Ditch the structural deficit: Why Osborne has struggled to hit this moving target

FALL-OUT from the Autumn Statement next week is likely to focus heavily on the slowdown in deficit reduction. Borrowing has been £3.7bn higher this year so far compared with last, and it looks unlikely that George Osborne will hit his fiscal target for 2014-15. But the key number the media will focus on is the Office for Budget Responsibility’s (OBR) estimate of the “structural deficit” – that is, how much of the deficit will remain even if the economy continues to grow. This number will determine what the OBR estimates is needed in tax rises or spending cuts in the next Parliament.

In 2010, Osborne laid out spending plans he forecast would reduce the overall “structural deficit” to 0.8 per cent of GDP by 2014-15. But the UK grew more slowly than expected and, in 2011, the OBR revised up how much of the deficit it thought was structural – the implication being that more spending cuts would be needed to eliminate it. By this year’s Budget, the forecast for the 2014-15 structural deficit was 4.5 per cent of GDP.

Now, some commentators have calculated that weaker-than-expected tax receipts and shrinking spare capacity in the economy show the structural deficit is higher still – meaning even more spending restraint will be needed. In other words, Osborne’s target is a moving one that keeps getting more difficult to achieve.

But perhaps we should discard this target altogether. The “structural deficit” is dependent on a host of variables which economists pretend to know more about than they actually do. First, there is the actual current level of economic activity, which is subject to huge revisions and uncertainty. Second, there is the so-called “output gap” – how far the economy is from its potential – which is a highly contested calculation, and a particularly difficult one as the economy has shifted away from physical outputs and towards often low-marginal-cost services. Finally, it also depends on how responsive government spending and tax revenues are to moving back to our potential. Recent evidence suggests that the former has been somewhat over-estimated and the latter vastly over-estimated.

In principle, there are two ways (which may well be complementary) of dealing with a structural deficit – taking steps to improve the productive potential of the economy, and reducing spending. Arguably, the coalition hasn’t done enough of either during this Parliament. However, from a practical perspective, it would surely be more sensible to move towards a way of budgeting that was more robust in the face of inevitable uncertainty than the OBR’s current approach.

What might this entail? One obvious way of doing this would be to take a more disaggregated approach and break down tax and spending items into smaller chunks. Then we should think separately about how individual events or trends might throw us off course, or how these trends might affect items of spending and taxation in the future. Not everything could be considered, but the effect, for instance, of a 1 per cent increase in employment on tax receipts is possibly very different from the effect of a 1 per cent rise in labour productivity and different again from the effect of a 1 per cent increase in total factor productivity. This is better than focusing on some vague notion of the economy moving back to its supposed potential.

There is more and more evidence that the deficit is stubborn in the face of recovery, but we should be very sceptical about the numbers the OBR churns out for us.

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