[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 20.9.2006

SEC(2006) 1159 final

COMMUNICATION FROM THE COMMISSION TO THE COUNCIL

Assessment of the action taken by the United Kingdom in response to the Council Recommendation of 24 January 2006 with a view to bringing an end to the situation of an excessive government deficit – Application of Article 104(7) of the Treaty

COMMUNICATION FROM THE COMMISSION TO THE COUNCIL

Assessment of the action taken by the United Kingdom in response to the Council Recommendation of 24 January 2006 with a view to bringing an end to the situation of an excessive government deficit – Application of Article 104(7) of the Treaty

1. THE EXCESSIVE DEFICIT PROCEDURE FOR THE UNITED KINGDOM

After a period of marked fiscal consolidation between 1996 and 2000, when the general government balance moved from a deficit of 5% of GDP to a comfortable surplus, the United Kingdom has seen a period of fiscal loosening mainly due to a planned increase in the ratio of public expenditure to GDP unaccompanied by a comparable rise in receipts. The government deficit first recorded an excess over the Treaty reference value in the 2003/04 financial year (running from April to March)[1] with a deficit of 3.2% of GDP[2]. Gross debt, which had declined from over 50% of GDP in 1996/97 to below 38% 2002/03, increased to 40.2% in 2004/05.

The general government deficit was 3.3% of GDP in the 2004/05 financial year, thus again exceeding the 3% of GDP reference value. The Council, on the basis of a Commission recommendation, placed the United Kingdom in excessive deficit on 24 January 2006 and, in accordance with Article 104(7) of the Treaty, addressed recommendations to the United Kingdom to " put an end to the present excessive deficit situation as soon as possible and by the financial year 2006/07 at the latest " and " to bring the general government deficit below 3% of GDP in a credible and sustainable manner and to this end ensure an improvement of the structural balance by at least 0.5 percentage point of GDP between the 2005/06 and 2006/07 financial years". The Council established a deadline of 24 July 2006 for the United Kingdom to take effective action to this end. Moreover, the Council invited the United Kingdom authorities to " ensure that, after the excessive deficit has been corrected, budgetary consolidation is sustained towards a medium-term budgetary objective that (i) provides a safety margin with respect to the 3% of GDP deficit limit; (ii) maintains prudent debt ratios taking into account the economic and budgetary impact of ageing population" and, taking into account objectives i) and ii), "allows room for budgetary manoeuvre, in particular considering the needs for public investment".

This Communication assesses the action taken by the United Kingdom in response to the Council recommendations, in accordance with Article 9(3) of Council Regulation (EC) No 1467/97, as amended by Council Regulation (EC) No 1056/2005[3], which states that, following the expiry of the deadline for a Member State to take measures following a 104(7) recommendation, "… the Commission shall inform the Council if it considers that the measures taken seem sufficient to ensure adequate progress towards the correction of the excessive deficit within the time limits set by the Council, provided that they are fully implemented and that economic developments are in line with forecasts ".

2. ASSESSMENT OF BUDGETARY PROSPECTS AND ACTION TAKEN BY UNITED KINGDOM IN RESPONSE TO THE COUNCIL RECOMMENDATION

THE ASSESSMENT OF COMPLIANCE WITH THE COUNCIL RECOMMENDATION UNDER ARTICLE 104(7) IS BASED ON THE COMMISSION SERVICES' SPRING 2006 FORECASTS, COMPLEMENTED BY MACROECONOMIC AND BUDGETARY INFORMATION MADE AVAILABLE AFTER THE FORECASTS' CUT-OFF DATE (24 APRIL 2006), AND IN PARTICULAR OUTTURNS FOR GDP GROWTH FOR THE FIRST TWO QUARTERS OF 2006, AND AN UPDATE OF THE PUBLIC FINANCES DATA, INCLUDING PARTIAL BUDGETARY DATA FOR THE EARLY MONTHS OF 2006/07.

The macroeconomic scenario underlying the public finances projections in the December 2005 update of the United Kingdom convergence programme, and retained in the March 2006 Budget, foresaw GDP growth accelerating from 1¾% in 2005/06 to 2¼% in 2006/07, to 3% in 2007/08, 2¾% in 2008/09, and 2¼% thereafter. For the initial years this scenario was broadly in line with the Commission services' spring 2006 forecast, which projected GDP growth of 2.4% in 2006 and 2.8% in 2007. Since the spring 2006 forecasts, the short-term macroeconomic outlook has improved. The Commission interim forecast published on 6 September 2006 projects UK economic growth at 2.7% in 2006 in the context of a general improvement in the EU economy. According to Commission services' estimates, these growth rates would imply that the negative output gap in 2006 is expected to narrow in subsequent years[4].

2.1. Government budget balances

2005/06

The March 2005 Budget projected a general government deficit in financial year 2005/06 of 2.7% of GDP, based on a GDP growth projection of 3%. The projected deficit was subsequently revised up to 3.1% of GDP in the December 2005 update of the convergence programme, following a marked slowdown of real GDP growth in 2005/06, with the official forecast for growth downgraded from 3% to 1¾%. The deficit registered in 2005/06 also reflects in part a sharp increase in government investment, although the current budget also registered a deficit. Preliminary outturns at the time of the Commission services spring forecast suggested an estimated deficit outturn of 3.1% of GDP. Since the spring forecast, more recent partial data point to a slight upward revision by about 0.1/0.2% of GDP to the deficit outturn[5].

2006/07

The March 2006 Budget projects a deficit of 3.0% of GDP in 2006/07. This is higher than the deficit of 2.8% of GDP projected in the December 2005 update of the convergence programme, and is mainly explained by a downward revision to United Kingdom oil production, which is expected to depress receipts from the corporate sector. Earlier, the December 2005 Pre-Budget Report (PBR)[6] (on which the convergence programme projections were based) had announced a set of discretionary actions, successively implemented, including an increase in taxation of oil-producing companies, which at the time were expected to tighten the fiscal position by 0.1 percentage point of GDP in 2006/07 and by an additional 0.1 percentage point thereafter. However, on the basis of the estimates for oil production in the March Budget, the measures announced in the PBR are now expected to leave the fiscal position unchanged in 2006/07 and to tighten it by 0.2 percentage point of GDP from 2007/08. No further deficit-reducing discretionary action was taken following the January Council recommendation besides the implementation of the small correction envisaged in the December PBR. The discretionary measures announced in the March Budget left the fiscal position broadly unchanged, and specifically there was no attempt to offset the reduction in receipts from the downward revision in projected oil production.

The Commission services' spring 2006 forecasts projected a deficit of 3.0% of GDP in 2006/07, similar to the official projections, albeit based on an assumption of higher oil prices (which would in the short term benefit corporation tax receipts). According to Commission services' calculations, the structural adjustment between 2005 and 2006 (on a calendar year basis) implied by the spring forecast was around ½% of GDP. However, on the basis of these estimates, on a financial year basis the adjustment was likely to be smaller and closer to ¼ percentage point[7].

Recent cash data for the first four months of 2006/07 are not inconsistent with the Commission services' spring 2006 forecast for the deficit. Revenues grew strongly, in line with or slightly above budgetary plans, although current expenditure also grew rapidly. Part of the fast growth in current expenditure can be attributed to a change in the macroeconomic situation, with higher than expected unemployment and therefore higher expenditure on social benefits. There is a clear risk that expenditure in this area could turn out higher than anticipated in the March Budget and in the Commission services' spring forecast. Discretionary expenditure, which is subject to annual nominal ceilings, also appears to have been growing rapidly. This component is likely to reflect fluctuations in the timing of expenditure within the annual limit for 2006/07 (which the Commission services' forecast assumes will be exactly met) and if so should slow in the remainder of the financial year.

However, monthly cash data tend to be volatile and a greater proportion of revenues are received in the second half of the financial year. Therefore only very partial inferences can be drawn from the cash data recorded so far.

Looking at the most recent macroeconomic developments, national accounts data seem to suggest a firmer recovery of the economy than expected at the time of the Commission services' spring forecast. Moreover, other developments should also support an improvement in the fiscal outlook. The increase in oil prices should boost the corporation tax base, as should the continued good performance by the financial sector. Moreover, higher than expected inflation should have, ceteris paribus, a marginally positive impact on the general government balance, while the recorded pick-up in consumption after the slowdown seen in 2005 should support revenues from indirect taxation.

However, there are large uncertainties surrounding future developments, and the possibility of offsetting effects. The composition of growth might turn out to be less favourable to the public finances, with investment playing a more prominent role than in the past. Moreover, the latest data registered a sharper fall in oil production than that anticipated in the March Budget, which could be reflected in lower corporation tax receipts later in the year, while a number of timing effects might lead to overestimating the strength of the growth in revenues based on data for the first months of the financial year 2006/07 alone. Moreover, a significant part of the fiscal consolidation depends on typically volatile drivers, such as the financial sector and high oil prices.

In general, given the volatility inherent in fiscal variables, and some of the uncertainties in the economic and financial outlook, it seems that, while the United Kingdom appears just on track to achieve a reduction of the deficit to 3% of GDP in 2006/07, there is no safety margin against the reference value, and there are significant risks that the deficit could continue to exceed it.

2007/08 and beyond

The 2006 Budget projects a reduction of the deficit to 2.4% of GDP in 2007/08, followed by a progressive tightening to 1.7% of GDP by 2010/11. The fiscal consolidation in 2007/08 is mainly due to a recovery in the ratio of revenue to GDP, driven by fiscal drag and by the discretionary measures implemented in December 2005, but also by a slight moderation of expenditure growth. The Commission services' spring forecast projects a somewhat larger general government deficit of 2.7% of GDP in 2007/08, chiefly due to a more cautious assumption for growth in tax receipts, but still suggesting that the deficit should be below the 3% reference value in the financial year.

Beyond 2007/08, the 2006 Budget projects an increase in the revenue ratio mainly driven by estimates of fiscal drag. However, the main driver of the fiscal consolidation planned by the UK authorities is a projected moderation in current expenditure growth, from an average annual rate of 3.2% in real terms over the previous 10 years to 1.9%, so that by 2008/09 the deficit is projected to be entirely used to fund public investment. The total expenditure ratio by 2010/11 would then be just above ½ percentage point below the 2007/08 level. Such a significant moderation in current expenditure growth would help keep the deficit firmly below the 3% of GDP reference value. However, this projected reduction in expenditure is not accompanied by specific departmental spending plans and needs to be confirmed in the forthcoming 2007 Budget and Comprehensive Spending Review, which will set the overall spending envelope for the three financial years beginning in 2008/09.

2.2. Government debt

General government gross debt, which according to the estimates at the time of the spring forecast rose to 42.0% of GDP in 2005/06, has been on a rising trend since 2002/03. However, the gross debt to GDP ratio remains well below the 60% of GDP reference value. The primary balance is in deficit over the horizon of the Commission services' spring forecast. In line with this, the UK authorities expect gross debt to continue to rise to 44½% of GDP by 2007/08 but to stabilise around that level thereafter, when the primary balance is projected to return to a small surplus. Debt stabilisation in the outer years is thus depending inter alia on the implementation of expenditure restraint in the Comprehensive Spending Review.

Table 1: Economic and budgetary projections

In % of GDP | 2005/06 | 2006/07 | 2007/08 |

COM | Budget 20061 | COM | Budget 20061 | COM | Budget 20061 |

General government balance | -3.1 | -3.2 | -3.0 | -3.0 | -2.7 | -2.4 |

Primary balance | -1.0 | -1.1 | -1.0 | -0.9 | -0.6 | -0.3 |

Structural balance2 | -2.9 | -3.0 | -2.7 | -2.6 | -2.5 | -2.2 |

Change in structural balance | +0.5 | +0.5 | + 0.2 | +0.4 | +0.2 | +0.4 |

Structural primary balance3 | -0.8 | -0.9 | -0.6 | -0.6 | -0.5 | -0.1 |

Government gross debt | 42.0 | 42.6 | 43.5 | 43.9 | 43.9 | 44.5 |

p.m. Real GDP (annual % change)4 | 1.8 | 1¾ | 2.4 | 2¼ | 2.8 | 3.0 |

p.m. Output gap5 | -0.5 | -0.6 | -0.7 | -0.9 | -0.6 | -0.7 |

In % of GDP | 2005 (COM) | 2006 (COM) | 2007 (COM) |

General government balance | -3.5 | -3.0 | -2.8 |

Primary balance | -1.3 | -1.0 | -0.7 |

Structural balance | -3.3 | -2.7 | -2.5 |

Change in structural balance | +0.2 | +0.6 | +0.2 |

Structural primary balance | -1.1 | -0.7 | -0.5 |

Government gross debt | 42.8 | 44.1 | 44.8 |

p.m. Output gap5 | -0.4 | -0.7 | -0.7 |

Notes: 1 Deficit figures in the March 2006 Budget adjusted for treatment of UMTS receipts, as explained in footnote 1 in the main text. Data for primary balance from the UK Budget adapted by the Commission services in line with the ESA definition of the primary balance using gross rather than net interest payments. 2 Cyclically-adjusted balance (CAB) excluding one-off and other temporary measures. In the case of the UK, there are no one-offs, so that the structural balance corresponds to the cyclically adjusted balance. Estimates for the output gap for financial years are an approximation and are not strictly based on the commonly agreed methodology (see footnote 7 in the main text). Output gaps and cyclical adjustment according to the March 2006 Budget are recalculated by the Commission services on the basis of the information in the Budget; since information is incomplete the Commission recalculation should be considered an approximation. 3 Cyclically-adjusted primary balance (CAPB) excluding one-off and other temporary measures. In the case of the UK, there are no one-off measures. 4 Commission projection on a calendar year basis. 5 In percent of potential GDP. Estimates for the financial year are an approximation and are not strictly based on the commonly agreed methodology (see footnote 7 in the main text). Note that recent revisions to the national accounts mean that, compared with the spring forecast reported here, estimates would be for a slightly narrower negative output gap in each year. Source: United Kingdom 2006 Financial Statement and Budget Report and 2006 Economic and Fiscal Strategy Report (Budget 2006); Commission services’ spring 2006 economic forecasts (COM); Commission services’ calculations. |

3. CONCLUSIONS

On the basis of current information, the United Kingdom seems to be just on track to correct its excessive deficit by financial year 2006/07, in line with the Council recommendations under Article 104(7). The outlook for the public finances appears now marginally more favourable than at the time of the Council recommendation, thanks inter alia to stronger growth and other factors such as higher oil prices and good financial sector performance. However, according to the Commission services' estimates on the basis of the spring forecast, the improvement in the structural balance in 2006/07 appears to fall short of the ½% of GDP recommended by the Council, being closer to ¼ percentage point. Moreover, the correction of the excessive deficit is subject to significant uncertainties and is vulnerable to even relatively small adverse changes in the macroeconomic and fiscal outlook:

- Since no further deficit-reducing discretionary action was taken following the January Council recommendation besides the implementation of a small correction envisaged in the December PBR, and the UK authorities rely on favourable fiscal trends to reduce the deficit to the reference value by 2006/07, there is no safety margin built against exceeding the reference value in 2006/07. This leaves the reduction of the deficit vulnerable to even small negative surprises. It is therefore important that the annual ceilings for discretionary expenditure are respected.

- While it appears likely that on current information and unchanged policies the deficit will be below the reference value in 2007/08, this is also subject to the uncertainties about the 2006/07 outturn.

Overall, in view of the above assessment, the Commission considers that no further steps in the excessive deficit procedure are needed at present for the United Kingdom. However, the Commission highlights the uncertainties in assessing current fiscal trends, meaning that there is a possibility that the fiscal outlook may fail to improve sufficiently on unchanged policies, which calls for surveillance on short-term budgetary developments.

Over the medium term, the fiscal consolidation projected by the UK authorities depends on achieving a significant moderation in expenditure growth. In this respect the medium-term expenditure plans due to be announced in the 2007 Budget and the subsequent Comprehensive Spending Review, covering the three financial years starting in 2008/09, will be particularly important.

The Commission will continue to monitor closely budgetary developments in the United Kingdom, in accordance with the Treaty.

[1] The EDP applies to the United Kingdom on a UK financial year basis. All UK general government balance data referred to in this Communication, apply the Eurostat decision of 14 July 2000 on the allocation of UMTS receipts. The UK has not generally applied this decision in domestic publication of its public finance data, which results in the general government balance on a Eurostat basis being up to 0.1 percentage point of GDP per annum lower than reported in UK national accounts from 2001/02 onwards.

[2] As a consequence of the deficit exceeding the reference value, the Commission initiated the excessive deficit procedure (EDP) in April 2004, with the adoption of the report foreseen by Article 104(3). Since the then assessment was that the excess of the deficit over 3% of GDP was small and likely to be temporary, the deficit was not judged by the Commission and the Economic and Financial Committee to be excessive. See: http://europa.eu.int/comm/economy_finance/about/activities/sgp/country/edp/edprep2004_uk.pdfhttp://europa.eu.int/comm/economy_finance/about/activities/sgp/country/edp/edprep2004_uk.pdf

[3] Respectively, OJ L 209 of 2.8.1997 and OJ L 174 of 7.7.2005.

[4] Recent upward revisions to GDP imply that the estimates of the output gap over the past five years would have a slightly narrower negative output gap or a slightly wider positive output gap compared with the estimates of the spring forecast.

[5] These data should be considered preliminary, and on current information it seems that carry over effects into 2006/07 should be limited. The UK Office for National Statistics will notify the outturn for the general government balance in 2005/06 on 29 September 2006.

6 The Pre-Budget Report, presented annually to Parliament in November or December, outlines the government's fiscal strategy and updates the previous Budget's fiscal and macroeconomic projections. It is consultative in nature, and it is meant to foster a public debate on the Government's strategy. However, it is also typically the vehicle to announce a number of budgetary measures.

[6] The output gap estimates are calculated according to the commonly-agreed methodology on a calendar year basis, so that it is not possible to have an estimate of structural balances (i.e. the cyclically-adjusted balance net of one-off and other temporary measures) on a financial year basis strictly based on the methodology. Given the milder improvement in the nominal balances on a financial year basis than on a calendar year basis, the structural improvement in financial year terms will also be lower. The estimate of by around ¼ percentage point should be considered an approximation.