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04 Aug 2022

Economy

What position will an incoming Prime Minister inherit? 

In its March 2022 Economic and Fiscal Outlook, the Office for Budget Responsibility (OBR) estimated that the government was on track to meet its self-imposed ‘fiscal mandate’ (to have public sector net debt falling as a fraction of national income by 2024–25) with £28 billion to spare. It added that the government’s target to balance the current budget (i.e. to cover all day-to-day spending out of tax revenue, borrowing only to invest, by 2024–25) was on track to be met with £32 billion to spare.  

But this does not mean that a new Prime Minister and Chancellor would automatically have £30 billion of ‘headroom’ for tax cuts. It is a projection around which there is a huge amount of uncertainty. There have been significant adverse economic developments since March and there remain plenty of downside risks. If you see this headroom and choose to cut taxes then you have to be prepared to raise them, and raise them sharply, ifas is all too likelythat headroom subsequently disappears. A prudent Chancellor serious about meeting these targets would, in the current economic climate, be wise to maintain some margin for manoeuvre.  

Immediate and long-term issues 

The new Prime Minister and Chancellor could, of course, choose to change these fiscal rules to allow for more borrowing. Another idea floated has been to put government debt ‘on a longer-term footing’. One interpretation of this would be a deliberate increase in the average maturity of government debt, thereby locking in current (historically low) interest rates for longer. There may well be advantages to this approach. But this would not have any impact on the amount of fiscal ‘headroom’ in the short term (the government would have the same amount of debt, just with a longer maturity) and so would not ‘pay for’ tax cuts. It could in fact push up debt interest costs in the short term, as long-term interest rates are currently higher than short-term interest rates, but would have the potential benefit of leaving the government less exposed to any future increases in interest rates.  

Ultimately, however government debt is structured and whatever borrowing the fiscal rules allow in the short run, lower taxes can only be paid for in the long run by lower public spending than we would otherwise see. Tax cuts and tax reform can help promote economic growth, if well implemented, but this is far from guaranteed. The view of the OBR is that ‘tax cuts don’t pay for themselves and would not improve the [government’s] long-term finances’. It is extremely unlikely that any of the tax cuts proposed during the Conservative leadership contest would increase growth enough to pay for themselves.  

If tax cuts were funded by additional borrowing, this would increase the level of aggregate demand in the economy, which – all else being equal – would act to push up inflation. But this would likely be met by a tightening of monetary policy by the Bank of England (i.e. larger and/or earlier increases in interest rates), offsetting any additional inflationary pressure created by the tax cuts. The key question then becomes one of redistribution: away from those who are exposed to the costs of higher interest rates, and towards the beneficiaries of the tax cuts.  

The OBR’s March forecasts, discussed above, were underpinned by the government spending plans set out in the October 2021 Spending Review. At that time the expectation was that inflation would peak at around 4%. It is now expected to peak at 13% and stay higher for longer.  

Because departmental budgets are set in cash terms, they do not automatically increase if inflation turns out to be higher than expected. Instead, they become smaller in real terms: when prices are higher, the same cash budget can buy fewer goods and services. In other words, unexpectedly high inflation imposes an unintended dose of austerity. What originally looked like increases in public service spending averaging 3.3% above inflation each year now look substantially lower. By March of this year, higher inflation forecasts had already wiped out at least 10% of the real-terms budget increases pencilled in last autumn (3.3% annual increases fell to 2.9%). To return to the intended rate of real-terms budget growth, plans would need to be topped up by at least £4 billion each year. If anything, this is likely to be an underestimate, due to a quirk in the inflation measure underpinning the official estimates.  

That’s also before accounting for any additional cost pressures from higher public sector pay awards, which workers might reasonably demand in the face of higher inflation, but which have the potential to add substantially to the budgetary challenges facing public services. It is possible that public sector pay decisions will be made before the new prime minister enters office. But in any case, public sector pay policy will pose some acute fiscal challenges later in the year. The government’s existing spending plans were predicated on pay growth of 2 or 3%. If public sector workers are instead offered something like a 5% pay rise – never mind 10 or 11% – and departments are not provided with any additional funding, that would necessitate cuts in headcount and/or an acceptance that some public service objectives cannot be met.  

The big question for the autumn then becomes whether or not to top up departmental budgets to compensate. Fully compensating all departments for a 5% across-the-board pay rise would mean a top-up of around £7 billion per year. If it were 10% across the board, it would require more like £18 billion. That would be on top of any compensation for non-pay pressures in the public sector (like higher energy bills).  

Implications of potential policy choices 

Providing such a top-up would help to shore up public services in the face of substantial cost pressures, but would eat into any fiscal headroom available for tax cuts. 

Looking further ahead, both candidates are committed to ensuring spending on defence will either rise or at a minimum not fall below the NATO target of 2 per cent of GDP, as countries across Europe step up their defence expenditure. A growing defence budget, alongside the well-known pressures on health, social care and pensions from an ageing population, would put strong upwards pressure on overall government spending.  

For any government seeking to shrink the size of the state, this poses some difficult questions. The level of tax and spending cannot diverge indefinitely. Lower taxes must eventually mean lower spending. The question for a government seeking to cut taxes and spending as a fraction of national income over the longer run is: where are those spending cuts going to come from? 

By Ben Zaranko, Senior Research Economist at the Institute for Fiscal Studies. This piece was originally part of the report ‘The Conservative leadership contest: a guide to the policy landscape’ with Full Fact.

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