So how fares Britain when you look at the world at large?

Government fiscal positions in all the advanced economies suffered severe deteriorations during the financial crisis. Between 2007 and 2009 (on a calendar year basis) the UK’s general government budget balance worsened by 8 per cent of GDP. The magnitude of this decline was not out of line with that observed in other countries. Over the same period, public balances in Canada, Denmark, Greece, the US and Finland also deteriorated by 7-9½ per cent of GDP. Much sharper declines materialised in Spain and Ireland, while public finances in Austria, Germany and Italy held up better, with declines of just 3-4 per cent of GDP.

Budget deficits have worsened in part because of the economic downturn, in part because of the policy response to the crisis, including both fiscal stimulus packages and certain fiscal costs related to government support of financial institutions, and in part because of a change in the relationship between revenue and production, which may prove permanent. A recent study by the National Institute of Economic and Social Research breaks down the fiscal deteriorations observed in a selection of OECD economies into these component parts, in order to identify the need for active fiscal consolidation in each country (National Institute Economic Review, July 2010, No. 213, pp. F13-F18). This note highlights some of the key points of the study, allowing the UK fiscal position to be viewed within a global context.

Impact of the cycle

A recession will necessarily lead to a deterioration of public finances. Job losses entail a decline in income tax revenue as well as higher payouts in benefits to the newly unemployed. Revenue from corporate taxation can also be expected to fall as profits are squeezed and firms suffer bankruptcy, while the slowdown in consumption leads to a decline in VAT revenue.

The severity of the global recession has, not surprisingly, taken a toll on public finances. From peak to trough, output declined by a cumulative 6.4 per cent in the UK between the first quarter of 2008 and the third quarter of 2009. The magnitude of the UK contraction was closely in line with that observed in Germany and Italy, but less severe than the very steep declines in Japan and Ireland. The UK compares less favourably to the US, Canada and France, where output declined by less than 4 per cent from peak to trough. The UK has also suffered a sharper output decline than the struggling economies of Portugal, Greece and Spain.

A common rule of thumb is that an output gap of 1 per cent of GDP raises the deficit by ½ per cent of GDP. However, this simple back-of-the-envelope calculation overlooks important nuances related to the source of economic slowdown, as well as cross-country differences in the size of the government sector and labour market policy. A slowdown in activity driven by falling export demand is likely to have  less impact on revenues than one driven by weak consumer spending, which is more tax rich. We estimate that a 1 per cent decline in consumption relative to trend worsens the budget deficit by 0.1-0.3 per cent of GDP in the OECD economies, while a 1 per cent decline in exports has an effect of about ¼-½ that size. The current recession was driven largely by a collapse in exports and investment, neither of which is tax rich, and the rule of thumb would be likely to overstate the impact of the cycle on the budget deficit.

The approach we use to estimate the cyclical component of the deterioration in public finances is based on a series of model simulation exercises, using the National Institute’s Global Econometric Model (NiGEM1). This allows us to take into account the relative contribution of each of the components of domestic demand to the decline in output in each country, as well as key data ratios that differ across countries, such as the size of total government spending as a share of GDP. The results also depends on key estimated parameters in the model, reflecting, for example, country-specific sensitivities of employment to wages and output and the price sensitivity of trade.

The figure illustrates the share of the budget deterioration in a selection of economies that can be attributed to the economic downturn (denoted as the ‘cyclical impact’). We estimate that the recession causes the UK deficit to rise by a cumulative 4.6 per cent of GDP. This is somewhat larger than the estimated cyclical impact in both Germany (2.2 per cent of GDP) and Italy (2.7 per cent of GDP), despite a similar contraction in GDP as a whole. These differences reflect the relative strength of consumption in Germany compared to the UK and structural differences that make the Italian deficit less sensitive to output. Our estimates suggest that the biggest cyclically-driven budget deterioration have materialised in Ireland and Greece. While in the former this is hardly surprising given the magnitude of output decline, about 75 per cent of the fiscal deterioration in Greece can be attributed to the downturn in output, reflecting the sensitivity of public finances in Greece to output.

Impact of policy responses

In response to the global financial crisis, leaders of the G-20 countries promised to implement a co-ordinated global fiscal expansion in an effort to stabilise the world economy. A fiscal expansion necessarily leads to a deterioration of public finances, as it entails higher spending or lower revenue. While this may stimulate demand, the magnitude of higher tax revenue derived as a result will generally not be sufficient to offset the expansion. A co-ordinated stimulus will induce a smaller deterioration of the fiscal position than a unilateral stimulus, as positive demand spillovers from the expansions abroad bring in additional tax revenue, partially offsetting the domestic tax rise or spending cut.

The figure illustrates the cumulative impact of the coordinated fiscal impulses introduced in 2008 and 2009 in each country, (denoted as ‘policy changes’). The fiscal stimulus packages allowed the UK deficit to deteriorate by 1.6 per cent of GDP over this period. The policy component in the US, Canada and Spain was slightly larger, while it reflected less than 1 per cent of GDP in Denmark, Belgium, the Netherlands, Italy and France. Ireland and Greece were the only countries in this sample to tighten fiscal policy over this period.

The ‘policy changes’ category excludes both direct and indirect fiscal costs related to the support of financial institutions. Most of the transactions related to bank bailouts accumulate directly onto the debt stock, but there have been some direct fiscal costs in certain countries. In addition, bank bailouts entailed indirect fiscal costs associated with interest payments on the newly issued government debt. The figure illustrates the cumulative direct and indirect fiscal costs associated with this support, denoted as ‘bank support’. We estimate that this worsened the UK deficit by just less than 1 per cent of GDP, somewhat smaller than the impact in the US and Ireland, but higher than in the other countries of the sample.

Impact of structural change

After factoring out the impacts of the economic downturn and the policy response to the crisis on the deficit, we are left with a large residual category in many countries, as illustrated in the figure. These excess deteriorations can be seen as first estimates of the structural budget problems that policymakers face as we come out of the recession. Our estimate of the structural deterioration in the UK amounts to about 1 per cent of GDP. This can in part be explained by the fall in revenues from the financial sector, while the downturn in the housing market has also contributed to the structural shift in deficit. This will leave a hole in public finances that will have to be closed by higher taxes or spending cuts.

Our estimate of the structural shift in UK public finances is relatively modest compared to declines in Ireland, Spain, Belgium, Denmark and Finland, which all require significant structural adjustment to public finances in order to regain pre-crisis budgetary positions. In Denmark and Finland the need for stringent adjustment may be less urgent, as both economies were running large fiscal surpluses in 2007. The US, Germany, Austria, Japan and Sweden appear to have experienced little in the way of tax-based structural deterioration.

Need for fiscal consolidation

A fiscal deterioration driven entirely by a recession may require little if any active fiscal consolidation measures in order to restore public finances. As the output gap closes, revenue flows revert to normal, spending on benefits reverts to pre-recession levels, and the fiscal balance is restored. There will be some upward drift in the government debt stock entailing higher interest payments, and a modest tightening would be needed to restore the debt-to-GDP ratio.

However, an economic shock that entails a permanent loss of output will require a permanent adjustment to fiscal plans in order to restore fiscal positions to their pre-recession levels. While it is too early to formally assess the long-run impact of the financial crisis on output, NIESR estimates point to a permanent loss of around 3 per cent or more in most of these countries. The loss is probably higher in the UK and the US than in the other economies, and there may be no permanent scar in Japan.

The withdrawal of fiscal stimuli introduced during the recession will clearly not be sufficient to restore government budget balances in most economies. On top of this, active fiscal consolidation measures must be introduced to cover any structural shift in tax revenue. Additional fiscal consolidation measures should also be introduced to cover the expected permanent loss of output associated with the crisis. While the direct fiscal costs associated with the support of financial institutions should have only a temporary impact on the deficit, the associated rise in government debt will put increasing pressure on fiscal positions through financing costs, especially as interest rates normalise, and this should also be taken into consideration.

Taken together, our estimates suggest that the UK will require cumulative fiscal tightening measures amounting to 5½ - 6½ per cent of GDP over the next few years to restore the deficit to pre-crisis levels. Additional measures may be required to return to pre-crisis levels of government debt. This is broadly in line with the required fiscal consolidation in the US, the Netherlands and Portugal, while Spain, Ireland and Belgium require somewhat more in the way of fiscal consolidation.

Despite the sovereign debt crisis that has emerged in Greece, our estimates indicate that the fiscal consolidation required to restore public finances to pre-crisis levels in Greece is smaller than that required in the UK. However, this must be viewed against the background of a 2007 deficit in excess of 5 per cent of GDP in Greece, and additional measures will be needed to restore public finances to a sustainable level. Germany, Italy, France, Japan, Sweden and Austria are likely to require smaller consolidation measures, amounting to 1½ - 4 per cent of GDP.

Dawn Holland is Senior Research Fellow, National Institute of Economic and Social Research.