Hunt is walking a fiscal tightrope – here’s what he should do in the Autumn Statement
If you think you clearly comprehend the state of the UK’s public finances, then you don’t understand what is really going on.
This week’s Autumn Statement by the chancellor may create more bafflement. It will be an object lesson in squaring circles. He must keep the financial markets onside, placate the fiscal watchdog and make an attempt to enthuse his own MPs with a view to pleasing the voters in the coming general election.
Let’s begin with the good news: despite the negative influence from increased debt interest payments, the Office for Budget Responsibility (OBR) is likely to forecast this year’s borrowing to be some £16bn lower than it thought in March. This prospect is stimulating Conservative backbenchers’ hopes for tax cuts, if not now then at least in the budget next March.
But the reality is much more complicated. The gods at the OBR are difficult to please. Having under-estimated the performance of the economy this year, the OBR is likely to reduce its forecasts for 2024 and 2025, with real GDP in 2027/28 forecast to be no higher than it envisaged back in March.
Even so, the level of nominal GDP will be a fair bit higher than the OBR previously thought because of higher inflation. This is important because tax revenues are related to nominal GDP.
At this point, you could be forgiven for feeling a bit confused. Isn’t inflation supposed to be a bad thing, including for the public finances? After all, it increases the interest payments on index-linked gilts, which make up about a quarter of all government debt. This is true but it means that about three quarters consists of debt whose interest payments are not tied to inflation.
More importantly, whereas tax revenues go up with higher inflation, the spending totals for government departments do not. They are set in the Spending Review in nominal terms for a few years ahead. This means that inflation erodes the real value of these spending totals – unless the chancellor intervenes to increase the planned totals to compensate for inflation. If he did this, then most of the advantage to public finances from higher inflation would be nullified.
If I were Jeremy Hunt, I wouldn’t increase the spending totals. Implicitly this would be reducing government spending in real terms in order to make room for tax cuts. Given that the tax burden is at a post-war high and government spending has ballooned, from a traditional Conservative standpoint this sounds like no bad thing.
Provided that the current chancellor eschews increases in government spending, then the OBR is likely to acknowledge that in five years’ time, there will be about £50bn of leeway to meet one of the fiscal rules – namely that borrowing should be no more than 3pc of GDP.
The trouble is that Hunt is also bound by another fiscal rule, namely that the ratio of debt to GDP should be falling in five years’ time. He will probably be deemed by the OBR as likely to meet this rule also, but with only some £12bn to spare. So, scope to reduce taxes by £12bn you might think? But chancellors tend to hold something in reserve in case of nasty surprises and this amount of leeway is extremely low by normal standards. Since 2010, the average has been £25bn.
Yet this fiscal rule is bizarre, especially because it says nothing about the level of public debt. The OBR will probably acknowledge that the ratio of public debt-to-GDP is already lower than it previously forecast. It will probably say that in 2027/28, on the underlying measure (don’t ask!), debt will amount to about 88pc of GDP, which is some 6pc of GDP lower than it forecast in March. This is a fair bit lower than the equivalent ratios for the US and France, never mind Italy, Greece and Japan.
So why not ditch this arbitrary fiscal rule to allow scope for tax cuts? There are good reasons not to.
Firstly, this would go down very badly with the financial markets. They would deem it to be Truss/Kwarteng Mark II.
Secondly, as both the PM and chancellor have stressed, inflation remains too high and big tax cuts would hinder the efforts to force it lower. In reality, it is these concerns, rather than the fiscal rules, that are constraining the scope for tax reductions.
These concerns are thoroughly understandable. The uncertainties and dangers besetting the public finances remain huge. The debt ratio is also still extremely high. Only 5 years ago it was 72.3pc, compared to 87pc this year. Moreover, last year government debt interest payments amounted to 4.4pc of GDP and, by 2027/28, they may still be almost 4pc of GDP.
It is true that there isn’t one single measure of public indebtedness and there is some room for interpretation. But if there is a major adjustment to be made to the published debt figures it is upwards – to reflect the huge level of unfunded public sector pension obligations.
The way out of this mess is through higher growth and a major component of stimulating growth is through lower taxes. On that point, Truss and Kwarteng were right. But that is the easy bit. The hard bit lies with getting from here to there. If you lose the confidence of the financial markets, the debt dynamics are frightening.
That said, bearing in mind the recent fiscal improvement, the chancellor would surely get away with a small tax giveaway of perhaps £10bn. That would allow him to reduce inheritance tax and make some favourable tweaks to business taxes, either this week or next March.
Beyond that, however, the only sensible way forward lies with very tight control of government spending. Mrs Thatcher and her senior ministers clearly understood this. But the modern Conservative Party does not want to acknowledge it. It will be interesting – in the sense of the apocryphal old Chinese curse, “may you live in interesting times” – to observe how the Labour Party grapples with this acute difficulty should they triumph in the next election.
Roger Bootle is senior independent adviser to Capital Economics
