For its June Budget forecast, the interim OBR said that while Budget measures could affect potential output, it would assume, for the purposes of its forecast, that there was no effect. Since the June Budget, the Government has set out further details of the planned reductions in government expenditure in the 2010 Spending Review, including additional measures to reduce welfare spending.

The possible effects of reductions in government expenditure on the economy’s trend growth rate are subject to great uncertainties. For example, some evidencea suggests that government investment in public capital can provide long-term “spill-overs” to output in the market sector – such as investment in infrastructure. The impact on potential growth is likely to be observed over a relatively long time horizon for certain types of government expenditure, such as education. However, this assessment is complicated by uncertainty around the counterfactual. For example, we do not know what the prospects for long-term interest rates and private sector investment would have been in the absence of changes to government spending. This compounds the uncertainties around the impact on the trend growth outlook, which is itself subject to a wide margin of error even without taking into account possible policy effects.

A further uncertainty is the response of the labour market to reductions in general government employment (see Box 3.7 for a discussion of our latest forecast of general government employment). On the one hand, a smooth transfer of employment to the market sector may have the effect of raising overall output per head if measured productivity differences between the market and government sectors are maintained. On the other, if market sector wages fail to adjust fully or if public sector employment reductions bring about significant sectoral or regional mismatch, then the risk of higher structural unemployment or lower output per head is greater.

Changes to welfare spending may also have an effect on labour supply and potential output. The government has announced a number of reforms to welfare expenditure, including (but not limited to) the withdrawal of Child Benefit from families with a higher rate taxpayer from January 2013; tighter eligibility requirements for Contributory Employment and Support Allowance (ESA); a three year freeze in the basic and 30 hour elements of the Working Tax Credit (WTC) from 2011-12; an increase in the working hours requirement for couples with children for the Working Tax Credit; and an increase in the child element of the Child Tax Credit. By changing out-of-work incomes and eligibility for benefits it is possible that these measures will have some bearing on individuals’ labour supply decisions. However, the overall effect of changes to welfare spending remains unclear: the Institute for Fiscal Studies, for example, have suggested that the Spending Review is likely to have mixed effects on work incentives in the short run.b