Things are looking up … but beware the budget mammoth

After a rocky start, things have been going the government’s way. Last week’s drop in inflation to 1.7 per cent paves the way for further interest rate cuts from the Bank of England, starting next month. And although official labour market figures are clouded by data uncertainty, the unemployment rate has fallen to 4 per cent.
Economists have something called the misery index, which is calculated by adding the unemployment and inflation rates together. A highly inventive American economist, the late Arthur Okun, was responsible for this index, as he was for the two-quarter definition of recession.
With the latest figures, the misery index is at its lowest level for well over three years, and probably longer, because unemployment figures during the pandemic were distorted by furlough.
Low inflation and low unemployment are good news for the government, though neither yet reflect its efforts, as former chancellor Jeremy Hunt pointed out again in questioning Labour’s “worst-ever economic inheritance” claim.
The improved picture on inflation and unemployment, and the fact that growth appears to have continued at a reasonable pace into the second half of the year, were not the only positives.
The International Investment Summit at London’s Guildhall was successful, judging by the mood music. I know the claimed £63 billion of new investment included much that had been previously announced or was always going to happen, but it was worth announcing and produced lots of warm words about doing business in Britain.
A government consultation document, Invest 2035: The UK’s modern industrial strategy, was also well received, though some feared that its focus on eight highly productive sectors — advanced manufacturing, clean energy industries, the creative sector, defence, digital and technologies, financial services, life sciences, and professional and business services — meant others would miss out.
Even so, that the government is serious about pushing forward with its industrial strategy is welcomed by businesses. There has also been some relief that ministers were in listening mode when it came to enhanced employment rights. After pre-election concerns that this would turn the UK into a low-productivity version of France, the government appears to have steered a middle course between the demands of the unions and the worries of firms.
So, whether or not it’s true that things can only get better, they are looking up. That is until you consider the elephant in the room, Rachel Reeves’s first budget in just over a week’s time. Elephant may not do it justice, with much of the speculation suggesting something more like the extinct mammoth Mammuthus meridionalis, which was bigger than modern elephants.
This elephant/mammoth needs a bit of explanation. You will have read or heard that there is now said to be a £40 billion job for the chancellor to do in her budget, by raising taxes or limiting public spending. That figure, which is not being denied by anybody close to the process, may change, as sometimes happens. Two weeks before the last Tory budget in March, there appeared to be no room for tax cuts … then suddenly there was.
We are in a different time now, though, and the only question is by how much taxes need to go up. Before getting into that, let me try to explain the figures.
You may remember that just after she took over as chancellor, Reeves, with the help of Treasury officials, identified a £22 billion “black hole” in the public finances. Now, just three months on, the talk is of £40 billion. How did we get from there to here?
The answer, as I have tried to point out before, is that they are different black holes. The £22 billion applied, as Reeves made clear, just to the current 2024-25 fiscal year. It reflected an element of “scorched earth” spending by the previous government, including higher Home Office expenditure and a delay in accepting the recommendations of the public sector pay review bodies.
It was a signal from the new chancellor that this year’s public borrowing is likely to turn out higher than was predicted by the Office for Budget Responsibility (OBR) in March, despite some measures announced by her to keep it down. That picture has been confirmed by the monthly statistics. The OBR notes that borrowing in the first five months of the current fiscal year was £6.2 billion higher than would be consistent with its forecast.
The £40 billion, as noted, is a different black hole — one that was always expected during the “conspiracy of silence” on the issue that characterised the election campaign. This one arises from the point that the public spending plans built into official projections for the budget deficit were unrealistically tight, and that future revenues had been reduced by Tory pre-election tax cuts.
This was the context in which the Institute for Fiscal Studies (IFS) said earlier this month that £25 billion of tax increases or spending cuts would be needed to put the public finances on a sensible and sustainable track. Some £9 billion of these tax rises were set out in Labour’s election manifesto, leaving £16 billion to find.
This external estimate of £25 billion has, it seems, become £40 billion during the budget process, both because the pressures on the public finances are greater than they look from the outside, and because the chancellor is said to want to meet her most important fiscal rule — only borrowing to fund investment, not day-to-day spending — by a reasonable margin, not a whisker.
This would mean, using the £9 billion figure, that new tax increases or spending cuts, mainly taxes, would need to be just over £30 billion, not £16 billion. That is a lot, particularly when increases in the main tax rates — income tax, national insurance, VAT and corporation tax — have been ruled out.
Increasing employers’ national insurance (NI), by extending it to firms’ pension contributions, gets you about halfway there, though sparking a debate about breaking manifesto promises. A strict reading would suggest Labour did not rule out extending the NI base, though that will not stop the outcry.
As for the rest, left-of-centre think tank the Institute for Public Policy Research (IPPR) has suggested that £14 billion could be raised from equalising capital gains tax and income tax rates — and it has drawn the support of a few entrepreneurs in saying so. They argue that they were not driven by the prospect of future capital gains in setting up their businesses.
The Centre for the Analysis of Taxation says the UK could be missing out on more than £4 billion of revenue by not having an “exit tax” for capital gains — something that all other G7 countries, except for Italy, have.
It also points out that a generous system of reliefs means most estates liable for inheritance tax pay it at relatively low rates. The effective rate on estates worth over £30 million is only 12 per cent, while one in six estates valued at more than £10 million pay inheritance tax at a rate of less than 4 per cent.
This is the territory in which the chancellor will be operating as she tries to make up the numbers. Getting there without introducing further distortions and disincentives into an already over-complicated tax system will be far from easy. These black holes are easy to create but hard to fill.
PS
How big a risk is the chancellor’s plan to borrow more to fund extra public investment? A new analysis, based on the Liz Truss-Kwasi Kwarteng “mini” budget of two years ago, suggests it would be wrong to worry too much.
“The role of borrowing in the rise of gilt yields during the Truss episode and some possible implications”, by former Bank of England monetary policy committee member Sushil Wadhwani, is published on the VoxEU website. He notes that the yield, or interest rate, on 10-year gilts — UK government bonds — rose nearly 3 percentage points, 288 basis points, between early August and late September 2022. Yields were also rising, however, in countries not under Truss’s leadership, and this international rise accounted for about half the increase.
Of the rest, significant factors were the then government’s questioning of the institutional framework, including the independent Bank and the OBR. The forced pension fund deleveraging, which arose from liability-driven investment (LDI) sales, was also a factor.
As for the bigger deficit implied by the mini budget, he estimates that it accounted for less than a quarter, 68 basis points, of the increase in yields. Wadhwani emphasises that his research in no way rescues the reputation of the Truss episode; it shows instead that when you attack the institutions that provide economic stability, you will suffer the consequences. Reeves has made a point of supporting those institutions.
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