The OBR foresees a £58bn permanent hole in the finances thanks to Covid
Despite now forecasting a slower economic recovery from the coronavirus pandemic, the OBR’s ‘best guess’ estimate of the long-term economic damage it will cause remains unchanged at 3% of total output. This is the key challenge to the public finances in the years ahead: tax revenues are now forecast to be about £58 billion lower in 2024–25 than they expected in March, and budget deficits £58 billion higher.
Some spending cuts to come but potentially tens of billions in tax rises too
The Chancellor made some efforts to fill in some of this hole in today’s Spending Review. ‘Core’, non-virus spending will be increased by less next year than he had signalled in March, though a further £55 billion of virus-related spending has also been budgeted for. The Chancellor hopes that this expenditure can be eliminated in 2022–23, so spending will be around £16 billion a year lower in the medium term than had been expected in March. With significant spending commitments already made before today on the NHS, schools and defence, other departments will see no growth in their funding in real terms. That leaves about three-quarters of the fiscal hole created by Covid to be filled either with tax rises or borrowing.
Spending may need to rise further
Keeping to these spending plans will be challenging, especially after a decade when these departments have seen significant spending cuts. The Chancellor will also face pressure to continue the £20/week uplift in Universal Credit payments and higher Local Housing Allowance rates after next April. This suggests that any further fiscal consolidation to be announced in the Budget is likely to be on the tax side. The OBR’s forecasts suggest that taxes would have to rise by £27 billion, equivalent to around a 3½p increase in all income tax rates, by 2025–26 to balance the current budget or by £42 billion, or about a 5½p increase in all income tax rates, to reduce deficits back to the levels planned in March. No doubt we will hear more about this in next spring’s Budget.
Now is not the right time for a pay freeze
At a time when interest rates on government debt are so low – forecast debt interest spending next year has fallen by £20 billion since March despite much higher debt levels – starting fiscal consolidation so soon by freezing public sector pay and reducing benefit levels next year risks undermining the economic recovery. Delaying until 2023–24 when the OBR expects the economy to be back operating near capacity would support people’s incomes in the meantime at little ongoing cost in terms of higher interest payments. It would also give policy makers more time to assess the extent of long-term economic damage, which remains highly uncertain, and to think strategically about the future structure of both public spending and the tax system
The size of the state is growing…
Overall the underlying size of the state – at least measured relative to the size of the economy – is set to increase significantly under Johnson and Sunak compared to Theresa May and Philip Hammond. Back in the 2019 Budget Hammond proposed to spend 37.8% of GDP in 2023-24. Sunak’s figures suggest that, even with the Covid crisis over by that year, he plans to spend 42.1%. That’s a substantially higher proportion of GDP than at any recent time when economic conditions have been broadly ‘normal’. Indeed between 1979 and the financial crisis, public spending averaged 38.4%.
…but largely because the economy is a lot smaller than hoped
While there is a fair amount more spending now planned than there was 18 months ago, the increase in spending as a proportion of GDP is as much a reflection of the damage that’s been done to economic growth prospects in recent years. A significantly harder Brexit combined with the damage from Covid has reduced the expected size of the economy in 2023–24 by about 4.2% compared to March 2019. Without those two things, the chancellor’s plans would have come in at 40.3% of GDP in that year. It all goes to show that fiscal responsibility is as much about not damaging prosperity as it is about tightening tax and spending.