Economics in business

NUTS to the North-South Divide

By Esmond Birnie, Chief Economist in Northern Ireland

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Every few years sees a resurgence of angst about a North-South Divide in the UK economy and it’s that time again. While it’s true that there are some significant differences between the UK regions, the reality is much more complex than merely an inexorable widening of the prosperity gap.

First of all, the performance of different regions in recent years does not fit a simple North-South pattern. Because we do not have measures of inflation specific to individual regions, recent comparisons of changes in living standards have to be made in nominal terms. On this basis, according to the Financial Times^[1], UK Gross Value Added (GVA) per head grew by a total of 1.5% between 2007  and 2010 (which implies a real terms decline). But according to the latest ONS data^[2] , the three top performing regions in terms of growth were in very different parts of the country - London at 3.9%, Scotland 3.7% and the East Midlands 1.6%.  Nor is there any clear pattern in terms of the weaker performing regions,  as the four sluggards were Yorkshire and Humberside  at 0.1%, West Midlands -0.2%, East of England -1.8% and Northern Ireland, at a worrying -2.3%. Again, this pattern is not a simple “North-South divide”. According to that view of the world, a number of regions appear in the “wrong” list.

How does the data look if we take a longer perspective? Divide regional GVA, including that produced by incoming commuters, by the regional resident population to get GVA per capita and London is the top performer amongst the larger (so-called NUTS1) regions. (NUTS is Eurospeak for Nomenclature of Territorial Units for Statistics and is how we reference subdivisions of countries for statistical purposes). London boosted its performance from 156% of the UK average in 1997 to (a provisional) 171% in 2010, while  at the other end of the scale, Wales was the worst performing NUTS region, posting a decline from 78% in 1997 to 74% in 2010 (though these figures do not adjust for differences in the cost of living between London and Wales).

But you can’t stop there because there are also significant variations within each of the NUTS1 regions. Get down to counties and cities at the NUTS3 level and we discover that two of the five richest UK ‘regions’ in 2009 - Edinburgh and Belfast - are actually in the “North”. True, Belfast’s relatively favourable standing is surprising, and partly reflects the contribution to the city’s economy made by commuters (some in relatively well paid public sector jobs) who are resident elsewhere in Northern Ireland. In fact, there may be a number of cities across the “North” (e.g. York, Leeds, Glasgow and Cardiff) with measured GDP per head above average which is “inflated” by this commuter factor. The presence of some high productivity manufacturing may also make a contribution.

In fact, the region with the greatest internal differences is London. The Inner West of the capital has a GVA per capita of around £109,000 – eight times that of London’s Outer East and North.  In simple multiplication terms, the East- West divide in London is greater than the FT’s so-called North- South divide. So the moral of this particular story is that nothing – particularly in regional economics – is as simple as it seems.

Contact details
Email: Esmond Birnie
Tel: +44 (0)28 9041 5808

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^[1] Budget 2012 Analysis 22 March 2012, p. 22

^[2] 14 December 2011, “Regional, sub-regional and local Gross Value Added 2010”, Statistical Bulletin

Tough times for savers

By Nick Forrest, Director, Economics

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The FSA has recently published our report containing new recommendations for projected rates of return on investment products.

Our recommendations are used as the basis for the financial benchmarks which the FSA expects investment providers to use. You may have seen such projections in market literature for investment products or in an annual pension plan performance update.  The illustration shows you how much your investment plan is likely to be worth using assumptions on investment returns, wage increases and inflation. These benchmark figures help to safeguard against mis-selling which could occur if financial institutions promised excessively high returns.

Currently the intermediate return figure prescribed by the FSA for balanced funds is 7% with a lower scenario at 5% and an upper scenario of 9%.

In a period of weak economic recovery and ultra-low interest rates, it will be of little surprise that we are suggesting the FSA lower its prescribed intermediate return assumption to around 6%.  Combined with lower expected real wage growth, our new recommendations  could reduce the likely future value of a regular savings or investment plan by as much as 10% over 15 years, or 17% over 25 years.

So what else did we uncover?

First, there is a clear challenge in making projections at a time of economic and market uncertainty. While the short-term economic outlook is weak, over the course of a 15 year projection, we assume some normalisation of economic conditions and investor returns. However, there are some factors (such as credit availability and demographic changes) which are likely to result in lower longer term economic growth compared to our experience before the financial crisis.

Second, investors can’t avoid low government bond yields.  Whether low yields are due to safe haven effects, or Quantitative Easing, it is unlikely that yields will quickly revert to levels considered “normal” before the financial crisis.  We need to get used to lower returns on government bonds for the time being.

A third key conclusion was that equity returns should hold up better than bond yields in the current climate of low investment returns.  It appears that the expected risk premium for investing in equity has increased with higher levels of equity market volatility. This increase partially offsets the impact of lower interest rates. But beware the bumpy ride if you are an equity investor. And for companies, the higher equity premium reduces the benefit they can expect from a reduction in the cost of equity capital.

And what are the implications?

The FSA is now consulting before finalising its decision, but there could be a number of implications of a reduction in projected investment returns.

One potential implication for savers is that they may need to save more to achieve desired levels of future income. Savers may see this is yet another setback resulting from the financial crisis. However, this would only be half the story. While low interest rates may dent prospective returns, they have supported rises in government bond prices (where a large portion of pension assets are held) and may also have boosted other asset values. It is difficult to assess what the level of equity prices would have been without the impact of low interest rates and Quantitative Easing (QE), but one Bank of England study suggests that asset values may be 20% higher than they would have been without QE.

If savers respond to lower returns by saving more, this could be seen as positive for the retail financial investment industry. But this benefit could be offset by other challenges. Lower projected returns and the increased transparency of fees and charges following the Retail Distribution Review (RDR) means that retail financial companies will have to work harder to design attractive RDR-compliant propositions.

Our report for the FSA contains a tough message for savers – returns may be lower in the future than previously expected. Savers may have to adjust their financial plans as a result. But that is surely better than relying on an over-optimistic view of the future.

Contact: Nick Forrest | Tel: +44 (0)20 7213 1650

Youthful South could outpace ageing North

By Yong Jing Teow, PwC Economist

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Over the course of the current decade the world will experience dramatic changes in its demographic profile as the figure below shows. Industrialised countries in the Northern hemisphere are expected to see their populations age and exit the labour force – an inevitable consequence of declining fertility levels and increased longevity - while significant numbers of the young in the Southern hemisphere will “come of age” and enter the workforce in droves.

[Click the image to view a larger version]

The biggest changes in Europe are an increase in the median age from 40 to 43 years (clearly the highest of any global region) and a decline in the working-age population as baby boomers entering retirement outnumber those entering the workforce. Similar trends will be observed in Russia, Northern America and indeed China, where the latter’s median age will rise to match that of Northern America by 2020. The demographic challenges that China faces will be great: it will soon have almost 57 million more pensioners that the state does not yet know how to support; whereas in the US the impact of population aging is expected to be cushioned to a degree by an influx of relatively young immigrants from Latin America.

These dramatic shifts in the global North (defined here to include China) pose several challenges. With lower worker replacement rates, there is the prospect that more of the elderly become dependent on a smaller generation of workers to support them. Without changes to retirement ages and pension systems, the public sector is likely to have to bear the burden of covering the costs of healthcare and ever-rising pension liabilities. Europe faces a particular challenge as repaying its high and recently rising government debt burden would become more arduous if at the same time the size of the workforce is diminishing.

By contrast, developing economies in the Southern hemisphere will continue to reap gains from the “demographic dividend”, where the number of economically-active adults are increasing relative to the number of dependants as there are fewer children due to lower fertility rates and fewer older people due to higher mortality in the past. This boosts savings and demand for goods and services, allowing countries to generate higher growth and incomes.

India is also set to overtake China as the world’s most populous country by 2030. With is dependency ratio falling by 15% between 2010 and 2030, India will move into the “demographic sweet spot”, spurring economic growth as its relatively youthful population enters the workforce. This trend also applies to Brazil, other parts of developing Asia and the MENA region – but to a lesser extent – as these regions already have higher median ages relative to India.

Sub-Saharan Africa stands out for having an exceptionally youthful projected median age of just 20 in 2020. However, it faces the challenges of high infant and adult mortality due to the ravages of HIV/AIDS, tuberculosis and other diseases. Unlocking Africa’s growth potential will require significant improvements in healthcare, lower infant mortality and consequent longer life expectancies.

These trends point to the South accounting for much of the world’s growth potential over the coming decade (and indeed beyond). The demographic dividend does not automatically guarantee growth, but if countries are able to harness the economic power of the demographic dividend and put its labour force to productive use, a youthful population will likely be a boon to the South.

Contact: Yong Jing Teow | Tel: +44 (0)20 7804 4257

Who will pay our £7 trillion pensions bill?

By John Hawksworth, Chief Economist

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At the end of April the Office for National Statistics (ONS) published, for the first time ever, official statistics on the total obligations of all UK pension providers, including the government. At the end of 2010, these obligations – which also represent the total pension entitlements that UK households had built up by that date - are estimated at over £7 trillion in total, or around 4.8 times annual UK GDP.

That estimate is subject to all sorts of uncertainties since it relates to the discounted present value of potential pension payouts stretching up to 100 years in the future. But more interesting than the headline number is how it breaks down: who is liable to pay these pensions and how much of this £7 trillion is backed by actual assets as opposed to unfunded promises to pay by future governments? There is a lot of detailed data in the ONS report, but I have boiled this down to a single table of key numbers for ease of reference.

Breakdown of total UK pension obligations (at end of 2010)

The first striking fact is that more than half of total UK pension obligations (£3.8 trillion) relate to state pension entitlements based on past work and national insurance contribution records. This includes the basic state pension and additional state pensions such as SERPS and S2P, but excludes other potential means-tested state benefit payments to pensioners since these are not entitlements that have already been earned.

There is no ring-fenced pot of assets to back these promises to pay future state pensions – rather they will be made out of future tax revenues on a ‘pay as you go’ basis. But current and future governments can and sometimes do change the rules as to exactly what age these state pensions will be paid at and how they will be indexed (e.g. to CPI, RPI or average earnings). If the state pensions bill proves too costly this is one way the circle could be squared – higher taxes on future generations are another option.

In addition to state pensions, current and past governments have also made unfunded pension promises to their employees, totalling around £850 billion at the end of 2010 according to these new ONS estimates. These will also have to be met by future taxpayers although the latest projections by the Office for Budget Responsibility (OBR) in July 2011 suggested that this cost, while rising in the short term, will be affordable in the long term even before the latest hotly contested round of reforms to public sector pensions has been implemented. This is largely due to a past decision to index these public pensions to CPI rather than RPI, which sounds like a technicality but saves the government a lot of money in the long run (£127 billion in present value terms according to ONS estimates).

Nonetheless, around two-thirds of total UK pension entitlements (around £4.7 trillion as shown in the penultimate row in the table above) take the form of promises by current and past governments to be funded by future generations of taxpayers. That could clearly cause some generational tension down the line.

The funded pension entitlements are mostly in the private sector (around £2 trillion in total) and, for now, mostly relate to defined benefit (DB) company schemes that have total obligations of over £1.3 trillion according to these ONS estimates. Most of these private sector DB schemes are now closed, either totally or at least to new members. But companies will still be on the hook to pay these pensions for many decades to come and, in doing so, will have to absorb both market risks on the future value of the assets in these schemes and longevity risks as reflected in future annuity rates. Managing legacy DB pension liabilities will remain a huge issue for many UK companies for a long time to come.

For the moment, defined contribution (DC) schemes make up a relatively small share of total UK pension entitlements – only around 10% if we add up both workplace and individual DC schemes. But this share will rise gradually in future and, while companies may contribute to these schemes (including the new NEST scheme to be launched by the government shortly), it will be individuals who bear the market and longevity risks associated with these kinds of pensions. If asset returns and/or annuity rates continue to disappoint as they have done for most of the period since 2000, then future generations will have to contribute significantly more and/or work significantly longer than current pensioners.

Contact: John Hawksworth | Tel: +44 (0)20 7213 1650

Digital switchover - more than just our TVs

By David Lancefield, Economics Partner

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Digital TV switchover is nearly complete in the UK. And it’s all taken place rather quietly, probably because most homes are already 'digital'.

The same is not true when we think of companies switching over to a more digital world. In fact we see a far more polarised picture. Innovators and disruptors - the likes of Google, Facebook, Apple, Zynga - act and think in a digital way. It's a norm. They've created and ridden the first digital wave, innovating in online search, social media, smartphones and games. And now they're looking to create the next wave, driven by passionate, creative leaders and demanding shareholders, let alone customers.

But the digital laggards - those incumbents who have struggled to rewire their organisation to cope, let alone thrive, in a digital world - are still learning to ride the first digital wave. The survivors are trying to 'fast follow' the innovators by creating a new digital energy in their organisation, typically by creating a digital division or appointing a string of digital executives. But they're mistaken if they think that's all it takes to catch up. It takes a change in behaviours - thinking faster, taking more risks, experimenting and making more decisions.

It's clear that digital technology offers the potential to innovate, and profit. Amongst other things, it supports far greater flows of information, at substantially lower costs, than previous technologies, and of course better products and services. Personalisation is easier. And therefore we see more effective price discrimination, for example through more effectively targeted advertising and proposition development.

But digital comes with challenges too. It's easier to free-ride, both on the investment in content (piracy) and infrastructure (the net neutrality debate). And some companies are tempted to control too much, driven by the behaviours of their leaders and pressure from their shareholders. But some consumers find that they're not quite as comfortable in either sharing as much information as they thought or being locked so much in to the system they use. Regulators and Governments are now alive to this issue. But they face a difficult challenge - how can they encourage innovation, which by its very nature affords a degree of monopoly power, whilst putting protections in place for consumers and the process of competition. Signals are important in this regulatory dialogue - regulators need to be careful not to dampen innovation, whilst innovators need to learn to use a conciliatory tone, quite a shift for the very people who have challenged conventional orthodoxy.

And we've yet to see 'digital' being used to its fullest. Digital has been used as a more effective channel for delivering products and services. But consumers often don't yet get the personalised service or the outcomes they're looking for that digital technology could provide. They’re often treated as a single group, or as a transaction rather than feeling like they have a relationship. Some companies don't think enough about the consumers' real interests, motivations and incentives to engage with companies. They target too hard or not enough to find that customers have switched to a competitor or turned off completely.

Reaping the benefits of digital demands new behaviours to overcome inertia and existing norms. Behavioural economics helps us to understand why some of the expected outcomes in the digital world take longer than we might expect. Executives have routines and habits formed in a different analogue or offline world - and it takes a new company, an active investor or a new colleague from a different environment to shake them out of their sleep. (See my perspective on leadership for more on this topic at:  http://www.pwc.co.uk/economic-services/publications/refresh-your-leadership.jhtml.)

So, while digital TV switchover is nearly complete, we have a long way to go to switchover to a fully digital world. The innovators face the challenge of working out how far to push their next digital wave innovation whilst not incurring the wrath of their consumers and the regulators. The laggards face the challenge of catching up to the 'New Digital Normal', which is grounded as much in learning and applying new business behaviours as in the technology itself.

Contact: David Lancefield  |  +44 (0)20 7213 2263

Has the UK really fallen back into recession?

By John Hawksworth, Chief Economist

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Today's preliminary data showed a small decline in GDP of 0.2% in the first quarter of 2012, implying a mild technical recession following the 0.3% drop in Q4 2011. However, these are only very preliminary data and there are reasons to believe that they could ultimately be revised up given that services growth of just 0.1% appears weak compared to indications from the Purchasing Managers Index (PMI) and other business surveys. Also, a 3% fall in construction output in Q1 2012 seems much weaker than recent construction PMI surveys would suggest.

Furthermore, a longer run perspective shows real GDP in Q1 2012 unchanged from a year earlier, while excluding volatile oil and gas output it was actually up slightly by 0.2% over the past year. So a reasonable representation of the data for the last year is that the economy has been relatively flat. Other indicators, such as the recent small fall in unemployment in the three months to February and the relatively strong retail sales growth figures for March, would also point to an economy showing very modest underlying growth rather than one heading back into recession.

There are still many uncertainties surrounding the future economic outlook, not least in regard to the ongoing eurozone crisis and global oil prices. The UK economy is clearly still going through a difficult period but nothing like the deep recession we saw in 2008 and early 2009. So we need to put these latest GDP figures into perspective and not talk the economy down too much on the basis of one set of highly preliminary estimates.

Contact: John Hawksworth | Tel: +44 (0)20 7213 1650

The value of innovation – from a cup of tea to Facebook!

By Rachel Lund, PwC Economist

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Innovation – the development of new products and processes – has a massive impact on the economy, raising living standards and supporting longer term growth. Innovation is also big business - just think of Facebook.  An idea that started in a university bedroom has underpinned a business which is now being valued at around $100 billion.

However, innovation is risky – with no guarantee of success, whatever the level of investment of brainpower, money or media hype. For those wondering how valuable Facebook or similar headline- grabbing companies are, history offers some valuable and surprising lessons about which innovations are really valuable.

We can calculate how much an innovation has added to the economy by looking at both how profitable it is (the producer surplus) and how much better off it makes  consumers (the consumer surplus). From a societal point of view the consumer surplus is more interesting and this is what economic historians tend to focus on. Consumer surplus measures the difference between what consumers would have been willing to pay for an item and the price they actually pay, which can be determined using historical data on consumer spending and prices. The results of some studies of the value to consumers of various innovations are shown in the table below.

Consumer surplus generated by a selection of innovations

Source: Hersch and Voth (2009), Leunig and Voth (2010)¹   Goulsbee and Klenow (2006), Hausman (2006), Broda and Weinstein (2006)

Two things stand out. First, it appears that humble cups of tea and coffee (with sugar) added more proportionately to the economy than mobile phones and the ability to shop over the internet. These 17th century innovations generated a consumer surplus of somewhere between 8 and 17% of GDP. That is equivalent to £2-4,000 per person in the UK, at today’s prices. When tea was introduced to England in the 17th century it was a huge deal. It rapidly became a staple for even the poorest households, and occupied around 5% of the household budget in 1790 (Hersch and Voth, 2009)² . Despite a period of severe economic difficulty and downward pressure on wages at the end of the 18th century, spending on tea did not really change. The fact is that when mobile phones were introduced we simply weren’t willing to give up the same proportion of income as our ancestors did for tea, coffee and sugar.

The second point of interest is that innovations which improve the process for making an already existing product have had just as much if not more impact than the invention of entirely new products. Both cotton spinning and the assembly line for cars added more consumer value (as % of GDP) than internet shopping and mobile phones. Process innovations have had big impacts because they make products cheaper and allow more people to buy them. Take Henry Ford’s assembly line for cars: The first cars improved the lives of their owners, but were very expensive and so relatively few people owned them, meaning that total consumer surplus was small. The assembly line made producing cars many times cheaper and enabled US car sales to increase from 64,000 in 1908 to 3.6m in 1923, creating huge benefits for American consumers.

There are a couple of important lessons here for prospective innovators and developers of new ideas like Facebook, for policy-makers looking to drive innovation and for investors trying to capitalize on the “next big thing”. First, life-changing products don’t have to be hi-tech. And second, making something that exists cheap enough for everyone to use it may be a much better investment of your resources than trying to invent something entirely new. Cuppa tea anyone?

¹  Leunig, Timothy and Voth, Hans-Joachim, Spinning Welfare: The Gains from Process Innovation in Cotton and Car Production (November 18, 2011). CEP Discussion Paper No. 1050. Available at SSRN: http://ssrn.com/abstract=1961473 or http://dx.doi.org/10.2139/ssrn.1961473
²  Hersh, Jonathan and Voth, Hans-Joachim, Sweet Diversity: Colonial Goods and the Rise of European Living Standards after 1492 (July 17, 2009). Available at SSRN: http://ssrn.com/abstract=1402322 or http://dx.doi.org/10.2139/ssrn.1402322

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Contact: Rachel Lund via email or +44 (0) 20 7213 3930

UK Labour Market: Reading the Runes

By John Hawksworth, Chief Economist

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After a period last year when unemployment started rising again, the latest published data from the Office for National Statistics (ONS) on 18 April brought some welcome news of a small fall in the headline unemployment rate to 8.3% in the three months to February 2012, down from 8.4% in the previous three months. As always with economics statistics, however, the detailed data revealed a more complex and mixed picture (the release itself runs to 50 pages) so it is worth taking a closer look at this data since it offers one of the best indicators of what is going on in the UK economy.

1.    Total employment up, but full-time employment down

The total number of people employed in the UK rose by 53,000 to 29.17 million in the three months to February 2012 relative to the previous three months. This still left it 57,000 lower than a year earlier, but almost half of the losses over the previous nine months have been clawed back, which is clearly good news.

On closer inspection though, this rise of 53,000 was driven by a rise of 80,000 in part-time employment (particularly in the administrative and support services and hotel and catering sectors) while full-time employment fell by 27,000. Based on a rule of thumb that a part-time job has around half the average hours of a full-time job, the net increase in full-time equivalent employment was only around 13,000. Still a positive trend but significantly lower than the 53,000 headline figure. The number of people working part-time because they could not find a full-time job rose to 1.4 million – the highest since comparable records began in 1992.

2.    Total unemployment down, but long-term unemployment up

Total unemployment on the Labour Force Survey (LFS) measure fell by 35,000 to 2.65 million in the three months to February 2012 compared to the previous quarter and youth unemployment also fell by 13,000, which was a particularly welcome development after the sharp rises seen last year. The claimant count measure of unemployment did rise slightly in March, but the pace of increase has slowed significantly since last autumn and this is generally a less reliable indicator than the LFS measure as it is influenced by changes in benefit rules.

But here too there is a caveat: the number of people out of work for more than a year rose by 26,000 to 883,000. This is of particular concern as those unemployed for more than a year are much more likely to become detached from the labour market, losing confidence and employability with severe detrimental effects on their long-term career prospects. This may just be a lagged effect of past high inflows into the unemployment pool, but for now it is still a matter of concern and a priority for policy to help these people back into the labour market as soon as possible.

3.    Earnings growth still subdued but unit labour costs rising

Average earnings growth excluding bonuses (which tend to be volatile) fell further to 1.6% in the three months to February and remains well below consumer price inflation of around 3.5%. This continued decline in real wages is a negative for consumer spending and the businesses that depend on it, but it does at least help to protect jobs. This has been a persistent feature of recent years and helps to explain why unemployment rates have not reached the double digit levels seen in the past two UK recessions.

However, the price of keeping employment up through real wage declines has been a lacklustre performance for productivity growth relative to past economic cycles. As a result, unit wage cost inflation has actually been increasing, which together with higher oil prices recently, could feed through later into increased inflation. This is something the Bank of England Monetary Policy Committee will want to keep a careful eye on since, if the economy does recover later this year and into 2013, firms may seek to rebuild profit margins by raising prices, even if a weak economy has restrained their ability to do this so far.

In conclusion, rising headline employment and falling headline unemployment support the message from business surveys of a gradual UK economic recovery since December, but the detailed data remains mixed and there is still a long way to go before we can be really confident that unemployment has peaked in this cycle.

Contact: John Hawksworth | Tel: +44 (0)20 7213 1650

Is the UK falling back into recession?

By Andrew Sentance, Senior Economic Adviser

Follow @asentance

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The OECD made the headlines last week by suggesting that the UK economy was heading back into recession. The definition of recession which underpinned their view is widely used by economists – two consecutive quarters of falling GDP. So because the OECD expects a further slight fall in GDP in the first quarter of this year (erroneously in my view) to follow on the 0.3% drop in the final quarter of 2011, that is taken to mean that we are “technically” back in recession – even though the projected fall in output is very modest.

I have never liked this definition of recession. It came to be widely used in the UK in the 1980s and 1990s, and its origins can be traced back to the United States in the 1970s.

There are four problems with it. First, the time period is relatively short. Two quarters is a period of six months, but data on GDP in one quarter can be heavily influenced by what happens in a single month. We saw this with the impact of the snow In December 2010.

Second, GDP figures are frequently revised. So the snap assessment which is made on the basis of one set of figures can be reversed by later revisions. This happened in the early 1990s, when initial figures suggested that the recession had continued through 1992 and into early 1993. With more data available, it now appears that the decline in GDP came to an end in late 1991.

Third, it is wrong to base your judgement of the state of the economy on a single economic indicator. GDP contains some useful information about the current state of the economy but it can also be affected by erratic factors like North Sea oil production. It helps to try and look at the underlying picture and take into account other relevant data like unemployment, business surveys, and retail sales.

The final problem with the widely used “technical” definition of recession is that economies vary greatly in their underlying growth potential, because of differences in population growth and trend productivity. An economy which has a low underlying growth rate (ie closer to zero) runs a greater risk of falling into “recession” simply due to normal fluctuations in GDP estimates.

So what can we do to come up with a better approach to defining recessions? One suggestion is to form a committee to do the job. In the US, the National Bureau of Economic Research (NBER) has the technical role of defining turning points in the economic cycle.

A less bureaucratic solution would be to follow two simple rules. First, focus on the underlying GDP picture and try and abstract from erratic factors influencing growth – like the volatile North Sea oil sector, where output is currently 25% down on a year ago – or the effects of weather. In the UK, services output was 1.8% up on a year ago in the final quarter of last year and recorded the same annual growth rate in January.  This sector accounts for over 75% of total GDP and over 80% of employment, and its growth does not seem consistent with an economy which is in a sustained contraction.

Second, we should look at a range of economic data – including evidence from the labour market and business surveys – alongside GDP to judge whether an economy is in recession. So far this year, this wider set of indicators has been relatively positive about UK growth – contrary to the OECD’s gloomy forecast. And we will receive new business survey information from the British Chambers of Commerce and the Purchasing Managers’ survey (PMI) this week.

So it does not seem likely that the UK is falling back into recession, even on the widely used “technical definition” of two negative GDP quarters. But perhaps the main conclusion is to beware of this narrow and potentially misleading definition. When economies move in and out of recession it is normally apparent from a wide range of economic indicators. And that wider range of data for the UK points to a temporary phase of weakness last autumn, from which we are now emerging, not a sustained downturn.

Contact: Andrew Sentance  |  Tel: +44 (0) 20 7213 2068

How globalisation shaped the 2012 Budget

By Andrew Sentance, Senior Economic Adviser

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The annual Budget is a wonderful piece of House of Commons theatre. The Chancellor of the Exchequer delivers his speech as the controller of UK public finances, dispensing or withdrawing tax reliefs and adjusting tax rates.

But the forces of globalisation are having a powerful influence behind the scenes. That was particularly noticeable in the 2012 Budget.

The intense period of globalisation across the world economy in the past two decades has allowed business activity to become much more mobile. International businesses are increasingly sensitive to the costs of operating in different countries, and the tax regimes they will face as a result of their locational decisions. If he is to attract business activity to the UK, George Osborne must ensure that we have an internationally competitive tax system – and this was a key theme of his Budget.

Some of the key features of the Budget reflected the Chancellor’s efforts to attract internationally mobile businesses and top executives to the UK. First, he cut the corporation tax rate further and faster than he had previously planned, targeting a tax rate of just 22 percent on corporate income from 2014/15. He hinted that he may go further and reduce the corporate tax rate to 20 percent.

Second, the Chancellor moved ahead with other reforms of the corporate tax system, designed to encourage international businesses to locate their headquarters in the UK and to provide an attractive tax regime for R&D and other intangible investments. He was rewarded the very next day when Glaxo SmithKline announced it would invest a further £500m in the UK and create around 1,000 new jobs, including a new manufacturing plant in Cumbria.

Third, George Osborne sought to defuse some of the criticism of the UK’s 50p top tax rate on high earners by cutting the rate to 45p. By doing this he hopes to reduce another potential barrier to businesses locating in Britain – the relatively high rate of tax paid by senior executives and other professionals.
However, there are potential costs associated with these tax incentives for mobile companies and high-paid individuals. In his Budget, the Chancellor argued that the extra incentive for individuals to stay in the UK from the cut in the top personal tax rate from 50p to 45p would make this measure largely self-financing. But the cuts in the corporate tax rate and other reforms made in the last three Budgets will cost the Exchequer over £5bn by 2014/15, with only just over £1bn of this cost offset by restricting tax allowances for business investment.

How can the Chancellor recoup this revenue reduction – particularly when he is also trying to take lower paid earners out of tax and cut the deficit? He needs to look at raising extra tax from activities in the economy which are much less mobile internationally.

One of his targets in the Budget was property transactions – with Stamp Duty changes which are expected to raise £3-400m in the longer term. Another target has been tax reliefs and benefit entitlements of higher earners. The withdrawal of Child Benefit for higher rate tax payers is set to raise around £2bn and the Budget also introduced a cap on tax reliefs for higher earners. VAT and other expenditure taxes are another source of additional revenue , and Budget changes raised another  £600m by tightening VAT rules and raising excise duties on gambling and cigarettes.

The direction of travel in the UK tax system is clear. In an increasingly globalised economy, there are competitive constraints on the taxation of business and other internationally mobile activities. That shifts the burden of tax towards people and activities which are less mobile – such as property transactions, consumer spending and middle earners. It is not just the public finances which limited the Chancellor’s room for manoeuvre in the Budget. The forces of globalisation are having a profound influence on his tax strategy too.

Contact: Andrew Sentance  |  Tel: +44 (0) 20 7213 2068