Page last updated at 17:54 GMT, Wednesday, 28 January 2009

Grim expectations for UK economy

Closing down sale sign
The UK is caught up in the global downturn

There have been more gloomy predictions about the state of the UK economy.

The burden of UK government debt will remain above pre-crisis levels for 20 years, says the independent Institute for Fiscal Studies (IFS), a think tank.

In its annual Green Budget, the IFS says that the government will need to raise taxes or cut spending by an extra 20bn to repair the public finances.

Meanwhile, the International Monetary Fund predicts that the UK will see its economy shrink by 2.8% in 2009.

It also expects the UK economy to grow by just 0.2% in 2010.

A road map to the future that makes for bleak reading indeed
BBC economics editor Stephanie Flanders

Official British government figures confirmed last week that the country's economy was in recession.

The forecasts came as the IMF said world economic growth would fall to 0.5% this year, the lowest since World War II.

The IMF prediction about the UK makes it the worst contraction among advanced nations this year - with the US economy expected to contract by 1.6%, the eurozone area by 2%, Germany by 2.5% and Japan by 2.6%.

Overall, the IMF expects the world's advanced economies to shrink by 2% in 2009.

Budget deficit

As well as the IFS and IMF reports, it was also another day of job cuts in the UK.

The biggest loss was at Shop Direct home shopping firm, which said it was cutting 1,000 jobs at its call centres.

Meanwhile, engineering group GKN said it had cut 2,800 jobs globally since October, 242 in the UK.

Thames Water said it was to cut up to 300 jobs in response to the economic downturn, while there are plans to shed 330 jobs at London Metropolitan University, because of funding cuts.

Cost of the crisis

In its report, the IFS suggests the government may have to freeze public spending in 2010.

Its report also says that taxes are likely to go up more than planned, with possible increases in VAT in the future.

The BBC's economics editor, Stephanie Flanders, says the IFS report provides devastating clarity on the scale of the UK's economic problems and how far Labour has come from the bright promises of 1997.

There clearly is a danger investors will take fright at the state of the UK public finances
Institute for Fiscal Studies

The government projects a budget deficit exceeding 100bn in the coming year.

The credit crunch will cost the chancellor 50bn a year (3.5% of GDP) in lost tax receipts and higher social security spending.

The government has already said, in its pre-Budget report (PBR) in November, that it will implement spending cuts and tax increases adding up to 38bn by 2015-16.

Even if everything goes according to plan, the IFS points out that it will be "the early 2030s before debt returns below the ceiling of 40% of national income" that Gordon Brown set as one of his key fiscal rules in 1997.

Of course, a number of other EU countries may still have a higher government debt-to-GDP ratio than the UK.

Shortfall

But the IFS believes the government may be over-optimistic on several fronts.

Firstly, it says that it does not expect tax revenues to grow as quickly as the government hopes.

This could increase the deficit by another 20bn (1.5% of GDP) by 2015-16, and take public sector debt above 60% of GDP, the level laid down for eurozone countries in the Maastricht Treaty.

Secondly, it points out that independent forecasters are, on average, more pessimistic than the Treasury about the length and depth of the recession.

In the short term, "this would push government debt and borrowing further above the PBR forecasts."

Borrowing costs

In the longer term, a bigger problem for the government could be the rising cost of servicing (paying the interest) on the huge government debt.

These costs are currently relatively low, because investors - such as banks - are seeking to buy Treasury bills (gilts) as a safe haven in uncertain times.

"But there clearly is a danger investors will take fright at the state of the UK public finances," which would push up interest rates, the IFS says.

The IFS says that if the cost of debt interest returns to the levels of the 1990s, then "further tax increases or spending increases would probably be required" to prevent debt costs rising unsustainably.

Taxing and spending

If further tightening of the public finances is required, where might it fall?

The Green Budget estimates that the government "will have to impose a real freeze on public spending" for the three years of the 2010 Spending Review, which would leave spending 22bn lower than projected in the March 2008 Budget by 2013-14.

Capital-intensive departments such as housing and transport would be hardest hit.

But the IFS also suggests that the government may be more likely to address "any emerging revenue shortfall" through tax increases.

It points out that in previous periods of big government deficits, such as in the early 1990s, taxes were raised much more substantially.

The IFS says one option to close the budget gap would be "to broaden the unusually narrow base of VAT by removing zero and reduced rates", which could raise at least 10bn even after compensating poorer families through increased benefits.

It admits that "this might not be popular politically, but neither would other methods of raising similar sums of money".

The IFS says that despite the need for an immediate fiscal stimulus, it is important for the government to "reassure voters and investors that it will take the necessary steps to repair the public finances as soon as the economy has stabilised".

So it suggests that the government should consider "pre-announcing a further fiscal tightening now", despite the economic and political risks of doing so.

Government debt



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