The chancellor has already indicated that he sees the growth and public finance forecasts issued by the Office for Budget Responsibility (OBR) as reinforcing the case for stepping up the pace of fiscal tightening, and he may well also point to recent statements by the credit rating agencies for further justification to do this. For example, Fitch stated on 8 June that the United Kingdom's "fiscal challenge is formidable and warrants a strong medium-term consolidation strategy—including a faster pace of deficit reduction than set out in the March 2010 Budget." Fitch also noted that it is "striking" that the budget deficit is not projected as things stand to fall below 3.0% of GDP within five years. Meanwhile, Standard & Poor's, which has had the United Kingdom's AAA rating on negative watch since May 2009, has indicated that it will make a decision after Tuesday's budget release.

The sovereign debt crisis in the Eurozone and the related faster fiscal consolidation that is now occurring or planned in many member countries are putting pressure on all governments with problematic public finances to take more ambitious corrective action. Failure to take such action risks suffering higher interest rates, and thus increased debt-servicing costs.

The OBR forecasts 2010 GDP growth at 1.3%, which is in line with the previous Labour government's projection of 1.0–1.5%. Thereafter, though, the OBR has cut the GDP growth forecasts appreciably to 2.6% in 2011 (from 3.0–3.5%) and to 2.8% in 2012, 2.8% in 2013, and 2.6% in 2014, compared with Labour's projections of 3.25–3.75%. In fact, we think the OBR's growth forecasts still look on the optimistic side for 2010–12, as we see growth at 1.1% in 2010, 1.8% in 2011, and 2.3% in 2012. Thereafter, we have similar forecasts at 2.6% in 2013 and 2.8% in 2014.

Despite the lower growth forecasts, the OBR's public-sector net borrowing forecasts are not that different from those contained in the last government's March budget. In fact, they are slightly lower. This partly reflects the fact that they are starting from a slightly less bad position as the 2009/10 shortfall was less than anticipated in the March budget. The OBR also makes less cautious assumptions about tax revenues and assumes that some modestly more favorable recent trends can continue. Specifically, the Public Sector Net Borrowing Requirement (PSNBR) is seen by the OBR at £155 billion in 2010/11, falling to £71 billion in 2014/15. In his March budget, then-chancellor Alistair Darling projected the PSNBR at £163 billion in 2010/11, falling to £74 billion in 2014/15.

Even so, the OBR forecasts still put the budget deficit up at 3.9% of GDP in 2014/15. Furthermore, the structural element of the deficit is 0.8% of GDP higher in 2011/12 and still 0.3% of GDP higher in 2014/15 on the OBR's reckoning than it was under the March 2010 budget. This is the element of the public deficits that will not disappear with improved economic activity, and its higher level according to the OBR reflects the fact that the office has taken a more pessimistic view of the United Kingdom's trend growth rate. The OBR came to the conclusion that trend output growth will be just 2.35% through to 2013, slowing to 2.1% from 2014. For planning purposes, the Labour government had forecast trend growth at 2.5%. Specifically, the cyclically adjusted PSNBR is seen by the OBR at 8.0% of GDP in 2010/11, falling to 6.1% of GDP in 2011/12 and 2.8% of GDP in 2014/15.

Spending Cuts to Lead the Way

We suspect that the chancellor will set himself the target of at least bringing the PSNBR under 3.0% of GDP by 2014/15. The government has made it clear that it believes the bulk of the corrective fiscal action should occur through spending cuts rather than tax increases. Specifically, the government has indicated that spending cuts and tax hikes will ideally be imposed around a 80:20 ratio. This means that further substantial spending cuts will be needed on top of those already announced, especially as there was already a large "black hole" of around £25 billion in the budget deficit targets previously set by the Labour government and the spending cuts actually announced. To get the PSNBR below 3% of GDP by 2014/15 could require additional net spending cuts and tax-raising revenues in the region of £45 billion on top of those already announced.

Nevertheless, while the budget will set out the spending cut targets for the next five years, full details of where exactly the spending axe will fall will remain elusive. These details will only be fully revealed when the government releases its comprehensive spending review, which will cover the period through to 2014/15. The review is due to be published before the end of the year. Some departments are facing annual average cuts of at least 20%, given the coalition government's pledge to ring-fence the National Health Service. Major public-sector job cuts seem inevitable, while public-sector pay, pensions, and benefits are set to be squeezed as well.

Taxes Will Have to Rise, Too

The scale of the fiscal correction needed means that taxes will have to rise in addition to the substantial spending cuts. The government has already indicated that capital gains tax will rise, and value-added tax (VAT) is another likely candidate.

Capital gains tax will rise on the sale of nonbusiness-related assets from 18% currently to be more in line with income tax rates of 20–50%. One of the main questions to be answered is whether or not sold assets will be taxed at a reduced rate if they have been held for a long time.

It also seems more of a question of when, rather than if, VAT will rise from 17.5% to 20.0%. A problem with raising VAT in the near term is that it would push consumer price inflation (3.4% in May) even further above the Bank of England's 2.0% target rate, further lift inflation expectations, and put pressure on the Bank of England to raise interest rates. The chancellor therefore could decide to delay raising VAT for a number of months in the expectation/hope that inflation will head down further. It is also possible that the chancellor could decide to raise the VAT rate on some zero-rated or lower-rated items.

Tighter Fiscal Policy Likely to Be Countered by Low Interest Rates

The indication is that the Bank of England is fully supportive of the chancellor's decision to step up the pace of fiscal tightening and is prepared to keep interest rates low to offset this. Specifically, in his 16 June Mansion House speech, Bank of England Governor Mervyn King commented that "monetary policy must be set in the light of the fiscal tightening over the coming years."

King also stated, "I know there are those who worry that too rapid a fiscal consolidation will endanger recovery. But the steady reduction in the very large structural deficit over a period of a parliament cannot credibly be postponed indefinitely. If prospects for growth were to weaken, the outlook for inflation would probably be lower and monetary policy could then respond. I do, therefore, Chancellor welcome your commitment to put the [United Kingdom's] public finances on a sound footing. It is important that, in the medium term, national debt as a proportion of GDP returns to a declining path."

Conclusion

There is undeniably a very serious risk that accelerated and intensified fiscal tightening could derail a still fragile U.K. economic recovery, especially as serious growth headwinds still stem from high consumer debt levels, ongoing significant problems in the banking sector, and, potentially, the Eurozone's current woes. Even if many of the measures are delayed until 2011, the fact that they have been spelt out, and people and businesses know that they are coming, could limit their spending, investment, and employment plans now.

Nevertheless, this is a risk that the coalition government believes is worth taking, as they argue that the longer-term risks to the economy of not taking stronger corrective fiscal action are even greater. In particular, the government argues that interest payments on the debt will rise to £70 billion by 2015 unless corrective action is taken as quickly as possible and stresses that this is a major waste of taxpayers' money. There is also the danger that investors' confidence in the U.K. economy will be undermined if it loses its AAA rating.

The case for and against accelerated fiscal tightening is a very close call, as is evident by the intense debate that has raged among economists in recent months. Only time will tell who is right. And much could yet depend on the general state of the global economy over the next couple of years. The better this is, the more chance that the U.K. recovery can survive the increased fiscal pain intact. If the global economy suffers serious problems over the next couple of years, particularly related to events in the Eurozone, then the U.K. economy could struggle terribly.