Despite planning biggest tax rises in more than 25 years, and an historic increase in size of the state, the Chancellor is still likely to have little money for hard-pressed public services

This year’s historic, and manifesto-breaking, announcements of tax rises will increase the UK’s tax take to its highest sustained level in peacetime. Spending will settle at 42% of national income, more than 2% above its pre-pandemic level and its highest level in ‘normal times’ since 1985. These are more the inevitable consequences of population ageing and pressures on health and care spending, than they are consequences of the pandemic. Tax rises that were always inevitable have been smuggled in under cover of the pandemic.

Even so, and despite improved economic forecasts, Rishi Sunak will have little room for manoeuvre in this month’s Budget and Spending Review. To meet his stated objective of achieving current budget balance, the Chancellor will have to increase spending on services other than health, defence, schools and aid by less than he was planning pre-pandemic, despite greater pressures across a range of areas. Indeed, to keep to currently planned totals, he may even have to implement cuts to some budgets over the next two years.

The good news for Mr Sunak is that government borrowing this year could be more than £50 billion lower than was forecast in the March Budget. But a slowing recovery thereafter – alongside rising costs of financing much-elevated debt – could limit the medium-term improvement in the public finances to less than half of that amount.

Looking at the wider economy, current imbalances and future uncertainties stand out. The key message from Citi’s assessment is that we should not be fooled by headlines of high-profile examples of labour shortages and supply disruptions into thinking the economy is overheating generally. In many sectors demand remains below pre-pandemic levels, the labour market is quite loose, and the outlook for wages remains rather weak. On balance, then, inflationary pressures should abate, and monetary and fiscal policy need, for now, to keep supporting the recovery. The key to understanding the economy at the moment is to recognise huge imbalances between sectors where supply is constrained, sectors where demand has grown, and much of the economy where demand remains weak.

These are among the headline findings of the 2021 IFS Green Budget, funded by the Nuffield Foundation and produced in association with Citi.

On the public finances and outlook for public spending, IFS analysis finds:

• Borrowing should continue to run at least £20 billion a year below the March 2021 Budget forecast from 2022−23 onwards, and the current budget should return to surplus from 2023–24. Debt would then fall, but at 89% of national income in 2025–26 it would still be 17 percentage points of national income above its pre-pandemic share.
• But uncertainty remains incredibly high. If the economy does better than expected, it may even turn out that the £28 billion package of tax rises announced in the March 2021 Budget will prove unnecessary for getting the public finances back to current budget surplus from 2023–24 onwards. If that happens, we can expect the Chancellor either to abandon some of his proposed tax increases or to reduce other taxes. But if things go badly, those tax rises could need to be almost tripled for a current budget surplus by 2025–26.
• High debt, combined with rising interest rates and RPI inflation this year, pushes up forecast debt interest spending by around £15 billion in this and future years compared with the March Budget forecast. Each additional 1% on interest rates adds £10 billion to annual debt interest spending. Each additional 1% on the RPI adds £6 billion.
• Following planned increases of 4.1% and 3.8% announced in the one-year Spending Reviews of 2019 and 2020, planned spending increases over the five years to 2024−25 are in the same ballpark as increases announced during the New Labour years of 2000 to 2007. Day-to-day public service spending is set to rise by 3.4% a year between 2019−20 and 2024−25, against 3.6% announced in Spending Reviews between 2000 and 2007.
• A combination of planned spending increases that pre-date COVID-19 and the fact that the economy is now projected to be smaller means that the Chancellor is likely to preside over a lasting increase in the size of the state of around 2% of national income. His problem is that this does not involve spending any more in cash terms than he was planning prior to COVID-19. Yet the pressures on spending are clearly greater than they were pre-pandemic.
• Sticking to the Chancellor’s planned spending totals (which were fixed only last month) for the next two years could require cuts to ‘unprotected’ day-to-day budgets of more than £2 billion (2.5%) next year, including perennially squeezed areas such as local government, further education, prisons and courts. These budgets were cut substantially in the 2010s, and a further round of cuts would be difficult to reconcile with the government’s stated objectives – particularly around ‘levelling up’.
• The totals appear more generous in 2024–25, potentially giving more wiggle room. But in reality, an ever-growing NHS budget, top-ups needed elsewhere, and the billions of spending likely required to deliver on priorities such as net zero, levelling up and social care reform will eat into what is available. If, as our analysis suggests is likely, the recent NHS funding settlement proves insufficient to deal with medium-run COVID pressures, and the health budget is topped up by £5 billion in 2024−25 without an increase in the overall envelope, ‘unprotected’ budgets would grow by less than 1% per year over the Spending Review period. A difficult two years for areas such as local government and justice could very easily become a difficult three.
• These challenges are heightened by the fact that no allowance has been made for pandemic-related pressures outside of the NHS. Ongoing support for public transport operators and a catch-up package for schools alone could easily require £3 billion of extra spending each year, and more may well be required elsewhere.
• Decisions over NHS funding increasingly drive not just the funding outlook for other departments, but also overall fiscal policy. Health spending has grown to account for an ever-growing share of day-to-day public service spending: an estimated 44% by 2024−25, up from 42% in 2019−20, 32% in 2009−10 and 27% in 1999−2000.
• It is the long-term pressures on health and social care and the increasing difficulty in finding cuts elsewhere to offset these, rather than the immediate consequences of the pandemic, that are the drivers behind the tax rises announced by the Prime Minister last month. If the new health and social care levy is to rise to meet future health and social care pressures then we estimate that its rate could need to more than double from 1.25% to 3.15% by the end of this decade. Other revenue-raising options are of course available but, regardless of the specifics, demographic pressures point to a need for future tax rises, not tax cuts.

On the economy, analysis from Citi suggests:

• The UK economy is in the midst of a sharp – but incomplete and wildly imbalanced – recovery. A better public health outlook, easing restrictions and the extension of fiscal support have all underpinned a faster economic reopening than was anticipated at the start of 2021. However, at the end of this year the UK economy is expected to remain around 4% short of its pre-pandemic trajectory – equivalent to a large recession – and the recovery is contorted by large sectoral and regional imbalances. Demand now exceeds supply in some widely publicised parts of the economy but is severely lagging it in many others. The recovery looks narrow: firm creation has been concentrated in just a small number of sectors. Many firms now seem to be expecting and preparing for a different economy in the years ahead. Firms in transport and storage expect sales to be around 5% higher in the long term as a result of the pandemic, but those in hospitality expect them to be 4% lower. Both COVID-19 and Brexit are driving a protracted period of economic adjustment.
• As the economy reconfigures, there is likely a stronger link than normal between the speed and ultimate scale of the recovery. A faster recovery could see COVID-related scarring (i.e. the permanent economic damage done by the pandemic) limited to just 1–1½% of GDP, versus 3% under the OBR’s March 2021 scenario. On the other hand, a slower recovery could mean greater permanent losses. The government and Bank of England should continue to focus on securing as complete a recovery as possible.
• Inflation looks set to increase sharply in the second half of 2021, with annual CPI growth forecast to peak at 4.6% in April 2022. But for now, the drivers – such as energy prices and trade disruption – seem largely transitory. Looking through the coming economic reconfiguration, the risk of a persistent domestically driven inflationary surge remains more contained: changes in the relative price of different skills, driven by an uneven recovery, are unlikely to drive permanently higher inflation. However, ifinflation expectations become embedded, firms may be willing to accept higher wages and offer higher prices – creating the potential for a genuine wage price spiral. The Bank of England should remain ready to act, but ought not to do so unless such a scenario actually starts to emerge.
• The economic recovery – both in the UK and globally – will likely hinge on the labour market. In the UK, the furlough scheme has preserved large parts of the ‘old’ economy, even as demand has rebounded in a very different form: sales have shifted across sectors at a much faster rate than has employment, with cumulative excess job reallocation across sectors since 2020Q2 24% below the equivalent figure for sales. As support is wound down, Citi expects unemployment to peak at 5.5% in the first quarter of 2022. While some specific labour shortages are likely to persist, aggregate wage pressures are expected to prove relatively subdued. Rapid wage growth in some jobs – for HGV drivers, for instance – is not expected to translate into strong wage growth across the labour market as a whole: the economy will adjust.
• The pandemic is not over globally, but economies have become more resilient and vaccination campaigns have reduced the likelihood of significant future lockdowns. The outlook for global growth has thus improved: Citi now project 5.8% growth globally for 2021, up from 5.4% in last year’s Green Budget. The key challenge is turning the initial rebound into a fuller and more complete recovery – though for the rest of 2021 at least, supply constraints will continue to weigh on growth momentum. One pressing issue for policymakers is ensuring that the reserves built up by households and companies during the pandemic are put to productive economic use, rather than just pushing up asset prices.

Paul Johnson, IFS Director and an editor of the Green Budget, said:

‘Rishi Sunak, a Conservative Chancellor, is presiding over an increase in the tax burden to record levels in the UK and an increase in the size of the state (public spending as a fraction of national income) to levels not seen since the days of Mrs Thatcher. Yet the combined effects of ever-growing spending on the NHS and an economy smaller than projected pre-pandemic mean that he is still likely to be short of money to spend on many other public services. On central forecasts, there will be little or no scope to increase spending on things like local government, the justice system and further education, after a decade of sharp cuts. That said, he still faces huge uncertainty over the direction of the economy and hence over the state of the public finances. He will be hoping against hope that stronger-than-expected growth in revenues over the next few years will help to dig him out of what still looks like a fair-sized hole.’

Christian Schulz, Director of European Economics at Citi, said:

'The global economic outlook has improved compared to a year ago, but uneven pandemic control and a series of supply shocks create treacherous crosscurrents. For the UK, a deeper fall in 2020 has meant a larger rebound as the economy has reopened. However, output is still likely to remain over 4% short of its pre-pandemic trajectory at the end of 2021. The medium term recovery also remains far from secure.  Instead, an uneven rebound to date points to more profound Brexit and Covid related reconfiguration in the years ahead. Inflation is now likely to peak higher and later than we had previously expected. But with higher prices more likely to weigh on disposable income than add to wages, this suggests a further slowing of the recovery in 2022.'

Tim Gardam, Chief Executive of the Nuffield Foundation, said:

‘The IFS Green Budget secures the foundations for an evidence-based public conversation about the huge economic and social challenges currently facing the UK, including COVID-19 recovery, Brexit and the transition to net zero. In its framing of the economic outlook, the IFS shows that ultimately, the questions to be addressed by the Chancellor are about people’s well-being, both individually and collectively, in a time of economic uncertainty.’