In each Economic and fiscal outlook we publish a box that summarises the effects of the Government’s new policy measures on our economy forecast. These include the overall effect of the package of measures and any specific effects of individual measures that we deem to be sufficiently material to have wider indirect effects on the economy. In our March 2020 Economic and fiscal outlook, we adjusted our economy forecast to account for the material increase in departmental spending and tax policy changes on GDP and inflation. In addition to this, our business investment forecast incorporates the reversal of the planned cut in corporation tax, increases in the structures and buildings allowance and R&D tax credits.
The Government has chosen to loosen fiscal policy materially, with the change dominated by higher departmental spending – both current and capital. To estimate the effect of fiscal policy decisions on GDP growth we use ‘multipliers’ drawn from the empirical literature.
The bulk of the rise in current spending in 2020-21 on health, education and policing was announced in the 2019 Spending Round. This Budget has increased spending in all future years and by increasing amounts. It has also raised capital spending plans significantly. We expect some of the planned increases to go unspent, as has been the case in the past, particularly when governments try to ramp up capital spending quickly. But even so, our post-measures forecasts for current and capital spending by departments exceed our pre-measures forecasts by 0.5 and 0.6 per cent of GDP respectively by 2024-25. The overall fiscal loosening boosts cumulative real GDP growth by early 2022 by around 0.5 percentage points, with growth slightly weaker than it otherwise would have been thereafter as the effect of the fiscal easing fades.
Over time frames that extend beyond our forecast horizon, higher government investment should boost the supply capacity of the economy. But the extent to which it does so will depend on the mix of projects chosen. Some spending may generate substantial future social returns but have little effect on potential GDP – for instance, building more hospitals. Other projects – notably transport infrastructure – are likely to raise potential GDP, but the benefits will probably take a significant amount of time to come through, especially where there are long build times (as with major railway infrastructure). Furthermore, increased competition for scarce construction resources may directly crowd out some private sector investment.
The extra spending on general government investment over the forecast period can be expected eventually to raise the public sector gross capital stock by around 5 per cent. Assuming an output elasticity of 0.1, based on a range of international studies,a this suggests an eventual impact on the level of potential productivity of perhaps 0.5 per cent, though that would depend on the precise mix of the extra investment. We have assumed that this would manifest itself largely beyond our forecast horizon. (As we explain in Annex B, if the increase in general government investment as a share of GDP were to be sustained indefinitely, the long-term impact on potential productivity might be of the order of 2.5 per cent.)
We have made several other adjustments to our economic forecast for measures announced in this Budget. The Government has announced several changes that are expected to affect the level of business investment, most importantly a reversal of the planned cut in corporation tax from 19 to 17 per cent, which was due to take effect this April. This more than offsets the expected rise in business investment generated by the more generous structures and buildings allowance and R&D tax credits. When combined, these measures are expected to reduce the level of business investment by 0.3 per cent by the end of the forecast, relative to what we assumed in March 2019.
We have adjusted our inflation forecast to account for the expected impact of freezing all alcohol duties, fuel duty and tuition fees this year, which reduce CPI inflation. Increasing the National Living Wage and reintroducing the tobacco duty escalator that lapsed at the end of the last Parliament more than offsets these. We expect that the combined effect of the policy measures will add 0.1 per cent to the level of CPI by the end of the forecast period. We have also adjusted the path of inflation to reflect the positive output gap generated by the fiscal easing.
The policy change that has the most significant impact on our house price forecast is the fiscal easing, which boosts real household incomes and house price inflation in the near term. We expect the announced change in the migration regime and the higher Bank Rate profile we have assumed (see paragraph 2.21) to weigh on house price inflation in the medium term.
This box was originally published in Economic and fiscal outlook – March 2020