The UK government is on course underspend by more than £3bn this year, according to analysis from the Institute of Fiscal Studies (IFS). Despite deep cuts to spending, Whitehall figures show that there is a £2.9bn undershoot, which will reduce the country's total borrowing requirement in 2011-2012.
However, the IFS warned that the downside risks - the potential collapse of the eurozone and the widespread fears that the UK will fall back into recession during 2012 - mean that the government has little room for manoeuvre. Growth may also undershoot the government's forecasts, putting more pressure on the budget.
“The Chancellor faces his third budget with the economy and public finances in considerably weaker shape than he had hoped a year ago," Paul Johnson, director of the IFS, said in a statement.
"While it looks as though central government is going to underspend against tight spending plans, this neither leaves much space for any permanent fiscal loosening nor avoids the fact that the vast majority of the planned – and unprecedentedly big – public service cuts are still to come. His room for manoeuvre is further curtailed by risks that the economy might do even worse than expected, especially if the Eurozone should break up."
Oxford Economics, which compiled the IFS report, predicts that growth will remain severely restricted in 2012 - with gross domestic product (GDP) increasing by just 0.3% during the year. This contrasts with projections of 0.7% from the Office for Budget Responsibility (OBR), which itself revised down its estimates in November.
Office for National Statistics (ONS) figures show that the UK economy contracted by 0.2% in the final quarter of 2011, heightening concerns that the country could be heading for a more sustained fall in growth. While the government has been quick to blame spillover of the eurozone debt crisis, and its accompanying economic slowdown, for the UK's woes, analysts said that the effects are only now beginning to bleed through, suggesting that worse is to come.
Eurozone leaders are struggling with dual crises of growth and debt. At a summit on Monday, the European Council talked of finding a compromise between the vicious austerity cuts needed to curtail its spiralling debt and the imperative to drive economic growth and job creation. While manufacturing figures released on Wednesday showed signs that the economy in the single currency area has begun to stabilise, the UK's largest export market remains very weak.
"A eurozone crisis would see the UK back into deep recession with GDP falling both this year and next. Even with a rapid recovery this would set national debt on course to rise above 90% of national income and in such a scenario the Chancellor might be best advised to abandon his fiscal targets," the IFS report said.
Since the financial crisis began, a £114bn hole has opened up in the public finances, according to the think tank, calling for hard choices on tax and spending. By the end of this financial year, only 6% of the total proposed cuts will have been implemented, and given the current performance of the economy, the rest may have to be rethought.
Changes to the tax system, including changes to corporation tax, business rates and road fuel tax, need to be considered, as does the way overseas aid is spent, the IFS said, while the proposal to cut child benefit from higher earners is "neither efficient or fair."
"Planning for the next spending review needs to start soon," Johnson said. "The tax system needs reforming to help promote growth in the medium run. Ill thought out plans for withdrawing Child Benefit from higher-rate taxpayers need to be revised. Time needs to be taken if real evidence of the effect of the 50p income tax rate is to be gathered. Getting all these sorts of policies right is the surest way to improve economic and fiscal performance in the medium term.”
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