall in wage drift is primarily due to a decline in the number of hours of overtime worked, although this may have been temporarily halted by Sunday bonus payments in the retail sector around Christmas.

Our forecast implies a sizeable fall in the level of average earnings in the first half of 1992 to around 6.5 per cent, with a large number of settlements around 9 per cent from the early part of 1991 dropping out of the figures. Wage settlements in the service and public sectors may hold up the overall figure, with the government accepting pay review body recommendations averaging about 6-5 per cent for many public sector workers.

The anticipated cut in income tax may give enhanced scope for further falls in wage settlements as smaller rises will be required to maintain existing post-tax real incomes. Indeed the tax and price index rose by 3-6 percent in the last quarter of 1991, some 0.6 per cent below retail price inflation. Settlements may be held up if the rate of consumer price inflation is used in bargains rather than retail prices. A further boost to real wages may result from continued improvements in productivity, with whole economy productivity forecast to rise by 3 per cent over 1992.

Costs and prices (Table 9)

With productivity beginning to rise in the latter part of 1991 and a continued moderation in settlement levels, unit labour cost inflation has recently fallen sharply. We expect that costs will continue behave counter-cyclically in 1992, with the year on year increase in whole economy costs being around 3 per cent. The balance of respondents in the CBI survey expecting a rise in costs over the coming four months was unchanged from that in October and lower than at any time since 1986.

Cost pressures in the manufacturing sector are also being eased by falls in the prices of bought in materials and fuels, with the seasonally adjusted input price index falling by 1 per cent over the year to December, helped by the appreciation in sterling against the dollar in the last quarter of 1991 and weak commodity prices in world markets. Our forecast assumes that oil prices average 19-5 per barrel over the course of 1992.

With demand weak, producer output price inflation is failing rapidly, with the rise in prices over the year to january being 3.1 per cent, the lowest rate of increase since 1969. It seems unlikely that many firms attempted to raise their list prices in the first weeks of this year.

The fall in manufacturing output price inflation will help to squeeze retail price inflation and we expect that the headline rate may fall below 3-5 per cent by the year end, although progress in the early part of the year may be limited by the slow pace of mortgage rate reductions and an assumed 7.2 per cent increase in community charge payments. Consumer prices should also rise more slowly over the course of the year, with demand remaining weak. A sharp slow down can be expected in the second half of the year as the effects of the VAT rise drop out of the figures.

The easing in the underlying inflation rate is projected to continue on into 1993, with both the price of imported goods and unit labour costs rising by around 3.5 per cent over the course of the year. The constraints imposed by membership of the ERM should ensure that prices remain subdued, although this necessarily rests on the assumption that costs in the non-traded and public sectors continue to move in line with those in the manufacturing sector.

Public sector finances (Table 11)

Our latest projections imply that the public sector borrowing requirement will be around L11-7 billion in 1991/2 and L22-2 billion in 1992/3, or some 3.5 per cent of money GDP. These projections are slightly higher than our previous estimates, reflecting the durability of the recession, the assumed income tax cut and the recently announced pay awards for the public sector. The deterioration over recent years reflects the operation of automatic stabilisers, notably transfer payments, and the decline in the rate of growth of tax revenues, especially from the corporate sector.

In the medium term the present forecast implies that the deficit will exceed 3 per cent of GDP in both 1993 and 1994, yielding little scope for either additional tax cuts or discretionary expenditure.

Part Three. The Initial Macrocconomic Impact of a Labour Government

The UK forecast described in Parts 1 and 2 of this chapter was constructed under the conventional assumption of an unchanged administration. However it is likely that a Labour administration would make a quite different Budget judgement to the Conservatives should it win the forthcoming election. This section considers the short-term impact of the main macroeconomic measures that a Labour government might announce in its first two Budgets, concentrating on the firm commitments made regarding taxation and expenditure. The analysis serves to complement that published in the Review in November 1990, which concentrated on the medium term impact of Labour's supply side policies.

The main proposals analysed in this section are the well publicised changes to higher rate taxation and benefits. We also consider the additional expenditure that might prove possible should the assumed cut in the basic rate of income tax be reversed and look at the likely short-term impact of both the proposed minimum wage legislation and an illustrative temporary change in investment allowances. Other possible macroeconomic measures such as the introduction of a National Economic Assessment and extension of National Insurance to investment income are not considered in this study.

Underlying this analysis is the assumption that a Labour government remains committed to eventual European Monetary Union and that the nominal exchange rate and interest rates remain fixed at their values in the main forecast. It is possible that a change of administration could require a temporary change in interest rates to maintain credibility, but it is difficult to obtain a precise estimate of such effects should they occur.

Firm commitments

The primary expenditure commitment made by the Labour party is to increase the level of benefits, with the real value of child benefit being restored to the 1987 level and retirement pensions being raised by E5 a week for a single person and L8 per week for a married couple. In addition there is a pledge that in the future pensions would be uprated in line with earnings or prices, whichever was the higher. The likely cost of these proposals is thought to be around L3.2 billion in the first full year, although some of this may be recouped as approximately two fifths of current grant recipients are taxpayers. (A detailed analysis of current grants was given in a variant in the UK forecast chapter in last August's Review).

The additional expenditure will be financed by changes in the structure of taxation, with a new higher rate band being introduced in the income tax schedule and the abolition of the upper earnings limit (UEL) for employees' National Insurance contributions. Over a full year the National Insurance changes may raise around L3 billion, while the income tax changes may yield an additional L1.2 billion. Greater detail on the impact of these tax changes is provided in Davies et al. (1992). We assume that the extra net L1 billion raised by this tax-benefit package is used to finance an additional expenditure package, with extra expenditure on training schemes, a temporary work programme and regional development grants. We assume that an additional 130,000 places would eventually be created on the Employment Training Scheme and a new scheme not unlike the old Community Programme, with most of the extra trainees coming directly from the claimant unemployed.

On top of this current expenditure, there is an additional commitment to allow local authorities to use the funds they have accumulated from council house sales to finance an expanded programme of housing construction. In a full year this may generate an additional L1 billion worth of investment expenditures. We have treated this as an addition to the the Public Sector Borrowing Requirement (PSBR), although there has been some recent speculation as to the appropriate accounting classification of such expenditure. Other changes to taxes and expenditure The UK forecast described in this Chapter assumes that the basic rate of income tax will be cut in the forthcoming Budget. The Labour party has spoken of reversing such a cut on assumption of office, but not necessarily a tax cut made by means of changes to personal allowances. Below we assume that the basic rate cut is reversed, yielding an extra L2 billion of revenue in 1992/93. Our illustrations assume that this revenue is used to raise public expenditure, with additional spending on current consumption, industrial subsidies and capital grants.

The breakdown of the tax and expenditure package we examine is shown in Table 1. Over the first year the package results in little change to borrowing, although this hides the likelihood that there will in fact be a reduction in borrowing in the first half of the fiscal year. Although the tax changes and benefit changes are likely to be announced simultaneously in the first Budget, we assume that only the income tax changes and the expansion in the Employment Training Programme come into full effect immediately. Other expenditure may require more extensive legislative changes and we therefore assume that most programmes feed through in the last quarter of 1992, along with the National Insurance changes and the benefit upratings. In the fiscal year 1993/94, the programme implies a small ex-ante increase in net expenditure of some E500 million or so, with the additional expenditure on housing investment possibly being offset by some reduction in benefits as the level of unemployment is lowered by the training programmes. Such flowbacks and time limitations on other additional expenditures could permit the higher rate tax increases to be phased in over several budgets if a small rise in the PSBR were to be allowed.

The Macroeconomic Impact

Analysis of the overall macroeconomic impact of this programme in the short-term is hampered by the uncertainty over the extent to which the introduction of the higher rate tax band and the abolition of the National Insurance UEL will affect the wage bargaining process. The cross-country results in OECD (1990) suggest that tax changes do not have a permanent impact on wage levels, although significant short-run effects exist in some countries. In contrast Church et al (1991) report that many of the main UK macroeconomic models, including that of the Institute, typically contain an important long-run role for at least some elements of taxation in their wage equations.

The recently estimated earnings equation in the Institute model treats all increases in direct taxation as leading to a high degree of real wage resistance, with employees attempting to restore their post-tax real consumption wage. The model imposes the property that changes to direct taxes financed by a change in the overall mix of taxation have little impact on wage bargains. However this is not the case for the changes in tax and expenditure proposed by the Labour party, with much of the additional expenditure going to people who are absent from the mainstream labour market and who exercise little influence over collective wage bargains.

Moreover, it is possible that changes to the top marginal rate of tax will have a delayed impact on wage bargaining, with managerial pay structures typically having closer links to company performance than pay lower down the earnings distribution. In addition, some of the revenue raised from the top rate of income tax will consist of tax on investment income.

To illustrate the importance of this issue we consider the impact of the proposed tax and expenditure package under two alternative wage bargaining structures. In the first, summarised as Case A in Table 2, the rises in the top marginal tax rate are allowed to have an immediate knock-on effect on the level of pre-tax earnings. In the second, summarised as Case B, the direct tax effects from the higher rate tax changes in the earnings equation are switched out. (The impact of the reversal of the basic rate cut is retained.) All figures give changes from our main forecast. The results should not be regarded as indicative of the longer-term impact of Labour's programme since this is likely to depend on a number of additional micro-economic reforms aimed at the supply side of the economy.

The key difference between the two cases considered in Table 2 is the considerably smaller increase in inflation in Case B, with inflation only rising by around -4 per cent by the end of the first year and 1 per cent by the end of the second. In Case A inflation rises by some -7 per cent after one year and 2 per cent after two, although this results from the impact of the higher level of activity as well as from the impact of the tax changes on wage bargains. The smaller impact on wage levels that results from the basic rate rise alone reflects the fact that considerably more money's being raised from the higher rate tax changes than from the reversal of the cut in the basic rate.

In other respects the outcome under Case A and Case B is fairly similar, with the impact of the tax and expenditure changes adding a little to the level of output and unemployment being reduced by close to 200,000 by the end of the second year, primarily because of the special employment measures. The higher level of activity helps to put upward pressures on pay and prices. The PSBR is reduced over the first six months due to the early introduction of the income tax changes, but thereafter is raised, possibly by some;60-5 billion in the second year in Case A. Much of the additional expenditure leaks into imports, with the current account deficit rising throughout the period.

It is possible that the model could underestimate the expansion in domestic output as the expenditure patterns of the retired population differ from those of the average household, with a higher marginal propensity to consume and a lower propensity to import.

One additional feature of interest is the likely impact of the commitment to uprate some proportion of current grants in line with earnings. (Here we assume that 50 per cent of grants are uprated with earnings and 50 per cent with retail prices). As we commented in our earlier analysis of Labour policies this commitment is likely to act as a check on the ability of a Labour administration to expand expenditure in other areas. When the Case A simulation was re-run with all current grants uprated by prices the PSBR was reduced by L100 million in the second fiscal year.

The Minimum Wage

A further important aspect of Labour's proposed programme is the commitment to introduce a legal national minimum wage (NMW), starting at a point equivalent to 50 per cent of median male hourly earnings including overtime). Our earlier estimates, described in Annex B of the November 1990 article, suggested that the initial impact of the legislation would be to raise real earnings by 1 per cent, although this might not occur immediately due to problems with enforcement. Thereafter it was argued that there would be a gradual restoration of differentials, with the 'knock-on' effect possibly rising to 60 per cent, in line with the estimates of Neuberger (1984). Here we continue to assume a similar degree of knock-on, but that enforcement is only 80 per cent successful.

The timing of any announcement of the legislation required for a minimum wage is also likely to prove of considerable importance, particularly if wage bargainers are forward-looking (as in the Institute model). In such a situation earnings may well rise before the legislation comes into force, with workers taking early action in an attempt to maintain existing differentials over the future. As detailed in the Nov 1990 review the initial effect of introducing a NMW is primarily felt in wages and earnings with little or no effect on output or unemployment.

This is illustrated in Table 3 which reports the short-term effects from the introduction of the minimum wage in the second quarter of 1993. We assume that this is announced at the time of the first Labour Budget in 1992. The effect of this pre-announcement is to raise the level of earnings by around 1/2 per cent before the legislation comes into force.

The only other noteworthy impact of a NMW over this time horizon is that it generates small net inflows of revenue to the exchequer and has little immediate impact on employment, with the higher level of activity proving sufficient to bring a tiny initial fall in unemployment. In the medium term employment might be reduced by around 150,000, in line with the projections shown in the November 1990 Review.

Investment Incentives

Recent Labour Party documents have also raised the possibility of introducing a temporary scheme to encourage investment by raising depreciation allowances on plant and machinery investment. We have not included this measure in the main package as the proposed time-scale and scope of such a scheme remain unclear. However we feel it is worthwhile to examine a hypothetical scheme whereby temporary 100 per cent capital allowances are introduced for the first year of a Labour administration.

In the long-run such a measure is fiscally neutral. At present firms can write-off 25 per cent of the value of their investment each year on a declining balance basis. Raising the allowance to 100 per cent allows the tax savings to be front-end loaded by permitting companies to set the entire value of their investment in a given tax year against the value of their profits. The tax foregone is recouped in future years as firms have exhausted their entitlement to allowances. A recent study by Young (1992) suggests that impact of a temporary one year scheme limited to manufacturing investment alone will raise the volume of manufacturing investment by some 7 per cent in the latter half of the year as firms bring forward planned investments. A somewhat greater estimate is given by Bond et al. (1992).

If such a scheme is introduced in the first Labour budget it will not affect the PSBR until 1993/94 as firms are only liable to pay corporation tax some 9 months after the end of their financial year. Thus the earliest possible effect would come in 1993Q2, with a fall in the tax paid by firms whose financial year ended in June 1992. Using the value of manufacturing investment in the forecast base and taking the estimates of the additional level of investment from Young (1992), we calculate that the impact of a one year temporary 100 per cent allowance scheme for plant and machinery in manufacturing would be to raise the PSBR by some f2.5 billion in 1993/94 and a further 4200-250 million in 1994/95. Thereafter the PSBR is reduced, possibly by L700 million in 1995/96, with further falls in subsequent years.

The wider macroeconomic impact of the investment allowance appears to be somewhat limited, with output only rising by 0.1 per cent after one year and little change in either inflation or the current account deficit.

Conclusions

The economic policy changes to which the Labour Party is firmly committed are primarily intended to redistribute incomes and to promote economic growth iD the medium term. The short-term macroeconomic impact of their immediate changes to taxes and expenditure is somewhat limited, with the overall picture being one of broad continuity rather than dramatic change. Output is likely to be around 1/2-1 per cent higher under the combined effects of the policies considered, with unemployment some 200,000 lower after two years, largely due to the special training programmes.

The key question concerns the impact that Labour's policies have on wage bargains, with both the tax reforms and the national minimum wage placing upward pressure on earnings. in turn this may lead to greater reliance being placed on the proposed National Economic Assessment as a means of reinforcing the required level of downward pressure on pay settlements that is required if the UK is to adjust towards a sustainable relationship with the main European economies within the framework provided by a commitment to eventual monetary union.

REFERENCES

Bond, S., Denny, K. and Devereux, M., (1992), 'Investment and the role of tax incentives', paper presented at NIESR conference on

Private investment as a policy objective'. Church, K., Mitchell, P., Turner, D., Wallis, K., and Whitley, J., (1991), Comparative properties of models of the UK economy',

National Institute Economic Review, no. 13 7. Davies, G., Dilnot, A., Walton, D. and Whitehouse, E. (1992), Tax options for 1992, The Green Budget', Institute for Fiscal

Studies, Commentary no. 28. Neuberger, H., 1984),'From the dole queue to the sweatshop', London, Low Pay Unit. OECD (1990), 'Employer versus employee taxation: the impact on employment', OECD Employment Outlook, july 1990,

Chapter 6. Young G. (1992), 'Industrial investment and economic policy', paper presented at NIESR conference on Private investment as a

policy objective'.
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Author:Pain, Nigel
Publication:National Institute Economic Review
Date:Feb 1, 1992
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