(Un)real terms

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Since the Scottish Budget for 2020-21 was agreed by the Parliament on 5 March 2020, government spending plans have changed significantly due to the response to the COVID-19 pandemic. One technical factor which has also changed significantly in this time is the GDP deflator, which has implications for how we discuss the budget in “real terms”. This blog explains how the updated forecasts for the GDP deflator might impact scrutiny of the budget in 2021.

What is the GDP deflator?

The GDP deflator is a measure of general price inflation in the domestic economy. HM Treasury produce the GDP deflator using data from the Office of National Statistics (ONS). The ONS produce two different measures of GDP; current prices and constant prices. The ratio of these two different measures is the movement in prices over time. By combining measures of hundreds of different deflators, the GDP deflator can give a broad measure of inflation across the economy.

While there are other measures of inflation, like the consumer price index (CPI) or the retail price index (RPI), these are narrower than the GDP deflator and so are not necessarily appropriate to measure the impact of inflation on government spending.

When analysing the Scottish budget, SPICe (and many other organisations like the Scottish Government and the Fraser of Allander Institute) use the GDP deflator data to calculate the ‘real terms’ changes in budget lines, which is the change in spending, without inflation distorting the picture. This gives a better indication of what can be purchased with a given budget i.e. the spending power.  If a budget increases only in line with prices, then there is no additional spending power. Over the medium term, inflation can contribute to significant increases in a budget. As an example, the total Scottish DEL (Department Expenditure Limit – the total amount of money allocated to and spent by the Scottish Parliament) in 1999-00 was £13.8bn, and this rose to £34.4bn in 2019-20, an increase in nominal terms (before adjusting for inflation) of £20.6bn or 149%. Some of this increase reflects the new powers that the Scottish Parliament has gained over this time period and ‘real’ increases in spending, but some is also the result of inflation. That chart below shows the difference if we use the GDP deflator to restate the earlier years spending in 2019-20 terms. Rather than an increase of £20.6bn from 1999-00 to 2019-20, the real term increase is £13.6bn, or 65%.

In nominal terms the Scottish Budget has grown from just under £14 billion to almost £35 billion between 1999-00 and 2019-20. However, if we recalculate the 1999/00 value in 2019/20 terms to remove the impact of inflation over time it is almost £21 billion. Around one third of the total increase in the Scottish Budget over these years is accounted for by inflation.

Why are 2020-21 and 2021-22 interesting?

The GDP deflator is not normally an interesting topic in itself – but its volatility through the course of the pandemic has attracted a lot of interest and comment.  The different way that the ONS measures government consumption compared to European peers means that the UK has recorded much greater volatility in government consumption than other European countries.  This in turn has fed through to the GDP deflator measure and the measurement of the ‘real terms’ economic impact of the COVID-19 pandemic in the UK.

The volatility in the GDP deflator – and the reasons underlying it – has significance for budget scrutiny as the GDP deflator is used for real terms calculations.  Debates around the spending proposals from the Scottish Government often focus on the real terms increase or decrease in spending across portfolios, and commentators tend to make these real terms comparisons (including our budget analysis). This is based on the latest GDP deflator produced by HMT, and uses the Office for Budget Responsibility (OBR) forecast of the GDP deflator for the budget year. The next publication of the GDP deflator will be as part of the OBR’s Economic and fiscal outlook, expected in Spring 2021 to coincide with the UK Government Budget, so the current forecast will be the most recent data we have when the Scottish Government publish their 2021-22 spending plans on 28 January 2021. The OBR published its forecasts for the GDP deflator as part of its updated economic forecasts in Economic and fiscal outlook: November 2020. The 2020-21 and 2021-22 projections for the GDP deflator are of particular interest, +6.8 per cent in 2020-21 and -2.8 per cent in 2021-22. These forecast values are quite unusual. Between 1999/20 and 2019/20 the average value of the GDP deflator was +2.0 per cent, and it has only once been negative since 1955/56 (in 1997/98, when it fell to -0.33 per cent). The latest forecast is for the highest GDP deflator since 1990/91, followed immediately by the lowest ever recorded.

The GDP deflator has typically been between 1 and 3 per cent in each year since 1999 and has not normally varied significantly year on year. The projected GDP deflator for 2020 is the largest value in this series during the period of devolution, while the projected deflator for 2021 is the lowest over the same period. The OBR projection then returns to trend for the later years.

The OBR explained this significant volatility in their November 2020 update:

Government consumption increased by 16 per cent in cash terms in the second quarter of 2020 to fund virus-related pressures on health and other public services, but in real terms it fell by 15 per cent. That difference reflects lower measured health and education activity due to the postponement or cancellation of elective healthcare treatments in response to the pandemic and the closures of schools.

In other words, one impact of the lockdown during this year has been to significantly reduce the output from the education and healthcare sectors as schools were closed and non-essential treatments were delayed. At the same time, particularly in the healthcare sector, there has been a considerable increase in Government spending.  This combination of higher spending and lower activity implies higher average prices for public services.

Conversely, as lockdown restrictions were eased in the summer, this led to a reversal of the situation, with activity levels rising faster than spending, implying a reduction in average prices paid for public services – or a negative GDP deflator. Following a sharp fall in the GDP deflator in the third quarter of 2020, the ONS provided some further detail on the drivers for the unusual movements of the implied GDP deflator in its quarterly GDP update for July to September, published on 12 November 2020:

This decrease occurred because the volume of government activity in the third quarter increased at a much greater rate than nominal government expenditure. This is partly because of the unwinding in some of the movements that occurred in the second quarter, which saw a fall in the volume of government activity at the same time as an increase in government expenditure in nominal terms.

For example, there was a large increase in nominal government spending on health in the second quarter while the volume of government healthcare consumption fell. In the third quarter, nominal spending on health was largely unchanged, while volumes increased, which has impacted upon the growth rate of the implied deflator in the third quarter. In education, the large fall in the volume of education activity in the second quarter followed by the large increase in the third quarter help explain the most recent quarterly movement in the implied deflator.

Impact on scrutiny of the Scottish Budget

As mentioned above, the GDP deflator is the index used to express spending plans in real terms, so these unusual movements will have an impact on the analysis of the Scottish Budget particularly when comparing just two years. In our analysis of last year’s budget, we outlined the real terms increases and decreases across portfolios. This analysis was based on the forecast GDP deflator for 2020-21 of 1.8 per cent. Simply put, this meant that spending had to grow by 1.8 per cent to maintain spending power between 2019-20 and 2020-21. Last year, we concluded that total managed expenditure (the total amount the government spends, all DEL budgets plus any areas outside of budgetary control) rose by 13.5 per cent in real terms. Using the updated GDP deflator for 2020-21, this would now be an illustrative real term increase of 8.3 per cent. The following portfolios move from a real term increase to a real term decrease:

If we use the updated 2020 GDP deflator, the Communities and Local Government portfolio changes from a real term increase of 1% to a real term decrease of 3.6%. Education and Skills from an increase of 2.9% to a decrease of 1.8%, Justice from an increase of 2.4% to a decrease of 2.4%, and Scottish Parliament and Audit from an increase of 3.7% to a decrease of 1.1%

This illustration is of course artificial. The amounts allocated to many portfolios in the Scottish Budget have changed far more than normal due to the considerable additional spending announced during 2020 in response to COVID-19. Secondly, while the GDP deflator is normally considered a good general measure of inflation, clearly over the next few years the forecast is skewed by the significant impact of the economic response to COVID-19. For comparisons involving the years 2020-21 or 2021-22, the current forecast deflator is not a good representation of the normal levels of inflation that will impact the cost of providing government services. There will have been some inflation which affects government spending, but for most portfolios this will not be anywhere close to the 6.77 per cent figure.  Over this period, the fluctuations in the GDP deflator are more a reflection of volatility in the provision of public services, rather than a reflection of volatility in the prices for these services.

The forecast GDP deflator for 2021-22 is -2.79 per cent. As this is a negative value, the normal real terms calculation would mean that portfolio spending could shrink by over 2 per cent in nominal terms but still be considered a real term increase. Just as the large positive value for the 2020-21 GDP deflator is somewhat artificial, it is very unlikely that public bodies will find that the cost of delivering their services has decreased in the 2021-22 fiscal year.

Other measures of inflation

In analysing government spending plans for the next fiscal year, commentators may need to think about how they express the real terms changes in portfolios. As noted above, while there are other measures of inflation, like the consumer price index or the retail price index, these are narrower than the GDP deflator and so are not necessarily appropriate to measure the impact of inflation on government spending. One way around this is to analyse over a multi-year period, as if we apply the large positive deflator in 2020-21 and the negative deflator in 2021-22 then to some extent these will offset each other. In its 2020 Spending Review, the UK Government presented real terms growth over a two year period 2019-20 to 2021-22 due to the atypical movement of the GDP deflator.  SPICe will consider the most suitable approach for its own budget analysis to reflect these anomalies and avoid misleading interpretations.

Andrew Feeney-Seale, Senior Researcher, Financial Scrutiny Unit

“Mathematics” by Robert Scarth is licensed under CC BY-SA 2.0