What to expect in the Spending Review

UK Policy Income and Inequality

What to expect in the Spending Review

Commentary
Posted on: 19th October 2021
James Browne
Head of Work, Income and Inequality Analysis

The Chancellor has raised taxes this year on a scale only exceeded by the two tax-raising Budgets of 1993. With the Budget and spending review next week, the Office for Budget Responsibility (OBR) is likely to upgrade its forecasts for tax revenues, giving him even more revenue coming in. So why has the Chancellor been raising all this cash and what’s he likely to do with the additional windfall? Here are a few things to look out for next Wednesday.

1) Will the OBR upgrade its economic forecasts?

There have been £40 billion of tax rises already this year. The March Budget included an increase in the main Corporation Tax rate from 20% to 25% and a four-year freeze in income tax thresholds, raising £25 billion a year in the long term. The Government’s announcement on 7 September that National Insurance Contribution rates would be raised by 1.25 percentage points from next April to pay for more spending on health and social care raises taxes a further £14 billion a year. This is a significant increase in the size of the state, a scale of reform that dwarfs most Budgets.

An updated set of economic forecasts from the Office for Budget Responsibility will be published alongside the budget next week. Much has changed since the last set of forecasts in March. The most important figure to look out for will be the OBR’s revised estimate of the damage done by Covid to the size of the economy in the long run.

Back in March, this was estimated at 3%. Since then, however, the economy has recovered more rapidly than had been expected. Latest monthly GDP figures show that the economy is already within 3% of its pre-pandemic path with some spare capacity remaining. As a result, other forecasters now think the long run damage from covid will be lower than this, and tax revenues commensurately higher. The Bank of England now believe that the economy will be only 1¼% smaller in the long run than it had expected before the pandemic.

Source: OBR, ONS.

If the OBR shares this assessment, the Chancellor could be in for a windfall in the Budget. An increase in long-term GDP of 1.75% could improve the state of the public finances by £28 billion a year.

It’s possible that the OBR will be less optimistic than other forecasters or doesn’t want to risk its projections swinging too wildly from pessimism to optimism. And by asking the OBR to finalise the forecasts early by not incorporating any data revisions after 24 September, upward revisions may be less dramatic than if the OBR were able to take the most recent positive news on GDP into account.   

Nevertheless, since tax revenues have been more buoyant this year than the OBR expected in March – they’re currently running 6.9% above the forecast level as of September – a significant improvement in the fiscal forecasts seems likely.

Against that backdrop the tax rises announced on 7 September appear surprising. If the OBR’s assessment of the potential of the economy is anywhere near in line with other forecasters’ (and it usually is), the Government could have spent more on health and social care and still met its target to balance the current budget by 2024–25 – which it was just on course to do in March – without clobbering households with the new levy. Why then did the Chancellor choose to do this?

2) A pre-election war chest?

He may choose to simply bank any improvements in the forecast deficit. Given the uncertainties that remain about the strength of the economic recovery, further forecast revisions are likely. In these circumstances, it might make sense to fine-tune decisions about appropriate tax and spending levels later on once the recovery is complete.

This is of course inconsistent with the Chancellor’s previous approach – twice this year he has raised taxes in spite of uncertainty about future tax revenues – but it makes sense politically. It would be much harder for the Government to raise taxes closer to a General Election if tax revenues were to disappoint. And if they didn’t, there would be room to cut taxes just before an election: a prospect that already has the Prime Minister excited.

3) Easing the departmental squeeze?

Alternatively, the Chancellor may decide to spend any windfall. He could choose to exceed the departmental spending limits set out in the March Budget and restated (with the addition of additional health and social care spending) on 7 September. Following £16 billion of cuts to spending plans in last year’s Spending Review and the March Budget, these plans implied tight settlements for departments other than health, schools, defence and foreign aid. On current plans, remaining departments will overall see increases in spending only in line with inflation for the next two years. There is scope for more spending in 2024­­-25, however. One option might be to bring forward these spending rises to allow public services to clear Covid-related backlogs more quickly.

The current plans look very tough to deliver. Several areas of spending seem in particular need of additional funding. It may be necessary to give local authorities additional funding to deliver the social care reforms announced in September. With little of the additional tax revenue being raised by the Levy going towards social care, there is a risk that local authorities will be unable to deliver what has been promised. The Chancellor may therefore choose to top up grants to local authorities, or allow them to raise more from Council Tax to prepare for these reforms.

Other spending areas are also likely to have strong demands for more money. Public transport operators are still suffering a loss of income from increased homeworking which is likely to continue.

The OBR has estimated that this could reduce their income by £3 billion next year and £1.3 billion in 2024–25, which the Government will have to make up to keep services running. And the previously-announced funds for catch-up classes in education were regarded as so inadequate that the Government’s ‘Education Recovery Commissioner’ resigned in protest. Additional funding to help pupils recover lost schooling during the lockdowns is also likely.

In other areas too, the strains of Covid and a decade of tight spending settlements are showing – court closures during the pandemic have caused a record backlog of criminal cases for example – and it is hard to see the government sticking to spending levels as currently planned without incurring some political pain.

4) Cushioning the blow on Universal Credit?

The ‘spending envelope’ only covers spending on public services by government departments. Other spending items including state pensions and benefits sit outside the envelope and are described as ‘Annually Managed Expenditure’. The Chancellor could use some of the windfall to increase spending in these areas.

Most notably, he will be under pressure to make some steps to compensate those who have lost out from the end of the £20/week uplift to Universal Credit rates since the start of October. The Government has resisted this pressure so far, other than introducing a small ‘household support fund’ for those facing hardship. But with ongoing pressure from the Conservative benches for action on this area, and a tough winter of rapidly rising fuel bills ahead, the Chancellor may try to head off a potential rebellion by increasing Universal Credit in some way.

Conclusion

As the reward for all his tax-raising the Chancellor has many options next week. While there are any number of pressing demands for funding, it’s likely that he will choose to bank most of the improvement in the forecasts for the meantime at least, and be on course to run a current budget surplus by the end of the Parliament. That will leave the possibility of pre-election tax cuts if things go according to plan.

Source: TBI calculations using OBR, IFS, HMRC.

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