To what extent could better growth improve the fiscal outlook – or weaker growth make it worse?

Whoever is Chancellor after the election will find themselves in a bind, with taxes at a historically high level, innumerable spending pressures and debt only just on course to be stable in five years’ time.  

One big cause of this fiscal trilemma, which leaves no easy options, is that growth is expected to be weak: in the March Budget forecast, the economy was set to grow by just 1.5% a year, on average, over the next five years. This would be very disappointing compared with a longer-term average of 2.7% a year between 1950 and the eve of the financial crisis, but not so distant from the 1.9% recorded between 2010 and 2019, just before the COVID-19 pandemic.  

But growth forecasts are inherently uncertain. Comparing the Office for Budget Responsibility (OBR) with other independent forecasters surveyed by the Treasury (the grey diamonds in Figure 1), its forecast is relatively optimistic in the short term (as shown by the solid blue line). It is especially optimistic compared with the Bank of England, which is itself more pessimistic than the average. This is a long-standing difference that remains substantial, although the Bank’s forecast was recently revised upwards. Of the 14 other forecasters who provided a new forecast in April, only two are more optimistic about growth by the end of 2025 than the OBR, whereas seven are more optimistic than the Bank (and a further two agree with the Bank almost exactly). The last time the Treasury surveyed independent forecasters about their medium-term expectations (in February), the average forecast growth rate over the next five years, at 1.3%, was also significantly below the Office for Budget Responsibility’s forecast of 1.7%.¹

Figure 1. Forecasts for real growth and illustrative scenarios 

_{Source: HMT survey of independent forecasters (April 2024 forecasts); Office for Budget Responsibility, Economic and Fiscal Outlook (March 2024); Bank of England, Monetary Policy Report (May 2024).} 

We might not be surprised if, come an autumn fiscal event, the OBR were to revise down its forecast, so that it was closer to the consensus. The dashed line labelled ‘weaker sustained growth’ represents an illustrative scenario where growth is forecast to be 0.5 percentage points a year lower than what the OBR currently forecasts, which would leave it roughly similar to the Bank of England’s forecast into the medium term.  

Conversely, things might turn out better than expected. The dashed line marked ‘stronger sustained growth’ shows a path where average growth between now and the end of the forecast turns out to be 0.5 percentage points a year higher than what the OBR currently forecasts, which would make it similar to the average over the 1990s (a decade that included a painful recession and a strong recovery). A return to such a growth rate would, in the context of growth averaging 1.9% a year between 2010 and 2019, be a great outcome. 

Good policymaking – in areas such as trade, competition, tax, planning, immigration and education – could all make a big contribution to increased sustainable growth. But this would require a concerted effort across government and patience. Even if it were well executed and ultimately successful, it would not yield a big immediate boost to growth in the next parliament. And in terms of the forecasts which matter for the fiscal targets, it is unlikely that the new government would be able to persuade the OBR to make a big upward adjustment off the back of any policies it could plausibly have fully worked out by the autumn. 

That is not to say higher sustained growth in the next parliament, even of the magnitude implied above, is implausible. We really could get lucky. 

The next fiscal event will be the first in the new parliament, as well as the current fiscal year 2024–25. This means that the main fiscal target that both the Conservative Party and the Labour Party have committed to will require them to have debt falling as a share of national income between March 2029 and March 2030. A multitude of moving parts and technical complexities mean it is difficult to predict whether the OBR is likely to judge that the rule would be met even if current growth rates continued and strict restraints were placed on spending growth for yet another year. This highlights the volatility of ‘headroom’ measures under the current, poorly designed, fiscal mandate. To abstract from this additional source of uncertainty and focus on the role of growth for a given baseline, we focus on the year 2028–29 in the discussion that follows. 

We also abstract from the fact that this really is a very badly designed target. It is the target the two parties have chosen, not one we would have recommended. 

What can recent out-turn data tell us? 

Public finance forecasts contend with uncertainty not only about the future, but about the recent past too. Since the March Budget forecast was published, the Office for National Statistics has published initial estimates of national income, borrowing and debt for the past financial year (2023–24). All of these are provisional out-turns and will doubtless be revised and revised again. Taking them at face value, the size of the cash economy in 2023–24 was slightly smaller than the March Budget forecast anticipated, and borrowing was slightly higher, primarily reflecting lower revenues from direct taxes levied on earned income (PAYE income tax and National Insurance contributions). The relatively favourable out-turn for growth of 0.6% in the first quarter of calendar year 2024 – taking the UK out of technical recession – did not outweigh the lower out-turns for the previous three quarters. 

If going forwards the economy grows in line with the OBR’s March forecast, this would mean that national income would be persistently lower, with knock-on effects on revenues, borrowing and debt. In Table 1, we analyse that case as the first of three alternative scenarios. The second and third cases take the same starting point as the first case but with weaker and stronger growth in each year going forwards. In each case, we estimate what the resulting impact of different economic performance might plausibly mean for tax revenues, and for changes in debt which will cause changes in debt interest spending in future years.  

Table 1. Illustrative growth scenarios and ‘headroom’ against the fiscal mandate 

_{Note: All alternative scenarios account for changes in debt interest spending based on the March 2024 Economic and Fiscal Outlook’s gilt rate forecast and include the borrowing and GDP out-turn for 2023–24. ‘Headroom’ in cash terms.} 

_{Source: Authors’ calculations using Office for Budget Responsibility, Economic and Fiscal Outlook (March 2024), Office for National Statistics, GDP first quarterly estimate time series (May 2024) and Public Sector Finances, UK: April 2024.} 

We show that if there is no catch-up growth to make up for the lower-than-expected out-turn for national income in the past year, debt in the final year of the current forecast would be almost 2% of national income higher. What ‘headroom’ against the debt target existed at the time of the March Budget would essentially be eliminated entirely. Again, this illustrates that ‘headroom’ in the March forecast is very small, relative to quite run-of-the-mill revisions to forecasts. 

An unlucky and a lucky scenario 

In the ‘weaker sustained growth’ scenario, we continue to assume the weak out-turn from the last year reduces revenues throughout the forecast horizon, but that, in addition, growth continues close to the Bank of England forecast – a significant deterioration relative to the baseline. Constraints on a Chancellor in this unenviable situation with a commitment to get debt falling would be tighter in two ways. First, any given cash trajectory for debt would be less favourable as a share of national income, which would now be lower. Second, lower national income would itself feed through to reduced tax revenues and higher borrowing. 

Cumulating over five years, this has a substantial impact. Without any offsetting policy changes, this would push debt up around 5% of national income higher than in the baseline scenario, and rising in 2028–29, which means the fiscal mandate to have debt on course to fall in that year would have been broken. It is also worth noting that borrowing would be at 2.6% of national income in 2028–29. That would be higher than the average 1.9% of national income a year borrowed over the 60 years up to the financial crisis but would still leave around £12 billion of ‘headroom’ against the outgoing government’s supplementary target, which constrains borrowing to be below 3% of national income in the final forecast year.  

This illustrates two important facts: first, the difficulty of getting debt falling in an environment of low growth and high interest rates; and second, the extremely loose nature of the supplementary target. Labour proposes to target current budget balance in the final forecast year instead. Such a target would – like the objective to have debt falling in year 5 – also have been breached in this ‘weaker sustained growth’ scenario. In other words, Labour has announced fiscal rules that are if anything more constraining than those set out by the Conservatives. 

In the ‘stronger sustained growth’ scenario, we use the most recent out-turn for national income, but then assume that growth returns to the 1990s average. Without any further changes, this would lead to debt falling much more decisively in the final year. ‘Headroom’ against the debt target would rise to £34.4 billion. Borrowing would be £26 billion lower than in the March Budget forecast. This would allow the Chancellor much more room for manoeuvre – for example, he or she might just about be able to avoid cuts to day-to-day spending on unprotected public services and end early the ongoing freeze in personal tax thresholds and still expect to have debt falling at the end of the coming parliament.  

Growth is a key determinant of living standards, as well as taking the edge off many of the difficult choices and sharp trade-offs currently facing any Chancellor. A relentless and well-executed focus on promoting sustained growth through good policy would be welcomed, as would any external, positive surprise on growth. But achieving higher growth through policy is difficult and requires patience. Luck could (and likely will) lead to growth turning out higher or lower than currently forecast, and it is notable that the March Budget forecast is more optimistic than most external forecasters and much more optimistic than the Bank of England. A sustained change in the growth outlook could make a meaningful difference to the public finance outlook, and a sustained improvement could ease many of the painful choices currently on the menu. But relying on such an improvement would make a Chancellor a hostage to fortune; hoping for good luck is not a strategy. We should question the Chancellor and the Shadow Chancellor about how they would respond were the economic outlook to disappoint, as well as their hopes in case of a better outcome that we should all wish for.