1 

Overview 

The Pre-Budget Report is now an established and integral part of the Government's annual Budget process. It provides a progress report on what the Government has achieved so far and the next stage of policy reforms on which the Government will be consulting in the run up to the next Budget. 
The key objective of the Pre-Budget Report is to launch a national debate on important economic issues, including taxation and spending, seeking the views of people and business in all regions of the country and all sectors of the economy to inform the Government's Budget decisions. 

The publication of this Pre-Budget Report, Building long-term prosperity for all, and a range of associated documents, will be followed by a series of regional meetings to discuss the issues raised and to listen to people's views.
 


INTRODUCTION 


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1.1 The Government's central economic objective, set out in 1997, is high and stable levels of growth and employment. Its aim is to fulfil Britain's national economic potential, building a stronger economy and a fairer society in which everyone can contribute to and share in rising prosperity and a better quality of life. 

1.2 Over the past three and a half years, the Government has taken the tough decisions necessary to secure a platform of stability. Through extensive reforms and a prudent approach to both monetary and fiscal policy, economic stability is now being delivered. The challenge in the period ahead is to remain focused on the long term and avoid the mistakes of past decades where short-termism in decision making was a major cause of economic instability. 

1.3 Locking in stability provides the opportunity to raise Britain's productivity performance and deliver stronger sustained growth in output and employment with low and stable levels of inflation and interest rates. The Government believes that workforces and management also have a key role to play in meeting the challenge of achieving a high productivity economy and that working together it is possible to build a stronger and fairer Britain with rising long-term prosperity for all. 

1.4 The key elements of the Government's economic strategy, as set out in this Pre-Budget Report, are: 

delivering macroeconomic stability (Chapter 2); 
meeting the productivity challenge (Chapter 3); 
increasing employment opportunity for all (Chapter 4); 
ensuring fairness for families and communities (Chapter 5); and 
protecting the environment (Chapter 6). 
1.5 The following section describes the comprehensive strategy which the Government is pursuing to meet its objectives. Each element of the strategy forms the basis of the subsequent chapters of this report, with an overview of each in the second part of this chapter. Full details of the Government's updated forecasts for the economy and the public finances are set out in Annexes A and B respectively. 

1.6 The Pre-Budget Report discusses the economic challenges now facing Britain, and outlines further measures which the Government is considering to boost productivity performance and deliver higher prosperity. The Government wants the Pre-Budget Report to be followed by a national debate on these major economic issues. It wants to hear the views of others and will be consulting widely over the coming months in the run up to Budget 2001 

Box 1.1: Meeting the Government's long-term economic goals 
In working to deliver its central economic objective of high and stable levels of growth and employment, the Government has set five key long-term economic goals: 

raising productivity: that over the next decade, Britain will have a faster rise in productivity than its main competitors as it closes the productivity gap; 
increasing employment opportunity for all: that by the end of the decade, there will be a higher percentage of people in employment than ever before; 
providing educational opportunity for all: that by the end of the decade, and for the first time, the majority of the UK's young people can expect to go on from school or college into higher education; 
abolishing child poverty: that by the end of the decade, child poverty will be halved as the Government moves forward with its commitment to abolish child poverty within 20 years; and 
delivering strong and dependable public services: with sustainable increases in spending on the Government's priorities of education, health, transport and tackling crime. 
 


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THE GOVERNMENT'S ECONOMIC STRATEGY 


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1.7 At the heart of the Government's economic strategy is the goal of full employment and rising prosperity for all. The Government's aim is to achieve sustainable growth in Britain's economic prosperity - ensuring that a strong economy goes hand in hand with a fair society and steps to protect and, where possible, improve the environment. 


Delivering macroeconomic stability 

1.8 Economic history clearly demonstrates that stability is an essential platform for achieving high and stable levels of growth and employment. Past instability in output, inflation and interest rates - as seen in the British economy over the past 30 years - created uncertainty and led to short-termism in the savings and investment decisions of individuals and businesses alike. 

1.9 Much of the economic instability seen in the UK in recent decades reflects policy errors by successive governments, themselves often the fault of weaknesses in the policy framework. Since 1997, the Government has therefore put in place a new open and transparent macroeconomic policy framework with well-defined policy objectives and clear and accountable divisions of responsibility. Ensuring a foundation of domestic stability is particularly important in what is an increasingly integrated but volatile and uncertain global economy. 

1.10 The economy which the Government inherited in 1997 was characterised by emerging inflationary pressures and a large structural deficit in the public finances. But through pre-emptive action and tough decisions under the new fiscal and monetary policy frameworks, a return to the stop-go cycle of the past was avoided and steady and stable growth is now being accompanied by record levels of employment, historically low inflation and a sound fiscal position. This has enabled the Government to raise investment in Britain's key public services on a sustainable basis in the 2000 Spending Review. 

1.11 The challenge moving forward is to lock in this stability for the long term and to take advantage of the opportunity which it offers to secure sustainable increases in growth, employment and higher living standards. 


Raising Britain's growth potential 

1.12 Macroeconomic stability is a necessary condition for raising Britain's long-term growth potential, but it alone is not sufficient. That is why the Government is pursuing a long-term strategy to increase the trend rate of growth of the UK economy, focusing on removing barriers to productivity and employment. 

1.13 The mid-point of the ranges for the Government's growth forecasts is based on a trend growth assumption of 21/2 per cent a year - the Government's neutral assessment of the economy's medium-term growth potential. The upper ends of the forecast ranges illustrate the potential for stronger non-inflationary growth over the medium term. The Government has set a Public Service Agreement target to raise the trend rate of growth over the next four years. 

1.14 The Government believes that this is an achievable target given the measures it has already put in place and the next stage of reforms it is planning. However, the projections of the public finances continue to be based - as they will be for Budget 2001 - on the low end of the forecast ranges, consistent with the deliberately cautious assumption of 21/4 per cent a year trend growth. Changing the trend growth assumption underlying the fiscal projections before there is firm evidence of an improvement in long-term growth prospects would be imprudent and risk repeating the mistakes of the past. Previous governments too readily concluded that the economy's long-term growth potential had increased and therefore mistook a cyclical improvement in the public finances for a structural one. 


Meeting the productivity challenge 

1.15 Productivity is the main driver of economic growth. Meeting the Government's long-term ambition of raising Britain's productivity performance and closing the productivity gap with other major countries will therefore be essential in increasing the economy's trend rate of growth. A lack of domestic competition, insufficient incentives and opportunities for enterprise and innovation, poor skills and a history of under-investment are some of the key causes which the Government has identified for Britain's poor productivity record and the Government's strategy to increase productivity, described in Chapter 3, addresses each of these issues. 

1.16 To succeed in meeting this productivity challenge requires a shared effort on the part of the Government, management, workers and trades unions. The Government has its role to play. But in a dynamic and increasingly competitive economy, individual businesses and sectors of the economy need to remain flexible and able to respond quickly to changing economic circumstances. Firms and industries which fail to learn from best practice elsewhere, do not invest in new technology and strong management, and which allow shortfalls in skills and training to persist will find it increasingly difficult to survive and expand. 


Increasing employment opportunity for all 

1.17 As well as by increasing productivity, the economy's trend rate of growth can be increased by achieving increasing levels of labour market participation. The Government's employment ambition is to deliver high and stable levels of employment, taking account of the economic cycle, so that at least three quarters of the working age population are in work by the end of the decade. Research also shows that work provides the best route out of poverty and therefore has an important role to play in building a fairer and more inclusive society. The Government's strategy for increasing employment opportunity for all who can work, set out in Chapter 4, matches rights with responsibilities. It comprises helping people move from welfare to work, easing the transition into work and making work pay. Once in work, the Government wants to ensure that people can work their way up into higher skilled, higher paid jobs. 


Fairness for families and communities 

1.18 At the same time as creating a strong and productive economy, the Government is working to build a fairer and more inclusive society in which everyone can contribute to and benefit from rising economic prosperity. A strong economy and a fair society both matter for a country's standard of living. Chapter 5 explains how the Government is delivering fairness for families and communities. The Government is pursuing an extensive programme to tackle poverty, particularly child and pensioner poverty, deliver strong and dependable public services, reward saving and strengthen community life. This does not just involve government action, but is often about bringing the private sector, voluntary and community groups, and the public sector together to find the best solutions to community problems. 


Protecting the environment 

1.19 Just as the economy cannot be thought of in isolation from wider social issues, nor can economic developments be allowed to proceed in a way which ignores the implications for the physical environment. The Government is committed to protecting and, where possible, improving the environment - both for the current generation and future ones. Too often in the past, economic growth has taken place at the expense of clean air, the efficient use of natural resources and sufficient consideration of the impact on the places in which people live and work. The Government has therefore developed an environmental strategy - explained in Chapter 6 - aimed at tackling climate change, improving air quality, regenerating towns and cities and protecting the countryside. 


Conclusion 

1.20 The Government has put in place a comprehensive strategy to deliver rising prosperity, with enterprise and employment open to all in every region of Britain. As a result of taking the necessary tough decisions, economic stability is being delivered. Now is the time to remain focused on the long term, maintaining fiscal and monetary discipline and avoiding quick fixes to short-term difficulties which would put at risk the gains made to date and the prospect of higher growth and employment in the future. The Pre-Budget Report describes how - with the Government, workforces, managers, trades unions and investors all working together - it is possible to remove long-standing barriers to productivity and employment and build long-term prosperity for all. It outlines the next stage of reforms which the Government is considering and consulting on in the run up to Budget 2001. 

DELIVERING MACROECONOMIC STABILITY 


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1.21 Chapter 2 sets out the macroeconomic policy framework which the Government has put in place and shows how it is working to deliver economic stability. It also summarises the Government's updated projections for the UK economy and the public finances (which are set out in full in Annexes A and B). 


The policy framework 

1.22 The Government has put in place new frameworks for monetary and fiscal policy, based on the principles of transparency, responsibility and accountability, to deliver economic stability for the long term. The monetary policy framework with monetary independence for the Bank of England is designed to deliver low and stable inflation, while the fiscal policy framework underpinned by two strict fiscal rules is designed to deliver sound public finances. Integrated into the fiscal framework, a new public spending framework provides greater certainty for long-term planning and a greater focus on the outcomes which will be delivered. 

1.23 Under these new policy frameworks, the Government is now delivering a strong and stable economy. Output growth has remained stable and positive, inflation has remained close to the Government's 21/2 per cent target and interest rates have been lower and more stable than in the past. At the same time, the public finances have been restored to a healthy and sustainable position. 

1.24 Budget 2000 set out firm overall spending totals for the next three years, allowing for current spending to rise by 21/2 per cent a year in real terms and a more than doubling of net investment by 2003-04. It ensured that the Government remained on track to meet its fiscal rules over the economic cycle. 

1.25 The 2000 Spending Review, which reported in July, set out detailed spending plans for the next three years consistent with the firm spending envelope set in Budget 2000. Within these limits, as a result of savings on debt interest payments and social security spending, the Government was able to provide a substantial and sustainable increase in resources for priority public services including education, health and transport over the next three years while ensuring that the fiscal stance was on track to be at least as tight as set out in Budget 2000. 


The economy 

1.26 The UK economy has experienced continued strong growth in output and employment combined with low inflation in 2000. The Pre-Budget Report forecast shows that: 

GDP is expected to increase by 3 per cent in 2000 as a whole, in line with the Budget 2000 forecast, easing to its estimated sustainable rate of 21/4 to 23/4 per cent in 2001 and later years; 
RPIX inflation is expected to rise gradually back to 21/2 per cent by mid-2001, remaining at the Government's target thereafter; and 
short-term upside inflationary risks from stronger consumer demand and higher business investment are balanced by the possibility of continued favourable developments in costs and margins. However, the recent sharp increase in oil prices poses a significant risk to global prospects if sustained. 

The public finances 

1.27 The public finance projections published in this Pre-Budget Report, and summarised in Tables 2.4 and 2.5, provide an interim forecast update. They do not necessarily represent the fiscal outcome which the Government is seeking and they therefore have a quite different status from those published at the time of the Budget since the latter include the effects of all Budget policy decisions. In line with the Code for Fiscal Stability, the updated fiscal projections include the effects of all firm decisions announced in the Pre-Budget Report on individual taxes and programmes within Annually Managed Expenditure. 

1.28 As noted above, the fiscal projections continue to be based on the deliberately prudent and cautious assumption of 21/4 per cent a year trend growth, as audited by the National Audit Office (NAO). Under the three-year rolling review of audited assumptions established in Budget 2000, the NAO has reviewed the assumptions for equity prices, price deflators and VAT receipts for this Pre-Budget Report and concluded that it is reasonable that the assumptions continue to be used. 

1.29 A current budget surplus of £161/2 billion is now expected in 2000-01, around
£21/2 billion higher than the Budget 2000 forecast. Much of this reflects stronger than expected receipts. This improvement in the current year is expected to persist across the projection period. 

1.30 In making discretionary policy changes in the Pre-Budget Report, the Government has ensured that the fiscal rules will continue to be met over the economic cycle, including in the cautious case. The updated forecast takes account of policy announcements in the Pre-Budget Report, including additional support for pensioners of £21/2 billion a year by 2003-04 and a one year freeze in all fuel duties in cash terms in Budget 2001. These are summarised in Table B4. Consistent with the Code for Fiscal Stability, the forecast does not take account of measures proposed in the Pre-Budget Report for consultation in the run up to Budget 2001. Decisions on these measures will be taken in the Budget when the Government will also review its AME forecast and the AME margin. In line with the usual convention adopted in previous Pre-Budget Reports, changes to the forecast for AME programmes have been offset in the AME margin. 

1.31 Taking account of the stronger than expected fiscal developments and the policy measures announced in the Pre-Budget Report, the fiscal stance is expected to be at least as tight as set out in Budget 2000 and the Government remains on track to meet its fiscal rules over the economic cycle, including in the cautious case. 

MEETING THE PRODUCTIVITY CHALLENGE 


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1.32 Productivity in Britain lags behind that of other major economies. Raising productivity performance is the key to achieving sustained increases in the economy's growth potential and higher living standards. The Government has put in place a long-term strategy designed to meet this productivity challenge and bridge the productivity gap with Britain's major competitors. 


Measures already announced 

1.33 The Government's strategy focuses on five key drivers of productivity performance, and it has already introduced an extensive set of reforms spanning each of these areas. These include: 

competition: to ensure vigorous domestic and international competition, greatly enhanced powers for the Office of Fair Trading under the new Competition Act and new measures to improve competition and services to customers in the banking industry; 
enterprise and innovation: to develop a culture and incentives that promote enterprise and innovation in every region of Britain, major reforms to capital gains tax, permanent 40 per cent first year capital allowances for small and medium-sized enterprises, a new all-employee share ownership plan and R&D tax credit, and a greater regional focus on enterprise and regeneration through the Regional Development Agencies and the new Small Business Service; 
skills: to provide a wide spread and high quality of skills in the workforce, substantial increases in education spending to raise standards in primary and secondary schools, measures to increase participation in higher education, the launch of individual learning accounts and learndirect to provide greater opportunities for life-long learning, and changes to the work permits system; 
investment: to create the right conditions for investment, reductions in corporation tax rates, the abolition of advance corporation tax, a new 10p rate for the smallest companies, and a review of whether there are factors discouraging institutional investors from investing in smaller companies; and 
public sector productivity: to deliver continuous improvements in the productivity of the public sector, output and efficiency targets for public service delivery through Public Service Agreements, the Public Services Productivity Panel, the new Office of Government Commerce to bring about a step change in public procurement practice, and Partnerships UK to help the public sector build more effective, value for money partnerships with the private sector. 
Next steps 

1.34 The Pre-Budget Report outlines the next steps in the Government's programme of reforms to increase Britain's productivity performance: 

a package of measures from April 2001 to help small and medium-sized firms manage their entry into the VAT system, reduce their administrative burden and improve their cashflow; 
extending, subject to consultation, the benefit of the business assets rate of taper relief in capital gains tax to employee shareholdings in a range of non-trading companies; 
consultation on ways to expand Enterprise Management Incentives so that small businesses can make more flexible use of the benefits in a way best suited to their needs; 
consultation on the Social Investment Taskforce's proposals for a Community Investment Tax Credit, and working closely with the venture capital industry and others on setting up the first Community Development Venture Fund, both to stimulate more private investment in under-invested communities; 
significantly increased freedom for the Regional Development Agencies from next year, enabling them to target resources more effectively - as a major step towards their strengthened role and additional resources and flexibility from April 2002 announced as part of the 2000 Spending Review; and 
an independent review of the management of the radio spectrum to advise on the principles which should govern spectrum management and what more needs to be done to ensure that all users are focused on using their spectrum in the most efficient way possible. 
INCREASING EMPLOYMENT OPPORTUNITY FOR ALL 


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1.35 The Government is working to deliver employment opportunity for all - the modern definition of full employment. Expanding the effective supply of labour will allow the economy to grow more rapidly without running into skills shortages and creating inflationary pressures. By providing employment opportunities for all, the Government is also tackling a key underlying cause of deprivation and helping to break the inter-generational cycle of poverty. 


Measures already announced 

1.36 The Government's strategy is based on helping people to move from welfare to work, easing the transition to work, making work pay and securing progression once in work. The Government has already introduced radical reforms of the tax and benefit system backed up by active labour market policies: 

welfare to work: with New Deal programmes for 18-24 year olds, 25+, the over- 50s, lone parents, people with disabilities and partners of the unemployed. Action Teams and Employment Zones are tackling the problems of worklessness in the most disadvantaged areas; 
easing the transition to work: with a new Job Grant of £100 from spring 2001, a four-week Income Support for Mortgage Interest run-on and simplified rules for the Housing Benefit Extended Payments Scheme, and increased provision of childcare facilities under the National Childcare Strategy; and 
making work pay: with the Working Families' Tax Credit, reform of NICs, a new 10p rate of income tax from April 1999 and a cut in the basic rate to 22p from April 2000. This is underpinned by the National Minimum Wage, the adult rate of which was increased to £3.70 an hour from October 2000. 
Next steps 

1.37 As a result of the 2000 Spending Review and the Pre-Budget Report, the Government is taking further steps to promote work: 

an extension of the New Deal for lone parents starting from autumn 2001 to provide help and support to all lone parents on Income Support who are not working, or who are working less than 16 hours a week; 
a new Job Transition Service to provide extra help to areas affected by large-scale redundancies, building on existing provision to help people into new jobs; and 
as confirmed in the 2000 Spending Review, the New Deal 25+ will be extended and intensified from April 2001, on a national basis. 
In addition, the Government will continue to work on the detailed design issues of the employment tax credit to be introduced from 2003. 

FAIRNESS FOR FAMILIES AND COMMUNITIES 


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1.38 At the same time as increasing the overall prosperity of the nation, the Government is working to build a fairer and more inclusive society. In particular, the Government is tackling child poverty, helping pensioners, rewarding saving, investing in public services and ensuring a fair tax system. 


Measures already announced 

1.39 The Government has already introduced a wide range of measures to ensure fairness for families and communities, including: 


support for families and children: through significant increases in Child Benefit, the introduction and subsequent increases in the Working Families' Tax Credit, the introduction of the Children's Tax Credit from April 2001, targeted support for low-income parents in the early months following the birth of their child and a new Children's Fund set up as part of the 2000 Spending Review; 

fairness for pensioners: through the Minimum Income Guarantee uprated by earnings for the poorest pensioners, an annual winter fuel payment of £150 for every 60+ household and concessionary TV licences for those aged 75 and over; and 

delivering strong and dependable public services: through substantial additional resources for Britain's frontline public services over the next three years in the 2000 Spending Review, including average annual real growth of 5.4 per cent for education and 5.6 per cent for health. 
Next steps 

1.40 Building on what has already been achieved, the Pre-Budget Report takes further steps towards a fairer society. These include: 

further measures to help raise the standards in schools with £5 million to help establish the National e-Learning Foundation and a £200 million investment to be paid directly to schools in 2000-01 to provide further help to tackle repairs; 
a major package of measures to boost pensioner incomes, in advance of the introduction of the Pension Credit in 2003 which will deliver substantial gains to all pensioners on low and modest incomes: 
increasing the winter fuel payment, which is set at £150 for future years, to £200 this winter. So this winter, 8.5 million pensioner households will be eligible for a payment of £200 - almost £4 a week - double the amount of last year's payment; 
increasing the basic state pension by £5 to £72.50 a week in April 2001, and by a further £3 to £75.50 a week in April 2002 for single pensioners. For couples this will mean an increase of £8 to £115.90 a week in April 2001, and of a further £4.80 to £120.70 a week in April 2002; and 
increasing the lower rates of the MIG to equal its highest rate, raise this by earnings, and further, by the real increase in the basic state pension, so that all pensioners gain fully from the increase in the basic state pension. From April 2001, the new, simplified MIG will be £92.15 a week for single pensioners, and £140.55 a week for couples. 
a £200 million a year package of measures helping disabled people and carers, to be announced by the Secretary of State for Social Security in the coming days; 
abolition of the £500 capital limits in the Sure Start Maternity Grant and Funeral Payments by October 2001, providing additional help for families on low incomes to cover the costs associated with the birth of a baby or the death of a close relative; 
retaining the current £7,000 Individual Savings Account (ISA) annual contribution limit (and the associated £3,000 cash limit) for a further five years until April 2006, rather than reducing it to £5,000 (£1,000 cash) in April 2001 as previously planned, and making cash ISAs available to 16 and 17 year-olds for the first time in April 2001; and 
further discussions about modernising General Betting Duty, with a view to an announcement at the time of Budget 2001. 
PROTECTING THE ENVIRONMENT 


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1.41 Economic growth must take place in a way which protects and, where possible, enhances the environment. The Government has therefore developed a clear framework to take account of the environmental impact of economic growth, focusing on tackling climate change and improving air quality, regenerating Britain's cities and protecting the countryside. 


Measures already announced 

1.42 The Government has already taken significant steps to deliver its environmental objectives: 

climate change and air quality: the climate change levy to be introduced in April 2001 to encourage more efficient business use of energy, reforms to VED and company car tax, a reduction in the duty on ultra-low sulphur petrol relative to unleaded from October 2000 and substantial additional investment in transport under the new Ten Year Transport Plan; and 
regenerating Britain's cities and protecting the countryside: new stamp duty relief for some Registered Social Landlords to encourage social housing provision and make better use of the existing housing stock, continuing annual increases in the standard rate of landfill tax, a new aggregates levy from April 2002 to tackle the environmental costs of quarrying and continuing work to reduce the environmental impact of pesticides use. 
Transport 

1.43 The Pre-Budget Report introduces a package of targeted measures which, consistent with the Government's environmental principles, will help motorists and improve the competitiveness of the UK transport sector while protecting the environment in the longer term. It includes specific help for farmers, and will encourage the modernisation of the road haulage sector in an environmentally-friendly way. 

1.44 Taking account of the strength of world oil prices, and the measures being taken to tackle climate change, the Government has decided to freeze all fuel duties in cash terms in Budget 2001. This will lower taxes on petrol and diesel by around 11/2 pence per litre in real terms, at a total cost of around £560 million in 2001-02. 

1.45 Subject to consultation in each case on the details and the environmental merits, the Government also intends to: 

cut the duty on ultra low sulphur petrol (ULSP) and widen its differential with standard unleaded petrol by a further 2 pence per litre in Budget 2001, on top of the 1 penny per litre reduction which came into effect on 1 October 2000. This would be conditional on the oil companies guaranteeing nationwide access to its environmental benefits. In these circumstances, the duty on ULSP would therefore have been cut by a total of 3 pence per litre since Budget 2000; 
subject to the cut in ULSP discussed above, cut the duty on ultra low sulphur diesel by 3 pence per litre in Budget 2001 to maintain the existing balance between duty rates on the most commonly available petrol and diesel; 
remove the 2 pence per litre duty premium on lead-replacement petrol; 
invite British industry to develop proposals for practical alternative fuels. Following consideration of these proposals, the Chancellor will announce major reductions in duty rates for the most promising environmentally-friendly alternative fuels; 
a further extension of the "small car" engine capacity threshold in vehicle excise duty (VED) to existing cars with engines up to 1,500cc, cutting VED for a further 5 million car owners; 
reform the system for lorry VED in Budget 2001 to reflect better the environment and track costs of different lorries. The reform is intended to reduce the cost of VED on lorries for British industry by around £300 million a year (equivalent to over 50 per cent); 
as a transitional arrangement, a rebate in lorry VED fees in the current year meaning cuts of 50 per cent for many of the largest vehicles, worth up to £4,000 each; 
introduce a "vignette" or "user charge" scheme for lorries so that foreign hauliers start to contribute towards the costs of maintaining the UK road network and the environmental costs that they impose; 
set up a £100 million ring-fenced fund to offer further incentives or allowances for scrapping older, more-polluting lorries or encouraging cleaner lorries and technology to secure environmental benefits and help the haulage industry modernise; 
help to improve the quality of training, especially for small haulage firms, working with the Road Haulage Forum which has already initiated a review of this area; and 
abolish VED for tractors, saving farmers in total over £9 million a year, or £40 for every agricultural vehicle. 
1.46 In total, these proposed measures would cost up to £13/4 billion a year, in addition to the cost of the freeze in duties. If all the measures which the Government is announcing and consulting on in the Pre-Budget Report are implemented then the tax on motorists will fall by the equivalent of about 4 pence per litre in real terms. Together with the reduction in ultra low sulphur diesel proposed and the freeze in fuel duties, the measures in the Pre-Budget Report would represent a reduction for freight transport of around £750 million a year in real terms, equivalent to a reduction of about 8 pence per litre for diesel used in road haulage. 


Next steps 

1.47 The Pre-Budget Report also sets out other steps to protect and improve the environment: 

a £1 billion cumulative package of tax measures over five years to help regenerate Britain's towns and cities, including: 
a complete exemption from stamp duty for all property transactions in Britain's most disadvantaged communities from April 2001; 
the intention to introduce an accelerated payable tax credit for the costs incurred in cleaning up contaminated land; 
immediate tax relief to property owners for the costs of converting redundant space over shops and other commercial premises into flats for letting; and 
a reduced rate of VAT for the services of converting residential properties into a different number of dwellings, for example, houses into flats, and an adjustment to the zero rate of VAT to provide relief for the renovation and sale of homes that have been empty for more than 10 years; 
a new £35 million aggregates Sustainability Fund to deliver environmental benefits to the areas subject to the environmental costs of quarrying; and 
building on the £30 million announced in the 2000 Spending Review to provide a financial incentive for firms to take on binding emissions reduction targets, consultation on outline proposals and options for the basic rules of the Emissions Trading Scheme. 
Environmental appraisal 

1.48 Table 6.1 shows how environmental tax measures fit in to the overall framework of the Government's environmental policy. An environmental assessment of these measures is detailed in Table 6.2. 

Chart 1.1 

GOVERNMENT SPENDING AND REVENUES 


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1.49 Chart 1.1 presents public spending by main function. Total public spending (Total Managed Expenditure - TME) is expected to be around £372 billion in the current financial year, 2000-01. TME is divided into Departmental Expenditure Limits, shown in Table B14, and Annually Managed Expenditure, shown in Table B17. A number of DELs, in particular those of the devolved administrations, contribute to spending on more than one function. Chart 1.1 includes spending by local authorities, rather than the grants they receive from central government which are included in Tables B14 and B17. 

1.50 Chart 1.2 shows the sources of government revenue. In total, public sector current receipts are expected to be around £380 billion in 2000-01. Table B11 in Annex B provides a more detailed breakdown of receipts consistent with the above chart. 

Chart 1.2 

 

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2 

Delivering macroeconomic stability 

The Government's macroeconomic framework is continuing to deliver macroeconomic stability, which is a precondition for high and stable levels of growth and employment. The policy framework is designed to achieve: 

low and stable inflation - the monetary policy framework is forward-looking, transparent and accountable with clear and precise objectives: 
inflation and inflation expectations remain low and stable, and in line with the Government's target. 
sound and sustainable public finances - the fiscal policy framework is based on coherent principles and objectives and strict fiscal rules. The interim forecast shows that: 
the fiscal stance is expected to be at least as tight as in Budget 2000 and that fiscal policy continues to support monetary policy over the cycle; and 
by taking a prudent approach and ensuring that cyclical improvements are not assumed to be structural, the Government remains on track to meet its fiscal rules, including in the cautious case. 
improved investment in public services - the public spending framework allows for sensible planning of public spending over the longer term and emphasises the importance of outcomes as well as inputs: 
savings from prudent management of the public finances are making room for substantial investment in frontline public services as set out in the 2000 Spending Review. 
The challenge for the Pre-Budget Report is to maintain and protect economic stability for the long term and to put in place policies that promote higher productivity and opportunity that will make the UK stronger and deliver rising prosperity for all. 
 


A FRAMEWORK FOR STABILITY 


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2.1 Economic stability is an essential precondition for achieving the Government's objective of high and stable levels of growth and employment. The macroeconomic policy framework which the Government has introduced is designed to deliver stability and avoid a return to the cycles of boom and bust that have characterised the British economy in the past. 

2.2 Economic instability imposes significant costs on the economy and society: 

it makes it difficult for individuals and firms to plan ahead, especially over the longer time horizons which business investment needs. Low levels of investment reduce the potential for long-term growth; 
high volatility in output growth - the stop-go cycles which the UK economy has experienced - results in a deterioration in the skills of people made unemployed, often having the largest impact on those with the lowest incomes; and 
high and volatile inflation has significant costs. Prices are a signal for the efficient market allocation of resources. Volatile inflation makes it more difficult to distinguish price movements caused by changes in demand and supply for particular goods and services from general increases in the price level due to excessive demand. The consequence is inefficient allocation of resources. 
2.3 The UK's economic record has made clear the importance the establishing a macroeconomic policy framework which promotes stability: 


between 1980 and 1997, among G7 countries the UK had the second highest average inflation (over 6 per cent) and greater inflation variability than all other G7 countries except France and Italy; 

over the same period, the UK suffered two of the deepest and longest recessions since the war, and had one of the worst records on growth instability of any of the G7 countries; 

interest rates have also been more volatile in the UK than in other G7 countries: for example, between January 1985 and April 1997, official interest rates in the UK were over twice as volatile as those in the US; and 

as a consequence of economic instability, as well as other factors, the UK's record on investment has been poor: before 1999, the UK invested less of its national income than the G7 average in every year since at least 1965. 
2.4 The economic outlook when the Government took office meant that the task of tackling economic instability had to be addressed urgently. GDP was growing at an unsustainable rate, household consumption was increasing sharply and, with rising equity and house prices and windfall payments from building society demutualisations, this trend was set to continue. Inflationary pressures were building, requiring a rise in interest rates to prevent a sharp rise in inflation. In addition, the public finances had deteriorated rapidly in the early 1990s, and in 1996-97 public sector net borrowing stood at £28 billion. 

2.5 The immediate task was to ensure domestic demand was restrained and to prevent inflation from accelerating, while at the same time bringing the public finances into line with what the economy could afford. The Government recognised the importance of tackling the problem within a well-defined and transparent framework for macroeconomic policy, which set clear rules and long-term objectives for policymaking. 


The macroeconomic framework 

2.6 The Government therefore put in place new frameworks for both monetary policy and fiscal policy to achieve economic stability for the long term. The monetary policy framework aims to deliver low and stable inflation, while the fiscal policy framework is designed to achieve sound public finances over the medium term, and to support monetary policy over the short term. Sound public finances are also a prerequisite of sustainable investment in public services. 

2.7 The policy framework is underpinned by four key propositions: 

there is no long-run trade-off between inflation and unemployment; 
for an open economy in a world of liberalised capital markets, a monetary policy framework based on rules which rely on a stable relationship between money and prices does not provide a reliable anchor for policy; 
the discretion necessary for the effective conduct of economic policy can only be exercised within a framework that commands credibility in the markets and generates public trust; and 
the credibility of a policy framework depends on clearly defined long-term policy objectives, a high degree of openness and transparency and policymakers' accountability to Parliament and the public. Accountability, openness and transparency all work together in a mutually reinforcing way to enhance the credibility of the policy framework. 
2.8 The importance of a credible framework to achieve stability is even greater now than in the past, as other economies have liberalised their capital account regime, floated their exchange rates and global capital flows have grown rapidly. The development of global markets emphasises the importance of global stability - as well as delivering economic stability at home, the Government is committed to promoting economic stability and growth and employment in the global economy (see Box 2.1). 

Box 2.1 Promoting international stability 
The UK Government is playing a leading role in international efforts to strengthen the international financial system and to ensure that all countries are able to participate fully in the world economy and share in the benefits of rising global prosperity. Building on a blueprint for reform agreed under the UK Presidency of the G7, the international community has made substantial progress in putting in place new rules and procedures to promote stability and growth. These include: 


a framework of internationally agreed codes and standards covering the key areas that all countries need to address if they are to achieve stability and participate in the international financial system. Developed following a UK proposal, these codes and standards can provide the transparency on which stability depends. The IMF has the lead role in the surveillance of countries' adherence to codes and standards; 
new models of cooperation in global financial regulation. The Financial Stability Forum has been established, bringing together the international and national bodies responsible for financial sector supervision. Over time, the Forum can become an early warning system for regional and global financial risk; 
a new framework for crisis resolution has been developed, based on a partnership between public and private sectors. The private sector has been successfully involved in the handling of a number of recent cases; 
wide-ranging reform of the IMF's various lending instruments, including the Contingent Credit Line, to better adapt them to the changing nature of the global economy. Taken together, these measures will enable the Fund to play a more effective role in supporting member countries' efforts to prevent financial crises; and 
the World Bank and UN are developing principles of good practice in social policy which will help to ensure that the burden of economic adjustment is not placed on the poorest and most vulnerable sectors of society. 
 



The monetary policy framework 

2.9 The UK's long-standing poor inflation record prior to the introduction of the current monetary policy framework reflected shortcomings in the previous design and conduct of monetary policy. Monetary policy in the UK did not have well-specified objectives, was not sufficiently forward-looking and lacked transparency and accountability. Decisions were too easily subject to the influence of short-term political considerations, harming credibility; and the roles and responsibilities of the Government and the Bank of England were not clear or consistent. The monetary framework implemented from 1997 onwards addressed these concerns and has helped to keep inflation close to the Government's target. 

2.10 Under the framework introduced in May 1997, the objectives of monetary policy are clear and precise. The primary objective of monetary policy, set out in the Bank of England Act 1998, is price stability. The Monetary Policy Committee (MPC) is required to hit a specific inflation target - 21/2 per cent for the 12-month increase in the Retail Prices Index excluding mortgage interest payments (RPIX) - at all times. This provides an anchor for inflation expectations and allows the MPC's performance to be assessed objectively. The fact that the target is symmetric - deviations below target are treated as seriously as those above - means that there is no incentive for the MPC to drive inflation below target at the cost of lost output and employment. 

2.11 Policy is implemented by an independent Monetary Policy Committee. Interest rate decisions are therefore removed from short-term political pressures and based solely on the long-term interests of the economy. While the main monetary policy instrument of the MPC is the two-week repo rate, and UK exchange rate policy is set by the Government, the MPC also has limited foreign exchange reserves available for intervening in the foreign exchange market to support its monetary policy objective (see Box 2.2). 

Box 2.2: Exchange rate intervention - roles and responsibilities 
The Government is responsible for determining UK exchange rate policy. As set out in the Chancellor's letter of 6 May 1997 to the Governor of the Bank of England, if the Government so instructs, then the Bank, acting as its agent, may intervene in the foreign exchange market by buying or selling the Government's foreign exchange reserves. Intervention in the foreign exchange market under instruction from the Treasury is conducted through the Exchange Equalisation Account (EEA) which holds the Government's official foreign currency reserves. 

Any intervention undertaken by the Bank on behalf of the Government would be automatically sterilised to avoid interfering with the MPC's monetary policy objective to meet the inflation target, with the Debt Management Office offsetting the impact of the Treasury's intervention on liquidity in the sterling money markets. 

The Monetary Policy Committee may instruct the Bank of England to use its own resources to undertake foreign exchange operations but only in support of its monetary policy objectives as defined in the annual remit letter from the Chancellor to the Governor. The details of any such action would be published in a manner consistent with section 14 of the Bank of England Act 1998. 

The intervention to support the euro, on 22 September 2000, was part of a G7 action. Following the co-ordinated intervention the G7 explained in a joint statement: 


"This action was taken as part of a concerted intervention by the G7 monetary authorities because of the shared concern about the potential implications of recent movements in the euro for the world economy." 
Details of the total holdings of official UK reserves are published monthly in a press release. In keeping with the UK Government's commitment to greater transparency, details of the 22 September intervention were published in the official reserves press release on 4 October. 
 


2.12 Improving the transparency and accountability of monetary policy tends to increase its credibility. The MPC is accountable to Parliament through the appearances of its members before the Treasury Select Committee and the Lords Select Committee on the MPC. Transparency is achieved through various different channels: the MPC publishes the minutes of its meetings and the voting record of its members as well as a quarterly Inflation Report. 

2.13 Monetary policy is able to respond sensibly to shocks. The monetary policy framework allows flexibility in the MPC's response to economic shocks (see Box 2.3). However, if inflation deviates from target by more than one percentage point, the Governor of the Bank must send an open letter to the Chancellor explaining why this has happened, the corrective policy action being taken by the MPC, the period within which inflation is expected to return to target and how the MPC's approach is consistent with the Government's objectives for growth and employment. The open letter system ensures that monetary policy is fully transparent and accountable during periods of possible stress and makes it possible to respond sensibly to shocks.

Box 2.3: Supply shocks and the macroeconomic framework 
A supply shock to the economy alters the cost of producing goods and services, with knock-on effects on the prices that firms charge and therefore the general level of prices. The difficulty for policymakers is to decide on the appropriate policy response to a supply shock. 

The short-run impact of an adverse supply shock is a fall in output combined with a rise in the general level of prices. If policymakers react to the increase in the price level by increasing interest rates to bring the price level back down, output will fall even further as aggregate demand is squeezed by the rise in real interest rates. However, if the supply shock is temporary but accommodated, so that the negative output effect of the supply shock is partially offset by allowing aggregate demand to expand, it leaves open the danger of a wage-price spiral and a permanently higher level of inflation, especially if inflation expectations also increase and are reflected in higher wage bargains. 

Economic policymakers must therefore carefully balance the objective of mitigating the negative impact of an adverse supply shock on output with ensuring price stability. 

There are several reasons why the UK macroeconomic framework, which rests on the pillars of the monetary and fiscal frameworks, is now more robust to adverse supply shocks: 


under its monetary framework, the Government has set an explicit inflation target of 21/2 per cent for the 12-month increase in the retail prices index excluding mortgage interest payments (RPIX) which the Bank of England Monetary Policy Committee (MPC) must target at all times under the Bank of England Act 1998. This provides an explicit anchor for inflation expectations; 

the independent status of the Bank of England has put monetary policy on a more credible footing, removing political influence from the setting of interest rates. Enhanced credibility has in turn meant that inflation expectations are now more firmly anchored to the Government's inflation target and are less fragile to temporary deviations of inflation from the target; 

becaues the inflation target is symmetric it ensures that the MPC responds sensibly to economic shocks. The Bank of England Act 1998 framework makes it clear that the MPC should support the Government's objective of high and stable levels of growth and employment subject to meeting the inflation target. If inflation deviates from target by one percentage point or more, the Governor of the Bank of England is required to write an open letter to the Chancellor. This transparency reinforces the accountability built into the monetary policy framework, further enhancing its credibility; and 

the Government's fiscal rules are set over the economic cycle to ensure that the automatic stabilisers built into fiscal policy are allowed to work to dampen the effects of economic shocks on output, while ensuring sound public finances in the medium term. 
 


The fiscal policy framework 

2.14 The public finances deteriorated rapidly in the early 1990s. By 1997, the ratio of net debt to GDP had risen to over 44 per cent and the current deficit exceeded £20 billion. This impacted on the quality of public services. Public investment as a share of GDP had fallen sharply and public sector net worth was falling. Fiscal policy failed to promote stability, with an insufficient focus on the long term. A lack of clear and transparent fiscal objectives and an inadequate basis for full and effective public and parliamentary scrutiny of fiscal policy contributed to the earlier deterioration in the public finances. 

2.15 The Government therefore took significant steps to strengthen the framework for fiscal policy. It implemented a new framework based on a set of five principles - transparency, stability, responsibility, fairness (including between generations) and efficiency. These principles were enshrined in the Finance Act 1998 and the Code for Fiscal Stability, approved by the House of Commons in December 1998. The Code sets out how these principles relate to the formulation and implementation of fiscal policy in practice. 

2.16 The Government's key objectives for fiscal policy are: 

over the medium term, to ensure sound public finances and that spending and taxation impact fairly both within and across generations; and 
over the short term, to support monetary policy; and, in particular, to allow the automatic stabilisers to play their role in smoothing the path of the economy. 
2.17 These objectives are embodied in the Government's two fiscal rules, against which the performance of fiscal policy can be judged: 

the golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending. It is met when, over the economic cycle, the current budget is in balance or surplus; and 
the sustainable investment rule: public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level. Other things equal, a reduction in public sector net debt to below 40 per cent of GDP over the economic cycle is desirable. 
2.18 The golden rule distinguishes between current spending, which benefits the current generation, and capital spending which benefits both current and future generations. By allowing the current generation to borrow only to fund capital spending, with current spending met by current receipts, the golden rule helps to match the cost and benefits of public spending over time. This is consistent with the Government's objective of generational equity. The golden rule also enhances the efficiency of government spending because it means that growth-enhancing public investment is not sacrificed for current spending. The sustainable investment rule complements the golden rule by ensuring that borrowing for public investment is conducted in a responsible way. 

2.19 Consistent with these objectives and the strict fiscal rules, firm action has been taken to return the public finances to a sound footing. Difficult decisions were required. The Government worked within the spending plans it inherited from the previous Government for its first two years. The Government also made a number of tax decisions, for example, continuing until the Pre-Budget Report 1999 announcement to raise fuel duties by more than inflation in line with the escalator introduced by the previous Government. This fiscal prudence led to a cumulative structural fiscal improvement of about 41/2 per cent of GDP between 1996-97 and 1999-2000, returning the public finances to a sustainable position. 

2.20 Sound public finances which are sustainable over the economic cycle are not only essential to ensure economic stability, they are also necessary for sustainable investment in public services1 


The new public spending framework 

2.21 In parallel with the strict control of public expenditure in the first two years of this Parliament, the Government undertook a root and branch assessment of spending needs. The Comprehensive Spending Review in 1998 addressed the issue of strategic reforms to planning and control of public spending, as well as setting new plans for the remaining three years of the Parliament. These plans were extended to 2003-04 in the 2000 Spending Review which reported in July. The Government's spending framework is based on: 

Department Expenditure Limits (DEL) which have now been set for all government departments. The DELs provide departments with a solid basis for planning their own costs effectively; and 
Annually Managed Expenditure (AME) which covers those elements of spending which cannot reasonably be subject to firm multi-year limits and are instead subject to tough annual scrutiny as part of the Budget process. This Pre-Budget Report provides revised projections of individual AME programmes. 
2.22 Together DEL and AME sum to Total Managed Expenditure (TME). For each department, separate budgets are set for resource (current) and capital spending, consistent with the distinction in the fiscal rules. Departments are required to manage their resource and capital budgets separately. This removes the bias against investment that was present in the previous planning regime. The switch to resource accounting and budgeting in the 2000 Spending Review builds on the previous arrangements by requiring departments to plan, control and account for their spending on a full accruals basis. 

2.23 Ensuring modernisation of public services and a focus on efficient and effective service delivery is also an important element of the new spending framework. Each department is committed, through Public Service Agreements (PSAs), to achieve specific performance targets. Departments have also drawn up Departmental Investment Strategies (DIS), first published in March 1999, to show how they will manage capital effectively and how investment decisions are taken on a robust basis so as to maximise the benefits of the extra investment. 

2.24 PSAs were first published after the 1998 Comprehensive Spending Review and have since been developed further. Progress against targets is monitored quarterly, with performance considered by Cabinet level committee. New PSAs form an integral part of the 2000 Spending Review settlement, with fewer targets that are more focused on outcomes. Service Delivery Agreements (SDAs) have been devised to complement and underpin the PSAs, providing more operational detail on how priorities will be delivered efficiently and effectively. These were published on 3 November and revised Departmental Investment Strategies will be published shortly. 

Box 2.4: Whole of Government Accounts 
The Government has already introduced resource accounting and budgeting to improve the management and measurement of public spending and is now working towards producing Whole of Government Accounts (WGA) as a further step in ensuring that best-practice accounting methods are used to construct the public accounts and fiscal reporting is as transparent as possible, as required by the Code for Fiscal Stability. 

WGA are commercial-style "true and fair" accounts covering the whole of the public sector. Like departmental resource accounts, WGA will be produced on an accruals basis and use generally accepted commercial accounting standards and practices, adapted where necessary for government. They will treat government as if it were a single entity by eliminating all significant transactions and amounts owed between public sector entities. 

WGA will provide better quality and more transparent data for the planning of fiscal policy, and facilitate better management of public services and more effective distribution of resources. In particular, WGA will give audited data to underpin the operation of the golden rule, and allow the public sector balance sheet to be used in fiscal management. 

Central Government Accounts (CGA) are a necessary first step towards WGA. The plan is to produce 'dry-run' CGA for 2001-02 and 2002-03, with the first CGA published for 2003-04. However the full benefits for fiscal policy will only be achieved when WGA covering the entire public sector are available. The aim is to produce 'dry-run' WGA for 2003-04 and 2004-05, with the first WGA published for 2005-06. 
 


2.25 The envelope for current spending announced in the 1998 EFSR set real growth in current spending at 21/4 per cent a year over the three year period covered by the Review, in line with what could be afforded while ensuring the fiscal rules were satisfied. This allowed more efficient long-term management and planning of public spending, while ensuring that fiscal consolidation was successful in delivering savings in debt interest and social security expenditure as the fiscal position moved into surplus and unemployment continued to fall. These savings have helped make room for the additional investment announced in the 2000 Spending Review. 


Performance of the frameworks 

2.26 Collectively, these reforms to the monetary and fiscal frameworks and public spending regime have created a broad and coherent strategy to put the UK economy on a sustainable path to deliver high and stable levels of growth and employment. 

2.27 The new macroeconomic framework has helped to deliver economic stability and avoid large and destabilising fluctuations in output. Despite a large external shock in 1998, output growth has remained stable and above 2 per cent in each of the last three years, with growth of 3 per cent expected this year. The latest economic forecast indicates that growth is expected to remain in the range of 21/4 to 23/4 per cent next year and thereafter. 

2.28 Large swings in output have been avoided for a number of reasons: 

interest rate decisions have been made in a forward-looking manner, taking account of the fact that they impact on output and inflation with a lag. Interest rates have thus been set pre-emptively to counteract any large swings in output and inflation before they occur. Rates have peaked at a much lower level than in previous economic cycles when they often responded to economic shocks too late; and 
fiscal policy has supported monetary policy throughout the economic cycle. The substantial fiscal tightening in 1997-98 and 1998-99 supported monetary policy when output was above its trend level, while also eliminating the large structural deficit. The fiscal tightening continued in 1999-2000, at a time when inflationary pressures were mounting. The MPC raised the repo rate until February this year. Since then it has remained unchanged at 6 per cent, while market interest rate expectations have fallen by over 50 basis points. 
2.29 Since May 1997, RPIX inflation has moved in a narrow band between a low of 1.9 per cent and a high of 3.2 per cent, averaging 2.5 per cent over this period, in line with the Government's target (see Chart 2.1). 

Chart 2.1 

2.30 Inflation expectations, as measured by survey and financial markets data, show that inflation is expected to remain close to the Government's target, having fallen from over 4 per cent in 1997. This suggests that the MPC continues to command a high degree of credibility and that wage and price setters in the economy may be keeping increases in real wages and prices more in line with increases in productivity and profits. 

2.31 The new fiscal framework has restored the public finances to a healthy and sustainable position, making possible the investment in public services awarded in Spending Review 2000, while allowing fiscal policy to support monetary policy through the economic cycle. 

Box 2.5: EMU and EMU preparations 
The Government's policy on membership of the single currency remains as set out by the Chancellor of the Exchequer in his statement to the House of Commons in October 1997, and restated by the Prime Minister in February 1999. The determining factor underpinning any Government decision on membership of the single currency is the national economic interest and whether the economic case for joining is clear and unambiguous. The Government has set out five economic tests which must be met before any decision to join can be made. The Government has said that it will produce another assessment of the five tests early in the next Parliament. Because of the magnitude of the decision, the Government believes that, whenever a decision to enter is taken by Government, it should be put to a referendum of the British people. 

The Government is committed to ensuring that the UK retains a genuine option to join a successful single currency. Over the past three years, the Government has worked intensively with the business community, wider public sector and voluntary groups both to ensure that the necessary preparations were in place to deal with the euro from 1 January 1999, and to take forward detailed planning work for possible UK entry, if that is what Government, Parliament and the people decide. 

The Government has provided a range of practical help for UK businesses trading in the euro, including case studies, fact sheets and electronic tools. It has carried out surveys, and worked with 12 Regional Euro Forums to provide help at the local level. It also prepares regular progress reports on euro preparations. 

The Treasury published the second Outline National Changeover Plan in March 2000. The plan, which was drawn up in consultation with business, the voluntary sector and the public sector, sets out the planning assumptions for a possible changeover to the euro. The public sector has given a clear signal of its commitment to prepare, undertaking targeted investment as part of the ongoing modernisation of public sector systems. 
 


FISCAL STRATEGY 


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Budget 2000 

2.32 The Government's fiscal strategy continues to be underpinned by the macroeconomic framework. Building on the achievement of sound public finances and the platform of stability which is now being delivered, Budget 2000 set a firm spending envelope for the three years covered by the 2000 Spending Review. The Budget locked in the fiscal tightening of Budget 99 and ensured that the Government remained on track to meet its fiscal rules, while also releasing resources for vital public services, allowing: 

an increase in real current spending of 21/2 per cent a year in line with the Government's neutral view of the economy's trend rate of growth; and 
a more than doubling of net investment by 2003-04. 
2.33 These spending increases were also consistent with meeting the fiscal rules in a more cautious case where the level of trend output is assumed to be 1 percentage point lower than in the central case. Maintaining this cautious approach is essential, given the inherent uncertainties surrounding projections of the public finances. 


2000 Spending Review 

2.34 The 2000 Spending Review in July provided a detailed breakdown of spending plans for the next three years, consistent with the spending limits announced in Budget 2000. Revised economic and fiscal projections were not published as part of the Spending Review outcome, but estimates of AME were revised incorporating the effects of updated assumptions. Within the Budget envelope, the Government was able to allocate additional resources to key public services as a result of prudent management of the public finances. Among the areas in which the Government has made savings are: 

lower growth in spending on social security, through cutting the cost of worklessness; and 
reduced debt interest payments resulting from lower interest rate expectations and the debt repayment following the auction of mobile phone licences. 
As a result, changes in social security benefits and debt interest payments are expected to account for 17 per cent of the change in TME in the period 2000-01 to 2003-04. This compares to 42 per cent in the period 1978-79 to 1996-97. Table 2.1 illustrates this and includes the impact of Pre-Budget Report measures. This means that a greater share of extra resources are available for priority public services. 

Table 2.1: Changes in Total Managed Expenditure accounted for by social security benefits and debt interest payments 


--------------------------------------------------------------------------------
 1978-79 to 1996-97 1996-97 to 2003-04 2000-01 to 2003-04  
Social security benefits1 33% 22% 21% 
Central Government Debt interest payments 9% -3% -4% 

1 For the purpose of comparison, social security includes Working Families' Tax Credit and Disabled Persons Tax Credit. 


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2.35 The Government also decided in the 2000 Spending Review to manage prudently the DEL underspends. The actual outturn for the DEL underspend in 1999-2000 was £2 billion above the Budget 2000 estimate of £1 billion. Instead of carrying forward the full amount, the Government used £1/2 billion of the additional underspend to repay debt and carried forward only £11/2 billion. This £11/2 billion was spread equally between 2000-01 and 2001-02 to help smooth the path of public spending. 

2.36 The additional resources provided for in the 2000 Spending Review settlement will have an important impact on the productivity and sustainable growth of the economy. They will improve economic infrastructure and the skills of the labour force enhancing capital accumulation. They will support research and development and improve the way technology brings together these resources. Important areas of investment include: 

increased capital investment in schools amounting to £7.8 billion over 2000-01 to 2003-04; 
the Ten Year Plan for Transport which set out a balanced package of investment in high quality public transport and targeted improvements to the road network; and 
a £1 billion Science Research Investment Fund, in partnership with the Wellcome Trust, to boost investment in buildings, laboratories and equipment over two years. 
2.37 This investment programme demonstrates the Government's commitment to the renewal and modernisation of the capital stock, reversing years of under-investment by delivering rapid growth in public investment over the next three years. Chapter 5 provides more details. 

2.38 At the same time, the Government has ensured that economic stability is not put at risk. The Government adhered to the fiscal rules in setting the firm spending envelope in Budget 2000, and in the Spending Review announcement in July. 

2.39 The challenge for this Pre-Budget Report is to ensure that the Government not only remains on track to meet its strict fiscal rules over the economic cycle, but that it also underpins the 2000 Spending Review settlement by putting in place policies that will improve public services and create higher levels of productivity and employment. In doing so, it remains important that fiscal policy continues to support monetary policy over the cycle. 

RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS 


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2.40 The Pre-Budget Report presents an update on the position and outlook for the economy and the public finances, taking into account economic and other developments since the Budget. The two are interdependent, and this section looks at the economy first before discussing the impact on public finances. This is the first full update covering the economy, receipts and spending to incorporate the outcome of the 2000 Spending Review. 


Recent economic developments 

2.41 The UK economy has witnessed continued strong growth combined with low inflation since Budget 2000. GDP grew by 0.7 per cent in the third quarter and 2.9 per cent on a year earlier, exceeding its estimated trend rate. The balance of growth has also improved, with stronger world demand boosting net exports and domestic demand growth moderating in 2000 - for example, in volume terms, total UK manufacturing exports grew by more than 12 per cent in the year to July 2000 despite the continued weakness of the euro against the pound. Domestic costs have decelerated significantly keeping RPIX inflation close to 2 per cent despite stronger external pressures, in particular due to the further sharp rise in oil prices. The combination of a pre-emptive monetary policy and supportive fiscal policy continues to ensure that there should be no repeat of the late 1980s. Then, an inappropriate macroeconomic policy stance failed to restrain aggregate demand in line with sustainable levels which resulted in a rapid rise in the output gap and inflation, precipitating a deep and long recession in the early 1990s when policy was forced to tighten. 

2.42 Favourable economic developments in 2000 and recent years reflect a clear underlying improvement in labour market performance. The Labour Force Survey (LFS) measure of employment has risen by 330,000 over the past year, driving unemployment to its lowest rates since the 1970s. Underlying earnings growth has, nevertheless, fallen just below 41/2 per cent, with the headline measure falling further in 2000 as the impact of strong bonuses and millennium-related payments dissipated. With no upward trend in unit wage cost growth in recent years, it appears that the sustainable rate of unemployment (NAIRU) has fallen broadly in line with actual unemployment, to around 51/2 per cent on the ILO measure. 

2.43 This has contained inflationary pressures and helped to keep interest rates historically low. Box A1 examines some possible explanations, in particular highlighting sharp falls in long-term unemployment related to a succession of labour market reforms including the New Deals. Nevertheless, the judgement on the NAIRU is subject to considerable uncertainties, with important implications for trend output and the public finances. This chapter later shows that the Government would remain on course to meet its fiscal rules even on much more cautious assumptions concerning the current cyclical position of the economy. 


The economic cycle 

2.44 Growth in domestic costs and measures of domestically-generated inflation have remained relatively subdued since the first half of 1997, when the economy is previously judged to have been on trend. The evidence suggests that output returned to potential around mid-1999, after moving above trend in 1997 and 1998, and was followed by a small deviation below trend in early 1999. Since then most survey measures of capacity and labour utilisation have begun to move above their long-run averages. Buoyant output growth - averaging just over 21/2 per cent between the first half of 1997 and mid-1999 - therefore appears to have been matched by a corresponding expansion in potential output over the same period. 

2.45 This assessment of the probable shape of the UK economic cycle since 1997 is broadly unchanged from Budget 2000. But recent revisions to measured GDP have increased estimates of potential output and trend growth over recent years. The Treasury's revised assessment is set out in detail in Annex A. Although trend growth has been boosted by sustainable increases in employment, underlying productivity growth has yet to improve. This is surprising, especially given increased ICT usage in the UK economy. The contrast with developments in the US may partly reflect measurement issues, but this productivity gap also highlights both the necessity and opportunity for a stronger performance in the period ahead. 

2.46 Given the closeness to trend throughout 1997 to 1999, possible measurement errors and the prospect of future data revisions, it is difficult to conclude for certain whether the economy has completed a full, albeit short and shallow, economic cycle between the first half of 1997 and mid-1999. For the purposes of this Pre-Budget Report and the assessment of the performance against the fiscal rules, the provisional judgement remains that a cycle may have been completed by mid-1999 when the current cycle is assumed to begin. On these bases, the fiscal rules were clearly met over this period. 


Economic prospects 

2.47 Buoyant output growth can be accommodated for a period, given the starting position of RPIX inflation below the Government's 21/2 per cent target. However, as argued in Budget 2000 and as noted by the Bank of England's MPC, it is important that domestic demand falls back to sustainable rates. Interest rates were raised pre-emptively in the six months up to the Budget, with the full impact on private spending likely to build further into 2001. Household consumption growth has already slowed markedly, reinforced by slower growth in wealth. As in Budget 2000, GDP growth is forecast to ease from 3 per cent in 2000 to its estimated sustainable rate of 21/4 to 23/4 per cent in 2001 and later years. 

Table 2.2: Summary of forecast 


--------------------------------------------------------------------------------
 Forecast 
 1999 2000 2001 2002 2003 
GDP growth (per cent) 21/4 3 21/4 to 23/4 21/4 to 23/4 21/4 to 23/4 
RPIX inflation (per cent, Q4) 21/4 21/4 21/2 21/2 21/2 

2.48 RPIX inflation has remained subdued, despite the inflationary impulse of dearer oil. Firms have experienced difficulties passing on increases in costs, particularly in manufacturing. However, stronger import price inflation overall, and a less negative contribution from falling business margins, is expected to return RPIX to the Government's target rate by mid-2001. Further moderation in domestic demand should help keep earnings growth within sustainable limits, though there remain some clear upside risks. In particular, the recent fall in the net household saving ratio has been unexpectedly sharp, as a result of higher borrowing by households, notwithstanding lower precautionary saving due to low inflation and greater economic stability (see Box A4). Chapter 5 describes the steps the Government is taking to promote savings. 

2.49 The inflation outlook, nevertheless, remains very finely balanced. In the short run, a stronger than forecast compression of retail margins is entirely plausible. The medium-term mix of growth and inflation might be more permanently improved through an underlying improvement in supply performance. Manufacturing firms will be looking to build on recent improvements in productivity growth to restore profitability. Moreover, the Pre-Budget Report forecast does not assume any underlying improvement in productivity growth associated with the rapid adoption of new economy technologies and associated diffusion of related know-how across the economy. Box A2 looks at these supply-side opportunities in more detail. 

RECENT FISCAL TRENDS AND OUTLOOK 


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2.50 The public finance projections in the Pre-Budget Report have a different status to those included in the EFSR and FSBR at Budget time. They present an interim forecast update and do not necessarily represent the outcome the Government is seeking. The fiscal effect of firm decisions announced now have been incorporated into the fiscal projections in accordance with the requirements of the Code for Fiscal Stability. In addition, a number of possible transport measures, detailed in Chapter 6, are subject to consultation, costing in the order of £13/4 billion a year. Decisions on these and other issues will be taken in the Budget and, along with revised forecasts for the public finances and the economy, will impact on the final Budget forecast. 

2.51 Nonetheless, the projections allow for an updated assessment of progress against the Government's two fiscal rules. They update the projections in Budget 2000 for the latest information and are presented in line with the November 1999 Treasury paper Analysing UK Fiscal Policy, under the five key themes of fairness and prudence, sustainability, economic impact, financing and European commitments. Full details of the updated fiscal projections are set out in Annex B. 

2.52 While the economic forecast is based on a neutral estimate of 21/2 per cent a year trend growth looking forward over the projection period, the public finances projections continue to be based on the deliberately prudent and cautious trend growth assumption of 21/4 per cent a year. The Government is determined not to repeat the mistakes of the past by assuming a potential improvement in trend growth before this has demonstrably been achieved and audited. The public finances will continue to be projected on the cautious assumption of 21/4 per cent a year trend growth in Budget 2001. 

2.53 The trend growth assumption is just one of a number of key assumptions audited by the National Audit Office (NAO) under a three-year rolling review established in Budget 2000. For this Pre-Budget Report, the NAO has reviewed the assumptions for equity prices, price deflators and VAT receipts. In each case the Comptroller and Auditor General has concluded that it is reasonable that the assumptions continue to be used. In addition, the NAO has audited the performance of these assumptions in the past three years as well as the assumption underlying the projected savings from Spend to Save programmes. The public finances projections which follow show the Government's central projection, based on these cautious assumptions and the latest information on receipts and public expenditure. 

Receipts 

2.54 Receipts for 2000-01 are now expected to be stronger than expected in the Budget. Full details of changes in tax and spending since the Budget are in Annex B. The better than anticipated position for receipts reflects a number of factors, including: 

higher outturns in 1999-2000 than expected at the time of Budget 2000, in particular for income tax. This has raised the forecast base, affecting the profile into future years; 
buoyant current year receipts, notably income tax and North Sea revenues, where outturns have been better than expected; and 
greater than expected proceeds from the radio spectrum auction which have increased receipts on an accruals basis and have also resulted in lower debt interest payments and higher receipts of interest and dividends. 
However, some offsets to these gains arise from lower expected receipts from corporation tax and capital gains tax. 

2.55 The detailed forecast shows that, while the outturn for receipts in the first half of this fiscal year has been strong in comparison to the equivalent period last year, the comparative increase for the second half of the year is expected to be less. Table B12 shows, in particular, the effects of corporation tax reforms to the timing of receipts in year. For April-September, receipts are £1 billion higher than the comparable period last year. Based on early outturns for October, the forecast is that receipts for October - March will be £3 billion lower than the same period last year. In addition, the forecast also shows that, based on a lower than expected outturn for receipts in 1999-2000 and latest information on asset disposals, the projection for this year for capital gains tax is £0.4 billion lower than expected at the Budget. 

2.56 Higher forecasts for receipts this year raise the forecast base for future years and the projections, based on the cautious assumptions, indicate that receipts will be higher than expected in the Budget throughout the forecast period. Higher income tax receipts resulting from stronger employment and earnings growth continue to offset reductions to the corporation tax forecast. 


Annually managed expenditure 

2.57 On public expenditure, projections for TME are unchanged for 2000-01 from the Spending Review White Paper. Projections for DEL from 2000-01 to 2003-04 are also unchanged compared to the Spending Review except for a single classification change which means a transfer from DEL to AME detailed in table B13. Since the Budget there have been significant savings in social security benefits and debt interest payments, before the effect of new Pre-Budget Report measures is taken into account. Table 2.3 decomposes the elements into those which were included in the Spending Review projections due to updated assumptions and further changes for this Pre-Budget Report. 

Table 2.3: Savings in Annually Managed Expenditure (AME) since Budget 2000 due to social security and debt interest payments 


--------------------------------------------------------------------------------

 £billion 
 2000-01  2001-02  2002-03  2003-04 
Changes from Budget 2000 to Spending Review 2000 due to updated assumptions 
Social security benefits1 -0.1 -0.4 -0.4 -0.8 
Central government debt interest -0.8 -1.0 -1.4 -1.5 
Changes from Spending Review 2000 to PBR 2000 
Social security benefits2 -0.8 -1.4 -1.4 -1.9 
Central government debt interest -0.1 -1.5 -0.5 -0.3 



--------------------------------------------------------------------------------

1Changes in social security benefits, including Housing Revenue Account Subsidy, due to updated assumptions in unemployment, spend to save and interest rates. 

2Excluding PBR measures. 


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2.58 Before taking into account the new measures, social security and debt interest payments are forecast to be about £1 billion lower this year and around £3 billion lower in 2001-02 than at the Spending Review, although there are some increases to forecasts for other AME spending programmes. Table B19 shows further details, including the offset in the AME margin. 


Discretionary policy changes 

2.59 In considering the impact of additional discretionary policy changes on the fiscal position, the Government has considered: 

the importance of ensuring that the fiscal rules are met over the economic cycle; 
its broader, medium-term fiscal policy objectives, including the need to ensure sound public finances and that spending and taxation impact fairly both within and across generations; and 
the need to ensure that fiscal policy supports monetary policy. 
2.60 Within these strict constraints, and in the light of improved forecasts, it has been possible to: 

release additional resources for pensioners worth £21/2 billion a year by 
2002-03; 
introduce a package of tax reforms to encourage UK productivity, while protecting the environment in the longer term. 
In the light of a reduced forecast for AME expenditure in the current year, the £50 increase in this year's winter fuel payment and the rebate of lorry VED, costing £0.7 billion in total, have been absorbed within the AME margin in 2000-01. From 2001-02, the additions to AME arising from discretionary policy changes have been added to TME. 

2.61 Table B4 gives further details of the measures. As noted above, the Pre-Budget Report also includes a number of transport measures which have not been included in the forecast since they are subject to consultation. These would cost in total around £13/4 billion a year if they were all to be implemented1. Decisions on these measures will be taken in the Budget when the Government will also review its AME forecast and the AME margin. In line with the usual convention adopted in previous Pre-Budget Reports, changes to the forecast for AME programmes have been offset in the AME margin. The interim forecast shows that the 
interim AME margin has increased over the level set in the 2000 Spending Review by £1.7 billion for 2001-02, £1.6 billion in 2002-03, and £1.6 billion in 2003-04. 

FISCAL POSITION AND MEDIUM-TERM PROJECTIONS 


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2.62 Table 2.4 compares the medium term projections for the surplus on current budget and public sector net borrowing with those in Budget 2000. The changes are decomposed into those explained by the policy measures and those explained by forecasting revisions and other changes. Annex B gives greater detail on these revisions, including the decisions taken in the Spending Review. Table B4 sets out the detail of the PBR policy measures. 

Table 2.4: Fiscal balances comparison with Budget 20001 


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 Outturn2 Projections 
 1999-00  2000-
01  2001-
02  2002-
03  2003-
04  2004-
05 
Fiscal balances (£billion) 
Surplus on current budget1 
Budget 2000 17.1 14 16 13 8 8 
Effect of SR2000/forecasting changes 2.3 2.5 3 5 4 5 
Effect of PBR policy measures on receipts  0.0 -1 -1 -1 -1 
Effect of PBR policy measures on spending  0.0 -2 -3 -3 -3 
PBR 2000 19.4 16.6 16 14 8 8 
Net borrowing1 
Budget 2000 -11.9 -6 -5 3 11 13 
Effect of SR2000/forecasting changes -4.5 -3.6 -4 -6 -5 -5 
Effect of PBR policy measures on receipts  0.0 1 1 1 1 
Effect of PBR policy measures on spending  0.0 2 3 3 3 
PBR 2000 -16.4 -10.1 -6 1 10 12 
Cyclically adjusted budget balances (per cent of GDP) 
Surplus on current budget - Budget 2000 1.8 1.3 1.3 1.0 0.7 0.7 
Surplus on current budget - PBR 2000 1.9 1.5 1.4 1.1 0.6 0.7 
Net borrowing - Budget 2000 -1.2 -0.5 -0.3 0.5 1.1 1.1 
Net borrowing - PBR 2000 -1.6 -0.8 -0.3 0.3 1.1 1.1 


1 Excluding windfall tax receipts and associated spending. Figures may not sum due to rounding. 

2 The 1999-2000 figures were estimates in Budget 2000. 


1Tax changes subject to consultation are not included in projections of the net tax burden set out in Table B10. 
If implemented, they would have the following impact: (per cent of GDP) 

2001-02 2002-03 2003-04 2004-05 
-0.2 -0.2 -0.2 -0.2 




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2.63 The fiscal position for 2000-01 has improved since the Budget. A current budget surplus of £161/2 billion is now expected for 2000-01, around £21/2 billion higher than the Budget 2000 forecast. The net borrowing position is also better than expected at the time of Budget 2000. A repayment of about £10 billion is now estimated for 2000-01, about £31/2 billion higher than the Budget forecast. 

2.64 The table distinguishes between the headline figures and the underlying structural position, which includes adjustments for the effects of the economic cycle. This is necessary because the Government takes care not to treat cyclical improvements to the public finances as structural improvements. The cyclically adjusted current surplus for 2000-01 is projected to equal 1.5 per cent of GDP, up on the Budget forecast of 1.3 per cent. 

2.65 Looking at Public Sector Net Borrowing (PSNB) on a cyclically-adjusted basis, a surplus of 0.8 per cent of GDP is estimated for the current fiscal year, compared with the Budget 2000 estimate of 0.5 per cent of GDP. In each year of the projection period, the fiscal stance - as measured by the cyclically-adjusted PSNB - is on track to be at least as tight as set out in Budget 2000. The Pre-Budget Report projections show that fiscal policy is continuing to support monetary policy, promoting economic stability. 

Table 2.5: Summary of public sector finances1 


--------------------------------------------------------------------------------
 Per cent of GDP 
 Outturn  Projections 
 1999-00  2000-
01  2001-
02  2002-
03  2003-
04  2004-
05  2005-
06 
Fairness and prudence 
Surplus on current budget 2.1 1.7 1.6 1.3 0.7 0.7 0.7 
Average surplus since 1999-2000 2.1 1.9 1.8 1.7 1.5 1.4 1.3 
Cyclically-adjusted surplus on current budget 1.9 1.5 1.4 1.1 0.6 0.7 0.7 
Long-term sustainability 
Public sector net debt2 36.8 32.3 30.9 30.1 30.2 30.3 30.4 
Net worth2,3 17.3 18.7 20.1 20.4 20.3 20.1 19.6 
Primary balance 4.3 3.3 2.6 1.8 0.8 0.7 0.5 
Economic impact 
Net investment 0.3 0.7 1.0 1.4 1.7 1.8 1.8 
Public sector net borrowing (PSNB) -1.8 -1.1 -0.6 0.1 0.9 1.0 1.1 
Cyclically-adjusted PSNB -1.6 -0.8 -0.3 0.3 1.1 1.1 1.1 
Financing 
Central government net cash requirement2 -1.0 -3.0 -0.1 0.5 1.4 1.4 1.4 
European commitments 
Maastricht deficit4 -1.8 -1.1 -0.6 0.1 0.9 1.0 1.1 
Maastricht debt ratio5 43.6 40.1 37.7 36.1 35.6 35.5 35.4 
Memo: Output gap 0.2 0.5 0.4 0.3 0.2 0.1 0.0 

1Excluding windfall tax receipts and associated spending. 

2Including windfall tax receipts and associated spending. 

3Previously net wealth. 

4General government net borrowing on an ESA95 basis. The Maastricht definition includes the windfall tax and associated spending. 

5General government gross debt. 


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Golden rule 

2.66 Table 2.5 demonstrates that, given non-discretionary changes to receipts and spending and after releasing additional resources, the Government remains well on course to meet both fiscal rules. The surplus on current budget represents the difference between current receipts and current expenditure, including depreciation. It measures the degree to which current taxpayers meet the costs of paying for the public services they use and so is an important indicator of the generational fairness of the finances. 

2.67 The surplus on current budget is projected to be equivalent to 1.7 per cent of GDP in 2000-01. It is then projected to decline to 0.7 per cent of GDP by 2003-04, because of the increased current spending provided by 2000 Spending Review , thereafter remaining broadly stable. 

2.68 On a cyclically-adjusted basis, the current surplus remains clearly positive through the period. The average surplus since 1999-2000, which on the Government's provisional judgement is the start of the current cycle, also stays positive, remaining over 1 per cent over the next five years. On this basis, the Government is on track to meet the golden rule. 

Chart 2.2 

Sustainable investment rule 

2.69 Net debt has declined more sharply than predicted. With the benefits of sound public finances, lower interest rate expectations and the proceeds from the auction of spectrum licences, the public sector net debt ratio is projected to fall to around 32 per cent of GDP this year and then to about 30 per cent in 2002-03, thereafter remaining broadly stable and well below 40 per cent. Debt interest payments are forecast to be £6 billion a year lower in 2003-04 than in 1997-98. The Government is firmly on track to meet the sustainable investment rule, while also releasing resources for investment in priority public services and maintaining a cushion against further shocks. Chart 2.2 shows the projections of the current budget remaining in surplus and falling net debt. 

2.70 Another measure of the sustainability of public finances is net worth, the difference between the total assets and liabilities of the Government. Net worth is projected to rise to at least 20.3 per cent of GDP by 2003-04. This follows a prolonged period in which the poor state of the public finances led to net worth falling below 15 per cent of GDP. The primary balance (PSNB excluding debt interest payments) also remains in surplus over the forecast period. It is forecast to be 3.3 per cent of GDP for 2000-01, falling to 0.5 per cent by 2005-06. 

Box 2.5: The radio spectrum auction and the public finances 
The recent auction of licences covering the use of part of the UK's radio spectrum raised £22.5 billion in total, considerably more than forecast at Budget time. In line with the view of the Office for National Statistics, the proceeds from the auction will be accrued over the length of the licences, which expire in 2021. 

The Government has decided that the payments will be used to reduce public sector net debt. The effect of this is to reduce debt interest payments over the next few years and beyond. This is in line with the Government's prudent approach, ensuring that a long-term view is taken of the public finances while fiscal policy continues to support monetary policy in the short term. 

Savings from lower debt interest payments were factored into the Spending Review and are making room for additional spending on key public services over several years and not just in the first year the money is received. This ensures that the proceeds from the auctions are spread over time so that future generations also benefit from the one-time improvement in the public finances - in line with the Government's objective of generational equity. 
 



Economic impact 

2.71 The overall impact of fiscal policy on the economy can be assessed by examining changes in PSNB. The interim forecast for net borrowing is set out in Chart 2.3 which shows the actual and cyclically-adjusted figures as a percentage of GDP. The cyclically-adjusted PSNB is projected to be tighter this year than the Budget 2000 forecast by an amount equivalent to 0.3 per cent of GDP. The difference between this cyclically-adjusted figure and the headline figure (amounting to 0.3 per cent of GDP for 2000-01) shows the effect of the automatic stabilisers, which are continuing to dampen the cycle. Looking forward, PSNB is projected to move into deficit by 2003-04 because the Government is planning to borrow modestly to fund its increased investment in the country's capital stock. This is fully consistent with the Government's long-term approach and the fiscal rules since net debt is being kept at a stable and prudent level, well below 40 per cent. 

Chart 2.3 

Financing 

2.72 The forecast for the central government net cash requirement (CGNCR) has been revised from - £4.9 billion to -£28.2 billion, a difference of £23.3 billion. This revision is largely due to the proceeds from the spectrum licence auction which were £19.5 billion higher than the Budget assumption. It was decided that these proceeds should be used to reduce net debt. In light of this, a revised Gilts Remit for 2000-01 was published on 12 June 2000. Planned gross gilt sales were cut by £2.2 billion to £10.0 billion and fixed at that level for the remainder of the financial year. Additionally, the remaining contingencies outlined in the Debt Management Report 2000-01 were exercised. It was also announced that further decisions on allocating the proceeds in the light of the revised forecast of the CGNCR would be announced at the time of the Pre-Budget Report. The further reductions in net debt in 2000-01 will be achieved by: 

increasing the total of planned debt buy-backs by £1.5 billion; 
increasing the reduction in the Ways and Means advance by £1.6 billion; 
reducing the planned Treasury Bill stock for end March 2001 by a further £4.5 billion; and 
planning for the residual cash position of £6.3 billion (to be reduced over the next three financial years). 
2.73 The rest of the financing requirement is accounted for by a further forecast decline of £0.7 billion in net financing from National Savings. Full details of these measures and an updated table for the Government's Financing Requirement for 2000-01 can be found in Annex B. Gross gilt sales for the financial year to date have been £4.9 billion with a further £5.1 billion planned. 


European commitments 

2.74 The Government also remains on course to meet the Maastricht Treaty and Stability and Growth Pact commitments. These require Governments to keep general government net borrowing below 3 per cent of GDP and general government gross debt below 60 per cent of GDP. The Pre-Budget Report projections indicate that these values will comfortably be achieved. 

The need for caution in the public finance projections 

2.75 Projections of the public finances necessarily involve a significant element of uncertainty. Public revenue and spending projections depend heavily on forecasts of economic growth and, in particular, on assumptions made about the position of the economy in relation to its long-term trend path. This means that projections of strong public finances in the medium term can quickly deteriorate if most of the strength was cyclical and if the economy slows to below trend over the forecast horizon. Therefore, it is important to build in a safety margin, as well as forecasting with cautious and prudent assumptions. 

2.76 Chart 2.4 illustrates a cautious case in which the level of trend output is assumed to be 1 percentage point lower in relation to actual output than in the central case. Even on this basis, the Government is on track to meet the golden rule over the economic cycle. This increases the probability of meeting the fiscal rules and, by minimising the need for unexpected changes of direction, allows a smoother path for public spending. 


The outlook for trend growth 

2.77 The Government entered office against an uncertain economic background. The Government judged that it was sensible to present its forecasts for economic growth in the form of opportunity ranges around a deliberately cautious assumption for trend growth of 21/4 per cent a year. This illustrated the potential for supply-side improvements to deliver stronger growth above the prudent 21/4 per cent a year assumption used for the fiscal projections. 

Chart 2.4 

2.78 The factors that influence trend growth can be grouped under those that determine trend population growth, the trend employment rate and those that determine trend labour productivity. The November 1999 Pre-Budget Report gave a firmer indication of the outlook for trend growth - on the basis of a careful and balanced assessment of past and future trends, the Government's neutral estimate of the UK's trend growth rate year-on-year over the future was raised to 21/2 per cent. This assessment is unchanged. 

2.79 This neutral assessment of trend output growth is, however, subject to considerable upside potential. Government policies to secure further progress towards full employment and continued responsibility in wage bargaining can help prolong the recent improvement in underlying labour market performance. But the key challenge now facing businesses, individuals and Government is to secure significantly stronger growth in productivity. In the US, rapid adoption of 'new economy' technologies and related diffusion of 'know-how' associated with ICT has been credited with securing a significant improvement in productivity and hence sustainable growth potential. Building on the UK economy's foundation of economic stability and policies to raise investment and innovation in a competitive business environment, there is the opportunity for firms to emulate US performance. These factors create the potential for stronger sustainable growth beyond the upper limits of the Pre-Budget Report forecast ranges. Chapter 3 describes the action which the Government is taking to build on this potential to improve productivity. 


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1See Planning Sustainable Public Spending: Lessons from Previous Policy Experience, HM Treasury, November 2000. 
 


    
  
3 

Meeting the productivity challenge 


The economy's productivity performance is the key to long-term growth and sustained increases in living standards. The Government's aim is that productivity in the UK will rise faster than in our major competitor countries over the next decade. To achieve this aim, it has put in place a long-term strategy built around macroeconomic stability and microeconomic reform through the five drivers of productivity growth: 
competition motivates firms to raise their game, innovating and minimising their costs. It rewards those firms that raise their productivity performance and reduces prices for customers; 
enterprise and innovation are at the heart of a dynamic business sector - new ideas for products and processes provide opportunities for productivity improvement. These chances can be exploited by entrepreneurs willing to take the risks necessary for success; 
investment underpins development of physical and human capital to produce productivity improvements in the future; 
higher skill levels not only help individuals and firms to be more productive but also encourage rapid take-up of new technologies and working practices; and 
alongside promoting macroeconomic stability and microeconomic reform, the Government can directly drive up public sector productivity. 
Improved productivity cannot be achieved by the Government alone. The sustainable improvements in opportunities and living standards that productivity growth promises can only be attained through an effort shared with managers and employees across the country, in public and private sectors alike. 
 


THE PRODUCTIVITY CHALLENGE 


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Raising UK productivity 

3.1 Raising productivity is one of the central conditions for meeting the Government's objective of high and stable levels of growth and employment and delivering sustained increases in living standards. This chapter sets out how and why the Government is working to increase productivity, the challenges that it faces and the environment that it is seeking to create. 

3.2 Over the past three years, the Government has secured a platform of stability which provides the basis for raising productivity. The challenge ­ for business, unions, educationalists and other organisations across the regions ­ is together to tackle the productivity issue. Meeting this challenge offers the prospect of higher growth and increased employment opportunities with low inflation and low interest rates. The Government is determined not to pass up this opportunity. 

3.3 The Government's strategy for productivity growth1 is based around macroeconomic stability and microeconomic reform. It is an agenda for Government, management and employees across the economy to raise their performance and take the opportunity for sustainable higher growth. 


UK productivity performance 

3.4 Productivity can be defined in a number of ways. Labour productivity can be measured as output per worker or output per hour worked. Total factor productivity measures the combined productivity of capital and labour in the economy. Whatever measures are used, the UK has long displayed lower productivity levels than its major competitor nations, and continues to do so (see Chart 3.1).2 

Chart 3.1 

3.5 Increasing productivity growth and starting to close the productivity gap should increase trend output growth, and so deliver greater economic and employment opportunities, and better living standards. The Government set a long-term ambition in the 1999 Pre-Budget Report: that the UK will have a faster rise in productivity than its main competitors over the next decade. To further this aim, the DTI and the Treasury have a joint Public Service Agreement (PSA) target to 'improve UK competitiveness by narrowing the productivity gap with the US, France, Germany and Japan over the economic cycle'. The DTI is preparing jointly with the DfEE a paper setting out their strategy to help achieve this. 


Meeting the challenge 

3.6 Closing the productivity gap cannot be achieved without a broader drive from workforces and managers across the country. In October the Chancellor therefore invited the TUC and the CBI to work together on an agenda for improving UK productivity. Six particular areas were identified for joint working: 

remedying shortfalls in workplace skills and training; 
overcoming long-term under-investment; 
accelerating the use and spread of technology; 
making business more effective in adopting best practice and innovative techniques from elsewhere, and from one another; 
by benchmarking the best, making modern industrial relations more effective; and 
improving the quality of management at every level to make it genuinely world-class. 
3.7 Together with educationalists and other organisations, the Chancellor invited the TUC and CBI to identify case studies of strong and poor performance. They have been asked to seek proposals from individual employers and unions for concrete improvements and to highlight issues for the Government to address. This will provide a starting point from which everyone can play a full role in raising UK productivity growth. 


Macroeconomic stability 

3.8 The first part of the Government's contribution to meeting the productivity challenge is to provide a platform of macroeconomic stability. Economic instability makes it difficult for individuals and firms to plan, save and invest ­ all of which are essential for productivity growth. 

3.9 As Chapter 2 sets out, implementation of the Government's fiscal and monetary frameworks has provided low inflation, significantly reduced volatility in output growth and a more favourable environment for long-term investment. 

3.10 UK productivity growth, slow throughout most of the 1990s, has shown recent signs of improvement (see Chart 3.2). But growth still trails that of the United States, which has seen an extraordinary acceleration in recent years (as discussed in Box 3.1). 

Chart 3.2 

Microeconomic reform 

3.11 The Government's microeconomic reforms are focused around the five drivers of productivity growth: competition, enterprise and innovation, investment, skills and 
public sector productivity. These address two issues: 

improving the quality and quantity of inputs (principally capital and labour); and 
improving the ways in which these inputs are used. 
3.12 Competition drives better use of inputs. It motivates firms and individuals to improve their productivity, rewarding those who perform better and sorting them from those who
do not. The Government has a vital role to play through ensuring that the regulatory environment is right and that markets are as open as possible to the forces of competition. 

3.13 Achieving these improvements requires enterprise and innovation. Entrepreneurs who are able to spot opportunities and to take on the necessary risks to achieve them are an energising force for productivity improvement. Equally, new ideas form the basis of many of these opportunities, whether innovations in processes or products. 

3.14 The Government can assist the development of a more entrepreneurial culture by reducing the fear of failure and promoting the benefits of success. This intervention can be particularly effective in cities and disadvantaged areas, where barriers to entrepreneurship can be especially severe. Further, it can encourage innovation across the economy by providing incentives for companies to carry out more research and helping them to extract the best from innovations developed elsewhere. 

Box 3.1: ICT, the 'new economy' and the opportunity for UK productivity 
The US economy has achieved an exceptional combination of high GDP growth and low inflation since the mid 1990s. This has been underpinned by strong productivity growth. In the year to the second quarter of 2000, US labour productivity grew by 5.1 per cent ­ the fastest rate since 1983. In manufacturing, productivity growth was even higher, at almost 7 per cent. 

 

Most economists agree that developments in information and communications technologies (ICT) are the principal cause of this strengthening in US productivity growth. Not only are companies that manufacture these technologies operating in a more productive way, but other sectors are investing heavily in ICT and there are 'spillover' effects from technological progress that give the broader economy the opportunity to improve. 

The US has led world productivity growth in recent years1. But the UK is well placed to benefit from these 'new economy' effects. A report by Merrill Lynch2 published in August 2000 rates the UK as the leading European country in terms of progress towards economic reform, and second only to the US globally. In some areas (such as mobile communications use and lack of barriers to entrepreneurship), the UK leads the US. 

Other new evidence shows that the UK has invested extensively in ICT over the past decade. This investment does not pay off instantly, and developments such as widespread use of the internet are too recent to have yet had a dramatic effect on productivity. 

But over the next few years, ICT should both give UK companies new opportunities to make productivity improvements and generate competitive pressure on them to do so. Combined with the effect of structural changes, this provides a basis for improving productivity growth in coming years, and so raising trend growth. As a recent study argued: "[T]here is now a good chance of a strong revival in productivity growth even without allowing for any special new economy effects. Adding the effects of ICT investment strengthens the likelihood of this."3
 
1There are, however, some important measurement issues affecting the comparative use of US data as referred to in Annex A. 
2Benchmarking the New Economy, Merrill Lynch, 2000. 

3'The New British Economy', Richard Kneller and Garry Young, NIESR, 2000.
 


3.15 The quality and quantity of inputs are both important. Sufficient investment needs to be available and it needs to be used productively. The UK is fortunate to have highly- developed capital markets. However, it has also suffered from prolonged under-investment in many areas. Despite strong growth in business investment, a cumulative investment gap with our competitors persists. The Government is working to improve this situation through ensuring that the tax framework is favourable, by promoting efficient financial markets, and by reversing a long trend of under-investment in the public sector. 

3.16 Both the quality and quantity of skills available affect productivity. Addressing the barriers that keep people from developing their full potential in the labour market is not only vital to address deprivation, it is key to driving economic growth. The Government is providing new opportunities for individuals to improve their skills and for companies to make the most of their human capital. It has invested in modernising education, providing lifelong learning and addressing skills shortages to close the gap between the UK skills base and those of our major competitors. 

3.17 Improvements in inputs will benefit public sector productivity as well as private sector productivity. Government has different mechanisms, however, at its disposal to motivate improvements in how these inputs are used. Achieving such improvements not only ensures better use of public money, but also increases productivity across the economy as a whole. 

3.18 These five drivers are inter-related in principle: competition, for instance, not only drives improvements in the use of inputs but can also improve inputs (for instance competition between training providers). They are also inter-related in practice: policies to motivate entrepreneurship can strengthen competition, for example. 

3.19 Since 1997, the Government has worked to reform and improve aspects of all five drivers (see Table 3.1). 

Table 3.1: The Government's productivity reforms 


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Competition Competition Act, 1998;
 
 Cruickshank Review of competition in banking;
 
 Utilities Act 2000, establishment of OFGEM to strengthen competition in gas and energy markets; and
 
 mergers reform, to take ministers out of merger decisions.
 
Enterprise and innovation reforms to corporate tax framework; improvements to Enterprise Investment Scheme and Venture Capital Trusts;
 
 creation of Small Business Service;
 
 establishment of Regional Development Agencies (RDAs);
 
 Social Investment Taskforce;
 
 investment in research infrastructure, such as the Higher Education Innovation Fund and University Challenge Fund; R&D tax credit;
 
 initiatives to promote clusters, including planning guidance and funding for RDAs to co-finance business incubators;
 
 Enterprise Management Incentives;
 
 Corporate Venturing Scheme;
 
 promoting employee share ownership; and
 
 National Campaign for Enterprise.
 
Investment 2000 Spending Review: doubling of net public sector investment by 2003­04;
 
 Myners review of institutional investment; and
 
 reforms of capital gains tax and corporation tax (now reduced to 30, 20 and 10 pence rates) to encourage investment.
 
Skills investments in education and training in 2000 Spending Review;
 
 national literacy and numeracy strategies;
 
 learndirect (the brand name for the University for Industry);
 
 Individual Learning Accounts; and
 
 work permit reforms.
 
Public sector productivity Public Service Agreements setting performance targets covering every government department;
 
 creation of the Office of Government Commerce, to deliver £1 billion of savings on government procurement; and
 
 Public Services Productivity Panel, helping the public sector to innovate and deliver change.
 


The role of regional policy 

3.20 The building blocks for productivity growth are grounded in the strengths of regions, and the rural areas and cities within them. The Government is committed to a regional policy that exploits these strengths, not through top-down initiatives but through regional and local initiatives enabled by a national Government that provides the necessary flexibility and resources. 

3.21 Through establishing Regional Development Agencies (RDAs), the Government has enabled regions to take a lead in developing productivity and delivering national and regional policies. The Pre-Budget Report gives RDAs more flexibility to make the most of their role as strategic leaders of regional and local economic development (see paragraphs 3.64­3.67). 

3.22 To promote enterprise in our communities the RDAs will work closely with Local Strategic Partnerships (LSPs). LSPs will bring together the local authority, all service providers (such as the police, schools and health and social services), local businesses and community groups in a single coalition for a community. By developing Community Strategies they will play a key role in maximising local strengths and addressing local problems. 


The European dimension 

3.23 The Government is committed to pursuing economic reform within the European Union, and the goal of raising productivity is shared by all EU member states. At the Lisbon summit in March 2000, EU Heads of Government established a new strategic goal for the new decade for Europe, "to become the most competitive and dynamic knowledge-based economy in the world". To achieve this, the Lisbon and Feira summits agreed concrete action plans and deadlines in a range of areas, including venture capital, electronic commerce, financial services and telecoms liberalisation. 

3.24 By monitoring performance through the use of agreed Europe-wide structural indicators, Member States are able to learn from each other and to share best practice. At the Stockholm Council in March 2001, the Government will look to build on the progress made since Lisbon. 

3.25 The Government has begun to make the changes necessary to meet the productivity challenge by ensuring that markets are able to operate efficiently and providing the incentives for businesses to grow. It has established a platform of macroeconomic stability from which microeconomic reform can proceed. Now it is necessary to build on this start and to seize the opportunity. This will ensure that increases in productivity performance are sustained, securing higher prosperity for all. 

COMPETITION 


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The importance of competition 

3.26 The Government has placed competition policy at the heart of its strategy to close the productivity gap. A competitive environment plays a central role in driving productivity growth in an economy. It encourages firms to innovate by reducing slack, putting downward pressure on costs and providing incentives for the efficient organisation of production. It also reorganises market structure, by reallocating resources away from inefficient firms. 

3.27 In this way, competition creates an environment within which productive firms flourish. When more productive firms gain market share and less productive firms shrink and exit the market, the overall level of productivity rises. Attempts to quantify this effect in the US and UK have led to broadly similar results, attributing 30 to 50 per cent of manufacturing productivity growth to the sorting of productive and unproductive plants.3 


Creating a framework for competition 

3.28 The Government has introduced a range of measures to improve competition in the economy as a whole. It has modernised the legal and institutional framework in order to ensure that market discipline acts across the economy to motivate productivity improvements and to sort the more and less productive firms. 

3.29 The Office of Fair Trading (OFT) has greatly enhanced powers to tackle anti-competitive practices, due to the Competition Act 1998, and to scrutinise the competition effects of financial services regulation, in light of the Financial Services and Markets Act. The Utilities Act, now in place, enhances the competition duty for the energy regulator. 

3.30 It is also important to ensure that the competition authorities have the resources and structures to use these powers effectively. The OFT received an additional £10.2 million over three years in the 2000 Spending Review, and has a new Director General in John Vickers, former Chief Economist at the Bank of England. 

3.31 The regime put in place by the Competition Act 1998 is already making an impact on competition in the UK: 

the OFT is targeting its resources on detecting and deterring as much anti-competitive behaviour as possible; 
in the first eight months of operation of the new Act, the numbers of complaints are running at around two to three times the rate received under the previous legislation; 
the OFT is currently formally investigating more than 15 cases of suspected infringement and has used its new investigation powers on numerous occasions ­ including exercise of powers to enter premises under warrant; 
it has dealt with a number of requests for informal advice and guidance from business and has received two applications for leniency; 
the deterrent effects of the Act are also becoming clearer. Some cartels known about by the OFT appear to have ceased after 1 March 2000; and 
in a number of cases the mere act of complaining to the OFT has led alleged infringers to modify their behaviour to the complainants' satisfaction. 
3.32 The Government is also consulting on the creation of a new board structure for the OFT. The Government believes that in view of the increased responsibilities and powers under the Competition Act it is no longer appropriate for all the body's powers to be vested in one individual. This should depersonalise regulation and broaden the basis of the decision making that informs it. 

3.33 The Government has announced how it plans to reform the process for controlling mergers to deliver the objective of depoliticising decisions and making competition the sole focus of assessment in the vast majority of cases. These changes require primary legislation to be implemented fully, but as a first step towards delivering these objectives, the Secretary of State for Trade and Industry has already committed himself to accepting the Director General of Fair Trading's (DGFT) advice on whether a merger should be referred to the Competition Commission, other than in exceptional circumstances. 


Ensuring competition in particular markets 

3.34 The new legal and institutional framework provides a powerful basis for ensuring effective competition. In key markets where competition has broader benefits for the economy as a whole (such as telecoms and banking), or where repeated questions about competitive pressure have been raised (such as the new car market), the Government has gone further to stimulate competitive intensity. 


Banking 

3.35 In Budget 2000, the Chancellor announced that the Government would act upon the recommendations of Don Cruickshank's report to improve competition and services to customers in the banking industry. The Government's immediate response included: 

a commitment to legislation, opening up access to payment systems and overseeing access charges; and 
referring the supply of banking services to SMEs to the Competition Commission. 
3.36 In August 2000, the Government and the Financial Services Authority published their detailed responses to the Cruickshank review. The Government announced a number of new measures, including: 

reviewing self-regulatory codes such as the Banking Code to see if they deliver real consumer benefits. The Consumer Codes Review Group is being chaired by DeAnne Julius, who currently also sits on the Monetary Policy Committee, and has members from a range of backgrounds, including those from consumer groups and the industry. The Group has been asked to report by April 2001; 
encouraging the provision of comparative information for consumers on banking products; 
agreeing to a two year review of the effect of the Financial Services and Markets Act on competition; 
introducing CAT standards for credit cards and consulting on extending CAT standards to other financial products; 
reforming the Treasury's objectives on promoting competition in financial services; and 
developing a payments strategy for all government departments to ensure a coordinated approach to e-commerce and modernising government. 
New cars 

3.37 Following the Competition Commission's investigation into the new car market, the Government has introduced measures to increase competition in the supply and sales of new cars. As a result, consumers have seen significant reductions in the new car prices on offer from major manufacturers. 


Supermarkets 

3.38 In its recent report on supermarkets, the Competition Commission found the industry to be broadly competitive. However, it raised a concern about the relationship between supermarket chains and their suppliers. The Commission made a number of recommendations which would put relations between supermarkets and their suppliers on a clearer and more predictable basis, including a Code of Practice. The Secretary of State for Trade and Industry has accepted their recommendations, and has asked the DGFT to seek appropriate undertakings from the leading supermarkets. The DGFT is due to report back at the end of the year. 


Water 

3.39 As the Department of the Environment, Transport and the Regions has recently announced, the Government is committed to ensuring that water consumers also benefit from the improvements in price, quality of service and choice which competition can deliver. The Government is now carrying out further work, involving the industry regulator Ofwat, on how best to implement this commitment while protecting environmental and public health standards. Options being examined include licensing new entrants for common carriage, separate licensing of different parts of the industry and how to ensure new entrants have access on reasonable terms to water resources. A full statement of conclusions will be