The fiscal black hole: How did we end up here?
On 7th July 2022, Boris Johnson resigned. In his farewell speech, Johnson predicted the Conservatives would replace him with someone “dedicated” to cutting taxes because, as he put it “that is the way to generate growth and income to pay for great public services”. What got far less attention, for understandable reasons, was at the same time, in another part of Westminster, the head of the Office for Budget Responsibility (OBR) - the government’s official forecaster - was busy contradicting Johnson. On the morning of the 7th July, the Chair of the OBR, Richard Hughes, was arguing that the government’s finances were on a completely unsustainable path in the medium to long term and the only reason the position was tolerable in the short-term was because Rishi Sunak had raised taxes (principally National Insurance and Corporation Tax). The OBR said explicitly that there is no compelling evidence that tax cuts generate enough economic growth to pay for themselves. Today, the status of the OBR has been greatly enhanced. On 7th July everyone in the Conservative Party ignored it. A leadership campaign began in which candidates variously promised to cut national insurance, corporation tax, fuel duty, business rates and VAT on energy bills. Rishi Sunak did urge the party membership not to believe in “fairy tales” of lower taxes and higher public spending but he found prudence a hard sell and, by the end of the campaign he was offering (admittedly much smaller) tax cuts too. Sunak’s pledge to cut the basic rate of income tax appears to have been ditched, it will be interesting to see if he goes ahead with his promise to cut VAT on energy bills from 5% to zero.
Can we blame Liz Truss for the hole in public finances?
Liz Truss’s mini-budget on 23rd September was a disaster. She delivered all the tax cuts she had promised in her campaign (corporation tax and national insurance), added few more good measure (stamp duty and the high rate of income tax) and, within days, her chancellor was promising more to come. This was on top of her package of subsidies for energy bills. Truss promised colossal giveaways, didn’t say how they would be financed and refused the OBR the opportunity to pass judgement. The bond market blew out and brought her down.
Not much remains of Truss’s mini-budget. Since she was ousted, yields on UK government bond have largely returned to where they were on 22nd September. Rishi Sunak and Jeremy Hunt can convincingly argue that market credibility has been restored and that this has significantly reduced the amount of money the government will spend servicing its debts. But not all the damage has been repaired. According to Moneyfacts, mortgages are more expensive and harder to obtain than they were before the mini-budget.
Trussonomics caused havoc in housing market and several hundred thousand households have already paid more they would have done to refinance their borrowing. Jeremy Hunt will argue he has less room for manoeuvre as a result of Truss’s policies. The markets are watching and he can’t afford to do anything to frighten the horses. In her leadership campaign, Liz Truss argued that tax cuts were the magic potion to revive our prosperity, now Jeremy Hunt is telling us “everyone will be paying more tax”. In August, Liz Truss declared a recession could be avoided. On Thursday, the OBR is likely to forecast the UK has entered recession and Labour will argue, with a little justification, that it is likely to be deeper and longer as a result of Truss’s actions. We are in bad situation economically. Liz Truss undoubtedly made a bad situation worse but she is not to blame. Back in March, the OBR forecast GDP growth of 3.8% in 2022 and 1.8% in 2023. On Thursday it will forecast a downturn. We are heading for what the Bank of England believes is a prolonged recession not because of banking crisis or pandemic but because squeeze on living standards. The UK has been hit by a series of economic shocks: Brexit, the pandemic and the war in Ukraine. Inflation is rampant, interest rates are rising and the labour market is tight.
What is the fiscal hole and why does it need filling? The “fiscal hole” exists because of the government’s fiscal rules. Fiscal rules are designed by the government and they exist to give a broad sense that it is in control of the things that matter financially - the UK can be trusted to repay the money it borrows and should therefore be charged the lowest rates of interest. Fiscal rules don’t resonate with most people. No one at The King’s Head has a strong view on what the UK’s debt to GDP ratio should be. Interestingly, before the 23rd September, I’m not sure you find many bond traders who could have told you what the UK’s fiscal rules are. The UK has two legislated fiscal rules: 1. That national debt as a share of national income (GDP) will be falling by the third year of rolling forecast period. 2. And that the government will balance the “current” (day-to-day) budget by the third year of rolling forecast period. Fiscal rules are pretty arbitrary - there is no academic consensus about what a country’s debt to GDP ratio should be - and, absurdly, government’s tend to change them if they start to look impossible to hit. The key point here is they exist to enshrine credibility with investors. “Market credibility” is devilishly hard to measure but goodness, woe betide any government that loses it, as Liz Truss discovered.
Okay, but what's this got to do with the black hole that needs filling? Ah, yes. Not so long ago there was no “fiscal black hole”. In March, the OBR calculated that the government was on track to hit both of its fiscal targets with £30 billion of “headroom” to spare. By July 7th, the day Boris Johnson resigned, the headroom has basically gone - eaten up up higher inflation, higher interest rates and slowing economic growth. So when Liz Truss and everyone else began pledging tax cuts, they were spending £30 billion the government didn’t have.
So how does £30 billion "headroom" turn into a £55 billion "black hole"? The two bits of big (bad) news since the OBR’s March forecast updates are higher inflation and higher interest rates (just before Truss’s mini-budget, the path of Bank Rate predicted by the markets was 2% higher than the OBR expected in March). These two things alone add around £40 to £50 billion to borrowing - turning headroom of £30 billon into a shortfall of £10 to 20 billion. On top of that are the £15 billion of tax cuts which are still left from Liz Truss’s mini-budget (National Insurance plus stamp duty minus the cut to basic rate of income tax) = £35 shortfall. That’s the minimum ground you need to cover to have debt to GDP stable at the three-year mark of the OBR forecast. To restore headroom, the government needs to go further. If you want to restore “headroom” (it’s always sensible to have a buffer - you never know what might happen in the next few years) then you need to go further. Robert Peston believes the “hole” the government wants to fill is £50 to £60 billion. The main thing to take away here is this hole is not the result of the last three months, it’s the creation of the last few years: the pandemic, the war in Ukraine and the inflation these events have caused. Additionally, there is the impact Brexit impact. Jeremy Hunt argues Brexit is “not the biggest issue” which is both fair comment and an acknowledgement that Brexit has damaged growth.
How might the chancellor fill the fiscal hole with tax rises? A large section of Tory MPs may feel chastened by the Liz Truss “low tax” adventure but Jeremy Hunt will still need to make the case for tax rises with his backbenchers. There is going to be resistance if the chancellor attempts to raise the main rates of any of the three big revenue raisers - Income Tax, VAT or National Insurance so, instead we are being told to prepare for so called “stealth” taxes. In March 2021, when Rishi Sunak was chancellor, he froze all the thresholds of income tax until 2025 - at the time he thought he’d raise up to £8 billion per year. A year later, rising wage inflation looked set to haul in up to £18 billion a year. The IFS now calculates the move will raise as much as £30 billion by 2026. That’s extraordinary, and the noises off suggest the government will extend the freeze for a further two years and may even lower the threshold for the highest rate (45p) from £150,000 to £125,000. What’s called “fiscal drag” means more people end up paying income tax and more of them have more of their money taxed at the higher rates. It’s all a bit sly and opaque but it’s a big revenue raiser and MPs are unlikely to complain because most people won’t be conscious of paying more to the Treasury. Higher “windfall” taxes on energy producers (who are profiting from higher market prices ) and banks (who are profiting from higher interest rates) look nailed on and would be popular. One tax rises the chancellor will want to ditch is fuel duty. Back in March it was cut by 5p a litre for 12 months. It’s due to rise by 5p a litre, plus Retail Price Inflation (currently 12%). But Jeremy Hunt will have to find the money to stop that happening. It will also be interesting to see if Rishi Sunak delivers on his leadership campaign pledge to cut VAT on energy bills to zero. The saving would be amount to 5% off the typical bill - significantly nowhere near enough to compensate for the colossal rises. The tax cut would benefit poorer households the most as a proportion of their budgets (as energy makes up a larger share of their bills) but it would benefit richer households the most in cash terms (as they spend more on energy). This cut would put a little money back in people’s pockets. It would also fulfil a pledge Boris Johnson made during the EU referendum.
How might the fiscal hole be filled by spending cuts? Various radical changes have already been ruled out on political grounds. Jeremy Hunt is not going to scrap the pensions triple-lock - it has become totemic - and he will link benefits to the prices rise (rather than wage growth). The savings here were big but the chancellor wants to demonstrate he is delivering on pledge to protect the most vulnerable. This really only leaves public sector spending. In the Spending Review, a year ago, the government published reasonably generous spending plans which saw departmental budgets rising by an average of 3% above inflation between now and 2024/25. If the chancellor sticks to these plans, which he looks like he will, then departmental budgets will still rise but high inflation makes the settlements look half as generous, according to the IFS. Depending on the path of inflation, it is still possible that some departments end up facing real terms cuts at some point in the next three year. Particularly those like defence, education and HMRC - which had lower real terms increases pencilled in. It’s not entirely clear that there are easy pickings to be had in the public sector. Many services are already under obvious strain, struggling to deal with the disruption that Covid caused and to accommodate more generous wage increases than had been budgeted for. Meanwhile industrial action looms. Nurses have voted to strike over pay and other health worker are being balloted. The demographics are against the chancellor. The population is living longer and pressure on public services is growing. In the past, increases in health and benefits/pensions has been accommodated by declines in spending on public investment, debt interest and defence. But all three of these are tending to increase. I think the smart money has to be on a fudge here. The chancellor will likely honour the curent spending commitments - not least because services are in such a sorry state - and mark down some agressive cuts three years out. Politically, it’s shrewd to backload the pain until after the next general election. In doing so the Tories set the ground rules for the debate over fiscal policy and Labour (and others) are forced to account for themselves. You want better public services than those we propose? Fine, who pays?
Is Thursday going to be painful? Some pain is inevitable but the chancellor has less painful options. The government will almost certainly push its fiscal target out to five years and pencil in large cuts to public services beyond the spending review (2024/25). The chancellor could also hack back investment spending plans in ways that would somewhat undermine the mission to revive growth but which the general public won’t notice. By chalking up further freezes to tax thresholds, the chancellor can raise quite a lot of money without doing anything that anyone will particularly feel now. All of these things have consequences, of course, when they finally bite but the day after Autumn Statement won’t feel so terrible for most people. Indeed, if the chancellor will have an ambition to be on the front pages on Friday for protecting the incomes of pensioners and those on benefits or for the unveiling of the next iteration of the Energy Price Guarantee which will come into effect from next April. The chancellor has talked a lot about “eye-wateringly difficult decisions” but it would be amazing if he did anything in the short-term which made the cost of living squeeze and the recession harder than it will already be. The key point is the government doesn’t have to do a lot that is immediately hitting the wallets of people or departments. Much of the pain can be delayed, potentially beyond the next election.
Will the markets blow out again? Anything that looks like unfunded largesse runs a very high risk of pushing up long-term interest rates for the government and everyone else in the economy. There’s surely no chance of this happening. The chancellor will produce something that has the debt falling as a share of GDP ratio by at least the end of forecast (2028). He will argue it’s perfectly okay to push back the fiscal target from three years to five years because we’ve had an unexpected shock (the war in Ukraine) so it will take longer to get things back under control. Rishi Sunak wouldn’t be able to say “I’m a fiscal conservative” with a straight face if he has excessive borrowing right at the end of forecast period.
Long shot The OBR may decide that because there are fewer people available for work in the economy and energy prices don’t look like they are going back to pre-war levels that it needs to downgrade the Potential Output of the UK economy. Potential Output is a view of how much the economy can produce when it is running efficiently and without generating inflation. A downgrade from its current level - 1.7% a year - would be very bad news because it would mean that the OBR believes the UK economy will be smaller in future than it had expected and less able to generate taxes to pay for public services. Such a judgement would inevitably indicate that we are poorer.
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