The run-up to the March Budget has seen the usual flurry of rumours about how much room Jeremy Hunt has for tax cuts and what he might do with it. This time, however, there is also a growing consensus that the current fiscal framework is not fit for purpose – and that we need to talk about spending too.
Even the chair of the Office for Budget Responsibility (OBR), Richard Hughes, has acknowledged that their projections could be described as a “work of fiction”.
Hughes was referring specifically to the lack of detail on the government’s plans for departmental spending beyond the end of the current settlement in 2024-25, after which spending is assumed to continue falling steadily as a share of national income.
This would still allow for some real growth in departmental budgets, so talk of plans for ‘savage cuts’ is misleading. But this assumption must be seen in the context of rising demands for more spending on everything from health and social care to infrastructure and defence.
This is only one of several problems. The current fiscal framework is based on rules that are frequently changed, or gamed in ways that deliver poor economic outcomes. It also places too much weight on forecasts that even the OBR admits are unreliable. We need to have some serious conservations about this as well.
There was at least some good news for the Chancellor this week. Borrowing in the financial year-to-January was £9.2bn less than the OBR had been projecting, with large downward revisions to previous data more than offsetting a smaller-than-expected surplus in January itself.
But this only helps a little. The ‘fiscal headroom’ is the amount by which the government could cut taxes – or raise spending – and still meet its targets for borrowing and debt by the end of the fifth year of the OBR’s rolling forecast period.
These targets are the ‘fiscal mandate’, which requires public sector net debt (excluding the Bank of England) to be falling as a percentage of GDP, and a ‘supplementary target’ that requires public sector net borrowing not to exceed 3 per cent of GDP (also by the fifth year).
Crucially, then, the ‘fiscal headroom’ depends on what the OBR is predicting for borrowing and debt at the end of its five-year forecast horizon, not on the recent past.
My best guess is that the OBR will judge that this number has increased to around £20bn, due mainly to the fall in the cost of government borrowing since the Autumn Statement.
The temptation may be to use almost all this £20bn for another round of pre-election tax cuts, on top of the reductions in National Insurance contributions announced in the Autumn Statement (which took effect in January).
But the law of diminishing returns often applies in politics, as well as economics. Opinion polls suggest that the public are now more worried about the state of public services. Critics will also argue that additional tax cuts would still only offset some of the previous tax increases, and that they may have to be reversed anyway next year given the extra pressures on public spending.
Large tax cuts might carry economic risks too.
The main reason why the UK slid into a technical ‘recession’ in the second half of 2023 was the drag from higher inflation and interest rates. This drag is now fading, with some early signs that the economy is already growing again in the first quarter of 2024.
It is therefore crucial that the Chancellor avoids doing anything that might reignite inflation and encourage the Bank of England to keep rates higher for longer.
So, what to do on tax?
The first decision the Chancellor will have to make is whether to cancel a planned tax hike. The OBR assumes an extra £6 billion in annual revenues by 2028-29 from the Government’s stated policy of increasing fuel duty in line with inflation and the reversal of the ‘temporary’ 5p cut.
Extending the current freeze for another year would not have a large impact on the ‘fiscal headroom’ at the end the five-year horizon, as long as the government maintained the fantasy that this is temporary. But it would at least knock another 0.2 percentage points off CPI inflation in April.
Which other taxes to cut should depend on what exactly the economic benefits are supposed to be – a question which is not asked often enough. ‘Putting more money back into peoples pockets’ and ‘reducing the burden of tax’ are worthwhile objectives in themselves, but still need fleshing out.
If the aim of tax cuts is to stimulate demand in the economy, the support should focus on poorer households who would be more likely to spend any tax savings.
These households would benefit more from ending the freeze on the personal allowance, which would lift more people out of paying income tax altogether, rather than a cut in tax rates. This might also be easier to justify as giving back some of the Treasury’s unexpected windfall from higher inflation.
However, poorer households will already see the biggest gains from the large increases in the state pension, state benefits and the national minimum wage in April.
The reduction in the Ofgem cap on domestic energy bills should be more than enough to take headline CPI inflation below 2 per cent in April too. The Chancellor could still cite this fall as giving the green light for more tax cuts, but the fall in inflation will itself provide another boost to real incomes.
If the emphasis is more on improving the ‘supply side’ of the economy – the incentives to work, create jobs or invest – tax cuts should target the punitive marginal rates faced by households across the income spectrum, not just the poorest.
A good example is the impact of the High Income Child Benefit Charge, which means that some middle-income families will pay more than 70p in tax on every additional £1 that they earn. The ‘squeezed middle’ deserve some relief too.
Tax cuts that improve the productive potential of the economy, as well as boost demand, would be less likely to worry the hawks at the Bank of England.
But either way, the UK’s economic problems clearly run deep, and some welcome tax cuts alone will not fix them. There is an urgent need for pro-growth policies across the board.
This should include regulatory reforms, measures that improve rather than hamper the flexibility of labour and product markets, and serious action to tackle the productivity crisis in the public sector. The latter might allow spending to brought under control without undermining services.
Unfortunately, this will require some unpopular choices – such as easing planning restrictions and fundamental reform of the NHS – which are even more difficult in an election year. We will probably have to make do with a few announcements that might generate some positive headlines – such as 99% mortgages and ‘British ISAs’ – but which only paper over the cracks.
This is an expanded version of an op-ed first published on 24 February by City AM
Plain-speaking Economics 