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Podcast | SPECIAL: What should the Chancellor consider in his autumn budget?

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This week, we published the IFS Green Budget, our flagship publication analysing at the outlook for the economy and the opportunities and challenges facing the Chancellor ahead of the autumn budget.

We speak to Benjamin Nabarro, Senior Associate at Citi Research, and Carl Emmerson, Deputy Director at IFS, to discuss the ongoing impacts of the COVID-19 pandemic, as the Chancellor aims to secure a lasting recovery and deliver on the government’s other objectives and priorities.

The IFS Green Budget is produced in partnership with Citi, and is funded by the Nuffield Foundation.

 

Transcript:

Paul Johnson:

Hello, and welcome to this edition of the IFS Zooms In with me Paul Johnson. And today I’m joined by Ben Nabarro, he’s an economist at Citi, and Carl Emmerson, Deputy Director here at the IFS. And we’re recording this edition on the day that we’re launching the IFS Green Budget, our annual look at the economy and at the choices facing the Chancellor as the budget approaches which it is doing on the 27th of October this year.  

And not only do we have a budget this autumn, we’re going to have a spending review, a chance for the Chancellor to set spending plans for the various bits of government over the next three years. So, a big event coming up following some pretty big events, of course, over the last few years, Brexit, COVID, huge tax increases in the budget at the beginning of the year, some more tax increases and spending commitments made by the Prime Minister in September to cover health and social care. So, an awful lot going on. And an awful lot going on in the world as we look at big increases in gas prices, petrol shortages, loss of HGV drivers and so on and so on, so plenty to talk about.

So, let’s start, Ben, with this picture of the UK economy, clearly, we’ve had this you know, biggest recession, pretty much ever last year and then this big bounce back, where are we and where are we going?

Benjamin Nabarro:

All very, very good questions and I think the first thing that inevitably one should say whenever trying to make comments on the sort of macro-outlook for the UK economy is just that uncertainty remains considerable. I mean the essence so far in 2021 has been that the UK economy has actually preformed better than maybe we had initially excited, so output in the first quarter fell less than we had initially thought and even was initially estimated as the UK economy was locked down for what we hope was the final time.

And indeed, as the economy has reopened, through the second quarter, we have seen a faster rebound than many of us also had initially expected with growth totalling 5.5% now in the second quarter. And that’s left GDP around about three, three and a half percent short of its Q4 2019 level, so its level pre-pandemic. Our sense, and one of the big take-aways of the research we did for the Green Budget, is while the initial rebound from the pandemic has proved somewhat faster, we continue to think this indicates relatively little concerning the medium-term recovery. In particular the growth in the second quarter was driven exclusively by both public and private consumption, and as we’ve moved into the latter part of the Summer and indeed into the Autumn, we’ve seen economic momentum actually slowing really rather sharply. So faster activity data for example has rolled over, and we’ve also seen a sort of broader loss of momentum, even in the monthly GDP figures.  

Now our sense is that rather than the faster rebound we saw earlier, sort of proving a pre-curser for a very strong medium-term recovery, we instead continue to think there are some notable challenges facing the UK and the really key issue we think is one of economic reconfiguration. You know the rebound to date has been quick but very, very uneven and household expectations continue to point to some lingering structural changes in the UK emanating from things like more permanent working from home, and also the ongoing adjustment to Brexit as well, which we think, you know having agreed the trade cooperation, agreement at the end of 2020, now constitutes still quite a meaningful structural change for the UK. Especially on the external side.

Paul Johnson:

So a key part of that, Ben, I think that something that will be on people’s minds at the moment, are these immediate supply constraints the problems about gas and petrol and recruiting staff in various sectors, I think you’re saying that your expectation is that that is a temporary thing, that we’ll get over those, and as we go into next year, and we kind of come through maybe this time next year, that will all have effectively blown over and we’ll have got back to some kind of more sustainable equilibrium. Is that right?

Benjamin Nabarro:

That’s broadly right, you know uncertainty here is always large, and I think it would be a bold person to say they necessarily knew many of these supply disruptions would dissipate for sure, for example by sort of April next year. But our current thinking is there isn’t any obvious reason to think that these supply disruptions or these contortions should be more lasting. The sort of structural impact, for example, of lower EU immigration seems like it may drive a gradual revaluation in different skills, so for example it may mean that lorry drivers in the long term are paid a little bit more compared to say their white-collar counterparts and you’d expect that to pan-out over the next eighteen, twenty-four months or so. So, there may be some relative price level effects, associated with some of the short-term disruption we’re seeing as the economy adjusts.  

But our thinking certainly is that there are some specific supply bottle necks that are currently constraining the recovery and have added to the slowdown in momentum. And our thinking would be that those do begin to dissipate one way or another quite meaningfully as we go through 2022, and indeed because of you know, the continued weakness of the recovery, our baseline expectation, especially within the labour market and for incomes more generally, is that we would start to see supply recover relatively well through that period, but demand to still face some lingering challenges you know, associated with a small increase in unemployment as furlough is wound down, losses in incomes as we see activity continue to linger and some of those other effects as well.

Paul Johnson:

So, Carl, I mean that bit all sounded quite positive, but Ben’s sort of medium-term forecast are for the economy to be a little bit smaller than we would have expected if COVID hadn’t happened and perhaps also a slightly more negative effect for Brexit than he was expecting a year or so ago. So, with a smaller economy, and as we come out of this year of huge borrowing to cover the cost of COVID, what does all that mean for the public finances?

Carl Emmerson:

Well, I think it’s really a story in two parts, in the near term Citi analysis shows us that yes, the economy now will be bigger than what we might have thought back in March, and that will be reflected therefore in stronger growth in government revenues, and the deficit, while it will be still incredibly high by historical standards, it won’t be quite as high as we might have feared back in March.

Over the medium-term some of that improvement simply fades away, were just getting some of the growth a bit earlier rather than getting more growth overall. So, while, for example in the current financial year we think that the amount the government borrows might be as much as fifty billion or so below what the March budget forecast, in the medium-term we think that number might fade down to twenty billion or so, a year. So still good news for the Chancellor, but not as good news as you might think looking at the headline numbers for this year. And again, I think I have to stress the huge amount of uncertainty around that, the economy could grow much better over the next few years, it could be that the degree of scaring that Ben is talking about could be substantially less, which would be great news for us all. But unfortunately, it could also be the case that there’s more scaring and we see a worse outlook and therefore borrowing ends up to be much more than we expect.

But in terms of the medium-term position on our central forecast, where we end up really is essentially borrowing about the same sum as what was expected before the pandemic with the damage done to the public finances in terms of the enduring impact on borrowing basically being offset by the fact the chancellor set out pretty big tax rises earlier this year in his March budget.

Paul Johnson:

So just give us a sense of that scale of tax rise, because we saw some big tax rises in the March budget, and we saw some more announced back in September. What is the scale of those and why did you pick out the March ones and not the September ones for explaining why we’re going to be in terms of borrowing where we otherwise would have been?

Carl Emmerson:

Well, the March budget set out in particular a very big increase in the rate of corporation tax and it also announced a four-year freeze in the point in which people start to pay the basic and the higher rate of income tax, taking together that’s going to raise something like 28 billion pounds a year, it makes the March budget the biggest tax raising budget since Norman Lamont’s last budget of 1993. So, a huge tax raising budget and if you’ll excuse the hypothecation, I think that budget really was about a big tax rise to try and reduce the medium-term deficit.

In September the Prime Minister announced a further tax rise, the manifesto busting raise in National Insurance contributions which is coming next April, and followed a year later instead, with a new health and social care levy, which is expected to raise something like 14 billion pounds a year, and I think that the rationale behind that tax rise wasn’t really any – it certainly wasn’t anything to do with trying to reduce borrowing going forwards – it was about the government’s desire to spend more and to finance that through higher taxes.

And I think that it seems pretty clear that the true driver of the need for that tax rise, was the fact that the government wants to be able to spend more on health and social care, because of the pressures there, and perhaps not surprisingly, it feels unable to be able to pull the trick that previous governments have done, of simply cutting elsewhere to find the money, that’s becoming more and more difficult to do as time goes on and therefore that was really a tax rise to pay for more health and social care spending, that perhaps we would have been going even if the pandemic hadn’t hit.

Paul Johnson:

So, I mean some enormous tax increases as you say, a big chunk of additional money for health and social care, we’ve got the spending review coming up but that’s part of the budget, so presumably plenty of money to go around?

Carl Emmerson:

Certainly, you’d expect that. And the size of the state is growing, it’s growing to about 42% of national income is going to be spent publicly after the pandemic, that’s up from where it was pre-pandemic and by UK historical standards, that’s pretty high, at least in normal years, we often spend more than that in unusual years, but in normal years, I think that’s a pretty high figure. But it’s surprising that it doesn’t seem to make the spending review very easy for the Chancellor, there’s a number of reasons for that.

One is that lots of the increases are going on capital spending, so there’s quite a lot of flexibility there, on day-to-day spending there’s less flexibility. He’s already announced big increases in spending for some areas, so we know that the health and social care budget is going up pretty considerably over the next year in particular, so once you take account of that, you also take account of commitments on over-seas aid, on schools, on defence, actually for the rest of what central government spends on public services, we’re looking at a cut in the coming financial year and actually even in two years’ time it looks like spending in those unprotected areas will be no higher than it will in the current year. That’s despite a very ambitious agenda for reform the government has around things like levelling up, around social care, and despite the fact that for some public services, perhaps the most obvious transport but also schools, there’ll be lots of potentially COVID pressures still kicking around in the system.

Paul Johnson:

So, we’ve got to this horrible position for the Chancellor who’s really raised taxes a lot, he’s bumped up spending on the health service, actually this conservative Chancellor is presiding over a record level of taxation in this country, and indeed he’s presiding overspending rising to its higher fraction of national income in normal times since the early 1980s so it looks like a big tax and spend agenda.

But, bizarrely in a way, still not very much money to go around, and that’s partly because we expect the economy to be a bit smaller than it otherwise would have been, and partly because of this ever increasing, every hungry beast called the National Health Service, which is pulling in all of this resource, leaving not so much for everything else.

Ben, one of the things that the Chancellor obviously has to worry about is paying the interest on the debt that he accumulated, he and his predecessors over the last decade had in some ways been incredibly lucky in the very, very, very low levels of interest on government debt. What’s your expectation about what might happen to those interest rates as we go through the next few years?

Benjamin Nabarro:

Our sense, at least for the time being, is that interest rates or more specifically the Bank of England policy rate will increase over the next six months or so, we’re expecting two interest rate rises most likely we think in February and then again in May. And the key driver for that is very much you know the immediate inflation outlook which we in the Green Budget, our analysis, is suggesting a peak of around 4.6% in April next year.

Now if we include the most recent volatility in wholesale gas and electricity prices, we’re now probably looking at CPI peaking at over 5, five and a half percent, and the difficulty for the bank in that context, is even with the economic momentum slowing and I should say that actually you know through at least the last few months and indeed the immediate outlook as well, the economic outlook does look considerably worse than what the Bank of England had previously expected. And even with that backdrop, when inflation is getting to these sorts of levels, we are starting to see household inflation, expectations begin to move around. Especially in sort of long durations so what households think about the outlook in five, ten years’ time and so on.

Now the difficulty for the bank in that context is people, what that suggests is people are starting to doubt the ability of the Bank of England to control inflation in the medium-term. That’s a direct challenge to their credibility, and therefore even with the outlook potentially underperforming with the risks to the labour market remaining to the downside, that’s still forces them to take some action to try and reaffirm those inflation expectations and hopefully do so in a way that minimises the potential risk to the broader sort of level of the recovery.

So, our thinking is they will do two hikes, they’ll do them relatively early, signal a willingness if not an intent to do more, but the key point is if the economic outlook develops broadly as we think with you know emerging headwinds both on the fiscal policy side potentially but more importantly for households and still for business investment, then that won’t be a scenario where the Bank of England is really beginning a genuine rate hiking cycle. Much more likely we sort of see two hikes and then sort of stuck at around fifty basis points for some time after that.

Paul Johnson:

And what does that mean for the public finances, Carl, if inflation and interest rates are a bit higher?

Carl Emmerson:

We have a lot more government debt than what we had prior to the pandemic, that’s the consequence of the huge amounts of borrowing we’ve done since March 2020, and we’ve borrowed that debt very much on short term duration, so it will respond very quickly if inflation or interest rates start to go up. And indeed, we see that in the forecast we’ve produced for the Green Budget, where a combination of the increase in RPI inflation since January, the increase in the gilt rates on government bonds that we’ve seen since January, and the outlook for interest rates and gilt rates that Ben just outlined, we think will add something like 15 billion pounds a year to debt interest spend, so that’s a huge sum of money. In some ways though it’s not one that should be troubling the Chancellor at the moment too much in the sense that that increase in inflation and interest rates has been associated actually with a stronger outlook for the economy and a stronger growth in receipts. So, while spending more on debt interest we think he’ll be getting more in in terms of revenues and therefore public finances are in a stronger position.

What he and indeed his successors are going to need to worry about, with elevated debt that will be around for such a long while is what would happen if interest rates were raising and the cost of government borrowing was going up, and it was doing that in a period where we weren’t getting an improved outlook for revenues. That’s the kind of scenario that will be problematic for a Chancellor.

Paul Johnson:

Ben, I mean this worry about interest rates is obviously part of a worry about how a government is going to respond to – or how the private sector’s going to respond to the sort of very unusual situation we’re now in, and it’s clearly something where if it happens, will affect households. And one of the things that was in the piece that you wrote that struck me particularly was I think your forecast that households’ disposable incomes was potentially looking really quite weak next year, rather at odds with the Prime Minister’s sort of claims that we’re getting into a new high wage economy. Could you just tell us a little bit about your expectations for household incomes, why they look so weak?

Benjamin Nabarro:

There are two important elements to this I think, the first is what I was describing earlier with respect to the labour market outlook which is currently you know, we’ve all seen the reports I think, of double digit pay settlements in a range of specific sectors that are seeing both new-found demand. And they’re seeing their, you know, had previously relied particularly on the European Union for the marginal worker, and have subsequently, in order to try and manage the increase in demand are having to increase pay settlements very profoundly indeed. But this is juxtaposed with many areas of the economy where pay settlements are broadly stagnant at best, and indeed aggregate pay settlements at least measured by the Bank of England agents are, you know, no higher than they were before the pandemic, so not particularly strong.

You know our thinking, with respect to the labour market is we will still get some emerging softness as GDP continues to lag its pre-pandemic trajectory and labour supply recovers, so we don’t see this as a particularly strong outlook for wage growth and aggregate.

And set against this of course was exactly the inflation outlook we were just discussing, and when we’re talking about things like increases in household energy bills, increases in the cost of food and indeed some consumer durable goods as well, all of which have been coming through in recent months, you know that, if it isn’t subsequently reflected in very strong wage growth, essentially becomes a tax on household consumption. And that is the key drag that we really expect to come through in the second and third quarters of next year which, as you described Paul, imply a level of real household disposable income growth after utility bills, you know roughly equivalent with what we saw in 2008/9, 9/10, 10/11, you know not a strong period for the UK consumer.

Paul Johnson:

Well, that’s a dangerous period then, Carl, for the Chancellor and the Prime Minister and if Ben is right and we’ve actually got falling real incomes next year, and that’s exactly the moment that the new health - National Insurance increases, health and social care levy start to bite, I mean that’s going to hit, particularly people in work on relatively modest earnings, potentially quite hard.

Carl Emmerson:

Yes, and indeed on one hand if inflation turns out to be higher than expected and perhaps higher than expected for longer, the kind of direct effect is actually to strengthen the public finances, because the tax system is largely taxing nominal incomes, it’s taxing nominal spending, whereas spending plans for public services are largely set out in cash terms. But of course, that ignores perhaps some of the reality of those tax decisions and spending decisions where on the tax side it will become perhaps much harder to be freezing peoples’ personal allowance, to be freezing their higher rate threshold, become much harder to be introducing increases in tax rates like the National Insurance increases that are coming in next April.

And on the public service side of course, it will become potentially harder to keep that squeeze on unprotected departments, what about the areas of the public sector which have energy bills themselves? What happens if wage rises do start to come through? That will put pressure on pay rises, pay settlements in the public sector too. So, while the direct effect might be, “oh we’ve set cash spending limits of three years for the public sector,” keeping to those cash limits could be much, much harder if inflation turns out to be higher.

Paul Johnson:

Ben, I’ve got one last question, but it’s quite a big one, which is about Brexit, it’s now five years, isn’t it, since we – more than five years since we voted to leave the European Union, we have left, what do we now think, what do you now think has been the effect on the economy so far and is like the ongoing effect? Because that is you know a big part of everything that we’ve been talking about in terms of the size of the economy and therefore everything that means for the public finances, we haven’t explicitly addressed the issue of Brexit, so what’s your sense of how it’s impacting us?

Benjamin Nabarro:

I think an incredibly important question and I think one that will also become more prominent in the public discussion over the next six months or so, because our sense is that Brexit is having a material impact on the UK economy and on the strength of the recovery, and we’d expect that to be somewhat clearer over the next six to twelve months or so. I mean the essence of our view on this, for quite a while has been that while clearly, we’ve all known about Brexit for what feels like an eternity now, indeed it’s rather hard to think of a world before Brexit, the weakness of the depreciation of Stirling that we saw in the immediate aftermath of the referendum has done an awful lot to reduce the incentive of firms to actually adjust.

So, while we may have seen some, particularly some weakness in investment, as obviously uncertainty went up and the longer-term viability of lots of firms’ operations came into doubt. You know in terms of actually relocating people and proactively trying to adjust to life outside the European Union, you know obviously all of us, and your cost going down by 20% compared to your alternative jurisdiction creates quite a strong incentive to keep people in the UK, to keep things, stuff here for as long as you can get away with, and that’s certainly how we characterise the recent period.

Now, there are two points that I think are worth sort of making when you’re thinking about the recovery from here, the first is the trade cooperation agreement really is a pretty rudimentary Brexit, if you sort of think back to the discussion in 2018/19, we were talking about hard Brexit, softer Brexit, yarda-yarda-yarda, in the sort of spectrum of options that we ended up with, we really got quite a rudimentary trade deal with the European Union. Not one that really enables lots of the more complex productive transnational activities, service trade that the UK really specialised in.

And the second element is without a lot of this particularly cyclical adjustment going on post 2016 what we’ve started to see at the start of this year is evidence of really quite profound adjustments. So, just to give you one example that we dug out in the Green Budget, if you imagine you know, COVID and Brexit together are clearly driven huge disruption to UK trade, but the way firms might react to each of them are rather different.

So, with COVID you think the shock is temporary, you don’t want to leave too many markets, but with Brexit you think of it as more persistent and that means, or permanent, and that means you exit markets that are no longer profitable, you have no reason to sort of pay to stay there if you like. And we can see huge discrepancies in the sort of concentration, at least across goods trade, between that with the EU and outside of the EU, with the latter very much sort of seeing a drop in concentration as firms have tried to keep a foot in every market. Whereas with the EU, some firms have just left, and particularly smaller firms have.

Paul Johnson:

So it’s a really important point there, I just wanted to clarify that for the listeners, something really struck me, I think what you’re saying is that there’s been some drop off in trade with the European Union, but the main thing that’s happened, is that lots of smaller companies have stopped exporting to the European Union because it’s become more difficult for them, they don’t see that as a big part of the future, and when you say concentration, you mean it’s basically now just something that’s being done by big firms.

Benjamin Nabarro:

Indeed, so there’s two elements to the concentration. One is big firms, and there are also, even those, you know firms that are still staying in the game, are also exporting fewer goods. So, we’re concentrating in a fewer, small, more profitable areas and losing a whole range of stuff. And you know, our sense is Brexit is still a meaningful impediment to the economy, we think a lot of the pandemic support is obscuring some of the impact, so for example there are around about a 170,000 people who were furloughed in manufacturing, there’s a reasonable correlation between the rate of furlough and trade with the EU, so we think there may be an element where pandemic support has been obscuring the impact a little bit. And we were talking earlier about the sort of scale of scarring, you know we think the long-term impact of the pandemic is in the order of around 1.4%, primarily to do with scrapping of fiscal capital. We still see, even compared to sort of forecasts which supposedly incorporated the impact of Brexit, so here I’m benchmarking to the OBR’s March 2020 scenario, we still see Brexit as adding around about another percentage point, 1.1% of scarring through to 2025, because we keep our slightly more pessimistic view of the way this is going to play out, both in the short term and long term.

Paul Johnson:

You’re comparing an additional effect of Brexit on top of what the OBR had in March 2020, what’s your overall sense? I mean how much smaller do you think by 2025 the economy will be, than it would have been had Brexit never occurred?

Benjamin Nabarro:

I think it’s better to talk about these things maybe in terms of long-term impacts, so over sort of fifteen years, if that’s all right? And there we think the scale of the impact is in the order of around about 8% or so, and that’s based on a net loss of trade of around about 12% in total. So, trade, over-all 12% lower, GDP 8% lower.

Paul Johnson:

8% of national income were talking, what £180 billion or so as the long run cost of Brexit. And I think you know one of the things you’re saying there very clearly is that in the long run, Brexit will be, what? Six times as expensive to the British economy as COVID?

Benjamin Nabarro:

Indeed.

Paul Johnson:

Well, on that cheerful note, perhaps it’s time to leave it there, you’ve heard an enormous amount from Carl and Ben today. I mean what I think we take from what Ben has said is that the economy is doing better from what we, well than we expected a year ago, we’ve had a pretty good bounce back this year, but we can still nevertheless expect an ongoing effect from the pandemic. You perhaps shouldn’t panic yet about the signs of inflation that we’re seeing; we hope at the moment specifics of particularly sectors, the danger there is if expectations change: because we’re seeing it in certain sectors and we all decide, we all sort of then start worrying that it will go up everywhere and then that ends up in a wage price spiral. But at the moment, that doesn’t seem to be the central likelihood.

You’ve also heard from Ben that we’ve got a big impact from Brexit on the size of the economy. And that impact on the size of the economy really underpins a lot of what Carl has been saying. We’ve got this smaller economy, we still want the public services we’ve had so, public spending as a fraction of national income has gone up to, or is going up to the highest level in at least forty years, under a conservative Chancellor. And at the same time, he’s raising taxes to their highest ever level actually in a sustained basis.  

So, we’ve got a conservative chancellor with very high taxes and spending, and yet, counter intuitively without very much money to spend. And the reason he doesn’t have much money to spend is partly because he’s spent an awful lot of it on the health service in a way that I’m sure many people would absolutely want, and that reflects the fact that you know we continue to demand more from the health service, and we’re an aging population. And of course, we’ve got a smaller economy than we expected, and therefore that higher level of taxes isn’t actually giving us anymore money. So, we’ve got this sort of perfect storm as it were, of high taxes, high spending as a fraction of national income but not much room for the chancellor to give extra money to things outside of the health service.

So, on that cheery note, I will say goodbye to Ben and to Carl and to say thank you very much to them. Thank you for listening to the IFS Zooms In and please do join us next time.

To see all of our Green Budget work, please visit www.ifs.org.uk/green-budget and to further support our work, consider becoming a supporter of the IFS for just £5 a month. You can find a link with further information in the episode description.

Thank you for listening and stay well.

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