Commission staff working document accompanying the report from the Commission - United Kingdom : prepared in accordance with Article 104(3) of the Treaty {SEC(2008) 2014 final}
Date: 2008-06-11
Institutions: European Commission
Subjects: United Kingdom, budget deficit, budget estimate, budget policy, economic analysis, economic forecasting, public debt, public finance

EN 

 
COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels, 11.6.2008 
SEC(2008) 2016 

COMMISSION STAFF WORKING DOCUMENT 

accompanying the 

REPORT FROM THE COMMISSION 

United Kingdom 

Prepared in accordance with Article 104(3) of the Treaty 

{SEC(2008) 2014 final} 

 
 
 
 
 
 
 
 
 
 
 
 
 
1. 

INTRODUCTION 

This  working  document  is  released  in  parallel  with  the  Commission  report  on  the  United 
Kingdom according to Article 104(3) of the Treaty1 and complements it by providing a more 
detailed  analysis  of  relevant  factors  taken  into  account  in  the  report.  Specifically,  Section  2 
analyses in greater detail the medium-term economic position, while Section 3 does the same 
for  the  medium-term  budgetary  position  (including  public  investment).  Section  4  examines 
the  other  relevant  factors  put  forward  by  the  Member  State  and  Section  5  other  factors 
considered relevant by the Commission. 

2.  MEDIUM-TERM ECONOMIC POSITION 

2.1.  Medium-term economic developments 

The UK economy has shown strong GDP growth over the last decade, with an average annual 
rate of 2.8% since 1998. GDP growth was also fairly stable, dipping below 2% only once, in 
2005. Since 2005, growth has again been strong, reaching 2.9% and 3.0% in 2006 and 2007 
respectively.  Over  the  past  10  years  UK  GDP  growth  has  been  entirely  driven  by  domestic 
demand,  with  private  consumption  making  the  largest  contribution.  The  past  decade  saw 
private  consumption  outpacing  GDP  by  around  0.5%  points  each  year,  thus  providing  a 
sizeable boost to growth. Meanwhile, net external demand has exerted a persistent drag since 
1998.  Over  the  same  period,  UK  potential  growth  is  estimated  to  have  averaged  2¾%  per 
year,  so  the  UK  has  achieved  steady  growth  broadly  in  line  with  potential.  Taking  as  a 
cyclical  starting  position  a  small  positive  output  gap  in  1998,  the  gap  remained  in  slightly 
positive territory up to 2007. It appears that the amplitude of the business cycle over the past 
ten  years  was  significantly  lower  compared  to  the  1980s  and  the  first  half  of  the  1990s, 
periods during which GDP growth tended to oscillate rather sharply.  

The  more  recent  period  of  high  and  stable  GDP  growth  has  taken  place  under  a  new 
macroeconomic  policy  framework,  marked  by  the  introduction  of  an  inflation  targeting 
regime in 1992 and the granting of independence to the Bank of England in 1997. The new 
framework  has  helped  to  achieve  generally  low  and  stable  inflation  over  the  past  ten  years, 
during  which  CPI  inflation  averaged  1.6%  per  year.  However,  rapid  increases  in  global 
energy and commodity prices had a marked upward impact on UK inflation in 2006 and 2007, 
and in March 2007 UK CPI inflation surpassed 3% for the first time since Bank of England 
independence.  CPI  inflation  fell  back  to  an  average  of  2.3%  in  2007,  but  continued  global 
inflationary  pressures  have  pushed  CPI  inflation  up  from  2.2%  in  January  2008  to  3.0%  in 
April  2008.  The  upward  inflation  trend  is  likely  to  continue  throughout  the  year,  as  high 
producer  price  inflation,  driven  by  higher  input  costs  resulting  from  energy  and  food  price 
rises and the sterling depreciation, feeds through into consumer prices. 

The UK labour market has performed very well over the last decade. Employment growth has 
been  steady  and  sustained,  averaging  1%  per  year  since  1998.  Over  the  past  decade  the 
employment rate has consistently exceeded the 70% Lisbon target, increasing from to 70.5% 
in  1998  to  71.3%  in  2007.  The  unemployment  rate  is  relatively  low  compared  to  the  euro 
area, and has averaged 5% over the past five years. This good performance is in part due to 
the  flexibility  of  the  UK  labour  market,  which  is  marked  by  largely  decentralised  wage 
bargaining  and  relatively  limited  statutory  employment  protection.2  Furthermore,  broad  and 

1 Treaty Establishing the European Community, Article 104 
2 See OECD (2004): Employment Outlook 2004 

1 

 
  
 
                                                 
deep supply-side labour market reforms going back to the 1980s were further strengthened in 
the 1990s. Moreover, the UK economy has experienced a positive labour supply shock over 
the past five years due to an increase in net inward migration, which significantly raised the 
working age population and boosted employment growth. This increase in the labour supply 
is  also  reflected  in  the  stronger  contribution  which  employment  has  made  to  potential  GDP 
growth over the past decade compared to previous periods, and this has helped to offset the 
trend decline in hours worked per employee.  

Despite  a  generally  positive  economic  performance,  a  number  of  imbalances  have  built  up 
during  the  past  decade.  These  weaker  aspects  of  the  UK  economy  include  the  low  rate  of 
household saving. The household saving rate declined from 7% in 1998 to under 3% in 2007, 
and was even negative if one disregards transfers to pension funds. This  gross  dissaving by 
households has been accompanied by very high growth of borrowing by the household sector, 
of  which  secured  borrowing  accounts  for  around  85%.  Expressed  as  a  percentage  of  gross 
disposable income, household borrowing doubled from 7% in 1998 to 14% in 2007. Much of 
this  has  contributed  to  rapidly  increasing  property  prices.  Facilitated  by  fully  liberalised 
mortgage lending and low nominal interest rates, house price inflation averaged 12% per year 
over  the  ten  years  to  2007,  and  even  reached  20%  per  year  between  2002  and  2004.3  As  a 
result, the average house price has nearly tripled over the past decade. This rapid appreciation 
poses a particular risk to economic growth and households' balance sheets if it were to unwind 
rapidly.  Further  imbalances  are  evident  in  an  increasing  current  external  deficit,  resulting 
mainly from a pronounced rise in the trade deficit for goods and services, which has widened 
steadily since 1998. Standing at 4.2% of GDP in 2007, the current external deficit so far has 
been largely financed by a surplus on the UK's financial account.  

Finally, some longer-term weaknesses of aggregate supply remain manifest in relatively low 
productivity  levels.  Despite  some  closing  of  the  productivity  gap  over  the  past  decade,  the 
UK's  GDP  per  hour  worked  in  2006  was  4%  below  the  euro  area  average.  A  number  of 
reasons have been proposed to explain this: notably the UK’s relatively low stock of physical 
capital, a shortfall in intermediate skills and comparatively low levels of R&D expenditure.  

2.2. 

Recent macroeconomic performance 

Overall, economic growth in 2007 continued in the strong vein of the previous year to reach 
3.0%. However, from the onset of the credit crisis in July 2007 growth slowed gradually to a 
quarterly  rate  of  0.4%  in  the  first  quarter  of  2008,  nearly  half  the  average  growth  rate 
achieved  in  the  first  half  of  2007.  From  the  start  of  the  credit  crisis,  financial  institutions' 
lending  behaviour  turned  increasingly  precautionary  as  the  size  and  distribution  of  balance 
sheet  losses  linked  in  part  to  mortgage-backed  securities  remained  uncertain.  As  a  result, 
financial market conditions were tense through the second part of 2007, during which credit 
conditions  tightened  and  liquidity  problems  in  the  banking  sector  persisted.  Risk  premia  on 
interbank, corporate and household lending increased appreciably, and still remained elevated 
during  the  first  half  of  2008.  As  a  result,  successive  base  rate  cuts  by  the  Bank  of  England 
from 5.75% in July 2007 to 5.0% in April 2008 have not fully translated into a commensurate 
fall in effective interest rates faced by private and corporate borrowers.  

Since  September  2007,  the  Bank  of  England  has  sought  to  ease  liquidity  problems  in  the 
interbank market through a number of channels, including additional auctions of short-dated 

3 Source: Nationwide and Halifax House Price Indices 

2 

 
 
 
 
 
 
                                                 
funds and widening acceptable collateral.  In April 2008, the Bank of England announced the 
details  of  its  "Special  Liquidity  Scheme",  whereby  the  UK  government  issues  bonds  to  the 
Bank  of  England,  which  will  then  offer  these  to  eligible  financial  institutions  in  a  swap 
operation.  The  scheme  is  to  remain  open  for  six  months  from  April  2008,  and  accepts  a 
relatively  broad  range  of  collateral,  including  AAA-rated  credit  card  debt  and  UK  and 
European  mortgage  debt.  While  setting  no  definite  limit  on  the  total  value  of  bond  swaps, 
initial take-up of the swap facility is estimated by the Bank at around £50bn (around half the 
value of net lending to individuals secured on dwellings during the 12-month period to March 
2008). Overall, the general borrowing environment has nevertheless remained restrictive since 
the  beginning  of  the  credit  crisis,  with  evidence  of  secured  and  unsecured  lending  spreads 
widening  further  in  April  2008  and  LIBOR  spreads  remaining  relatively  high.  Furthermore, 
national  accounts  data  for  the  fourth  quarter  2007  and  preliminary  data  for  the  subsequent 
quarter show a marked slowing in business and financial services activity.  

While the labour market in the second half of 2007 showed robust employment growth and 
falling  numbers  of  unemployed  workers,  latest  data  show  that  the  slowdown  has  begun  to 
depress  the  labour  market.  In  the  first  quarter  of  2008,  a  quarterly  rise  in  unemployment  of 
14,000 was recorded, and employment grew by a comparatively moderate 117,000. Earnings 
growth increased to an annual rate of 4.7% in March, thus bringing average earnings growth 
(including bonuses) to 4.0%. 

The residential property market has cooled appreciably since September 2007, partly due to 
concerns  over  housing  affordability,  a  deteriorating  economic  outlook  and  the  successive 
tightening  of  mortgage  lending  terms,  including  the  almost  complete  closing  by  lenders  of 
sub-prime  mortgage  facilities.  Annual  house  price  inflation  fell  from  an  average  of  11% 
observed  in  the  months  of  January  through  August  2007  to  -5%  in  May  2008.4  This  has 
already brought average house prices down by 7% from their peak in mid-2007, and further 
falls are expected. Similarly, turnover in the housing market has slowed significantly, with the 
number of property transactions having fallen by 25% between the third quarter 2007 and the 
first quarter 2008.  

Significant movements in the pound sterling's bilateral exchange rates have also taken place 
since July 2007, with a fall of 15% against the euro in the eight months to April 2008 being 
the  most  significant  given  the  UK's  strong  trade  integration  with  the  euro  area.  Overall,  the 
pound's  nominal  effective  exchange  rate  weakened  by  12%  over  the  same  period. 
Macroeconomic repercussions of this depreciation are not yet evident with regard to changes 
in external trade, although the improved export competitiveness can be expected to strengthen 
the  UK's  weak  net  exports  balance  so  as  to  make  a  positive  growth  contribution  over  the 
medium  term.    However,  the  weaker  exchange  rate  has  raised  inflationary  pressures,  and 
output prices rose in April by 7.5% year-on-year, with input prices up by 23.3%, although this 
is  in  part  also  due  to  recent  increases  in  global  energy  and  food  prices.  The  more  recent 
portion  of  the  pound’s  depreciation  can  be  expected  to  raise  import  prices  further  over  the 
year and, depending on the ability of retailers to absorb these in their margins, may partly feed 
through  to  consumer  prices.    At  the  same  time,  inflationary  pressures  are  compounded  by 
rising  inflationary  expectations  by  households,  as  evidenced  in  surveys  having  recorded 
inflation expectations edging up over the past six months to around 3¾% one year ahead.5  

4 Average of Nationwide and Halifax house price indices 
5 Source: Bank of England and Citigroup/YouGov  

3 

 
 
 
 
 
                                                 
2.3. 

Economic prospects 

The Commission services' 2008 spring forecast, published on 28 April, forms the basis for the 
following  assessment  of  the  UK’s  short-  to  medium-term  growth  prospects.  Incoming  data 
available  subsequent  to  the  forecast  cut-off  date  of  15  April  have  broadly  confirmed  the 
projections,  though  skewing  the  balance  of  risks  up  the  forecast  horizon  further  to  the 
downside (as regards real activity) and upside (as regards inflation). GDP growth in the first 
quarter of 2008 is officially estimated at 0.4%, in line with the 2008 spring forecast. Further 
news  relates  to  the  housing  market,  where  month-on-month  falls  in  average  house  prices 
continued  to  be  observed  in  April.  Furthermore,  PMI  readings  for  April  came  in  very  low, 
especially  for  the  service  sector,  which  accounts  for  around  75%  of  UK  GVA.  Both 
manufacturing  and  services  PMI  levels  have  fallen  well  below  their  three-year  average. 
Overall, the analysis presented in the spring forecast therefore continues to reflect the UK’s 
current  economic  outlook.  Overall,  this  sees  developments  in  the  housing  market  and  the 
financial sector as dampening growth in the medium term. Domestic demand is likely to slow 
significantly,  driven  by  moderation  in  both  private  consumption  and  gross  fixed  capital 
formation.  However,  the  significant  depreciation  of  the  pound's  nominal  effective  exchange 
rate since August 2007 is likely to improve the price competitiveness of UK exports, while at 
the same time aggravating inflationary risks. 

A  marked  slowing  of  private  consumption  is  expected  in  2008,  driven  by  more  restrictive 
borrowing conditions, a downward correction in house prices and a squeeze on real incomes 
due  to  rising  inflation,  with  only  a  limited  recovery  in  2009.  The  Bank  of  England's  April 
2008 credit conditions survey showed that conditions  for all  types of lending to  households 
and corporations tightened in the first quarter and were expected to be restricted further in the 
second quarter. Expected falls in net housing equity will also weaken the collateral value of 
housing  for  secured  borrowing,  thus  compounding  the  ongoing  tightening  of  credit 
conditions.  As  a  consequence,  household  spending  growth  will  slow  on  account  of  lower 
secured  and  unsecured  borrowing.  Whilst  moderate  earnings  growth  would  tend  to  support 
private consumption, in the current inflationary environment its positive effect on consumer 
spending is likely to be offset by marked increases in consumer prices and  living expenses, 
leaving  consumption  growth  weak  in  volume  terms.  In  2009,  upward  wage  pressures  from 
higher  CPI  and  RPI  inflation  will  be  countered  by  increased  labour  market  slack,  as 
employment growth slows to almost zero over the forecast horizon and unemployment rises 
appreciably.  The  UK  government's  fiscal  package  announced  on  13  May  2008,  which 
increases  the  tax-free  allowance  of  basic-rate  taxpayers  (i.e.  those  earning  less  than  around 
£40,000 per year) by £600 during for the financial year 2008/9, amounts to a deficit-funded 
transfer to households worth £2.7bn, equivalent to around 0.3% of gross disposable household 
income.  Depending  on  the  propensity  of  households  to  spend  this  windfall,  private 
consumption  growth  may  rise  slightly  but  is  unlikely  substantively  to  alter  overall  GDP 
growth prospects. Inflationary effects of this demand stimulus would then be commensurate 
to household's marginal propensity to spend.  

Investment  is  also  set  to  moderate  in  2008  on  account  of  tighter  lending  conditions  and  the 
consequences  of  the  housing  market  correction  on  residential  investment.  Together  with  a 
weaker  business  climate,  these  factors  will  dampen  business  investment  in  2008,  though  it 
should  return  to  more  robust  levels  in  2009  due  to  improved  prospects.  Government 
consumption will provide a moderate stimulus in 2008, notwithstanding the fact that the 2008 
budget confirms a relatively tight expenditure envelope over the forecast horizon. The growth 
contribution  of  net  external  demand  is  expected  to  turn  sharply  positive  from  2008.  This  is 
driven by a slowdown in imports in line with a moderation of domestic demand growth and 

4 

 
 
 
 
the weaker exchange rate, while the pound's depreciation will support a recovery in exports 
that more than offsets the effects of subdued growth in key markets such as the euro area and 
US.6  

Table 1: Macroeconomic developments and outlook 

Real GDP (% change) 

Contributions: 

        -Domestic demand 

        -Change in inventories 

        -External trade 
Employment a (%change) 
Unemployment (% of labour force) 

Nominal unit labour costs (%change) 

HICP (% change) 
External Balance b (% of GDP) 
Euro area real GDP (% change) 

Average 
1995-1998 

1999 

2003 

2004  2005 

2006 

2007 

2008 

3.0 

3.0 

2.8 

3.3 

1.8 

2.9 

3.0 

1.7 

3.4 

0.0 

-0.4 

1.3 

7.3 

2.2 

2.2 

-0.7 

2.3 

4.1 

0.2 

-1.2 

1.4 

5.9 

2.8 

1.3 

-2.4 

2.9 

2.8 

0.1 

-0.1 

1.0 

4.9 

3.0 

1.4 

-1.3 

0.8 

3.8 

0.1 

-0.6 

1.0 

4.7 

2.0 

1.3 

-1.6 

2.1 

1.8 

-0.1 

0.1 

1.0 

4.8 

3.5 

2.1 

-2.5 

1.6 

3.0 

0.0 

-0.1 

0.9 

5.4 

2.9 

2.3 

-3.9 

2.8 

3.5 

0.4 

-0.6 

0.7 

5.3 

1.5 

2.3 

-4.2 

2.6 

1.7 

-0.2 

0.3 

0.1 

5.6 

2.6 

2.8 

-3.2 

1.7 

2009 

1.6 

1.3 

0.0 

0.3 

0.0 

5.9 

2.8 

2.2 

-3.2 

1.5 

Notes: 
a Ful-time equivalents 
b Current external balance, in % of GDP 
Source: Eurostat and Commission services' spring 2008 forecasts 

Overall, growth in the UK economy is expected to slow to just below 1¾% in 2008, with a 
substantial  carryover  effect  from  the  previous  year  masking  a  more  significant  slowdown, 
with  in-year  growth  slowing  to  around  1%  by  year-end.  In  2009,  the  gradual  recovery  in 
domestic demand through the year will lift in-year growth above 2% by year-end, but with no 
large carryover effect from 2008 annual growth will be limited to around 1½%. By contrast, 
the  GDP  growth  projections  in  the  UK's  latest  budget,  published  in  March  2008,  differ 
notably from those in the Commission services' spring 2008 forecast. The UK's official GDP 
forecast appears somewhat optimistic by virtue of significantly higher forecast growth figures 
in financial years 2008/09 and 2009/10 compared to the spring 2008 forecast. While the latter 
expects growth of 1.4% and 1.8% in 2008/09 and 2009/10 respectively, the UK's 2008 budget 
factors in growth of 1 ¾% and 2 ½% in these years. Underpinning this divergence of views is 
a somewhat different assessment of the outlook for domestic demand. While the UK's 2008 
budget  expects  "sluggish  or  flat  house  price  growth  in  2008",  the  spring  forecast  expects 
substantially  weaker  housing  market  performance.7  Indeed,  nominal  house  prices  have 
already  fallen  by  7%  since  mid-2007,  and  current  indicators  point  towards  a  further 
weakening. A weaker housing market would tend to depress both residential investment and 
private consumption, and so the weaker spring 2008 GDP forecast would appear warranted in 
terms of the recent deterioration in housing market prospects in terms of turnover and price 
developments. Furthermore, differences in the assessment of future credit conditions are also 
likely  to  contribute  to  differences  in  overall  growth  forecasts.  The  Commission  services' 
spring 2008 forecast is also more cautious than the UK's budget forecast regarding the speed 
of  reversion  to  normal  credit  market  conditions,  including  for  secured  and  unsecured 
household borrowing, which the spring forecast expects to last into 2009. 

This 2008 spring forecast scenario is subject to predominantly downside risks relating to the 
length  and  severity  of  financial  market  problems,  which  remain  highly  uncertain  but  are 

6 The projections for export and import volumes exclude the impact of Missing Trader Intra-Community (MTIC) 
fraud on trade figures. 
7 HM Treasury (2008): Budget 2008, Chapter B, p.161 

5 

 
 
 
  
  
  
  
  
  
  
  
  
  
 
 
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
 
  
  
  
  
  
  
 
 
 
                                                 
crucial  in  view  of  the  relatively  high  contribution  of  the  financial  sector  to  the  UK's  GDP. 
Over the forecast period employment growth is expected to slow to near-zero as a result of the 
moderation  in  activity.  The  supply  of  labour  is  also  projected  to  increase  at  a  slower  pace, 
reflecting reduced immigration, and as a result of slowing activity the unemployment rate is 
set to increase. Slowing labour supply growth and a moderation in fixed capital formation will 
have  a  dampening  impact  on  potential  growth  in  the  medium  term.  Given  the  above  GDP 
growth forecasts, the economy is expected to move into negative output gap territory in 2008 
and further so in 2009.  

Table 2: Sources of potential output growth 

Potential GDP (% change)  
Contributions: 
      - Labour 
      - Capital accumulation 
      - Total factor productivity 
Output gap (% of potential GDP) 

Average 
'95 - '98 
2.7 

1999 
3.0 

2003 
2.7 

2004 
2.7 

2005 
2.7 

2006 
2.8 

2007 
2.7 

2008 
2.4 

2009 
2.3 

0.3 
0.7 
1.7 
-0.1 

0.4 
0.9 
1.6 
0.4 

0.3 
0.9 
1.5 
0.1 

0.3 
0.9 
1.4 
0.7 

0.3 
0.9 
1.4 
-0.1 

0.3 
1.1 
1.4 
0.0 

0.1 
1.2 
1.4 
0.4 

-0.1 
1.1 
1.4 
-0.3 

-0.2 
1.1 
1.4 
-1.0 

Note: 
aBased on the commonly agreed method for calculating 
potential output 

Source: Eurostat and Commission services' spring 2008 forecast 

3.  MEDIUM-TERM BUDGETARY POSITION 

According  to  the  United  Kingdom's  March  2008  EDP  notification,  the  2007/088  general 
government deficit is estimated at 2.9% of GDP9, up from 2.6% in 2006/07; in the notification 
the  UK  authorities  confirmed  their  projection  of  a  2008/09  deficit  of  3.2%  of  GDP10.  The 
Commission services' spring 20008 forecast projects a deficit in 2009/10 that will remain in 
breach of the Treaty reference value of 3% of GDP.    

3.1. 

Budgetary developments until 2007/08 

The United Kingdom undertook remarkable fiscal consolidation efforts during the late 1990s. 
The  general  government  balance  swung  from  a  deficit  of  3.8%  of  GDP  in  1996/97  to  a 
surplus of 1.3% by 1999/00, while gross government debt declined from over 50% of GDP in 
1996/97 to a low of 36.8% in 2002/03. Although higher revenues, especially from income and 
corporation tax, contributed to the adjustment, the greater part of the consolidation was driven 
by a marked slowdown in expenditure growth.  

Thereafter,  the  government  adopted  a  looser  fiscal  stance,  mainly  as  a  result  of  an  explicit 
policy objective to raise expenditure on public services. As a result, the general government 
balance  moved  from  a  surplus  position  in  the  late  1990s  to  a  deficit  of  3.2%  of  GDP  in 
2003/04. With output gaps estimated to be positive over this period, this was equivalent to a 
deterioration of the structural balance of 4¼ percentage points of GDP11 between 1999/00 and 
2003/04. During these years, the government expenditure-to-GDP ratio increased by about 3½ 

8 The UK financial year runs from April to March. 
9  In  this  document,  all  data  quoted  from  the  EDP  notification  and  the  convergence  programmes  have  been 
adjusted to exclude receipts from the sale of UMTS licenses from the government's annual revenue flow, in 
line with Eurostat decision of 14 July 2000.  This adjustment increases the deficit figures submitted by the UK 
authorities by just over £1.0 billion (0.07% of GDP in 2007/08).  

10  For the purpose of the EDP notification, the outturn data were submitted by the Office for National Statistics, 

whereas the forecast data have been notified by HM Treasury.  

11 Estimated by the Commission services, applying the common methodology on estimating output gaps. 

6 

 
 
  
 
 
 
 
 
 
  
  
  
  
  
  
  
  
  
  
  
  
  
 
  
  
  
  
  
  
  
  
  
  
  
  
 
                                                 
percentage points, to 42.2%, with government gross fixed capital formation rising from 1.3% 
of  GDP  to  1.6%.  At  the  same  time,  the  ratio  of  government  revenue  to  GDP  fell  by  1.0 
percentage  point,  to  38.9%,  mainly  due  to  reduced  growth  of  intakes  from  personal  income 
taxes as a result of slower economic growth and a drop in taxes on financial sector corporate 
profits, down by ½ percentage points of GDP in 2002/03, following the burst of the dot-com 
bubble. As shown in Figure 1, fiscal policy in the UK remained pro-cyclical in 2004/05, with 
the headline deficit rising further to 3.5% of GDP12 while the economy continued to expand at 
a rate above potential. Compared to the previous year, the structural balance is estimated to 
have deteriorated by 0.4 percentage points of GDP.  

Figure 1: UK fiscal stance and cyclical conditions

Pro-cyclical fiscal 
tightening

2005/06

2006/07

2007/08

2003/04

Counter-cyclical 
fiscal tightening

2004/05

Counter-cyclical 
fiscal loosening

2002/03

Pro-cyclical fiscal 
loosening

)
P
D
G

f
o

%

s
a
e
c
n
l
a
b
l
a
r
u
t
c
u
r
t
s
n
i

e
g
n
a
h
c
(

e
c
n
a
t
s

l
a
c
s
i
F

1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5

-2.0

-2.5

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

Source: Commission services

Cyclical conditions (output gap as % of GDP)

Notwithstanding a slowdown in GDP growth, in 2005/06 the deficit fell to 3.1% of GDP. The 
consolidation, however, partly reflected a one-off imputed transaction that reduced the deficit 
by  0.3%  of  GDP13;  in  structural  terms,  the  consolidation  is  nevertheless  estimated  to  have 
been equivalent to 0.4 p.p. of GDP.  In 2006/07, the headline deficit fell to 2.6% of GDP and 
the structural deficit was reduced by ½ percentage point of GDP over the previous year. The 
fiscal  consolidation  between  2005/06  and  2006/07  was  driven  by  strong  growth  in  taxes  on 
corporate profits, which accounted for four-fifths of the increase in the revenue ratio during 
this  period.  In  turn,  taxes  on  financial  sector  profits,  boosted  by  strong  equity  market 
performance  and  mergers  and  acquisition  (M&A)  activity,  accounted  for  a  third  of  the 
increase in corporate taxation during the two years.   

Box 1: The Previous Excessive Deficit Procedure for the United Kingdom  

12 The March 2008 notification confirmed a deficit for 2004/05 of 3.5% of GDP, whereas the Council decision 
that the United Kingdom was in excessive deficit was based on a deficit estimate for 2004/05 of 3.2% of GDP. 
The upward revision in the deficit figure mainly reflects the reclassification of proceeds on disposals of social 
housing from revenue to disposal of equity. 

13  Following  the  restructuring  of  the  nuclear  energy  sector,  which  led  to  the  transfer  to  central  government  of 
assets held by a public corporation, the United Kingdom's Office for National Statistics decided to record an 
imputed transaction, valued at 0.3% of GDP in 2005/06, to central government as a deficit-reducing flow.  

7 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                                 
In  financial  year  2003/04,  the  UK  general  government  deficit  breached  the  3%  of  GDP  Treaty 
reference value for the first time since the abrogation of its previous excessive deficit procedure (EDP) 
in 1998. As a consequence, the Commission initiated the EDP in April 2004, with the adoption of the 
report foreseen by Article 104.3. With the deficit for 2003/04 estimated at 3.2% of GDP and against 
expectations that the excessive deficit would revert to below the threshold level in the following year, 
the  Commission  and  the  Economic  and  Financial  Committee  concluded  that  the  United  Kingdom 
could not be considered to be in an excessive deficit situation as defined in the Treaty. a 

Following  the  August  2005  EDP  notification,  which  reported  a  deficit  of  3.2%  of  GDP  in  2004/05,   
on  21  September  2005  the  Commission  initiated  the  EDP  for  the  UK  with  the  adoption  of  a  report 
under  Article  104.3.  On  24  January  2006,  the  Council  decided,  on  a  recommendation  from  the 
Commission,  that  the  United  Kingdom  was  in  excessive  deficit  according  to  Article  104.6.b  At  the 
the  Council  addressed 
same 
recommendations under Article 104.7 to the UK with a view to bringing the situation of an excessive 
government deficit to an end by 2006/07 at the latest. 

time,  and  also  based  on  a  Commission  recommendation, 

On  the  12  September  2007,  the  Commission  adopted  a  recommendation  for  a  Council  decision 
abrogating the EDP against the UK. The Commission’s assessment was based on the 2006/07 deficit 
outturn, which was below the Treaty reference value, the spring 2007 forecast and the trends in public 
finances  for  2007/08.  While  the  effects  of  the  emerging  financial  market  turmoil  on  the  budgetary 
situation  were  taken  into  account,  forecast  developments  as  a  whole  indicated  that  the  UK  deficit 
would remain below the 3% reference value throughout the forecast period.  On the 9 October 2007, 
ECOFIN decided to abrogate the EDP according to Article 104.12 of the Treaty.  

a  All  EDP-related  documents  for 

the  United  Kingdom  can  be  found  at 

the  following  website: 

http://ec.europa.eu/economy_finance/netstartsearch/pdfsearch/pdf.cfm?mode=_m2  

b   OJ L 51, 22.2.2006, p. 14. 

Fiscal  policy  was  again  pro-cyclical  in  2007/08,  when  the  budgetary  situation  deteriorated 
notwithstanding  favourable  economic  conditions.  The  deficit  is  estimated  to  have  risen  to 
2.9% of GDP in both the Commission services’ spring 2008 forecast and in the data reported 
by  the  UK  in  March  200814.  This  exceeded  the  projection  in  the  2006  convergence 
programme  by  0.6  percentage  points,  though  compared  with  the  programme  a  deficit-
increasing  national  accounts  reclassification  of  around  ¼%  of  GDP  per  annum  should  be 
noted15. The increase in the deficit was due to sluggish revenue growth, with the revenue-to-
GDP  ratio  estimated  to  have  fallen  by  ½  percentage  points.  In  turn,  developments  on  the 
revenue side were driven by lower than expected intakes from corporate taxation, primarily as 

14 The provisional public sector finances' data for April 2008, which were published on the 21 May 2008, imply 
a headline 2007/08 general government deficit on an EDP-basis of 2.7% of GDP, 0.2 p.p. less than estimated 
in  the  2008  Budget  and  in  the  spring  forecast.  The  better-than-expected  outturn  was  primarily  due  to  a 
downward revision to previously-published figures for central government current expenditure, which ceteris 
paribus  also  implies  a  lower  structural  deficit  in  2007/08  by  0.2%  of  GDP.  Under  a  no-policy-change 
assumption,  the  spring  2008  forecast  assumes  that  the  government  will  adhere  to  the  non-cyclical  primary 
expenditure plans  announced  in  the  2008  budget, which  were practically  unchanged  from  those  in  the  2007 
Comprehensive Spending Review. Lower departmental spending in 2007/08 would not pass-through into the 
expenditure  planned  in  2008/09  and  2009/10,  since  the  departmental  spending  limits  for  those  years  were 
established  in  the  2007  Comprehensive  Spending  Review.   Indeed  under  the  End-year  Flexibility  (EYF) 
scheme,  departments  are  allowed  to  carry  forward  under-spends  on  their  departmental  allocations  from  one 
year to the next.   

15 This refers to the reclassification, from the local government sector to outside the general government, of local 
government revenues from the sales of social housing. The reclassification, retropolated since 1997/98, led to 
an increase in the general government deficit in 2006/07, through the combined effects of foregone revenue 
from housing sales and an increase in the subsidy payments’ component of expenditure.  

8 

 
 
 
 
 
 
 
 
                                                 
 
a  result  of  higher  repayments,  due  to  companies'  having  overpaid  corporate  tax  in  previous 
years,  as  well  as  to  lower  revenues  from  oil  and  gas  extraction  activity  due  to  lower 
production  and  rises  in  operating  costs.  The  substantially  higher-than-usual  repayments  of 
overpaid  corporate  taxation  in  2007/08  suggest  that,  perhaps  particularly  in  2006/07,  such 
revenues could have been artificially boosted by overstated profits, though the extent of this 
effect is uncertain. According to the Commission services' spring 2008 forecast, as a result of 
the  pro-cyclical  fiscal  loosening  in  2007/08,  the  structural  deficit  is  estimated  to  have 
increased by ¼% of GDP.  

Table 3: Budgetary developments and outlook a  

General 
government 
balance 
Primary balance 
One-off and other 
temporary 
measures 
Total expenditure 
  of which: 

Government 
gross fixed 
capital 
formation 
Interest 
expenditure 

Total revenue 
  of which: 

Taxes and 
social security 
contributions 
Cyclically-adjusted 
balance 
Cyclically-adjusted 
primary balance 

1999/00  2003/04  2004/05  2005/06  2006/07  2007/08  2008/09  2009/10 

1.3 

4.1 

- 

-3.2 

-1.2 

- 

-3.5 

-1.4 

- 

-3.1 

-1.0 

0.3 

-2.6 

-0.4 

- 

-2.9 

-0.7 

- 

-3.3 

-1.1 

- 

-3.3 

-1.2 

- 

38.6 

42.2 

43.2 

44.1 

43.9 

43.6 

44.2 

44.1 

1.3 

1.6 

1.8 

0.6 

1.8 

1.9 

2.0 

1.9 

2.7 

39.9 

2.0 

38.9 

2.0 

39.7 

2.1 

41.0 

2.1 

41.2 

2.2 

40.7 

2.2 

40.8 

2.1 

40.8 

37.1 

36.0 

36.6 

37.6 

37.9 

37.4 

37.6 

37.8 

1.0 

3.7 

-3.3 

-1.3 

-3.7 

-1.7 

-3.0 

-0.9 

-2.7 

-0.6 

-3.0 

-0.8 

-3.1 

-0.9 

-2.9 

-0.8 

Notes: 
a In percent of GDP. 
b Cyclically-adjusted balance excluding one-off and other temporary measures. 
Source: Eurostat and Commission services’ spring 2008 forecasts. 

Looking at the track record of the UK authorities' fiscal projections over the past ten years, on 
average the forecast error was close to zero (on average the actual outturn was 0.3% of GDP 
worse than the one-year-ahead forecast in the programme16) over the period from 1998/99 to 
2007/08. However, the average over the past ten years hides two distinct trends, as Figure 1 
shows.  Between  1999/00  and  2001/02,  projections  tended  to  be  cautious,  generally 
underestimating  the  size  of  future  surpluses,  typically  because  revenue  growth  was 
understated.  By  contrast,  from  2002/03  onward,  in  spite  of  relatively  accurate  forecasts  for 
economic  growth  (except  in  2005,  when  the  economy  decelerated),  the  convergence 
programme projections underestimated the size of deficit ratios, on average by 1 percentage 
point in the forecast for the subsequent year. 

16 Excluding forecast error as a result of deficit-reducing revenues from UMTS sales in 2000/01. 

9 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                                 
5.0

4.0

3.0

2.0

1.0

0.0

-1.0

-2.0

-3.0

-4.0

Figure 2: General government balance projections in successive convergence programmes (% of GDP)

Actual and forecast

CP 2001

CP 1998

CP 1999

CP 2002 

CP 2004

CP 2005

CP 2006 CP 2007

CP 2003

CP 2000

Reference value

2008 Budget

2010/11

2011/12

2012/13

1997/98

1998/99

1999/00

2000/01

2001/02

2002/03

2003/04

2004/05

2005/06

2006/07

2007/08

2008/09

2009/10

Source : Commission services' spring 2008 forecast, 2008 Budget and successive convergence programmes

Box 2: The UK’s fiscal rules and respect of the 3% of GDP reference value 

The UK’s fiscal policy framework is based on two fiscal policy rules for the public sector: the “golden 
rule”, adherence to which ensures that over the course of the economic cycle, the government borrows 
only to finance net investment a, and not to fund current expenditure; and the “sustainable investment 
rule”, which aims to keep public sector net debt (i.e. net of financial assets) at “a stable and prudent 
level”.  Within  this  framework,  the  authorities  set  an  explicit  objective  of  maintaining  sound  public 
finances. 

With its emphasis on the economic cycle as a whole, application of the UK’s golden rule allows for 
deficits  on  the  current  budget  (current  revenues  minus  current  expenditure)  to  be  offset  against 
surpluses credited elsewhere in the cycle. The government's judgement is that a new economic cycle 
began in the first half of 1997, but there is still uncertainty on whether or not that cycle was completed 
in  the  second  half  of  2006.  The  golden  rule  combined  with  the  current  dating  of  the  cycle  has  thus 
effectively allowed the deficits on the public sector current budget between 2002/03 and 2007/08 to be 
offset against the surpluses posted between 1998/99 and 2001/02. As a result, despite the recent scale 
of deficit outturns, the government maintains that it continues to meet the golden rule.  

The budgetary strategy consistent with the 'golden rule' does not ensure deficits below 3% of GDP, as 
confirmed by the results in 2003/04, 2004/05 and 2005/06, as well as those in prospect for 2008/09 
and 2009/10b. The golden rule is framed over the course of the cycle, rather than on an annual basis; as 
already noted, the deficit can fluctuate widely from year to year, and it cannot be excluded that general 
government  net  borrowing  will  exceed  the  3%  of  GDP  reference  value  in  one  or  more  years  of  the 
cycle, while still meeting the golden rule (indeed, part of the rationale for framing the golden rule in 
this  way  was  to  protect  investment  expenditure  from  short-term  budgetary  pressures).  With  the  UK 
authorities  targeting  an  average  net  investment-to-GDP  ratio  of  around  2¼%  of  GDP  over  the  next 
five years, a small deficit on the current budget would translate into a net borrowing approaching 3% 
of GDP.  

The degree of constraint imposed by the 'sustainable investment' rule on the UK's deficit depends on 
the government's interpretation of "low and sustainable" debt levels. The 'sustainable investment' rule 

10 

 
  
 
 
 
is interpreted as requiring net debt to remain below 40% of GDP in every financial year. With net debt 
well  below  that  level  over  the  past  ten  years,  the  'sustainable  investment'  rule  has  not  appeared  an 
important  constraint  to  the  government's  budgetary  decisions  during  the  past  decade.  On  the  other 
hand,  with  the  2008  budget  forecasting  an  increase  in  net  debt  to  39.8%  of  GDP  in  2010/11,  the 
'sustainable investment' would soon become binding should there be some slippages from the current 
medium-term projections.  
a Gross investment (net of asset sales) less depreciation. 
b  Since  2002/03,  the  UK  budget  balance  has  remained  persistently  well  above  the  estimated  minimum 
benchmark (the estimated budgetary position in cyclically-adjusted terms that provides a sufficient safety margin 
for automatic stabilisers to operate freely during normal economic downturns without breaching the 3% of GDP 
deficit reference value), which for the UK is estimated as a deficit of around 1½% of GDP.  

3.2. 

Short-term prospects 

The UK authorities' latest fiscal projections were published in the 2008 Budget Report on the 
12  March  2008.  According  to  the  2008  Budget,  the  general  government  deficit  in  2008/09 
will  rise  to  3.2%  of  GDP,  up  by  0.3  percentage  points  when  compared  to  the  convergence 
programme submitted in November 2007. The upward revision to the 2008/09 deficit forecast 
was entirely due to a reduction in revenue projections, primarily reflecting the view that the 
volume  of  property  transactions  and  the  level  of  equity  prices  will  both  be  lower  than  had 
been  assumed  in  the  programme.  A  reduction  in  expected  property  transactions  (relative  to 
what had been assumed in the programme), contributed to a downward revision in the official 
forecast for receipts from stamp duties and capital taxes, although the official projections do 
not assume a fall in house prices in 2008 and 2009. Meanwhile, lower-than-expected equity 
prices  (down  by  almost  15%  when  compared  to  the  assumption  in  the  programme)  are 
expected to reduce intakes from stamp duty on share transactions and from corporation tax.  

The Commission services' spring 2008 forecast also projects a deterioration in the budgetary 
position in 2008/09. The deficit for the current financial year was projected to reach 3.3% of 
GDP,  with  the  economic  slowdown  feeding  through  slower  revenue  growth.  Weaker 
employment earnings and reduced corporate profitability were expected to constrain receipts 
from  income  taxation,  while  lower  housing  market  activity  was  set  to  dampen  intakes  from 
stamp duties. Indirect tax revenues were forecast to grow at a lower rate than in 2007/08 due 
to lower household spending and an increase in the share of expenditure on food, which is not 
subject to the standard VAT rate. The spring 2008 forecast took into account all discretionary 
measures announced by 15 April (the forecast cut-off date), including those announced in the 
2008  Budget.  Those  measures  were  expected  to  have  an  essentially  neutral  effect  on  public 
finances.  The  increased  revenues  from  the  removal  of  the  10%  starting  rate  of  tax  on 
employment income and the reduction in allowances for investment were expected to finance 
reductions in the basic rate of personal income tax and in the main corporate tax rate. On the 
expenditure side, the envelope set in the government's 2007 Comprehensive Spending Review 
for the three years beginning in April 2008 envisages a deceleration in non-cyclical primary 
expenditure,  which  the  spring  2008  forecast  assumes  will  be  adhered  to,  but  which  also 
implies a greater risk of spending overruns relative to previous years.  

In  2009/10,  the  Commission  services  had  forecast  the  deficit  to  remain  at  3.3%  of  GDP,  ½ 
percentage point higher than the 2009/10 deficit projected in the 2008 Budget.  The latter was 
mainly due to differences in revenue growth projections as a result of the weaker economic 
context  underpinning  the  spring  2008  forecast.  In  particular,  the  Commission  services 

11 

 
 
 
 
 
 
 
expected a more protracted economic slowdown relative to the 2008 Budget, with the spring 
2008 forecast projecting real GDP growth well below potential and contributing to a further 
widening  of  the  negative  output  gap.    On  the  expenditure  side,  the  Commission  services 
forecast  assumes  that  the  government  will  adhere  to  the  2009/10  non-cyclical  primary 
expenditure plans announced in the budget, which were practically unchanged from those in 
the  2007  CSR  (and  assumed  in  the  convergence  programme).  However,  the  Commission 
services'  higher  inflation  forecast  for  the  third  quarter  of  2008  implies  upward  pressure  on 
index-linked  social  benefits  in  2009/10.  In  structural  terms,  the  deficit  was  forecast  to 
decrease by ¼% of GDP, reflecting the combined effects of discretionary measures, including 
the higher taxes on alcohol and motor vehicles introduced in the 2008 Budget, and continued 
slower growth in government expenditure. 

Commission  services’  simulations  of  the  budget  balance  assuming  (i)  different  real  GDP 
growth  scenarios  for  2009/10;  (ii)  trend  output  based  on  the  HP-filter  and  (iii)  no  policy 
response from the UK authorities (notably, the expenditure level is as in the spring forecast) 
indicate that for the 2009/10 deficit to fall to the Treaty reference value, real GDP in 2009/10 
would  have  to  grow  at  a  rate  not  less  than  2¼-2½%.  The  latter  is  well  above  the  spring 
forecast, the May 2008 update of the Consensus Forecasts for 2009 (1.7%), and the average of 
independent forecasts (1.6%) as published by the Treasury in May 200817.  

The Commission’s spring 2008 fiscal projections (and the 2008 Budget Report) pre-dated the 
government's statement on the 23 April 2008 that it now envisaged elements of compensation 
to some of those negatively affected by the removal from April 2008 of the 10% starting rate 
of income tax (one of the measures announced in the March 2007 budget). The government 
subsequently  announced  on  13  May  2008  that  for  financial  year  2008/09  the  compensation 
would  be  provided  through  an  increase  in  individual  personal  tax  allowances  and  that  this 
measure  would  be  financed  through  additional  borrowing18.  As  a  result,  the  Commission 
services  now  expect  the  headline  deficit  in  2008/09  to  reach  3.5%  of  GDP,  0.2  percentage 
points  higher  than  the  annual  deficit  level  forecast  by  the  Commission  services  in  spring 
2008.  The  compensation  plans  also  imply  that  the  structural  deficit  in  2008/09  is  now 
expected to deteriorate by 0.3 percentage points of GDP, to 3.3% of GDP. The government 
also announced that for future years it aims to "continue the same level of support for those on 
lower incomes"19. The announcement does not commit the government to extend to 2009/10 
the  fully  debt-financed  compensation  offered  in  2008/09  (thus  opening  the  possibility  of 
offsetting  tax  and  expenditure  measures20).  It  nevertheless  carries  a  significant  risk  for 
2009/10 of a deficit overshoot, compared with the March 2008 budget plans, with a similar 
impact ceteris paribus on the spring forecast projection.  

3.3. 

The quality of public finances 

17   The  Consensus  Forecasts  and  the  Treasury's  comparison  of  independent  forecasts  do  not  publish  growth 
projections for financial year 2009/10. However, the Commission services estimate that, given whole-year 
and quarterly growth projections for 2009, quarter-on-quarter growth in the first quarter of 2010 would have 
to reach around 2% - compared to an average of 0.7% since 2000 - for an annual growth rate in 2009/10 of 
2¼%.  

18   See statement by the Chancellor of the Exchequer:   
     http://www.hm-treasury.gov.uk/newsroom_and_speeches/speeches/statement/Speech_statement_130508.cfm   
19   See paragraph 35 of the statement by the Chancellor. 
20   Further policy announcements are expected in the autumn 2008 Pre-Budget Report.  

12 

 
 
 
 
 
 
                                                 
In recent years the ratio of general government expenditure to GDP has risen by more than 5 
percentage  points  from  39%  in  1999/00  to  44%  in  2006/07.  In  comparison  the  EU  average 
was  around  47%  in  both  1999  and  2006.  Underpinning  this  rise  is  the  government’s  2002 
policy  of  increasing  expenditure  on  public  services,  with  a  particular  focus  on  increasing 
public  investment  from  the  relatively  low  levels  seen  in  previous  years.  However,  until 
2006/07 the expenditure increase was mainly driven by higher intermediate consumption and 
compensation of employees (accounting for around half of general government expenditure), 
although public sector net investment since 2001/02 increased substantially as a share of Total 
Managed  Expenditure21  from  2.6%  in  2001/02  to  4.6%  in  2006/07.  This  translates  into 
average public investment growth of around 15% per year in real terms (compared to 4% on 
average for current expenditure growth).  

The 2007 Comprehensive Spending Review (CSR) – announced together with the 2007 Pre 
Budget Report in October 2007 – set departmental spending plans and priorities for the years 
2008/09,  2009/10  and  2010/11.  The  spending  plans  over  the  2007  CSR  period  are  tight  in 
comparison with the three preceding spending reviews. Total public spending is expected to 
increase  by  an  average  of  2.1%  per  year  in  real  terms  in  the  2007  CSR  period,  against  an 
average  of  4.0%  for  the  spending  reviews  covering  the  period  from  April  1999  to  March 
2008. The 2007 CSR seems to confirm the UK’s continued effort to change the composition 
of public spending by further increasing the level of public sector net investment (from 2.1% 
of GDP in 2007/08 to 2¼% of GDP by the end of the CSR period) and refocusing resources 
towards budgetary items that are central to citizen’s’  welfare and/or conducive to economic 
growth  such  as  education  and  health,  although  in  the  light  of  the  overall  lower  spending 
envelope,  at  a  much  slower  pace  than  seen  in  recent  years.  However,  the  outturn  of  higher 
spending in growth-enhancing areas such as education depends very much on the degree of 
efficiency in the system.   

Table 4: Total public expenditure on services by function as a percentage of GDP  

1997/98 

2001/02 

2006/2007 

13.6 
5.9 
5.1 
2.7 
9.8 

13.8 
5.4 
4.7 
2.6 
10.8 

Social protection 
Health a 
Education a  
Economic affairs 
Other functions b 
Note: 
a Measured consistently with international definitions from the UN classifications of the functions of government (COFOG). 
Actual outcomes are subject to spending decisions by local authorities and devolved administrations.  
b  Includes “general public services”, “defence”, “environmental protection”, “recreation, culture and religion”, “public order 
and safety” and “housing and community amenities” and “EU transactions”.  
Source: HM Treasury, Public Expenditure Statistical Analyses 2008, the March 2008 Financial Statement and Budget Report 
and the 2007 Comprehensive Spending Review. 

13.4 
7.1 
5.5 
2.9 
10.7 

Estimated 
2007/08 
13.3 
7.3 
5.6 
2.9 
10.8 

Planned 
2010/11 
- 
7.8 
5.6 
- 
- 

The annual real increase in public sector spending on health and education between 1997/98 
to 2006/07 was 5% and 6% respectively. In 2007/08, public health and education expenditure 
are estimated at 7.3% and 5.6% of GDP respectively, rising from 5.9% and 5.1% of GDP in 
2001/02.  Whereas  health  spending  is  currently  planned  to  grow  further  to  7.8%  of  GDP  in 

21   Total  Managed  Expenditure  (TME)  is  the  national  measure  of  total  public  sector  expenditure  and  a  key 
element  of  the  government’s  fiscal  framework.  TME  comprises  expenditure  by  the  entire  public  sector  – 
namely  the  central  government,  local  authorities  and  public  corporations.  TME  consists  of  public  sector 
current  expenditure,  public  sector  net  investment  and  public  sector  depreciation.  It  differs  from  general 
government  expenditure by  including  spending by public  non-financial  corporations,  such  as  the formerly 
nationalised utilities, but excludes financial transactions.   

13 

 
 
 
 
 
                                                 
2010/11, the share of education spending to national income is planned to remain stable over 
the  CSR  2007  period.  As  part  of  its  Science  and  Innovation  Investment  Framework  2004-
2014,  the  government  set  a  target  to  increase  the  UK's  R&D  intensity  (public  and  private 
investment) to 2.5% of GDP by 2014.22 In 2005, The UK spent £21.8 billion or 1.76 per cent 
of  GDP  on  R&D  (0.58%  of  GDP  financed  by  government).  Total  public  R&D  spending  as 
percentage of GDP fell from 0.72% in 1997/98 to 0.67% in 2005/06.  According to the 2007 
CSR,  the  UK  science  spending  is  expected  to  remain  stable  over  the  next  three  years  at 
around 0.4% of GDP.  

To  support  the  departmental  spending  plans  and  enable  the  release  of  resources  for  priority 
areas,  the  government  has  also  within  the  context  of  the  2007  CSR  introduced  a  range  of 
initiatives to further enhance the efficiency and effectiveness of public spending, including a 
value for money programme and a performance management framework.23 The former aims 
at  minimum  3%  efficiency  savings  per  year  over  the  CSR  period  across  central  and  local 
government,  releasing  £30  billion  by  2010/11.  It  is  still  too  early  to  judge  whether  the 
introduced  measures  will  actually  lead  to  a  real  improvement  in  the  efficiency  and 
effectiveness  of  public  spending.  There  is  a  risk  that  some  of  the  declared  efficiency  gains 
could  represent  pure  cost-savings,  entailing  lower  public  service  output.  Furthermore,  the 
targets are intrinsically hard to evaluate.  

3.4. 

Government debt and long-term sustainability 

The UK’s general government gross debt ratio is set to remain under the reference value of 
60% of GDP, even if projected to be on a rising trend up to 2009/10. The spring 2008 forecast 
estimates  that  gross  debt  at  end-2007/08  rose  to  43.2%  of  GDP  and  forecasts  a  further 
increase in the debt ratio to 47½% of GDP by 2009/10. The acceleration in the accumulation 
of  government  debt  is  in  part  due  to  the  deterioration  in  the  primary  balance.  However,  in 
2008/09  the  forecast  3-percentage  point  rise  in  the  debt  ratio  also  reflects  the  denominator-
effect  from  lower  growth  in  real  GDP  and  the  GDP  deflator,  as  well  as  a  stock-flow 
adjustment of almost 1.0% of GDP due to the expected replacement of the Bank of England's 
loan to Northern Rock with government financing. 

The 2008 Budget Report includes projections for public sector net debt (i.e. gross debt net of 
financial  assets),  which  is  the  fiscal  aggregate  against  which  the  “Sustainable  Investment 
Rule”  is  assessed  in  the  domestic  fiscal  framework  (see  Box  2).  Public  sector  net  debt  is 
projected to rise from an estimated 37.1% of GDP in 2007/08 to 39.8% of GDP in 2010/11, 
and then decline slightly to 39.3% in 2012/13. The projections in the 2008 Budget imply that 
the constraint of the 40% public sector net debt ceiling might become binding should there be 
some slippages compared to the current projections.  

Table 5: Debt dynamics a  

Government gross debt ratio  
Change in debt ratio b (1 = 2+3+4) 

39.7 
1.1 

41.7 
2.1 

42.5 
0.8 

43.0 
0.6 

46.2 
3.0 

47.5 
1.3 

2004/05  2005/06  2006/07  2007/08  2008/09  2009/10 

22   HM Treasury and Department for Innovation, Universities and Skills (2007): Science and Innovation 
Investment Framework 2004-2014: Annual Report 2007. http://www.berr.gov.uk/files/file40538.pdf  

23   For further information see Commission (2007): United Kingdom: Macro Fiscal Assessment. 

http://ec.europa.eu/economy_finance/publications/publication11832_en.pdf 

14 

 
 
 
 
 
 
 
 
                                                 
 
Contributions: 
• Primary balance (2) 
• “Snowball” effect (3) 
    of which: 

Interest expenditure 
Real GDP growth 
Inflation (GDP deflator) 

1.5 
0.1 

1.0 
0.4 

2.0 
-1.3 
-0.7 
-0.4 

2.1 
-0.7 
-1.0 
0.7 

0.5 
-0.3 

2.1 
-1.2 
-1.2 
0.6 

0.6 
-0.3 

2.2 
-1.2 
-1.3 
0.3 

1.2 
1.0 

2.2 
-0.6 
-0.6 
0.9 

1.2 
0.1 

2.1 
-0.8 
-1.2 
0.0 

• Stock-flow adjustment (4) 
Notes: 
a In percent of GDP. 
b The change in the gross debt ratio can be decomposed as follows: 

D
t
Y
t

−

D
t
Y
t

1
−

1
−

=

PD
t
Y
t

+

⎛
⎜⎜
⎝

D
t
Y
t

1
−

1
−

*

i
t
1

−
+

t

y
y

t

⎞
+⎟⎟
⎠

SF
t
Y
t

where t is a time subscript; D, PD, Y and SF are the stock of government debt, the primary deficit, nominal GDP and the 
stock-flow adjustment respectively, and i and y represent the average cost of debt and nominal GDP growth. The term in 
parentheses represents the “snow-ball” effect, measuring the combined effect of interest expenditure and economic growth on 
the debt ratio. 
Source: Eurostat and Commission services’ spring 2008 forecasts. 

The United Kingdom appears to be at medium risk with regard to the sustainability of public 
finances. The long-term budgetary impact of ageing is close to the EU average, with public 
pension expenditure showing a somewhat more limited increase than on average in the EU, in 
part as a result of the fact that the UK relies relatively more on private pension arrangements 
than  do  other  EU  countries.  The  2007  reforms,  addressing  the  concern  of  potentially 
inadequate future pension provision, are likely to involve a somewhat higher increase in age-
related  expenditure.  The  budgetary  position  in  2007,  which  is  significantly  worse  than  the 
starting position of the previous programme, constitutes a risk to sustainable public finances 
even before the long-term budgetary impact of an ageing population is considered. Achieving 
high  primary  surpluses  would  contribute  to  reducing  risks  to  the  sustainability  of  public 
finances. 

Based  on  the  long-term  budgetary  projections  provided  in  the  Ageing  Report  and  the  UK's 
2008  Budget  Report,  sustainability  indicators  can  be  calculated.  Table  6  shows  the 
sustainability  indicators  for  two  scenarios;  the  2007  scenario  assumes  that  the  structural 
primary  balance  in  2007  is  maintained  and  the  programme  scenario  assumes  that  the  plans 
outlined in the Budget Report are fully attained. 

Table 6: Sustainability indicators and the required primary balance 

Value 
of which: 

Initial budgetary position (IBP) 
Debt requirement in 2050 (DR) 
Long-term change in the primary balance (LTC) 

Source: Commission services. 

2007 scenario 
S2 
S1 
4.9 
3.3 

1.5 
-0.3 
2.0 

1.6 
- 
3.2 

RPB 
3.9 

- 
- 
- 

Budget report scenario 
S2 
S1 
3.9 
2.3 

RPB 
3.9 

0.5 
-0.3 
2.0 

0.7 
- 
3.2 

- 
- 
- 

The "2007 scenario", in which it is assumed that the structural primary balance in 2007 was 
maintained, showed that the sustainability gap (S2) which  satisfies the intertemporal  budget 
constraint would be 4.9% of GDP.24 The Budget Report plans a structural primary budgetary 
consolidation of one percentage point of GDP between 2007/08 and 2012/13. If the "Budget 

24  

The sustainability gap (S1) that assures reaching the debt ratio of 60% of GDP by 2050 would be 3.3% 
of GDP. 

15 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
  
  
  
  
  
 
                                                 
Report  scenario"  was  achieved,  such  a  consolidation  would  appreciably  reduce  the  S2 
sustainability  gap  to  3.9%  of  GDP.  In  both  scenarios,  the  initial  budgetary  position  is  not 
sufficiently  high  to  stabilize  the  debt  ratio  over  the  long-term  and  entails  a  risk  of 
unsustainable  public  finances  even  before  considering  the  long-term  budgetary  impact  of 
ageing. The long-term budgetary impact of ageing is close to the average of the EU. Since the 
budgetary  adjustment  planned  in  the  2008  Budget  Report  is  less  than  that  sketched  in  the 
November  2007  update  of  the  convergence  programme,25  the  sustainability  gaps  in  the 
Budget Report scenario have widened compared with the convergence programme scenario. 
While the structural primary balance according to the 2008 Budget Report would amount to 
0.1% of GDP, the primary balance required to stabilise the debt ratio and to finance the cost 
of ageing would amount to a surplus of 3.9% of GDP. 

In  addition  to  the  common  long-term  projections,  the  2007  reform  to  the  state  pension 
(changing  pension  indexation  from  prices  to  earnings),  which  makes  the  system  more 
generous  while  increasing  the  statutory  retirement  age,  tends  to  increase  long-term  pension 
expenditure. 

Indeed, the 2008 edition of the 'Long-term Public Finance Report' projects a somewhat larger 
increase  in  age-related  spending  between  2007/08  and  2047/48  in  all  its  scenarios  than  the 
common projections. It also provides sustainability gap calculations, which – though not fully 
comparable  to  the  above  approach  –  are  of  similar  magnitude  as  the  S2  indicators  of  the 
"Budget Report scenario" above.26 

4.  OTHER FACTORS PUT FORWARD BY THE MEMBER STATE 

In a letter of 20 May 2008, the authorities of the United Kingdom listed some relevant factors 
in  accordance  with  Article  2(3)  of  Council  Regulation  (EC)  No  1467/97.  The  authorities 
noted  that  public  finance  projections  contained  in  Budget  2008  were  based  on  cautious, 
independently audited assumptions, an approach designed to build additional contingency into 
the  headline  fiscal  numbers  and  to  protect  against  unexpected  events. The  forecasts 
incorporate  negative  impacts  and  downward  revisions  in  a  range  of  areas  including  tax 
revenues from the financial sector, and from the property market. The authorities note that the 
increase  in  the  deficit  projected  in  Budget  2008  reflects  the  operation  of  the  automatic 
stabilisers  as  well  as  non-discretionary  factors,  in  the  short  term,  resulting  from  exceptional 
disruption in global financial markets. The letter notes that UK forecasts indicate that the UK 
fiscal deficit will fall below the 3% reference value in 2009/10, highlighting the exceptional 
temporary  nature  of  the  excess  over  the  3%  reference  value.  The  authorities  also  highlight: 
debt levels well below the reference level, which in their view allow flexibility for sustained 
investment in public services; commitments made to improve efficiency and value for money 
in  public  spending;  spending  plans  which  allow  for  improvements  in  public  services; 
significant commitments to implement the Lisbon Strategy for Jobs and Growth including on 
science  spending,  the  Technology  Programme  and  higher  education  teaching;  and  planned 
spending  on  Official  Development  Assistance  (ODA).The  analysis  presented  above  covers 

25  

26  

Section  5.2  of  European  Commission  DG  ECFIN,  "United  Kingdom:  Macro  Fiscal  Assessment,  an 
analysis of the November 2007 update of the convergence programme", ECFIN/G1/2008/REP 50238-
EN, available at: http://ec.europa.eu/economy_finance/publications/publication11832_en.pdf 
In  particular,  in  contrast  to  the  common  projections,  which  assume  a  no-policy  change  scenario,  the 
non-age-related  revenues  and  expenditures  are  not  kept  constant  as  a  share  of  GDP  over  time.  See 
Chapter  4  in:  HM  Treasury,  "Long-term  public  finance  report:  an  analysis  of  fiscal  sustainability", 
available at: http://www.hm-treasury.gov.uk/media/A/E/bud08_longterm_586.pdf 

16 

 
 
 
 
 
                                                 
the items put forward by the authorities, except the observation by the authorities on the UK's 
international  aid  commitments.  Under  the  latter  item,  the  authorities  record  the  UK's 
programme to increase its international development contributions, particularly in the context 
of the EU's collective commitment to provide an average of 0.56% of Gross National Income 
as Official Development Assistance by 2010. The UK plans to reach that level in 2010/11.  

In 2005 and 2006, the ratio of the UK's net Official Development Assistance (ODA) to Gross 
National Income (GNI) stood at 0.47% and 0.51% respectively27.  The ODA figures for those 
two years included the debt relief given to Nigeria which was agreed by the Paris Club group 
of creditors. In 2007 ODA fell to 0.36% of GNI, reflecting the lower levels of debt relief. 

5.  OTHER FACTORS CONSIDERED RELEVANT BY THE COMMISSION 

Risk of expenditure overruns 

The  Commission  services’  spring  2008  forecast  assumes  that  the  non-cyclical  primary 
expenditure plans that were announced as part of the 2007 Comprehensive Spending Review 
will  be  adhered  to.  During  the  six  years  between  2002/03  and  2007/08,  annual  total 
expenditure  outturns  have  exceeded  the  original  total  spending  envelopes  that  had  been 
established  in  previous  Spending  Reviews.  Total  expenditure  outturns  deviated  from  the 
original ceilings  by an annual average of 1.7%. In addition, as explained in section 3.3, the 
sharp slowdown in expenditure growth that is targeted in the latest CSR implies considerable 
control  and  efficiency  challenges  for  the  public  sector,  which  suggests  a  heightened  risk  of 
spending  overruns  relative  to  previous  years.  Past  trends  show  that  typically  expenditure 
overruns are smaller in the first year of the spending review period, suggesting that the risks 
from  higher  than  planned  expenditure  are  relatively  smaller  for  the  deficit  forecast  for 
2008/09 but higher for 2009/10 and 2010/11. The 2008 Budget projections for 2011/12 and 
2012/13,  which  are  not  backed  by  detailed  discretionary  spending  plans,  assume  continued 
moderation in real expenditure growth and a further drop in the expenditure-to-GDP ratio. 

Nationalisation of and Bank of England's loan to Northern Rock bank 

The  nationalisation  on  22  February  2008  of  Northern  Rock  bank,  which  had  been  facing 
severe  liquidity  problems  since  September  2007  as  a  result  of  the  financial  market  credit 
squeeze, did not have any direct effect on the general government accounts for the time being. 
The UK’s statistical office classifies Northern Rock in the public corporate sector, but it is not 
within the general government, the sector that is relevant for SGP purposes.  However, it is 
not  yet  fully  clear  whether  the  Bank  of  England's  loan  to  the  bank,  which  stood  at  £24.1 
billion or 1.7% of GDP at end-March 2008, should have already been reported as government 
debt, on the basis that the loan was granted on behalf of the State and with State guarantee. 
This  issue  is  currently  being  discussed  between  the  UK’s  Office  for  National  Statistics  and 
Eurostat. Meanwhile, the Bank of England's liquidity support and the Treasury's guarantees to 
the bank's other creditors (about £30 billion or 2.0% of GDP) are a contingent liability and, as 
such,  do  not  show  up  in  the  government  finance  figures.  A  partial  or  full  call  of  these 
contingent  liabilities,  if  it  ever  happened,  would  be  recorded  as  a  debt  assumption,  with  a 
corresponding increase in the deficit ratio (accounted for through a capital transfer) at the time 
of call.  

27 

  Annex 

1, 

2008  Annual 

Report,  Department 

for 

International  Development. 

http://www.dfid.gov.uk/pubs/files/departmental-report/2008/Annexes-bcov.pdf  

17 

 
  
 
 
 
 
 
                                                 
Accounting treatment of Public Private Partnership contracts  

The  accounting  treatment  of  some  Public  Private  Partnership  contracts  is  subject  to  an 
ongoing  discussion  between  Eurostat  and  the  ONS28.  According  to  data  released  in  March 
2008,  the  total  capital  value  of  signed  Private  Finance  Initiative  (PFI)  projects  amounts  to 
4.0% of GDP in 2007/08, of which almost 2.5 percentage points are currently treated as off-
balance-sheet.  The  Commission  is  aware  that  the  UK  authorities  aim  to  adopt  the 
International  Financial  Reporting  Standards  for  the  preparation  of  the  annual  financial 
statements  of  government  departments  and  other  public  bodies  from  2009/10.  This  move 
could  see  some  of  the  current  Private  Finance  Initiative  (PFI)  projects  that  are  off-balance-
sheet  reclassified  onto  the  public  sector's  books.  Reclassifications  would  not  necessarily 
adversely affect the general government accounts.  Nevertheless,  it  remains possible that  the 
changes in the accounting treatment could lead to a small increase in the general government 
deficit estimate, depending inter alia on the share of off-balance sheet PPPs that would end up 
on the general government accounts. 

Council opinion on the 2007 convergence programme 

In  its  opinion  on  the  most  recent  update  of  the  convergence  programme,  the  Council 
concluded that the programme confirmed a significant deterioration in the United Kingdom’s 
budgetary  position  that,  coupled  with  a  probably  weaker  macroeconomic  context  than 
envisaged, carried a clear risk that general government deficit would breach the 3% of GDP 
deficit reference value in the near term. The Council therefore invited the United Kingdom to 
implement measures necessary for the deficit not to exceed the reference value of 3% of GDP. 

28  

of 

6.6 

section 

See 
http://epp.eurostat.ec.europa.eu/pls/portal/docs/PAGE/PGP_DS_GFS/PGE_DS_GFS_9/FINDINGS%2
0FROM%20THE%20MISSION%20TO%20THE%20UK%20ON%2025-
26%20JANUARY%202007_WEBSITE.PDF      

on  Eurostat's 

latest  EDP 

report 

visit 

the 

to 

the  UK:  

18