Budget 2015: Gambling on productivity

10 July 2015

The fiscal policy movements in the Summer Budget have been obscured by headline-grabbing welfare announcements but deserve greater attention. The Chancellor’s speech announced “a Budget for economic security” but the Office for Budget Responsibility’s forecasts show that he has again chosen to sacrifice growth in favour of rapid deficit reduction.

The Summer Budget significantly changed the projected rate of fiscal consolidation, relative to the March Budget, accelerating it for 2015-16 and then easing for the following three years, as shown in the chart.

With conventional monetary policy instruments at their limits, fiscal tightening feeds directly in to GDP and income growth. The Office for Budget Responsibility estimates that austerity has cost about £4,000 per person over the past five years and the fiscal tightening in 2015-16 will depress GDP growth by an additional 0.1 per cent, relative to the March Budget. For the following years, the OBR assumes that monetary policy will be able to offset the continued austerity so the effect on growth will be minimal.

The critical assumption underlying these forecasts is that the economy will return to pre-recession productivity growth rates. If the productivity puzzle evaporates and growth returns, then the Bank of England will be able to offset the Government’s continued cuts to spending, and growth will be unhindered by fiscal policy. On the other hand, if productivity remains stagnant and interest rates remain low, the cuts will bear down upon the fragile recovery and reduce incomes below the OBR’s forecast level.

The chart below compares the OBR’s forecasts for productivity with a continuation of the current trend. At the very least, it demonstrates the enormous uncertainty about future growth rates. At worst, it suggests that the OBR’s forecasts are hugely over-optimistic. The Chancellor set out measures intended to improve productivity in his Budget, but the OBR did not consider them significant enough to adjust their economic forecasts.

The result is that Osborne’s continued pursuit of rapid deficit reduction is certain to reduce incomes in the next year, and very likely to do so for years to come. This Government may succeed in reducing the debt burden on the next generation but the cost is significantly lower incomes both today, and in the future.

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