George Osborne will have to frame his Budget next week against the backdrop of significantly weaker economic forecasts, making the process of deficit reduction all the more difficult.
The new and independent Office for Budget Responsibility on Monday cut the forecast for growth in 2011 and in subsequent years as it assessed the previous outlook for the economy as too rosy.
The chancellor has said he will use these forecasts as the basis for his Budget next Tuesday and the worse medium-term outlook for the public finances suggests there is a more urgent need for announcements of deferred spending cuts and tax increases.
Even though the OBR expects lower borrowing in 2010-11 than Alistair Darling predicted in the March Budget, this benefit is offset by a weaker medium-term outlook for the economy and for tax revenues.
Instead of predicting the economy would grow by 3.25 per cent in 2011 and by 3.5 per cent in the subsequent three years, the OBR cautions that growth is likely to be only 2.6 per cent next year and an average of 2.7 per cent into the medium term.
The improved public sector borrowing requirement numbers meant however that sterling extended its session highs. The pound was up 1.1 per cent at $1.4722, while the FTSE 250 share index rose to a session high of 9,769.54. UK gilt futures pared their losses by over 10 basis points.
The OBR said in its document: “Our conclusion is that there is a smaller amount of spare capacity and that future trend growth is likely to be weaker than was estimated in the March Budget.”
The long-term growth rate of the economy is estimated at 2.25 per cent over the next three years, slowing to 2 per cent thereafter instead of the 2.75 per cent the Treasury said as recently as March. The OBR said this slowdown in the likely rate of longer-term growth was a result of a slowing growth in the number of potential workers.
On the public finances, the OBR accepts that tax revenues have been flowing into the exchequer faster than expected and this is likely to leave borrowing standing at £155bn in 2010-11 and £127bn in 2011-12 compared with Mr Darling’s worse figures of £163bn and £131bn respectively in the March Budget.
But the lower growth assumption into the medium term slows tax revenue growth thereafter and the borrowing figures are only marginally better by 2014-15. The OBR says it is most likely that the country will still be borrowing £71bn in 2014-15 on unchanged policies, compared with £74bn in the Budget forecast..
The OBR said the lower deficit forecast was the result of higher inflation and strength of some receipts such as value added tax, but it added that “the judgment that growth will be lower than assumed in the March Budget . . . leads to less medium-term strength”.
The OBR stressed that the new forecasts were not certain and insisted on putting wide margins of error around its growth and deficit predictions.