How good is the OBR's forecast of the corporate surplus and what does it tell us?
If the public sector deficit is to come down, the other sectors’ surpluses must come down too, especially that of the corporate sector which is the biggest of them. This is indeed what the Office for Budget Responsibility (OBR) expects. How, though, does it reach this conclusion? How plausible is it? And even if things work out as forecast, what kind of economy would it leave us with in 2015/16?
The OBR’s forecast for the corporate sector surplus
One of the most welcome aspects of the way that the OBR has set about its work is how much of the data needed to probe their forecasts is part of the routine publication. Combined with prompt responses to requests for further clarification plus the detail needed to link forecasts back to historical data, the scope for scrutiny of official forecasts has never been greater.
Graph 1 takes advantage of this openness to show the latest OBR forecasts of the four sector balances (expressed as a percentage of GDP) alongside the values they have taken in each financial year back to 1987/88. As the main focus of interest here, the corporate sector balance is shown as a series of bars while those of the public, household and overseas sectors are lines. Each year, the four balances always add up to zero.
Chart 1: OBR forecasts and historical values for the fours sector balances (financial years)
Source data. Historical to 2009/10: net lending/borrowing (all ONS Economic Accounts table A12 updated 29/03/2011) – private corporations (RPYN+RQBV), households (RPZT), public (RPYH+RQAJ+RQBN), rest of world (RQCH); GDP at market prices (YBHA - ONS Economic Accounts table A1 updated 29/03/2011). Forecast from 2010/11: table 1.7, OBR economy supplementary tables 21/03/2011
The public sector deficit, which reached a high of 11% of GDP in 2009/10, is forecast to decline to about 1.5% in 2015/16. This fall, of around 9.5% of GDP over six years, is matched by compensating falls in the surpluses of the other three sectors, with the overseas sector falling by 1% of GDP, the household sector by 4% (taking it into deficit) and the corporate sector by 5%.
How does the OBR achieve this? The answer (confirmed in correspondence with the OBR) is that while explicit forecasts are made for the public, household and overseas sector balances, the corporate sector balance is simply whatever it needs to be in order ensure that the four add to zero. The corporate sector balance is the residual in this forecast. It is what it is through arithmetic necessity alone.
Since the forecast for the corporate sector is just an arithmetic consequence of the other three, it carries no weight in its own right. On the other hand, like any residual, it is a potential source of weakness for the rest of the forecast if a separate assessment should cast doubt upon it. If that happens, it is not just the forecast for the corporate sector that is called into question but the forecasts for the other sectors too.
One way of doing this is to look at other components of the OBR forecast that directly determine the corporate sector balance in reality even though they do not do so in the model. We can then ask two questions. First, how internally consistent does the forecast look? Second, does the forecast for these components look plausible?
The internal consistency of the corporate sector forecast
To get to grips with this, it is helpful to start with the basic definition of the corporate sector balance as the difference between corporate resources on the one hand and the uses that are made of them on the other. The main components of each, along with a rough indication of their size (as a share of GDP) over the decade up to 2009, is as follows:
● Resources (24% of GDP) made up of: non-oil, non-financial trading profits (15% of GDP); oil trading profits (2%); other gross operating surplus including financial profits (5%); net reinvested earnings on direct foreign investment (2%); net capital transfers (1%).
● Uses (21% of GDP) made up of : gross investment (10%); dividends, interest and rent (8%); taxes on income (3%).
As part of its supporting information, the OBR provides forecasts for the two largest components namely non-oil, non-financial sector trading profits and gross investment. It also provides a forecast for corporation tax. The question then is this: how does the forecast five percentage point fall in the corporate sector surplus between 2009/10 to 2015/16 looks in the light of the OBR’s forecasts for these three components?
Graph 2 shows the forecast path for business investment plus the change in inventories. As can be seen, this measure of investment is forecast to rise by nearly 4.5% of GDP between 2009/10 and 2015/16. Together with a forecast rise of some 0.3% in corporation tax as a share of GDP over the six year period, this increased use of corporate resources is almost equal to the forecast fall in the surplus.
Chart 2: OBR forecasts and historical values for business investment and change in inventories (financial years)
Source data. Historical to 2009/10: (all ONS Economic Accounts updated 29/03/2011) – business investment (NPEM, table A8), inventories (CAEX, table A8), GDP at market prices (YBHA - table A1). Forecast from 2010/11: tables 1.1 and 1.2, OBR economy supplementary tables 21/03/2011. Note that a CP value measure for business investment has been constructed using the published volume measure (table 1.1) adjusted by the implicit fixed investment deflator (tables 1.1 and 1.2).
Against this can the set the effect of the forecast for of non-oil, non-financial trading profits which are seen as rising about one and half times as fast as GDP over the period. This has the effect of increasing the corporate surplus as a share of GDP by 2%. Putting this altogether – an increase in uses of just under 5% and an increase in resources of about 2% – implies a fall in the corporate sector surplus over the six year period of only about 3%.
Internal consistency therefore requires that the other components of the corporate sector balance should contribute something like a 2% fall. This, though, seems unlikely. First among these other components are the profits of financial companies which have been growing rapidly in recent years. Though smaller, net reinvested earnings on direct foreign investment have also been rising steadily. If these trends continue they would add to, rather than reduce, the surplus.
A rise in the dividends paid out by the corporate sector as a whole and/or a fall in the net rent and net interest received would reduce the surplus. Collectively this was down in both 2008/09 and 2009/10 by about 1% of GDP compared with the average over the immediately preceding years. A rise of about that amount could therefore reasonably be expected as part of the recovery from the recession and financial crisis. But the trend prior to these two years had actually been downwards. So again, if this trend continues, it adds to rather than reduces the surplus.
This is the key point: while some further reduction in the surplus can reasonably be expected as an immediate reaction to the end of the recession and associated financial crisis, there is probably still a gap of something like 2% of GDP (approaching £30bn) between the components that go to make up the corporate sector balance and the OBR’s residual forecast of it. To close that gap, one or more of either financial company profits, retained earnings of direct foreign investment or dividends, interest and rent must start following a different trend in the next few years from the ones they have been on since about 2000. That, it seems to us, is the implicit condition upon which the forecast for the corporate sector balance – and therefore those for the other three balances too – depends. Trends do shift but this is a strong assumption to make.
The external consistency of the corporate sector forecast
Turning to the plausibility of the forecasts for the individual components, although the rise in profits is both interesting and important, our focus here is on investment, shown in graph 2.
Over the full 30 year period, there is nothing obviously over-optimistic about the OBR’s forecast which, even in 2015/16, suggests a level of investment below that achieved in 10 of the 15 years up to 2001/02. This, though, is not a sufficient yardstick by which to judge the forecast because it overlooks the problems in the period between 2001/02 and the onset of recession in 2008/09.
The sharp step up in investment for 2010/11, due mainly to a turnaround in corporate inventory or stock levels, can be seen as an aspect of recovery from the depths of recession. This is surely reasonable. The forecast of investment in years beyond that is not just a matter of recovering from recession but of recovering, too, from the slowdown in investment in the years immediately after 2001/02, Without a clear explanation of what caused this slowdown – and why the policies now being pursued in some way address it – this is another strong assumption. As things stands, the OBR foresees investment by 2014/15 at levels not seen since 2001/02.
The OBR foresees an unbalanced economy
On the evidence presented here, the OBR is found to be over-optimistic about the extent to which the corporate surplus will fall. That is because, in both its explicit forecast for investment and its implicit assumptions about other key variables, notably financial corporation profits, it downplays the factors that caused a persistent corporate surplus to develop after 2001.
Correcting for this over-optimism will mean either that the overseas surplus will turn out to be lower than forecast or the public and/or household deficits will turn out to be higher. The first of these is unproblematic but unlikely. The latter two are more likely – and more problematic too.
But even if the OBR turns out to be right, the economy it foresees in five year time is still a very unbalanced one. Any economy with a chronic, as opposed to a cyclical, corporate sector surplus is an unbalanced one and by the end of the forecast period, the UK’s corporate surplus will be 14 years old.
In this situation, politicians and economic policy makers will be faced with different questions from those that preoccupy them today. One group will concern whether, and how to reduce the surplus directly . Measures to cut corporate profits, and in particular financial profits, will be high on this list.
A second group will be about how best to accommodate a corporate surplus in a way that is sustainable. The uses to which public and household sector deficit spending ought to be put will be high on this list.
If the corporate sector surplus fails to come down as the OBR expects, these questions will be seen to be pertinent long before the end of the forecast period in 2015.