The week ahead: How will firms manage rising NICS costs?

One big uncertainty over our forecasts for the economy next year is how businesses will deal with the NICs increase. We’ve assumed there is some impact on profits, inflation and wage growth, but if most of the adjustment falls on only one of these channels then it could quite significantly change the economic outcome. That creates a risk to our view that interest rates will fall at a quarterly pace in 2025. 

The problem with rising NICs costs

The Autumn Budget contained a number of measures to raise taxes, the most significant of which was the increase in NICs, which raises about £25bn a year for the first few years. That is essentially an extra £25bn of costs that firms have to deal with. 

There are three broad options to businesses; accept lower profits, raise prices or reduce labour costs elsewhere. 

Lower profit margins

This is probably one of the most likely options in the short-term. However, the private sector profit share has already fallen sharply recently, meaning that firms margins are squeezed and there probably isn’t a lot of room to absorb a significant increase in costs. This raises the chances that firms try to recoup or offset the increase in costs. 

Lower labour costs

The most obvious way that firms might try to offset the increase in costs is by reducing employment and hours worked. There isn’t a good relationship between employment costs and employment or hours worked. Indeed, even big increases in the national minimum wage tend to have a negligible impact on the labour market. But modelling by the OBR suggests that it will reduce employment by 0.1% – in a worst case scenario where firms try to recoup most of the increase in costs through lower employment then the unemployment rate could rise to close to 5%.

Alternatively, firms could look to recoup the costs by passing on lower wage growth to employees. This will take time as wages tend to be set annually, but this is a less disruptive way of offsetting the increase in taxes. Indeed, this is a key reason why we expect wage growth to slow over the next year, which when combined with higher inflation, means we aren’t expecting real wages to rise much in 2026.

Higher prices could be Higher prices for consumers

The final option is to pass on as much of the costs as possible to consumers. We already expect firms to pass on some of the increase in costs, that’s one of the reasons why inflation is likely to hit 3% in early 2025. But since growth is likely to start to pick up next year firms could look to take advantage of higher demand and pass on costs. If, for example, firms passed on 75% of the increase in costs it would mean inflation peaking at 3.5% rather than 3%.

Implications for the Bank of England

This presents a bit of a dilemma for the Bank of England (BoE). At the minute the Bank is assuming there is a roughly equal distribution between profits, prices and wages. But if more of the impact were to fall on prices, that would push inflation higher and mean fewer rate cuts. Alternately, a big hit to employment or wages would probably mean a weaker economy, lower inflation and more rate cuts. This presents some risks to our forecast that inflation rises to just 3%, rates fall to 3.75% and growth accelerates to 1.8%. 

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