Treasury forecast is uncertain

When it comes to market predictions, how many people would look to the ivory tower analysts in the Government?

As part of its forecasts for future tax revenues, the Treasury makes assumptions about where equity prices will be in the following year. This is because equity valuations affect bonus payments to those in the City, as well as stamp duty and capital gains, corporation and inheritance taxes.

In its pre-Budget report in December, the Treasury said it expected the FTSE All-Share index to rise in line with money GDP from its close of 2154 on November 27.

Money GDP is expected to grow by 5.8% to £1,174bn in the financial year 2004/05 from £1,111bn in the current financial year. This would mean the FTSE All-Share climbing by 124.9 points to 2278.9.

The actuarial report on the Government accounts by the National Audit Office admits such a measurement is imprecise. In its audit of assumptions for the pre-Budget report, the comptroller says: “Equity prices are very difficult to predict, and the relationship between them and money GDP growth remained imprecise and was significantly so in the rolling review period.

“For the future, I remain of the view that the relationship between equity prices and money GDP is uncertain. But no obviously better alternative is available, and there remain theoretical and practical grounds to support the continued use of the assumption as a sensible and transparent rule for the Treasury’s forecasting purposes.”

The theory is that the value of equity prices will reflect the profitability of businesses and grow in line with this. The share of GDP represented by companies’ profits has tended to be stable and is likely to remain so, according to the NAO. But from 1997 to 2000 this assumption was pessimistic and from 2000 it was over-optimistic, resulting in a £1bn revenue shortfall for the Government.

Steven Andrew, senior economist at Isis Asset Management, says the measure misses out on the equity risk premium: “It would be overcomplicated for the Government to try to guess the equity risk premium and it is not trying to take the investor’s point of view.”

As a result, the Treasury’s yardstick is likely to underestimate this year’s returns, judging by fund managers’ forecasts.