1 Equipping Britain for our long-term future

The challenge

1.02 Moreover, the economic environment is changing more quickly than ever before. Technology is radically reforming the way we work. The development of the global marketplace is bringing new challenges and new opportunities. Old certainties such as jobs for life or even skills for life can no longer be taken for granted. In this ever more competitive world, the British economy and British people must be prepared to adapt continuously to change. The challenge for business and individuals is to work together to ensure that Britain is well equipped to meet these challenges and that everyone can play a full economic role.

1.03 The new Government's central economic objective is to achieve high and stable levels of growth and employment, goals which have proved elusive in the past. In meeting this objective, the Government wants to encourage a fair society in which everyone can share in higher living standards and greater job opportunities, and to see economic development taking place in a way which respects the environment. Achieving these aims in the new global economy will require a major re-equipping of the British economy.

The new Government's approach

(i) improve the underlying rate of growth and employment by:
- creating economic stability based on low inflation and low government borrowing; and

- improving the environment for long-term investment in technology and in education and training; and encouraging a climate of entrepreneurship and competition;

(ii) modernise the welfare state so it provides an effective way of supporting people back into work rather than trapping them in poverty;

(iii) ensure high quality public services are delivered in the most effective way;

(iv) develop a tax system which is fair and seen to be fair; and

(v) ensure that economic development takes place in a way which is consistent with high standards of environmental protection.

Improving the underlying rate of growth

Britain's record

1.06 This poor economic performance is, to a large extent, a reflection of inadequate levels of investment in the British economy. The Government wants to increase the quantity of long-term investment. The climate for investment will be improved by:

• ensuring a stable economic environment. A major reason why business has held back from investing has been Britain's record of economic instability which has made it difficult for firms to plan ahead with confidence and discouraged investors from providing the necessary finance; and

• tackling the other obstacles holding back investment, productivity improvement and growth.

Economic stability

1.08 Without stability, and the confidence of future stability, businesses and individuals cannot plan effectively for the long term. This damages investment and savings. And without higher levels of productive investment, the economy's full potential will not be realised. The Government is setting in place arrangements to ensure financial stability and sound public finances to underpin a stronger and more robust economy.

Financial stability

1.10 Over the last 18 years, the UK's record on inflation has been poor. Even in recent years, inflation in the UK has exceeded that of most of our major competitors. Measured by the retail price index excluding mortgage interest payments (RPI ex MIPs), inflation has averaged over 6  per cent since 1979 and has ranged from 2  per cent to 21  per cent. This performance has been one of the poorest among G7 countries.

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1.11 The previous arrangements for monetary policy were not generating the confidence that is necessary. That is one of the reasons why Britain has had higher long-term interest rates than most of our major competitors. The new monetary policy framework, introduced on 6 May, will remove the perception that monetary policy decisions are dominated by short-term political considerations.

1.12 Difficulties have, in the past, been due to a lack of clarity about roles and accountability. The new arrangements tackle this issue.

1.13 Under the new arrangements, the Government's role is to set the economic objectives and, in particular, the inflation target. The Bank of England's role is to take the operational decisions to meet the inflation target.

1.14 Without prejudice to the price stability objective, the Bank is required to support the Government's economic policy, including its objectives for growth and employment.

1.15 The goal of monetary policy is price stability. Low inflation is central to the Government's economic objectives. In his Mansion House speech, the Chancellor set the target for inflation (as defined by the 12-month increase in RPI ex MIPs) at 2 1/2  per cent. If the ability of the British economy to sustain growth with low inflation is strengthened, and if international conditions permit, a lower target might be set in due course.

Operational independence for the Bank of England

The MPC will comprise the Governor, two Deputy Governors and six members, four of whom are recognised outside experts, appointed by the Chancellor. The Treasury is also represented on the Committee, in a non-voting capacity.

The MPC meets on a monthly basis. Decisions, which are announced at a fixed time and without delay, are made by simple majority vote. If necessary, the Governor will have the casting vote. The Committee is also responsible for taking full account of regional and sectoral information in its monetary policy decisions. Minutes of the meetings, including a record of votes, are published within six weeks.

Although the Government retains the right to override the operational independence of the Bank this can only happen in extreme economic circumstances and for a limited period. It is also subject to ratification by Parliament.

The MPC is accountable to the Government for meeting the inflation target, as set out in the Chancellor's letter to the Governor of 12 June. The Committee's performance and procedures will be reviewed by the reformed Court of the Bank on an ongoing basis (with particular regard to ensuring the Bank is collecting proper regional and sectoral information). The Bank is accountable to the House of Commons through regular reports and evidence given to the Treasury Select Committee. Through publication of the minutes of the MPC meetings and the Inflation Report, the Bank will be accountable to the public at large.

The new arrangements mean that while the Government retains clear responsibility to Parliament for defining the goals of monetary policy, the Bank will be accountable for their achievement. The well defined inflation target, publication of the minutes and the Bank's quarterly Inflation Report and the open letter system provide clear information against which the performance of the Bank in achieving price stability can be judged.

1.17 The Government recognises that the effectiveness of the inflation target in guiding the actions of the Bank will depend on the seriousness with which breaches of the target are treated. In this respect, inflation outcomes below the target should be viewed in the same way as outcomes above the target. If inflation is 1 percentage point higher or lower than the target, an open letter will be sent by the Governor to the Chancellor so that the public is fully informed as to:

• why the divergence has occurred;

• the policy action being taken to deal with it;

• the period within which inflation is expected to return to the target;

• how this approach meets the Bank's monetary policy objectives.

1.18 The new framework puts monetary policy on a credible, long-term footing to ensure that price stability is delivered in practice. Long-term interest rates fell after the Chancellor announced that the Bank was to be given operational responsibility for setting interest rates and have remained some 30 basis points lower since around that time, supporting the view that credibility has already been enhanced.

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Fiscal Policy

• the golden rule: over the economic cycle the Government will only borrow to invest and not to fund current expenditure; and

• public debt as a proportion of national income will be held over the economic cycle at a stable and prudent level.

1.20 These rules will ensure that borrowing will be kept under firm control. But the rules also make a proper distinction between public investment and current expenditure which will no longer be treated as if they are equivalent economic categories. The rules require that current taxpayers pay for current spending since it is the present generation which enjoys its benefits. Future generations gain from public investment so it is reasonable to borrow to finance investment, with future generations bearing the corresponding debt servicing and depreciation costs.

The golden rule, debt ratio and net wealth

The golden rule means that over the economic cycle the Government will borrow only to finance public investment and not to fund current expenditure. The golden rule will be met if current spending is paid for by taxation and other government receipts: in other words, if the public sector current account is in balance, or in surplus, over the economic cycle.

Over the last economic cycle, 1985-86 to 1996-97, the public sector current balance averaged a deficit of over 1 1/2  per cent of GDP. Performance thus did not accord with the rule. But this deficit (excluding windfall tax and associated spending) is set to fall this year and the current balance moves into surplus next year and thereafter, thereby meeting the golden rule.

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Debt ratio

Progress against the debt ratio objective can be judged by looking at the ratio of net public sector debt to GDP, which balances out most financial assets with liabilities; and by looking at the ratio of gross general government debt (GGGD) to GDP, which is the measure used in the European Union excessive deficits procedure. Both measures of the debt ratio have risen very sharply since 1990. The introduction of the Government's deficit reduction plan means the ratios fall steadily from this year onwards, with the gross general government debt ratio remaining comfortably below the 60  per cent Maastricht reference value.

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Net wealth

Net wealth is a more comprehensive measure of the public sector's position than the debt ratio. It includes tangible assets held by the public sector as well as net financial liabilities. At present, the data for tangible assets is subject to significantly wider margins of error than those for net financial liabilities. The National Asset Register and the development of resource accounting should help to improve the quality of data for public sector tangible assets, and therefore public sector net wealth.

The steady increase in government debt throughout the 1990s resulted in a sharp deterioration in the public sector's balance sheet. Public sector net wealth fell from over 65  per cent of GDP in the late 1980s to 14  per cent in 1995, the latest year for which information is available. The Government's fiscal framework will ensure this deterioration is halted.

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1.21 The deficit reduction plan set out in the Budget is intended to ensure sound public finances and builds in a margin to guard against future uncertainties.

Table 1.1 Changes to PSBR forecast(1)

	£ billion
	1997-98	1998-99
PSBR in November 1996 Budget	19.2	12.2
Effects of:
Changes in assumptions	0.6	3.2
Forecasting changes(2)	-3.3	-6.7
LA capital receipts initiative	0.2	0.7
Budget tax changes(3),4	-3.4	-4.1
Total changes(4)	-5.9	-6.8
PSBR in July 1997 Budget, excluding windfall tax & associated spending	13.3	5.4
Effects of:
Windfall tax	-2.6	-2.6
Welfare to Work spending(5)	0.2	1.2
PSBR in July 1997 Budget	10.9	4.0
1 In this and other tables, the totals are based on unrounded figures. They may therefore differ from the sums of the rounded figures. 2 Of which (see also Table 4.8):
Estimated corporation tax yield from higher profits	-2.1	-3.3
Estimated other tax yield from higher money GDP	-1.8	-3.0
Other forecast changes (net)	0.6	-0.4
4 Excludes windfall tax and associated spending. 5 See Table 2.1.

1.22 This prudent approach aims to avoid the mistakes of the past. The last time the economy faced a similar cyclical conjuncture (in the mid to late 1980s) saw large policy errors. The costs, in terms of unemployment and lost output, were severe. Following the recession, the PSBR rose to a peak of 7  per cent of GDP. The Government regards it as important that no similar risks should be taken with fiscal policy again. The Budget tax measures, particularly the reduction in mortgage interest relief and increases in stamp duty, will help encourage stability in the housing market and the economy more generally.

1.23 The measures announced in this Budget, excluding windfall tax and associated spending, tighten fiscal policy by around 1/2  per cent of GDP by 1998-99. The PSBR (excluding privatisation proceeds, windfall tax and associated spending) is forecast to fall by 3  per cent of GDP between 1996-97 and 1998-99. A significant part of this reduction reflects tight control of public spending: the ratio of GGE(X) to GDP is expected to fall by 2 1/4 percentage points over this period. In addition, the planned real increases in road fuel and tobacco duties raise the projected ratio of tax receipts to GDP by between 1/4 and 1/2 percentage point by 1998-99.

1.24 Fiscal consolidation at a time of strengthening demand should help to encourage a more balanced recovery and help to offset some of the pressures on monetary policy. Successful deficit reduction should also help raise the level of national saving and increase resources for investment.

1.25 The Government's plans for spending over the next two years are set out in Chapter 2. The medium-term plans will be determined by the Comprehensive Spending Review. For the purposes of the medium-term public finance projections in the Budget arithmetic, three different illustrative assumptions have been used for the annual real growth of the Control Total after 1998-99: 3/4  per cent, 1 1/2  per cent and 2 1/4  per cent.

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1.26 On the basis of the projections, the Government is well on track to meet its fiscal policy objectives over the course of this Parliament. The golden rule is met from 1998-99 onwards, while both debt ratios fall from now on. Nonetheless, the uncertainties surrounding the assessment of the current conjuncture (see box) suggest that a prudent approach to tax and spending will continue to be necessary. Moreover, the decline in the debt burden is much less than the rise that took place during the first half of the 1990s; and the improvement in public sector net wealth is modest in comparison with its earlier deterioration.

1.27 The UK expects to meet the Maastricht reference values for the government deficit and debt. The general government financial deficit (GGFD) is forecast to be 2 per cent of GDP in 1997, well below the 3  per cent reference value; and the relevant debt ratio (GGGD) is also forecast to be well below the 60  per cent Maastricht level. Continuing improvements in the fiscal position will ensure the sustainability of the public finances in future years.

Uncertainties and the fiscal projections

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There is considerable uncertainty in estimating the position of output relative to its potential level. The Treasury's best view of the current conjuncture is that the economy is close to its trend level, ie that the output gap is close to zero. However, if the output gap were significantly different from this it would have implications for the estimates of the structural deficit. Moreover, the potential cost of being optimistic is likely to be greater than that of being pessimistic. Estimates of the structural PSBR, based upon the Treasury forecast and medium-term projections, are therefore shown with an alternative, more cautious, projection based on a level of trend output 1 1/2  per cent lower (i.e. a significant positive output gap) than our central view. The cautious case highlights the continuing need to keep borrowing under strict control to ensure the fiscal objectives are met.

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Building trust in fiscal policy

1.29 The transparency of fiscal policy will be further underpinned by the planned introduction of resource accounting and budgeting. The Government is drawing up a full National Asset Register which it plans to publish in November, and full information about the assets and liabilities of central government departments will become available from resource accounts for the year 1998-99 onwards. Resource budgeting will be developed to provide a system of public expenditure planning and control which distinguishes clearly between current spending and capital investment.

Green Budget

- new deficit reduction plan and long-term structure for fiscal policy

- new commitment to openness in public finances

- tax changes to encourage stability in the housing market and more balanced economic growth.