WHATEVER HAPPENED TO THE GOLDEN LEGACY? THE ECONOMIC BACKGROUND TO THE 2005 BUDGET Ruth Lea THE AUTHOR Ruth Lea is Director of the Centre for Policy Studies. She is on the University of London Council and is a Governor of the London School of Economics. She has served on the Council of the Royal Economic Society, the National Consumer Council, the Nurses’ Pay Review Body, the ONS Statistics Advisory Committee, the ESRC Research Priorities Board and the Retail Prices Advisory Committee. She is the author of many papers including The Price of the Profligate Chancellor: higher taxes to come, The Essential Guide to the EU, Tax ‘n’ Spend: no way to run an economy and Pollyanna, not Prudence: the Chancellor’s finances. She was Head of the Policy Unit at the Institute of Directors (IoD) from 1995 to 2003 before which she was the Economics Editor at ITN, was Chief Economist at Mitsubishi Bank and Chief UK Economist at Lehman Brothers. She also spent 16 years in the Civil Service in the Treasury, the Department of Trade and Industry and the Central Statistical Office. The aim of the Centre for Policy Studies is to develop and promote policies that provide freedom and encouragement for individuals to pursue the aspirations they have for themselves and their families, within the security and obligations of a stable and law-abiding nation. The views expressed in our publications are, however, the sole responsibility of the authors. Contributions are chosen for their value in informing public debate and should not be taken as representing a corporate view of the CPS or of its Directors. The CPS values its independence and does not carry on activities with the intention of affecting public support for any registered political party or for candidates at election, or to influence voters in a referendum. Centre for Policy Studies, March 2005 ISBN No: 1 903219 94 9 Centre for Policy Studies 57 Tufton Street, London SW1P 3QL Tel: 020 7222 4488 Fax: 020 7222 4388 e-mail: [email protected] website: www.cps.org.uk Printed by The Centre for Policy Studies, 57 Tufton Street, SW1. CONTENTS 1. INTRODUCTION AND SUMMARY 1 2. THE POLICY BACKGROUND 9 3. ECONOMIC ANALYSIS 14 4. THE PUBLIC FINANCES 23 ANNEXES CHAPTER ONE INTRODUCTION AND SUMMARY “These are fantastically good figures”, the official concluded. “The state of the economy is much better than predicted.” Eyes swivelled to Brown. “What am I supposed to do with this?” he snarled. “Write a thank-you letter?” Tom Bower, Gordon Brown, HarperCollins, 2004. 1.1 INTRODUCTORY COMMENTS The starting point for this paper is the “fantastically good” economic figures, referred to by the anonymous Treasury official. They represent, without doubt, a true “Golden Legacy” that was handed over from the outgoing Major Government to the Labour Government under Tony Blair in May 1997. There is little doubt that the economy was, at that time, performing very well indeed. The Treasury official was not exaggerating. The question that this paper seeks to answer is how the Labour Government’s eight years of stewardship has affected the performance and health of the economy they inherited from the Conservatives. In order to analyse this question quantitatively, the economy’s performance under the full Major Government (from 1992 to 1997) 1 is compared with that under the Labour Governments (from 1997). For the Major Government, 1992 is taken as the “base” year for calculations, and 1997 is taken as the year the “legacy” was handed over to the Labour Government. 1 For the Labour Government 1997 is taken as the “base” year for calculations, running on to 2004 (or 2003, if 2004 data are unavailable). Annex 1 elaborates on this basic methodology and annex 2 lists some of the main economic events over this period. All the major economic variables are assessed in this paper: economic activity, balance of payments, the labour market, inflation, interest rates and the public finances. The analyses are covered in chapter 3 (for the general economy) and chapter 4 (for the public finances). Doubtless the Chancellor, in his upcoming budget (16 March 2005), will be boasting about the British economy. No one wishes to run the economic performance of this country down and it has performed very creditably over the last 12 to 13 years. But the British economy’s performance under Labour should be qualified in at least two respects. Firstly, the Labour Government was fortunate to inherit a “Golden Legacy” from the Major Government in 1997, not that the Chancellor has ever had the courtesy to acknowledge this. On the contrary, he is keen to inform the electorate that he has transformed the economy since 1997; and he likes to give the impression that the country was floundering in a swamp of economic chaos prior to 1997. Nothing could have been further from the truth. And, secondly, the economy is not currently performing as well as it did when it was under the Major Government. This is because the current Government’s policies have hindered rather than helped business and have undermined competitiveness. And when the Chancellor refers to the fact that the economy has technically grown every year since 1991, it is worth remembering that for the first 5½ years of this period there was a Conservative Government. A final point to make: the official above made the point that the state of the economy was “much better than predicted”. It is instructive to note the degree to which this was the case. The July 1997 Financial Statement and Budget Report (FSBR) 2 contains a table outlining the changes to the PSBR forecast between the November 1996 budget and the July1997 budget. The main data are shown on the next page. 2 CHANGES TO THE PSBR FORECAST (£BN) BETWEEN NOVEMBER 1996 AND JULY 1997 FY1997 FY1998 PSBR in November 1996 budget 19.2 12.2 Effects of: Changes in assumptions & LA capital receipts initiative 0.8 3.9 Forecasting changes (including higher corporation tax -3.3 -6.7 revenue, and beneficial effects on revenue of higher money GDP*) Budget tax changes (including the effect of the -3.4 -4.1 removal of the tax credit on dividend payments) PSBR in July 1997 budget, excluding the windfall tax 13.3 5.4 and associated spending Net effect of windfall tax and welfare to work -2.4 -1.4 spending PSBR in July 1997 budget, including the windfall 10.9 4.0 tax and associated spending Source: HM Treasury, Equipping Britain for our long-term future, FSBR, July1997, HC85. For the definition of the PSBR, see annex 3, the glossary. * The forecasts in July 1997 for money GDP were £752bn for 1996 and £798bn for 1997. The equivalent forecasts in November 1996 had been £746bn and £787bn. The PSBR had, therefore, been “over-forecast” by the Treasury by £3.3bn for FY1997 and £6.7bn for FY1998 in November 1996. If one believed in conspiracy theories, one could even believe in a conspiracy. 1.2 THE POLICY BACKGROUND (SEE CHAPTER 2) Before discussing the comparative economic performance of the Major Government and the Labour Government since 1997, this paper looks at the policy background. There are, without doubt, two main reasons for the economy’s relative strength: ! the supply-side reforms of the 1980s including trade union reform, privatisation of the utilities and the reform of the tax system; ! the post-ERM transformation in macro-economic policy designed to deliver low inflation and economic stability. Chancellor Norman Lamont introduced inflation-targeting and the first steps towards an independent Bank of England. He also began a programme of fiscal consolidation, which transformed the public finances. These “Lamont reforms” were radical. His successor, Kenneth Clarke, consolidated Norman Lamont’s innovations. By 1997 the Conservatives “low inflation stability” policies were very effective and had succeeded admirably in reducing inflation and delivering sustainable growth. 3 Chancellor Gordon Brown built on the Conservatives’ policy framework for delivering “low inflation stability” in 1997. He gave the Bank operational independence in setting interest rates and introduced a more “rules based” approach to fiscal policy. His policy was, however, by no means revolutionary, whereas the “Lamont reforms” were. Brown’s policies were consolidatory. This is not to condemn or criticise Brown’s policy. But it is to put it in perspective. Gordon Brown’s fiscal reforms were not revolutionary. They merely consolidated the Lamont reforms which had succeeded in reducing inflation and delivering sustainable growth. 1.3 ECONOMIC ANALYSIS (SEE CHAPTER 3) The Major years were a remarkably successful time for the British economy. The official quoted at the beginning of this chapter was not exaggerating. Specifically, for the period 1992 to 1997: ! GDP growth averaged over 3% compared with about 2¾% since 1997. Manufacturing output performed quite well compared with a flat performance since 1997. The growth of business investment was also superior during the Major years. The household saving ratio was 9.5% in 1997, by 2004 it had dropped to 5.5%; ! the current account of the balance of payments improved significantly and was almost in balance in 1997 as resources were shifted from the domestic sector to the overseas sector. Last year the Labour Government clocked up the worst-ever visible trade deficit, which at £57bn, was £10bn higher than 2003’s deficit (which had been a record visible trade deficit); ! the labour market showed substantial improvements. Unemployment, including youth (16-24 year olds) unemployment, fell sharply and workforce jobs picked up. The fall in unemployment has slowed since 1997 with the drop in youth unemployment especially disappointing. The number of workforce jobs has undeniably picked up since 1997.