As we wait for the first full OBR public finance forecast since the scale of the Covid-19 pandemic became apparent, the ONS has today published monthly data on tax revenues, public spending and borrowing in September. They show that public sector net borrowing in October was £22.3 billion, some way below the £28.3 billion in the OBR’s ‘Coronavirus Reference Scenario’ updated in August as, among other things, the Coronavirus Job Retention Scheme has contracted more quickly than expected, and that the size of the national debt has reached 100.8% of GDP.
Although deficit have been lower than forecast so far this year, in the months to come the deficit is likely to be higher than in the OBR’s published scenario as a result of the additional measures announced on 5 November to provide support during the second lockdown in England. A third wave of the Self-Employed Income Support Scheme will cost £7.3 billion and the Coronavirus Job Retention scheme is now expected to cost £6.2 billion in November. If this level of spending were to be maintained until the end of the financial year – that is, if there were no reduction in the use of furlough until April and there were a fourth, equally generous round of support through the SEISS – it would increase the overall deficit to exceed £400 billion (close to 21% of GDP) rather than the £372 billion or 19% of GDP forecast by the OBR in August.
However high the deficit for 2020–21 ultimately ends up being, it is already clear that it will be at an unprecedented level for peacetime and that debt will jump significantly, having already passed 100% of GDP in August. How worried should we be about this? Not very, we would argue: it should not prevent the government taking necessary measures to protect viable firms and maintain existing employee-employer relationships during the crisis. There are several reasons for this. First, the cost of additional debt remains very low. Despite a big jump in debt levels, the exceptionally low cost of borrowing means that debt servicing costs are now expected to be lower than was expected in March. Secondly, it is reasonable to expect a relatively swift return to near-normality in 2021 given positive news of the effectiveness of the first Covid-19 vaccines, which would increase tax revenues and allow emergency spending measures to be switched off. Barring a big surprise, the deficit should fall quite substantially next year. In July, the OBR forecast that the deficit would be significantly lower in 2021–22 at 7% of GDP, falling to 4.6% by 2024–25.
This is still a higher deficit for 2024–25 than the OBR expected in March. The OBR expects the pandemic to permanently reduce the size of the economy by 3%, which will in turn affect tax revenues. The emergency spending measures to protect firms and jobs that the government has announced should minimising the extent of this damage, another reason for not skimping on this support in the short term. The OBR will update its assessment of the economic damage caused by the pandemic next week, but it will remain highly uncertain: the OBR has little more to go on than it had in July. If primary deficits (i.e. excluding interest payments) were maintained at their forecast level for 2024–25 of 3.6%, the debt-GDP ratio would stabilise at around 100% (see chart below, solid green line). Alternatively, if the primary deficit were to fall back to their levels planned before the pandemic of around 1.5% of GDP, either because economic damage from the pandemic was less than expected, or because of policy action taken to reduce the deficit, debt would fall relatively quickly as a share of national income, reaching its pre-pandemic levels by the early 2040s (solid grey line).
Keeping the deficit this low will be challenging, however. As well as providing an update on its view of the deficit in the short term, the OBR also updated their long term fiscal projections. These once again show the challenges to the public finances of an ageing society, with health spending expected to more than double as a share of national income and the cost of state pensions to rise from 4.5% to 6.9% of GDP. Without policy action, deficits will start rising again and ultimately put the public finances on an unsustainable path (solid blue line).
Another risk to the long-term sustainability of the public finances is if interest rates on government debt rise from their current extremely low levels. The OBR assumed in July that interest rates would gradually increase to reach historically normal levels by 2040. If this happens, budget deficits will need to be further reduced to keep the public finances on a sustainable path (dotted lines).
Debt-GDP ratio under various scenarios
Note: Solid lines show scenario where interest rates on government debt remain at the OBR’s 2024–25 forecast level. Dotted lines show scenario where interest rates increase in line with OBR assumptions.
Therefore, as we argued in June, and as our fiscal framework published in February would suggest, policy in the coming years should follow the following principles:
Budget deficits should not be a concern while the economy is operating far below capacity and unemployment remains high, especially when borrowing costs remain low
In the medium term, any shortfall in tax revenues caused by the pandemic will need to be made up. But there is also scope to take advantage of low interest rates to borrow for productive investments
In the longer term, the challenges to the public finances of the costs of an ageing society remain, and if interest rates start rising again, borrowing should be cut back
The Spending Review next Wednesday will announce spending allocations for the next financial year, and overnight leaks suggest the Chancellor is considering freezing the pay of 4 million police officers, teachers and military personnel for starters. While it is understandable to avoid long-term decisions at a time of so much uncertainty, at some point the government will have to make far harder decisions about the path ahead.
The OBR’s Economic and Fiscal Outlook that will be published alongside the Spending Review will give some more information about how difficult those choices might be. But it already seems inevitable that taxes will have to rise in the wake of Covid. In future work, we’ll be thinking about the principles that should guide policy makers when designing tax changes and particular policy challenges.