[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 11.1.2006

SEC(2006) 20 final

Recommendation for a

COUNCIL DECISION

on the existence of an excessive deficit in the United Kingdom

(presented by the Commission)

EXPLANATORY MEMORANDUM

The application of the excessive deficit procedure (EDP) is governed by Article 104 of the Treaty and by Council Regulation (EC) No 1467/97 of 7 July 1997[1] “on speeding up and clarifying the implementation of the excessive deficit procedure”, which is part of the Stability and Growth Pact. However, while most provisions apply to the United Kingdom in the same manner as to other countries not participating in the euro area, Article 5 of the Protocol on certain provisions relating to the United Kingdom[2] states that the obligation under Article 104(1) of the Treaty to avoid excessive general government deficits does not apply to the United Kingdom unless the country moves to the third stage of EMU. Instead, while in the second stage of EMU, the United Kingdom is committed under Article 116(4) of the Treaty “to endeavour to avoid excessive deficits”.

In the period since the UK’s previous EDP was abrogated in May 1998, the UK general government balance moved from a comfortable surplus position in the late 1990s to a deficit of 3.2% of GDP in 2003/04[3]. This development was equivalent to a change in the structural fiscal balance of around 4 percentage points of GDP in the period between 1999/00 and 2003/04. During these years, the general government expenditure ratio increased from less than 40% to about 43% of GDP. In the same period, government gross fixed capital formation increased from 1.2% to 1.6% of GDP; the government gross debt ratio went down to 37.6% of GDP in 2002/03 and has been increasing since then. Such an evolution coupled with developments in interest rates led to interest payments having fallen from 2.9% to 2.0% of GDP in that period. As a consequence of the deficit for 2003/04 exceeding the reference level, the Commission initiated an excessive deficit procedure with the Article 104(3) report prepared in April 2004[4]. However, 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 to be excessive.

According to the EDP data notified by the United Kingdom in August 2005, the general government deficit in the United Kingdom reached 3.2% of GDP in the 2004/05 financial year (running from April to March)[5],[6], thus exceeding again the 3% of GDP reference value. The reported figure for the 2004/05 financial year deficit provided prima facie evidence on the existence of an excessive deficit in the United Kingdom in the sense of the Treaty and the Stability and Growth Pact.

The Commission therefore adopted a report according to Article 104(3) of the Treaty assessing the fulfilment of the Treaty requirements concerning the deficit and the debt criteria[7]. The report considered that, although above the 3% of GDP Treaty reference value, the 2004/05 deficit was close to it. The excess over the 3% of GDP reference value was not exceptional. In particular, it did not result from an unusual event and the growth performance accompanying the breach of the reference value in 2004/05 does not qualify as a severe economic downturn. Growth of 3.2% in 2004 was estimated to have been above-potential as was growth in financial year 2004/05. The estimated output gap in 2004 was positive. As regards the issue of temporariness, the deficit was expected to persist above 3% throughout 2005/06 and 2006/07, based on an interim updated economic and budgetary outlook for the United Kingdom.

In its report the Commission also analysed all relevant factors for the medium-term economic and budgetary positions as well as others that appeared relevant to the assessment of public finances in the United Kingdom. According to the Stability and Growth Pact, relevant factors can be taken into account in the steps leading to the decision on the existence of an excessive deficit [thus including the Economic and Financial Committee opinion in accordance with Article 104(4), the Commission opinion in accordance with Article 104(5) and the Council decision in accordance with Article 104(6)], “if the double condition of the overarching principle that – before other relevant factors are taken into account - the excess of the reference value is temporary and the deficit remains close to the reference value - is fully met”. In the case of the United Kingdom, although the projected deficit for 2004/05 was close to the reference value, the report concluded that the government deficit was projected to be above 3% of GDP in financial years 2005/06 and 2006/07.

Article 104(4) of the Treaty states that “the Committee provided for in Article 114 (i.e. the Economic and Financial Committee) shall formulate an opinion on the report of the Commission”. The Committee issued its opinion on 30 September 2005, this opinion being consistent with the assessment made by the Commission in its report, and noting that the excessive deficit could not be considered temporary. The Committee nevertheless recommended that further steps under the EDP should await the finalisation of the Commission’s forthcoming autumn forecasts.

In the Commission services’ autumn forecasts, assuming United Kingdom fiscal policy remains as announced, the deficit was expected to widen to just below 3½% of GDP in 2005/06 and to remain over 3% of GDP in 2006/07, showing a gradual improvement to around 3% of GDP only in 2007/08. These projections confirmed the Commission’s assessment made in its report under Article 104(3) and the EFC opinion adopted under Article 104(4) that the deficit was expected to remain over 3% of GDP in 2005/06 and 2006/07 and was therefore not temporary. Based on these projections, the excess over the 3% of GDP reference value is therefore neither exceptional nor temporary, although the deficit is close to the reference value.

Subsequent to the Commission services’ autumn forecasts, the United Kingdom announced fiscal measures in the Pre-Budget Report presented to Parliament on 5 December 2005. In net terms, United Kingdom authorities’ costings of these measures, compared with the baseline of announced policy (as taken into account in the autumn forecasts), represent an easing of policy by 0.1 pp of GDP in the current financial year and a tightening of policy by just below 0.1 pp of GDP in 2006/07. Taking into consideration these measures, which are all structural, the Commission’s assessment nevertheless remains that the deficit through to 2006/07 is expected to exceed 3% of GDP, with the deficit in 2006/07 estimated at around 3.1% of GDP, and is therefore not temporary.

Therefore, again based on the double condition above not being satisfied, for the purpose of the Commission opinion in accordance with Article 104(5) and the Council decision in accordance with Article 104(6), other relevant factors are not taken into account in the case of the United Kingdom. This analysis therefore suggests that the deficit criterion in the Treaty is not fulfilled. In contrast, the general government debt ratio remains well below the 60% reference value (having recorded 40.8% of GDP in the 2004/05 financial year) although, given the scale of actual and projected primary deficits, on a rising trend: in the Commission’s autumn forecasts reaching around 44½% of GDP in 2007/08. The table below shows the Commission services’ autumn forecasts for UK general government deficit and debt ratios on a financial year basis.

United Kingdom: public finance projections on a financial year basis

(% of GDP)

Outturn | Projections |

2004/05 | 2005/06 | 2006/07 | 2007/08 |

General government deficit | 3.2 | 3.4 | 3.2 | 3.0 |

General government gross debt | 40.8 | 42.7 | 43.7 | 44.5 |

The Commission, having taken into account its report, the opinion of the Committee, the Commission services’ autumn forecasts and the United Kingdom’s December 2005 Pre-Budget Report, is thus of the opinion that an excessive deficit exists in the United Kingdom. This opinion, adopted by the Commission on 11 January 2006, is herewith addressed to the Council, according to Article 104(5) of the Treaty. The Commission is recommending that the Council shall decide accordingly, in conformity with Article 104(6).

In addition, the Commission is submitting to the Council a recommendation for a Council recommendation to be addressed to the United Kingdom with a view to bringing the situation of an excessive deficit to an end, according to Article 104(7) of the Treaty. According to Council Regulation (EC) No 1467/97, the Council recommendation should “establish a deadline for the correction of the excessive deficit, which should be completed in the year following its identification unless there are special circumstances. In the recommendation, the Council shall request that the Member State achieves a minimum annual improvement of at least 0.5% of GDP as a benchmark, in its cyclically adjusted balance net of one-off and temporary measures, in order to ensure the correction of the excessive deficit within the deadline set in the recommendation”.

In the case of the United Kingdom, the consideration of relevant factors does not suggest the existence of special circumstances warranting a departure from the standard deadline for correcting the deficit. In particular, while the negative output gap is expected to widen between 2005 and 2006 by approaching 0.5 percentage point, output in the Commission services’ autumn forecasts (before taking account of the measures in the December Pre-Budget Report) was projected to be strengthening from late 2005, with approximately trend-level growth from 2006. The measures announced in the Pre-Budget Report do not materially affect this growth profile, with the slight fiscal tightening from 2006/07 focused on the offshore oil sector of the economy which can be assumed not to react to the measures in a conventional cyclical manner. As for the cyclically-adjusted deficit, in the Commission services’ autumn forecasts this was assessed to improve by 0.3 percentage point of GDP between 2005 and 2006; this improvement can be expected to be around 0.4 percentage point of GDP, after taking account of the Pre-Budget Report measures. In sum, therefore, on the basis of announced policies, output growth is projected to remain reasonably strong in a situation of moderate reduction of the cyclically-adjusted deficit, but with the actual deficit remaining slightly above the reference value. Against this baseline, the application of the benchmark annual improvement of at least 0.5% of GDP would require only a further slight degree of fiscal effort.

Accordingly, in the recommendation, since overall growth performance in the United Kingdom remains reasonably satisfactory and the structural improvement in the government balance required to put to an end its excessive deficit is modest, it is considered as being consistent with the Stability and Growth Pact that a budgetary correction should be completed at the latest by financial year 2006/07.

Recommendation for a

COUNCIL DECISION

on the existence of an excessive deficit in the United Kingdom

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community, and in particular Article 104(6) thereof,

Having regard to the recommendation from the Commission,

Having regard to the observations made by the United Kingdom,

Whereas:

(1) Article 104 of the Treaty lays down an excessive deficit procedure (EDP) to ensure that Member States avoid excessive government deficits or that they correct such deficits when they occur.

(2) Pursuant to point 5 of the Protocol on certain provisions relating to the United Kingdom of Great Britain and Northern Ireland, the obligation under Article 104(1) of the Treaty to avoid excessive general government deficits does not apply to the United Kingdom unless it moves to the third stage of economic and monetary union[8]. While in the second stage of economic and monetary union, the United Kingdom is required to endeavour to avoid excessive deficits, pursuant to Article 116(4) of the Treaty.

(3) The Stability and Growth Pact is based on the objective of sound government finances as a means of strengthening the conditions for price stability and for strong sustainable growth conducive to employment creation.

(4) The excessive deficit procedure under Article 104 of the Treaty, as clarified by Council Regulation (EC) No 1467/97 on speeding up and clarifying the implementation of the excessive deficit procedure[9], which is part of the Stability and Growth Pact, provides for a decision on the existence of an excessive deficit. The Protocol on the excessive deficit procedure annexed to the Treaty sets out further provisions relating to the implementation of the excessive deficit procedure. Council Regulation (EC) No 3605/93[10] lays down detailed rules and definitions for the application of the provision of the said Protocol.

(5) Article 104(5) of the Treaty requires the Commission to address an opinion to the Council if the Commission considers that an excessive deficit exists in a Member State or may occur. Having taken into account its report in accordance with Article 104(3) of the Treaty and having regard to the opinion of the Economic and Financial Committee in accordance with Article 104(4), the Commission services’ autumn 2005 forecast, as well as the United Kingdom’s December 2005 Pre-Budget Report, the Commission concluded that an excessive deficit exists in the United Kingdom. The Commission therefore addressed such an opinion to the Council in respect of the United Kingdom on 11 January 2006.

(6) Article 104(6) of the Treaty states that the Council should consider any observations which the Member State concerned may wish to make before deciding, after an overall assessment, whether an excessive deficit exists. In the case of the United Kingdom, this overall assessment leads to the following conclusions.

(7) In the period since the United Kingdom’s previous excessive deficit procedure was abrogated in May 1998, the UK general government balance moved from a comfortable surplus position in the late 1990s to a deficit of 3.2% of GDP in 2003/04[11]. This development was equivalent to a change in the structural fiscal balance of around 4 percentage points of GDP in the period between 1999/00 and 2003/04. During these years, the general government expenditure ratio increased from less than 40% to about 43% of GDP. In the same period, government gross fixed capital formation increased from 1.2% to 1.6% of GDP; the government gross debt ratio went down to 37.6% of GDP in 2002/03 but has been increasing since then. Such an evolution coupled with developments in interest rates led to interest payments having fallen from 2.9% to 2.0% of GDP in that period. As a consequence, the Commission initiated an excessive deficit procedure with the Article 104(3) report prepared in April 2004[12]. However, 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 to be excessive.

(8) In the 2004/05 financial year, according to the EDP data notified by the United Kingdom in August 2005, the general government deficit remained at 3.2% of GDP, again above but close to the 3% of GDP Treaty reference value. The excess over the 3% of GDP reference value was not exceptional. In particular, it did not result from an unusual event outside the control of the United Kingdom authorities, nor was it the result of a severe economic downturn. Growth of 3.2% in 2004 is estimated to have been above-potential as was growth in financial year 2004/05. The estimated output gap in 2004 is estimated to have been positive. Therefore, the excess of the deficit over the reference value cannot be considered as resulting from a severe economic downturn. The excess over the 3% of GDP reference value is also considered not temporary, based on the Commission services’ autumn 2005 forecasts. Assuming United Kingdom fiscal policy remained as hitherto announced, the deficit in these forecasts was expected to widen to just below 3½% of GDP in 2005/06 and to remain over 3% of GDP in 2006/07. Based on these projections, the excess over the reference value could not be considered either exceptional or temporary in the sense of the Treaty and the Stability and Growth Pact although the deficit is close to the reference value. Subsequent to the Commission services’ autumn forecasts, the United Kingdom announced fiscal measures in the Pre-Budget Report presented to Parliament on 5 December 2005. In net terms, United Kingdom authorities’ costings of these measures, compared with the baseline of announced policy (as taken into account in the Commission services’ autumn forecasts), represent an easing of policy by 0.1 pp of GDP in the current financial year and a tightening of policy by 0.1 pp of GDP in 2006/07. Taking into consideration these measures, which are all structural, the assessment nevertheless remains that the deficit in 2006/07, at around 3.1% of GDP, is expected to exceed 3% of GDP and is therefore not temporary. This indicates that the Treaty requirement concerning the deficit criterion is not fulfilled.

(9) In contrast, the general government debt ratio remains well below the 60% reference value (the August EDP data reporting a ratio of 40.8% of GDP in the 2004/05 financial year) although, given the scale of actual and projected primary deficits, on a rising trend. In the Commission’s autumn forecasts the debt ratio is projected to reach around 44½% of GDP in 2007/08.

(10) According to Article 2(4) of Regulation (EC) No 1467/97, “relevant factors” can only be taken into account in the Council decision on the existence of an excessive deficit in accordance with Article 104(6) if the double condition - that the deficit remains close to the reference value and that its excess over the reference value is temporary - is fully met. This double condition is not met in the case of the United Kingdom. Therefore, other relevant factors are not taken into account in this decision.

HAS ADOPTED THIS DECISION:

Article 1

From an overall assessment it follows that an excessive deficit exists in the United Kingdom.

Article 2

This decision is addressed to the United Kingdom of Great Britain and Northern Ireland.

Done at Brussels, […]

For the Council

The President […]

[1] OJ L 209, 2.8.1997 as amended by Council Regulation (EC) No 1056/2005 (OJ L 174, 7.7.2005, p. 5).

[2] http://europa.eu.int/eur-lex/en/treaties/selected/livre340.html

[3] August 2005 EDP notification, revised down from 3.3% of GDP. The United Kingdom August data were validated by Eurostat on 26 September 2005.

[4] See: http://europa.eu.int/comm/economy_finance/about/activities/sgp/country/edp/edprep2004_uk.pdf

[5] The EDP applies to the United Kingdom on a UK financial year basis. Actual UK general government balance data reported here 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 net lending balance on a Eurostat basis being approximately 0.1 percentage point of GDP per annum lower than reported in UK national accounts from respectively 2001 and 2001/02 onwards.

[6] However, the 2004/05 deficit outturn has been revised upwards since the August notification. The outturn consistent with that reported in the December 2005 Pre-Budget Report is 3.3% of GDP.

[7] http://europa.eu.int/comm/economy_finance/about/activities/sgp/edp/com_rep_uk.pdf

[8] http://europa.eu.int/eur-lex/en/treaties/selected/livre340.html

[9] OJ L 209, 2.8.1997, p. 6. Regulation as amended by Regulation (EC) No 1056/2005 (OJ L 174, 7.7.2005, p. 5).

[10] OJ L 332, 31.12.1993, p. 7. Regulation as amended by Regulation (EC) No 475/2000 (OJ L 58, 3.3.2000, p. 1) and by Commission Regulation (EC) No 351/2002 (OJ L 55, 26.2.2002, p. 23).

[11] August 2005 EDP notification, revised down from 3.3% of GDP. The United Kingdom August data were validated by Eurostat on 26 September 2005.

[12] See: http://europa.eu.int/comm/economy_finance/about/activities/sgp/country/edp/edprep2004_uk.pdf