We are in a horrible fiscal bind as low growth and high debt interest payments mean no room for manoeuvre.

The UK economy remains stuck between weak growth on the one hand and the risk of persistently high inflation on the other. Fiscal and monetary policy must strike a delicate balance. An ill-timed fiscal loosening – such as an unfunded package of pre-election tax cuts – might give a short-term economic sugar rush, but could prove unsustainable and ultimately mean a protracted recession as interest rates rise even further to bring inflation back under control. 

The state of the public finances also undermines the case for net tax cuts any time soon. The Chancellor is in a terrible bind, as will be whoever is Chancellor after the general election. 

It might feel like there should be room to spend money on tax cuts or spending increases. Taxes are heading to their highest ever level. Post-election spending plans are extremely tight – perhaps implausibly so. Official figures show that as long as these plans are kept to, we will be heading for the biggest primary surplus (that is, government revenues above non-interest spending) in a generation.

Yet there is no room for a fiscal loosening, whether tax cuts or spending increases. The Chancellor is right – he should not be cutting taxes at the forthcoming Autumn Statement. 

These are among the headline findings of the 2023 IFS Green Budget, funded by the Nuffield Foundation and produced in association with Citi.

One problem is that debt interest spending is so high and is expected to settle at its highest sustained level since the mid 1980s, around £30 billion above levels to which we have become accustomed. That’s £30 billion each year that can’t be put to better use. In addition, the growth outlook is poor. Debt as a fraction of national income is set to rise to, and then settle not far below 100% of GDP. 

Into the medium term, we face huge fiscal pressures – from spending on health and state pensions in particular. The NHS workforce plan alone – to which the Conservative government and the Labour opposition have signed up – will raise spending by 2% of national income by the mid 2030s. Cutting defence spending is no longer on the cards. We live in a demonstrably risky political and economic environment which could require a big spike in borrowing at any moment. More economic growth on a sustained basis would help, but this is not something that policymakers or politicians can simply will into existence, and even the best-designed policies would take time to bear fruit. Now is not the time to plan for debt to rise further in the medium term.

The Chancellor’s specific target is that debt should be falling as a fraction of national income between the fourth and fifth years of the forecast period. This is a badly designed target. It may well be that the Chancellor will be able to meet the letter of this target, helped by the fact that the forecast ‘rolls forward’ by a year each autumn and so will apply to 2028–29 rather than 2027–28. But any ‘headroom’ against this poorly-designed target would not indicate space for tax cuts – especially if a certain and immediate tax cut is ‘paid for’ by future tax rises and/or unspecified spending cuts that may never happen. 

While borrowing is likely to be around £20 billion lower this year than the OBR expected in March, it is still likely to come in at around £112 billion which, at 4.2% of GDP, is much higher than its long-run average, over £60 billion more than was forecast in March 2022 in Rishi Sunak’s final Budget as Chancellor. Jeremy Hunt should not do as so many of his predecessors have done: accept higher borrowing when the figures get worse from one forecast to another but then spend any apparent windfall when forecasts improve. That would mean borrowing and debt always ending up higher than forecast.

Into the medium term, we expect the OBR to be forecasting higher deficits than it did back in March. It may well reduce its growth forecast and will surely assume much higher debt interest payments going forward. It will not be providing Mr Hunt with additional room for manoeuvre.

Furthermore, most of the risks to the fiscal forecasts are on the downside:

  • They are dependent on the government being able to keep to its promised six-year freeze in personal tax allowances and thresholds. This is a colossal £52 billion a year tax increase. It will further depress already feeble growth in net pay. It will mean 6.5 million more income taxpayers and 4.5 million more higher-rate taxpayers by 2027 than there were in 2020. Government may find this hard to maintain.
  • The forecasts assume that fuel duty rates will rise with inflation and that the ‘temporary’ 5p cut will expire. They almost certainly won’t – at a cost of £6 billion in 2027–28.
  • The Chancellor has pencilled in growth in day-to-day public service spending of just 1% a year after next year. With commitments on health, defence and childcare, among others, this would imply cuts to most public service spending. That will be tough medicine for them to swallow, meaning there will be pressure to increase spending by more than planned.
  • Also underlying the official forecasts will be a sharp fall in investment spending as a fraction of national income: not a policy especially conducive to long-term growth. Again, this could prove difficult to sustain.

Citi expect a reduction in CPI inflation from 6.7% in August to a little over 4% by the end of the year – which would mean the Prime Minister meets his goal to halve inflation over the year. But Citi are more pessimistic than most about the UK’s growth prospects. Recent ONS revisions paint a rosier picture of the UK’s past economic performance, but do not translate into an improved future outlook for growth. 

Even post-revisions, UK GDP is still 5.2% short of its 2012 to 2019 trend: a worse relative performance than either the United States or the Euro Area where the shortfalls range between 2% and 3%. There are signs of a turning point in the labour market: unemployment has increased from 3.5% in the 2022 trough to 4.3% now; Citi expect an increase to 5.8% by the end of 2024. Citi also expect a moderate recession through the first half of 2024, owing to weak corporate margins and policy tightening.

Monetary policymakers are now in a conundrum. The significant risks associated with inflation becoming embedded in wage and price setting mean that the Monetary Policy Committee (MPC) may want to wait for firm evidence of disinflation before it considers cutting rates. But by that point it might be too late and the result could be a deep recession. Fewer households have outstanding mortgages, and more households are reliant on private savings and housing wealth for retirement, so the transmission mechanism of monetary policy is much less predictable than in the past, and could work with longer lags. This complicates matters even further. The MPC could certainly do without its job being made even harder by an ill-timed fiscal giveaway.  

Paul Johnson, Director of IFS, said:

‘We are in a horrible fiscal bind. With taxes at record levels, and government revenues forecast to exceed non-interest spending for the first time in a generation, you might expect plenty of room for either tax cuts or spending increases. But poor growth and very high spending on debt interest over the next few years mean that the national debt is stuck at close to 100% of national income, even with tight spending settlements and further big tax rises in the pipeline. The price of our high levels of indebtedness, failure to stimulate growth, and high borrowing costs is likely to be a protracted period of high taxes and tight spending.’

Benjamin Nabarro, Chief UK Economist at Citi, said:

‘The UK still faces a challenging macroeconomic outlook ahead. The terms-of-trade shock that has dominated the last 12 months is thankfully fading. But the massive increase in interest rates now poses a newfound challenge for the public and private sectors alike. With activity already beginning to slow, and the labour market also showing tentative signs of loosening, most of these effects still lie ahead. 

‘For the MPC, efforts to manage still meaningful risks around embedded inflation have to be increasingly weighed against the potential for a more protracted downturn – and in particular the risk to vulnerable private sector balance sheets. 

‘The lesson of the 1970s was to hold rates tight until you can see the “whites in the eyes” of disinflation. In a highly financialised, debt-driven economy, that may turn out to be only half the story.’ 

Mark Franks, Director of Welfare at the Nuffield Foundation, said:

‘The UK economy and public finances are in a difficult place, given sluggish economic growth, a high tax burden, high government debt and rising costs of servicing that debt. Demographic change is adding to these pressures, with the NHS alone expected to need an extra £50 billion in annual funding in 15 years’ time, which amounts to more than the total cost of the recently scrapped HS2 extension to Manchester every year. This all makes an efficient taxation system and effective public spending vital, and the Green Budget sets out a number of credible and evidence-based options in this regard.’

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