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The IFS Green Budget January 2008 Stuart Adam Melanie Baker Antoine Bozio Robert Chote Claire Crawford Carl Emmerson Malcolm Gammie Rachel Griffith Paul Johnson Andrew Leicester David Miles Helen Miller Alastair Muriel Laurence Mutkin Cormac O’Dea David Phillips Vladimir Pillonca Graham Secker Jonathan Shaw Luke Sibieta Gemma Tetlow Copy-editor: Judith Payne Editors: Robert Chote, Carl Emmerson, David Miles and Jonathan Shaw The Institute for Fiscal Studies 7 Ridgmount Street London WC1E 7AE Published by The Institute for Fiscal Studies 7 Ridgmount Street London WC1E 7AE Tel: +44 (0) 20-7291 4800 Fax: +44 (0) 20-7323 4780 Email: [email protected] Website: www.ifs.org.uk in collaboration with Morgan Stanley 25 Cabot Square London, E14 4QA Tel: +44 (0) 20 7425 8000 Website: www.morganstanley.com Morgan Stanley’s contribution to this publication was prepared in accordance with its conflict management policy, which is available at www.morganstanley.com/institutional/research. Support from the ESRC-funded Centre for Microeconomic Analysis of Public Policy (CMAPP, reference RES-544-28-5001) at IFS is gratefully acknowledged. Printed by Patersons, Tunbridge Wells © The Institute for Fiscal Studies, January 2008 ISBN 978-1-903274-52-1 Preface Welcome to the Institute for Fiscal Studies’ 2008 Green Budget, in which we discuss some of the issues confronting Alistair Darling in his first Budget as Chancellor of the Exchequer. We are delighted once again this year to be producing the Green Budget in collaboration with Morgan Stanley. David Miles, managing Director and Chief UK Economist, has had a long association with IFS as a Research Fellow and as an editor of Fiscal Studies between 1999 and 2004. He and his colleagues have contributed chapters on the economic outlook, and on debt management and the recent problems in the credit markets. We are also grateful for financial support from the Economic and Social Research Council’s Centre for the Microeconomic Analysis of Public Policy at IFS. As with all IFS publications, the views are those of the authors of the particular chapters and not of the institute – which has no corporate views – or of the funders of the research. Robert Chote Director, Institute for Fiscal Studies Contents List of figures viii List of tables xi 1 Summary 1 2 The public finances under Labour 9 2.1 Introduction: Labour’s fiscal objectives 9 2.2 Labour’s inheritance 10 2.3 Labour’s record to date 11 2.4 Performance relative to the Conservatives 17 2.5 Labour’s plans and forecasts 20 2.6 Uncertainty and the Treasury’s fiscal forecasts 23 2.7 Conclusion 28 3 The fiscal rules and policy framework 29 3.1 Introduction 29 3.2 The golden rule 31 3.3 The sustainable investment rule 46 3.4 Reforming the rules: a golden opportunity? 58 4 The economic outlook 62 4.1 Introduction 62 4.2 Recent developments and near-term outlook 63 4.3 Trend growth and the economic cycle 77 4.4 The next five years: two scenarios 82 5 Green Budget public finance forecasts 88 5.1 Introduction 88 5.2 Short-term projections 89 5.3 Medium-term prospects 94 5.4 Alternative macroeconomic assumptions 100 5.5 The fiscal rules and the budget judgement 103 6 Funding, debt management, and credit market problems 108 6.1 Introduction 108 6.2 The likely scale of debt issuance 108 6.3 Government debt and the money market crisis 114 6.4 Optimal debt management 119 6.5 Government policy and the `credit crunch’ 122 6.6 Mortgages and mortgage financing – the role of indexation 127 6.7 Conclusion 131 v 7 Pressures on public spending 133 7.1 Introduction 133 7.2 Trends in aggregate public spending under Labour 134 7.3 Trends in key areas of public spending 136 7.4 Conclusion 156 8 Public sector pay and pensions 158 8.1 Introduction 158 8.2 The public sector pay bill and workforce 160 8.3 Public sector pay trends and levels 163 8.4 Public sector pensions 171 8.5 Pay review bodies 176 8.6 Public sector pay policy and inflation 180 8.7 Conclusion 185 9 Aviation taxes 187 9.1 Introduction 187 9.2 Economic principles of aviation taxation 188 9.3 Air passenger duty 193 9.4 Aviation duty: illustrative options for reform 197 9.5 Issues in aviation tax reform 204 9.6 Conclusion 210 10 Capital gains tax 212 10.1 Introduction 212 10.2 Background 213 10.3 CGT design and the proposed reform 218 10.4 Managing transition 229 10.5 The policymaking process 233 10.6 Conclusion 235 10.7 Postscript: entrepreneurs’ relief 235 11 Corporation tax and entrepreneurship 238 11.1 Introduction 238 11.2 Corporation tax rates and entrepreneurship 239 11.3 Conclusion 245 12 Taxation of companies’ foreign profits 246 12.1 Introduction 246 12.2 The current UK system 247 12.3 Principles guiding the taxation of foreign profits 248 12.4 The June 2007 proposals 249 12.5 Implications of the proposed exemption system 252 12.6 Conclusion 258 vi 13 Tax simplification 260 13.1 Introduction 260 13.2 A 10-yearly simplification cycle? 261 13.3 Recent `simplifications’ in practice 263 13.4 Conclusion 266 14 The impact of tax and benefit reforms to be implemented in April 2008 268 14.1 Introduction 268 14.2 The changes due in April 2008 269 14.3 The impact on effective marginal tax rates 271 14.4 Winners and losers 278 14.5 The impact of tax and benefit changes since 1997 283 14.6 Conclusion Appendix A: Forecasting public finances 289 Appendix B: Headline tax and benefit rates and thresholds 296 vii Figures Figure 2.1 Revenues, spending, budget balances and debt 12 Figure 2.2 Revenue raised in 2007-08 by Labour-announced measures 15 Figure 2.3 Debt, deficits and investment: Labour vs. Conservatives 19 Figure 2.4 Total managed expenditure 21 Figure 2.5 Sharing the proceeds of growth 22 Figure 2.6 Treasury public sector net borrowing forecasts 24 Figure 2.7 Treasury current budget balance forecasts 25 Figure 2.8 Probabilities for net borrowing outcomes 26 Figure 2.9 Probabilities for current budget balance outcomes 27 Figure 2.10 Probabilities for public sector net debt outcomes 27 Figure 3.1 Current budget balance: cyclical and structural 35 Figure 3.2 Treasury current budget balance forecasts 38 Figure 3.3 The output gap and the economic cycle: Treasury estimates 40 Figure 3.4 Current budget balance in the 2007 Pre-Budget Report 41 Figure 3.5 Treasury cumulative current budget balance forecasts 42 Figure 3.6 General government debt ratios in OECD countries in 2007 48 Figure 3.7 Treasury public sector net debt forecasts 57 Figure 4.1 Economic growth and inflation since 1957 63 Figure 4.2 Real consumer spending growth 65 Figure 4.3 Saving rate 65 Figure 4.4 Household gross financial liabilities 66 Figure 4.5 Household capital gearing: increased debt and assets 66 Figure 4.6 Debt servicing and interest rates 68 Figure 4.7 Sluggish real disposable income growth 69 Figure 4.8 Employment growth 69 Figure 4.9 Private non-financial corporate gearing (ratios) 70 Figure 4.10 Our central inflation forecasts 72 Figure 4.11 Subjective probability distribution: June 2008 policy interest rate 72 Figure 4.12 House prices relative to average household disposable income 75 Figure 4.13 Labour participation 78 Figure 4.14 Cyclical fluctuations in the UK economy since 1972 80 Figure 4.15 Comparing the Treasury’s recent estimates of the output gap 81 Figure 4.16 Treasury and statistical filter output gap revisions 82 Figure 4.17 Alternative GDP growth scenarios 83 Figure 4.18 Quarterly GDP growth 86 Figure 5.1 Treasury forecasts for corporation tax revenues and Morgan Stanley 93 forecasts for UK stock-market growth Figure 5.2 PBR and IFS forecasts for revenue growth, 2007-08 to 2012-13 97 Figure 5.3 Forecasts for corporation tax receipts under HM Treasury and Green 98 Budget assumptions Figure 5.4 Probabilities of current budge balance outcomes (Green Budget 99 baseline) viii Figure 5.5 Probabilities of public sector net debt outcomes (Green Budget baseline) 100 Figure 5.6 Current budget balance forecasts 102 Figure 5.7 Cyclically-adjusted current budget balance forecasts 102 Figure 5.8 Public sector net debt forecasts 103 Figure 6.1 National debt as a proportion of national income since 1855 111 Figure 6.2 Overseas holdings of gilts 111 Figure 6.3 International real yields on inflation-proof government bonds 112 Figure 6.4 Long-term real interest rates on UK conventional debt 113 Figure 6.5 Secured-unsecured spreads in the UK and Europe, and the US 114 Commercial Paper AA-A2/P2 spread Figure 6.6 Forward LIBOR-SONIA spreads 115 Figure 6.7 2-year gilt yield vs base rate (%) 117 Figure 6.8 2-year swap spread 118 Figure 6.9 The gilt yield curve 118 Figure 6.10 30-year index-linked real yield and breakeven inflation (BEI) 119 Figure 6.11 Gilt portfolio maturity and duration 121 Figure 6.12 Major UK banks’ wholesale funding as a percentage of total funding, 123 median Figure 6.13 Major UK banks’ issuance of residential mortgage-backed securities 125 (RMBS) and growth in mortgage lending Figure 6.14 The effective mortgage spread 125 Figure 6.15 The repayment burden of standard and indexed fixed-rate mortgages: 131 proportion of income taken by repayments Figure 7.1 Total public spending 134 Figure 7.2 Firm and fixed departmental spending plans? 136 Figure 7.3 Health spending 137 Figure 7.4 NHS budget deficit/surplus in England 138 Figure 7.5 Education spending 141 Figure 7.6 Education spending per pupil and average maths scores 143 Figure 7.7 Actual, required and projected path of child poverty 145 Figure 7.8 UK defence spending since 1965 149 Figure 7.9 Transport spending 150 Figure 7.10 Department for Transport budget compared

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