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The UK economy.

Section I. Recent Developments and Summary of the Forecast

The economic recovery in the UK is continuing to progress, with provisional estimates suggesting that the level of non-oil GDP in the first half of the year was over 1 per cent higher than in the second half of last year. It is likely that the recovery will gain momentum over the coming months, giving calendar year growth of 2 per cent, with the stimulus provided by the relaxation in monetary policy since last Autumn continuing to support activity and underpin investment and employment. However we anticipate that the growth rate may begin to slow by the middle of next year with the impact of the recent interest rate cuts beginning to dissipate and tighter fiscal policy acting to constrain the growth of domestic incomes and expenditure.

Recent activity and labour market indicators suggest that the recovery became more firmly based in the second quarter of this year, with unemployment continuing to decline throughout the country and both the service and manufacturing sectors recording further growth. The expansion in activity is led by manufacturing industry, where output in the three months to May was some 2 per cent higher than in the previous three months and 3 per cent above the levels of a year ago. Retail sales and car registration data suggest that the volume of consumers' expenditure has continued to expand, with the level of sales in the second quarter some 3 1/2 higher than a year earlier. The property market has also continued to stabilise after the downturns experienced during the recession, with house prices rising by some 1 1/4 per cent in the second quarter, commercial property values rising in June for the first time in 3 1/2 years and housing starts in the first half of the year some 24 per cent higher than in the second half of 1992. Vacancies have also risen this year, although as Chart 1 illustrates, they remain well below their pre-recession level.

Doubts continue to be expressed about the likely durability of the recovery this year. One notable feature of recent business surveys by both the CBI and the Chambers of Commerce is that confidence has not risen by as much as might be expected given recent trends in activity, even after allowing for normal seasonal fluctuations. This appears to stem primarily from concern about the state of demand in foreign markets, particularly in the EC. The statisticians best guess for trade in the first quarter of this year shows an increase over the previous quarter of 1.4 per cent in the total volume of exported goods from the UK. However, as we show in Box B below, this rise is more than accounted for by sales outside the main EC market, with the volume of exports of goods to the EC (excluding oil and erratics) estimated to have fallen by 3 per cent. The weak state of trade in the EC has been accompanied by a recent appreciation of sterling against the main European currencies. (At the time of writing sterling had appreciated by some 10 per cent against the D-Mark from the low point of DM2.33 reached in February this year). With domestic producer prices continuing to rise more rapidly than prices elsewhere, particularly within Europe, further appreciation in sterling could easily reverse the new-found competitiveness of much of British industry.

Considerable uncertainty remains over the future course of domestic inflation. Whilst import prices have risen much as expected in the immediate aftermath of the sterling depreciation, this has as yet had little noticeable impact on domestic prices, suggesting that the higher import costs have been offset by declines in unit labour costs, particularly in the retail sector or absorbed in profit margins. The weakness of final prices is apparent from the GDP deflator, which in the first quarter was some 1.9 per cent higher than a year earlier, after falling in the fourth quarter.

Retail price inflation has also remained subdued, with the June rate of 1.2 per cent being the lowest since 1964. This primarily reflects a combination of a large fall in mortgage costs, continuing pressure on retail margins and the switch from the poll tax to the council tax, the latter accounting for a fall of some 0.7 per cent in annual underlying inflation in April. In the long-run there is a limit to which these factors can postpone inflationary pressures. At present the best guide to underlying inflation is probably the RPI excluding all housing costs, which averaged some 3 per cent in the second quarter, a little below the rise of 3.4 per cent we anticipate in the consumers' expenditure deflator once housing costs are excluded. In the short-term continuing restraint in inflation would probably be symptomatic of weaknesses in domestic demand.

The surprise fall in unemployment at the start of the year has continued in recent months, with the claimant count falling by an average of 16,000 per month since January. As we suggested in the last Review there appears to be more to this reduction than just a change in the behaviour of the Employment Service. However it is still not possible to fully account for the turnaround as there remains little hard evidence of any recovery in employment levels, although a balance of firms in both the service and manufacturing sectors in the latest Chambers of Commerce survey indicate that they plan to raise employment in the third quarter.

The improvement in unemployment is likely to have an significant effect on household expectations. One factor behind the rise in the savings ratio of the personal sector over the course of the recession may well have been a rise in precautionary savings following revisions to the expected future level (and volatility) of incomes from employment. The decline in the unemployment rate can be expected to induce some downward adjustment in the level of savings.

Our latest research into consumption, discussed further in the Appendix to this chapter, also indicates that the stabilisation of real house prices will help to support expenditure. Chart 2 indicates that the decline in the real value of the net housing assets held by the personal sector that begun in 1989 has recently come to an end, with net housing assets over 30 per cent below their peak in 1989 in real terms. The impact of this decline on the overall balance sheet of the personal sector has been offset by the relative buoyancy of net non-housing financial wealth, with higher equity and bond prices and the increased sterling value of foreign currency assets forecast to raise the real value of assets held in financial institutions by over 10 per cent this year. However it may be some time before the full effect of these changes appears in the actual figures for consumers' expenditure. (The short-term prospects for the housing market are discussed in Box A below.)

Policy assumptions

The level of sterling at the time of writing is some 3 per cent higher than projected in our previous forecast. It seems likely that the appreciation in sterling since the middle of the year reflects the difference in the underlying economic cycle in the UK and continental Europe, since there has been little change in the bilateral sterling-dollar rate. UK short-term interest rates have remained unchanged since January. The prospects for further significant cuts depend upon both the likelihood of significant reductions in European interest rates and the policy stance adopted in the November Budget.

In common with bond yields elsewhere, long-term interest rates in the UK have fallen by around 1/2 to 3/4 of a percentage point over the last three months, with the extent of disinflationary pressures in the domestic economy becoming apparent and signs appearing that the economic recovery, and consequently tax revenues, in the UK might be more robust than the authorities anticipated at the time of the Budget.

Future inflation expectations as measured by the different yields between conventional and index-liked gilts have fallen by around 0.5 per cent to 4 1/2 per cent, a level close to that prevailing prior to the sterling depreciation last September.

At present it appears likely that the November Budget will contain further rises in net taxation, primarily to reassure the financial markets that the government is determined to correct the present imbalances in the public finances. We assume that indirect taxes will be raised by some |pounds~2.5 billion (0.4 per cent of GDP), although the actual policy changes could involve some highly political calculations. A further tightening of fiscal policy is likely to be accompanied by some relaxation in monetary policy and thus we assume that interest rates will be reduced by 1/2 a percentage point at that time. However there remains some danger that such a cut will have to be reversed in the early part of next year, with underlying inflation forecast to move above the top of the official target range.

We continue to project slightly smaller deficits than anticipated in the FSBR, with borrowing forecast to be |pounds~46 billion this year (7.2 per cent of GDP) and |pounds~35.8 in 1994/5 (5.2 per cent of GDP). In the medium term projections shown in Table 12 and discussed in more detail in the separate note on the state of public finances in this Review, the PSBR to GDP ratio settles down at around 2 1/2 per cent by the end of the decade, with the ratio of general government debt to GDP beginning to stabilise at around 50 per cent. In the absence of the tax changes announced at the time of the Budget (plus the additional ones we assume will be announced in November), our present projections suggest that the PSBR/GDP deficit would have been some 1 1/4 per cent higher, a slightly smaller estimate than the Treasury gave in the FSBR. The implicit assumption we make that current grants and tax allowances continue to be uprated in line with inflation rather than earnings growth is an equally important factor in determining the medium term profile of the public finances; again our model suggests that if the uprating factor was based on earnings growth from this year the PSBR/GDP ratio would be some 1 1/4 percentage points higher by 1999.

In judging the sustainability of fiscal policy, attention needs to be paid to both the solvency of the public sector, the ratio of debt to income, as well as to trends within the overall balance sheet of the public sector. The present stance of fiscal policy implies that the ratio of government debt to capital is likely to rise sharply, to levels last seen 25 years ago. Whilst such a development might have been appropriate prior to the exploitation of assets such as North Sea oil, it is less so now, given what is known about future trends in the age structure of the population. The need to reduce the PSBR is presently as pressing as it was in the mid-1970s; the decline in the level of income from the remaining net assets of the public sector reinforces the need to correct the present deficit by taking action to restrain current expenditure and raise tax revenues.

Summary of the Forecast

The present forecast implies that the growth rate of GDP will accelerate in the second half of the year, with output in the fourth quarter some 3 per cent higher than in the fourth quarter of last year. To a large extent this reflects the continuing feed through of the reduction in interest rates and the depreciation of sterling since last September. This can also be expected to support activity in the early months of next year; thereafter the expansion may lose some momentum, with the prospective tax changes announced in the Budget, along with the additional changes we expect in November serving to constrain the growth of real disposable incomes. Overall, we presently anticipate growth of 2.9 per cent next year, with growth slowing to 2 1/2 per cent by the second half of 1994. An indication of the margin of error attached to the forecast is given by the past errors summarised in Table 13.

One difference from our earlier forecasts is that the forecasts for private and public consumption have now been adjusted so as to allow for the transfer of responsibilities for further education and sixth-form colleges from local authorities to the new Further Education Council from of April this year. The effect of this accounting change (worth around |pounds~1 1/2 billion at 1985 prices) will be to add a 1/2 per cent to the growth rate of consumers' expenditure this year and reduce the growth rate of public consumption by some 1 3/4 per cent. This latter reduction is offset by a rise in current (education) grants to the personal sector. If this accounting change is excluded, the forecast would show a rise of 2 per cent in consumers' expenditure this year, some 1/4 per cent higher than our previous projection. If the grant income is all spent as it is received, the savings ratio of the personal sector will be a little lower than would otherwise have been the case.

Total export volumes of goods and services rose by 3.3 per cent in the first quarter and provisional data for non-EC trade indicate a further rise of 7.2 per cent in exports of goods to those markets in the second quarter. TABULAR DATA OMITTED For the year as a whole we expect a rise of over 6 per cent in total export volumes, considerably higher than the forecast rise in UK-weighted world trade of 1 1/4 per cent. In fact the downward revisions made to world trade growth since the May forecast have made little difference to the prospects for exports in the remainder of the year. They largely reflect the deterioration in continental European markets in the early part of the year, making the overall UK export performance at that time appear even more creditable.

Export growth in the first quarter was also boosted by a rise of 11 1/2 per cent in exports of services, with insurance earnings returning to more normal levels after the higher level of claims in the second half of 1992 (following hurricane Andrew). The present forecast allows the higher level of the first quarter to be maintained throughout the year, although there is considerable uncertainty as to the extent to which claims will rise as a consequence of the flood damage in the American mid-West.

Import growth in recent months has been surprisingly subdued given the large rises in import penetration experienced during the latter part of the recession. Total import volumes rose by 1.9 per cent in the first quarter after a small drop in the fourth quarter of last year. It appears likely that this reflects both the improvement in the competitiveness of domestically produced goods since withdrawal from the ERM and the recent decline in stock levels, with destocking of some |pounds~1.5 billion having occurred since the third quarter of last year. We expect that import growth will pick-up in the latter part of this year, with the stock cycle turning round and domestic demand growth gaining momentum.

Overall, we expect that the competitiveness of UK exports will improve by some 9 1/4 per cent this year, as Chart 3 shows. This improvement is a little smaller than we had previously anticipated, with UK producers having raised profit margins in the early part of this year. Export prices rose by 6 1/2 per cent in the first quarter of the year, close to the rate expected over the year as a whole. One additional consequence of this was that the estimated visible trade deficit for the first quarter was smaller than we had previously anticipated; as a result we have revised down our estimate for the likely current account deficit over the year as a whole to some |pounds~17 billion (2.7 per cent of GDP).

The relatively weak state of the world economy has contributed to the recent weakness of many primary commodity prices, with the forecast level of oil prices in the third quarter of $16 1/2 per barrel some 10 per cent lower than a year ago. This should help to contain input cost pressures in the domestic economy; over the year as a whole the prices of material and fuel inputs may only rise by around 5 per cent, with prices in the fourth quarter little changed from the levels of a year ago.

The recent rise in import prices has been offset by declines in unit labour costs. In the three months to May unit costs fell by 1 per cent to a level 3.6 per cent down on a year ago. This decline has been associated with some large estimated improvements in productivity, with manufacturing productivity rising by around 9 per cent in the first half of the year. We would not expect improvements of this magnitude to be sustained for any length of time. The recession indicated that employment levels had become more flexible than before, with the rate of job losses outstripping the decline in output. It is likely that this effect will be reversed as the economy continues to improve and we expect a small rise in manufacturing employment in the coming months. For the year as a whole we expect economy wide unit labour costs to show little change, with a rise of 2 1/4 per cent next year as wage growth begins to pick up and productivity growth slows. With employment improving and the special employment measures announced in the Budget beginning to come into operation, unemployment is expected to fall further over the coming months, averaging 2.84 in the fourth quarter of this year and 2.80 million next year.

The continuing impact of the recession has also helped to delay the speed at which higher import costs are passed through into final prices. However we do not expect that inflation will fall much further from its present level, and anticipate that producer price inflation (excluding food, drink and tobacco) will rise to 3 per cent by the year end, with consumer price inflation rising to 4 per cent. In contrast to earlier forecasts we now expect underlying retail price inflation to remain within the target range of 1-4 per cent this year, averaging 3.6 per cent in the fourth quarter.

However, we continue to expect that inflation will move outside the target range in the early part of next year, helped by changes in the structure of indirect taxation. The introduction of VAT on household fuel, the over-indexation of petrol duties and the assumption of a 'normal' uprating of the council tax will add close to 1 per cent to the inflation rate. The forecast shows both headline and underlying retail price inflation reaching around 4 1/2 per cent by the middle of next year, with the restriction of mortgage interest tax relief to 20 per cent from next April adding some 0.3 per cent to the headline rate.

Section II. The Forecast in Detail

Personal Sector

The volume of consumers' expenditure rose by 0.5 per cent in the first quarter of the year, to a level 2.3 per cent higher than a year ago. With real personal disposable incomes declining by 0.6 per cent in the quarter the savings ratio fell to 10.3 per cent from 11.3 per cent in the fourth quarter of last year. The recent indications from retail sales (which account for around 40 per cent of total consumption), and changes in the narrow monetary aggregate M0 suggest that consumption has continued to rise further in recent months. The seasonally adjusted figure for car registrations in May showed registrations TABULAR DATA OMITTED 11 per cent higher than a year ago, with total registrations over the period from January some 6 per cent above those in the first five months of 1992. For the year as a whole we expect consumption to rise by around 2 1/2 per cent, with around 1/2 per cent coming from the change in the coverage of the personal sector.

The low level of recent pay settlements is likely to ensure that real incomes show little change over the course of the year. This is often a feature of the early stages of recoveries, with strong productivity growth boosting corporate incomes at the expense of the personal sector. Interest rate spreads have continued to widen in recent months, with average mortgage rates now 2 per cent above base rates, a differential some 1 1/4 percentage points wider than in the middle of last year. As a consequence further declines in the savings ratio are to be expected over the coming months if expenditure continues to strengthen.

At present we do not expect any further acceleration in the growth of consumption from its present level, with growth being held back by the anticipated rises in the tax burden announced in the Budget. The appendix to this chapter discusses the new forward-looking consumption function in the Institute model and illustrates the extent to which the announcement of future tax changes can affect current expenditure.

Investment and Stockbuilding

The changes in capital allowances announced in the Autumn Statement included enhanced first year capital allowances of 40 per cent for investment in plant and machinery undertaken before the end of the present calendar year and an additional allowance of 20 per cent for industrial buildings investment across the same period. The forecast suggests that the overall cost-of-capital in the manufacturing and non-manufacturing sectors will fall to around 9 percentage points by the end of this year, some 4 percentage points below the level prevailing at the onset of the recession. It is to be expected that the extra investment induced by the higher tax allowances will be concentrated in the final quarter of this year. For the year as a whole we expect a rise in investment volumes of 2 1/2 per cent, with manufacturing investment rising by 4 1/2 per cent. Some signs of a future recovery in investment are TABULAR DATA OMITTED provided by the recent pick-up in the production of investment goods, with output rising by 2 3/4 per cent in the three months to May.

For 1994, we expect little change in the volume of public sector investment from the level for this year. However private sector investment is likely to expand further as output recovers and capacity utilisation rises. The latest CBI survey suggests that the proportion of firms expecting capacity to limit output is at the highest level for 2 1/2 years. Overall investment volumes are forecast to rise by a little over 4 1/2 per cent.

Over the past year the total level of investment has been supported by the rise in the level of capital formation by the public sector and the newly privatised public utilities. The volume of public sector investment rose by around 10 per cent in 1992 and there was a further substantial increase of 14 per cent in the first quarter of this year. It is likely that this latter rise was partially due to a desire by many departments to fully spend their budgets before the end of the financial year, with the continuing weakness in the price of investment goods resulting in a greater than usual expansion in the volume of spending. It is probable that the volume of public sector non-residential investment will decline a little in the middle of this year, before rising at the end of the year as work begins on the Jubilee Line project.

Public housing investment may also peak this year, with the Autumn Statement having temporarily relaxed the constraints on the freedom of local authorities to spend receipts generated from the sale of council houses. Capital funding for Housing Associations is also planned to TABULAR DATA OMITTED decline in future years, with the 1992 Autumn Statement having reallocated funds from future expenditure plans to finance the purchase of unoccupied housing stock in the present financial year.

Investment in the water supply sector has been maintained at a high level throughout the recession, primarily through the need to improve water quality, with investment in 1992/3 some 3/4 per cent higher than in 1990/1 at |pounds~3 1/2 billion. Investment in the North Sea doubled from 1989 to |pounds~5.4 billion in 1992. Indications are that the pace of new investments will slow in the energy sector as additional capacity comes on stream.

Stock levels fell sharply in the first quarter of the year by |pounds~0.8 billion, with manufacturing stocks declining by |pounds~0.9 billion as much of the additional foreign demand arising as a consequence of the sterling devaluation was met out of existing stockholdings. It is to be expected that stock levels will begin to stabilise in the latter part of this year, with stocks of work in progress rising as production expands. For the year as a whole we expect the stock-output ratio in manufacturing to decline by 8 per cent; as Chart 4 illustrates, this continues the longer-term decline in the level of stocks.

Elsewhere in the economy there has been little recent change in stock levels, with distribution stocks showing a small rise in the first quarter in spite of the heavy price discounting in the winter sales promotions. The latest CBI Distributive Trades Survey indicates that present stock levels continue to be regarded as excessive by many retailers. Construction stocks are likely to show little change over the year, with a decline in the number of previously unsold completed dwellings being offset by a rise in the stocks of work in progress following the recent pick up in housing starts. Energy stocks remain at relatively high levels. In April coal and petroleum stocks were respectively 8.1 and 2.1 per cent higher than a year ago.

Overall, the forecast shows destocking of |pounds~0.9 billion this year (adding some 0.1 per cent to GDP growth) and additions to stocks of |pounds~1.3 billion in 1994, adding some 0.6 per cent to GDP growth.

The Balance of Payments

The preliminary estimates published in June for total UK trade in the first quarter of the year indicate that the visible trade deficit widened a little to |pounds~4.5 billion, from |pounds~4.35 billion in the fourth quarter, with a deterioration in the balance of both oil and non-oil trade. In volume terms, total exports rose by 1.4 per cent, and imports by 2.1 per cent. The analysis in Box B indicates that export volumes to the EC probably declined in the first quarter, reflecting the sharp downturn in GDP particularly in Germany. It is likely that the overall change in exports in the second quarter will be somewhat smaller than the 5 1/4 per cent rise in exports to non-EC countries.

The first quarter figures for total trade are more provisional than usual. This reflects the changes to the statistical procedures for collecting intra-EC trade following the abolition of requirements for customs declarations associated with the single market programme. Indeed it is possible that data for the early part of the year will never be known with any degree of accuracy. Nonetheless, we have used the provisional national accounts estimates for total trade in the present forecast, with the sectoral allocation of trade being determined by the behavioral equations on our econometric model. The resulting estimates suggest that exports and imports of manufactures rose by 2.3 and 1.2 per cent in the first quarter, with a small fall in exports of food and basic materials.

For the year as a whole we expect total exports to rise by some 6 3/4 per cent, with manufacturing exports improving by some 7 1/2 per cent. Import growth has recently been relatively subdued, but we expect sharper growth in the second half of the year, with a resumption in stockbuilding and further expansion of consumers' expenditure. Much depends on the extent to which the gains in competitiveness achieved in the latter part of last year are maintained.

The invisibles balance in the first quarter was little changed from that of the fourth quarter, with a rise in the net earnings from foreign direct investment in this country offset by an improvement in the balance of trade in services. The total current account deficit was |pounds~4 billion, lower than we had previously anticipated due to a smaller decline in the aggregate terms-of-trade. As a result we now expect a current account deficit for the whole of this year of some |pounds~17 billion (2.7 per cent of GDP).



Output and Employment

Provisional figures indicate that all sectors of the economy, with the exception of construction, have begun to recover this year. Service sector output rose by 0.7 per cent in the first quarter and 0.5 per cent in the second, taking output to a level 1 1/2 per cent above that of a year ago. The recovery has been led by the manufacturing sector, with output in May some 4.7 per cent higher than a year earlier, with new demand increasingly being met by new production after the sizable rundown in existing stockholdings around the turn of the year. For the year as a whole we presently expect manufacturing output to rise by around 4 per cent, with a further rise of 2.4 per cent projected for next year.

One potential difficulty with estimating value added output at the present time lies in distinguishing between gross and net output. Movements in the former are often used as the basis for estimating movements in the latter category, the basis for the National Accounts. Statistical problems with this procedure can arise at times when the gross/net ratio changes substantially, such as when there is a marked change in the relative price of production inputs. Manufacturing input prices rose by 7.8 per cent in TABULAR DATA OMITTED the year to June. Thus it is possible that the most recent estimates for output could be overstating the true changes in value added output. However there is little significant evidence for this at the present time, with the implied residual discrepancy between the output and expenditure estimates of GDP in the first quarter being little different to that immediately prior to the depreciation of sterling.

The forecast continues to show a rise of 2 per cent in both non-oil and whole economy GDP this year. Oil output was depressed in the first half of the year, reflecting both the relatively high level of petroleum stocks and renewed maintenance programme work, but is expected to rise in the second half of the year, with production beginning in a number of new fields. In the medium-term the projections show oil output rising toward the mid-point of the 'Brown Book' range.

As yet there are few signs of any significant turnaround in employment. However the provisional employment numbers are notoriously subject to revision; the combination of high productivity growth and falling unemployment suggests that employment may presently be underestimated. This is particularly so at a time when the TABULAR DATA OMITTED indications from business surveys suggest that employment prospects are brightest in smaller firms. In the latest CBI Industrial Trends Survey only the small sized firms with less than 200 staff anticipate some future job rises.

The present forecast shows total employment beginning to recover from the middle of this year and rising by 0.6 per cent in 1994. Over the course of next year the prospective fall in unemployment may well be smaller than the forecast increase in employment, with a number of 'discouraged workers' re-entering the active labour force.

Wages and Prices

The latest figures for pay settlements indicate that pay pressures have continued to moderate over the course of the year, with the Industrial Relations Service estimating that average settlements in the three months to June were close to 2 per cent, partially as a result of the imposition of the 1 1/2 per cent basic pay ceiling in many parts of the public sector. The total growth in earnings per head is likely to be more rapid, both because of wage drift and because the higher pay settlements reached last Autumn remain in the annualised figures.

The overall growth in average earnings we project this year and next has been revised down from our previous forecasts to 3.4 and 4.9 per cent, largely reflecting the increasing evidence of subdued inflationary pressures within the economy. The present level of settlements, together with the prospective changes to indirect and direct taxation announced in the Budget, implies that there may be a small decline in real take-home pay in the early months of next year, with retail price inflation rising to around 4 1/2 per cent by the middle of the year.

Thereafter it would not be surprising to see some attempts to restore the real value of take-home pay, particularly with the assumed relaxation of controls on TABULAR DATA OMITTED public-sector pay and continuing falls in unemployment. Although the forecast makes the technical assumption that from 1994 public sector pay rises in line with that in the private sector, a number of public sector groups, such as MP's and firefighters have already received some indication that previous differentials might be restored.

As we have commented before, there are an increasing number of factors which serve to drive a wedge between basic pay settlements and changes in post-tax earnings. In the past overtime payments have accounted for much of the difference between the two. Over the course of the recession measures such as merit pay, pay freezes and profit related pay have become more important. Around 1 million employees were part of profit-related pay schemes at the end of 1992, and a number of larger companies have begun new schemes in the early part of this year. Use of such schemes offers companies a means of raising take-home pay, without changing employment or reducing profits, since profit-related pay is paid without deduction of tax (up to a certain threshold). In principle such schemes can lead to gross pay reductions but higher net salaries. The increased prevalence of such schemes is likely to be one factor behind the relative weakness of income tax receipts at the present time and may increasingly help to restrict the growth of unit labour costs.

Public Finances

The PSBR in the first three months of the present fiscal year totalled |pounds~13.9 billion, some |pounds~2 1/2 billion higher than a year earlier. We continue to expect that total borrowing this year and next at |pounds~46 billion (7.2 per cent of GDP) and |pounds~35.8 billion (5.2 per cent of GDP) will be somewhat smaller than the estimate made in the March Budget. Our implied expenditure estimates are close to those contained in the official projections, suggesting that differences in the estimate of prospective tax revenues account for the improved outlook for the public finances in the present forecast. A more extensive analysis is given in the separate note in this Review on the state of the public finances.

In part the more optimistic short-term outlook in our forecast stems from the policy assumption that additional net tax increases will be introduced in the November Budget. However we have also made a change to our corporate tax model which generates higher revenue TABULAR DATA OMITTED in the early stages of the economic recovery. A recent change to corporate tax legislation has allowed companies to extend the period in which current tax losses may be set against past profits. This has effectively reduced both current tax payments (with some companies having past payments refunded) and the stock of losses to be carried forward, thereby raising future tax payments. This increases the expected cyclicality of tax revenues. As a result revenues are higher by some |pounds~2.5 billion in 1994/5 and |pounds~6 billion in 1995/6 than in our previous forecast.




Appendix: What if consumers are forward-looking? by Peter Westaway and Nigel Pain

In the March 1993 Budget not only were tax increases announced for the forthcoming fiscal year, but more unusually, a series of prospective measures were set in place for 1994-95 onwards. The motivation for advertising this fiscal stringency in advance was to allay the fears of the financial markets that the Major administration was not serious about tackling the public sector deficit. To achieve solvency, it was argued, fiscal tightening was required not only in the current year but for a number of years ahead. It was believed that this pre-announced but gradualist approach to reining back the deficit was preferrable to a more severe but instant contraction since the latter would run the risk of stalling the nascent recovery in its tracks.

This strategy was widely agreed to be one of the attractive features of the 1993 budget, since it seemed to combine short term discretion with longer term prudence. Yet the success of such a strategy is dependent upon a particular view of how the economy operates since it assumes that whilst financial markets will immediately reflect the effects of the announced future tax changes, the pattern of consumer spending will not. Although this view may be consistent with the macroeconomic model maintained by the Treasury (see HM Treasury, 1992, for example), it may not necessarily be true for the UK economy. Nor is it true for the National Institute model which embodies anticipatory behaviour not only in financial asset prices (gilts, foreign exchange and equity prices) but also in wage and price setting behaviour and in the decision making of firms. An important additional factor in the most recent version of our domestic econometric model is the incorporation of forward-looking expectations in our model of personal sector behaviour, affecting both consumer spending decisions and demand and supply in the housing market (see NIESR, 1993 and Box A in this chapter).

Most theoretical models of consumer behaviour assume that individuals will base their spending decisions on a forward-looking assessment of their total expected lifetime stream of earnings, borrowing in their younger years to increase their spending, paying back the debt and saving later in their careers when incomes are higher. Certain consumers are likely to be constrained in their ability to borrow, and for them consumption growth will more closely match that of their income. Expectational considerations will be less important. Whatever the proportion of credit constrained consumers, long run aggregate consumption behaviour will be characterised by a tendency towards a constant consumption to income ratio and a constant (or slowly trending) ratio between wealth and income; for details of the micro-to-macro model which confirms these results, see Westaway (1992a). When credit conditions ease, due, for example, to financial liberalisation as occurred in the UK during the 1980s, then the equilibrium wealth to income ratio should fall and debt income ratios should rise.

These long-run properties are normally captured in the type of consumption equation used in most macroeconomic models. Much recent research effort has been aimed at finding adequate proxies for the effects of financial liberalisation. Rather less effort has been channelled into building in forward-looking behaviour. Blake and Westaway (1993) extend the conventional 'error correction' type of consumption function so that the adjustment path towards the long run equilibrium is affected by expectations of future income developments and by future changes in interest rates or wealth. Of course, this has a significant policy implication since any policy which announces future tax increases on the assumption that consumers will ignore them may be misguided.

Ultimately, the significance of this anticipatory effect is an empirical question; econometric details of the equation are described in Blake and Westaway (1993). Below, we illustrate the implications of building in forward-looking behaviour by simulating the effects of a stylised fiscal tightening, a 2 per cent permanent increase in the income tax rate, which is assumed to take effect one year after it is announced. The effects are compared with those implied by a more conventional specification which is designed to have approximately the same long run properties. In both simulations exchange rates are held fixed.

Chart A2 shows the effect on consumer spending over the first three years of the simulation. With the non-anticipatory specification, consumption hardly moves in the first year until the tax increase is actually implemented (there is a very small movement due to the anticipatory effect on prices). By contrast, the forward-looking specification shows a fall in consumption of some 0.4 per cent in advance of the actual tax rise. After three years, the conventional specification still lags behind but has made up some three quarters of the gap. Table A1 gives more details of the simulation comparison, showing the short run effects for GDP and inflation, and also the more medium term implications.

It is important to note that the long run implications are identical by construction, showing a long run fall in consumer spending of just over 2 per cent after approximately five years. Two further points are worthy of emphasis; first, the forward-looking model does not display the instantaneous adjustment which occurs in many stylised rational expectations models, since the forward-looking behaviour arises precisely because consumers are assumed to be trading off their desired consumption to income ratio against their desired wealth to income ratio. Second, the simulations just described assume that the announced tax increase is completely credible. In practice, it may be more realistic to assume that consumers give only partial weight to the announcement of future policy. If so, the true simulation response should lie somewhere between the two shown; a more formal approach to the evolution of beliefs about future policy is given in Westaway (1992b).
Table A1.
changes are per cent differences from base unless otherwise

 Consumption Real GDP Consumer prices

Quarter 4 -0.83 -0.41 -0.05 -0.23 -0.02 -0.15
Quarter 8 -0.66 -1.04 -0.39 -0.57 -0.09 -0.34
Quarter 20 -2.00 -2.07 -1.12 -1.11 -0.56 -0.82

Note : BL denotes the simulation with the non-anticipatory
consumption and FL the simulation with the forward-looking


Blake A.P. and Westaway, P.F. (1993), 'Why have UK consumption functions broken down?', National Institute Discussion Paper, New Series no.38.

H.M.Treasury (1992), HM Treasury Macroeconomic Model documentation, Public Model, December.

NIESR (1993), NIDEM: National Institute Domestic Econometric Model, August.

Westaway, P.F. (1992a), 'A simulation model of consumer spending and housing demand', National Institute Discussion Paper, New Series no.15.

Westaway, P.F. (1992b), 'A forward-looking approach to learning in macroeconomic models', National Institute Economic Review, May.

Box A. Modelling the Housing Market

An important factor in any assessment of the strength and durability of the economic recovery is the outlook for the housing market. Nominal house prices fell by close to 15 per cent between 1989 and the end of last year, implying a fall of nearly 30 per cent relative to prices more generally. As a result the latest estimates from the Bank of England suggest that over 1 3/4 million households currently have mortgage debts in excess of their property. In recent months house prices have begun to stabilise (at least in nominal terms), with the Halifax index showing a rise of 1 1/4 per cent in the second quarter of this year. In this box we summarise the updated model of the housing market recently incorporated into our domestic econometric model and discuss the prospects for house prices over the next two years.

The approach adopted in the model is to treat the average aggregate house price as a 'market clearing' price in the medium term. In the short-term the key factor behind any movements in prices is 'housing disequilibrium', the imbalance between long-run housing demand and present housing supply. Housing demand is driven by the expected costs of servicing mortgage debt, trends in owner-occupancy and consumers' expenditure (and therefore indirectly affected by more conventional factors such as disposable income and unemployment). Changes in the real value of housing supply largely depend upon the expected profitability of housebuilding and the expected cost of credit. Both sides of the housing market are considerably affected by changes in expected future real interest rates. Further details are given in NIESR(1993) and Pain and Westaway (1993).

The resulting series for 'housing disequilibrium' is shown in Chart A1; it can be seen that periods when prospective demand exceeds supply (shown as a negative number on the chart) for example the early-1970s and the mid-1980s, have coincided with period of rapid house price inflation. In contrast, supply has exceeded demand throughout the recession. The balance of pressures within the housing market now points to renewed price rises in the medium term, reflecting the recent sharp reduction in interest rates.

This estimate of disequilibrium will not necessarily provide a precise guide to the year-by-year movement in house prices. For example in the mid-1980s the rise in real house prices was somewhat higher than might be inferred from Chart A1, with an additional temporary boost being provided by a change in the average loan-value ratios offered by financial institutions to first-time buyers. At the present time, the immediate recovery in prices is likely to be more subdued than the estimate of disequilibrium would indicate, with repossessed properties and the prevalence of negative equity acting to restrain prices. Nonetheless, it does appear that the gradual reductions in real mortgage interest rates since 1990, together with the revival in consumers' expenditure, has generated conditions which, on the basis of past behaviour, can be expected to eventually lead to rises in real house prices. Our housing model implies that prices will continue to stabilise in the second half of this year, before rising by 5 per cent in 1994 and 7 1/2 per cent in 1995, restoring real prices to their level in the latter half of 1991


NIESR (1993), NIDEM: National Institute Domestic Econometric Model, August 1993.

Pain N. and Westaway P.F. (1993), 'A Prototype System of Equations for the Housing Sector', HM Treasury Academic Panel paper AP(93)9

Box B. The Recent Composition of UK Trade

One notable feature of recent business surveys in the UK has been the relatively sharp decline in the expected outlook for export orders. On the basis of the official statistics for visible trade published so far this year, such a deterioration is somewhat surprising, with total exports in the first quarter some 6.6 per cent higher than a year ago, and exports to non-EC countries in the second quarter some 17 per cent higher than in the equivalent period of 1992.

It is possible that the subdued outlook for export orders is related to the present weakness of the continental European economies. Unfortunately the official statistics for trade only provide a geographical decomposition of export and import values, that is trade at current prices. However, since separate estimates are published for the volume of trade with all regions and for trade outside the EC it is possible to construct separate estimates of both the volume and price (on an average value basis) of trade with the EC. The figures in this box exclude oil and erratics, trade in which tends to be more volatile than trade in other goods, and therefore provide a guide to the recent underlying trading performance with the EC.


These figures indicate the extent to which trade within the EC and outside the EC has diverged since the devaluation of sterling. This largely reflects differences in the underlying volume of exports, with export volumes to the EC falling back in the first quarter of this year. There is little difference between the trade price responses in the different markets up to the first quarter, suggesting that the moderation in prices shown in the non-EC trade data for the second quarter can be expected to be reflected in the eventual data for EC trade. However, the estimates above (and implicitly, the official figures for the first quarter) should be treated with some caution; given the respective price responses, there is little immediate explanation for the apparent divergence between UK imports from within the EC and from outside the EC.
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Title Annotation:includes related articles
Author:Pain, Nigel
Publication:National Institute Economic Review
Date:Aug 1, 1993
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