07 July 2022
The replacement of Rishi Sunak as Chancellor of the Exchequer with Nadhim Zahawi probably means fiscal policy will be looser for the rest of this year than we previously thought. However, the new Chancellor will have to be careful that any extra spending or tax cuts don’t feed inflation and prompt the Bank of England (BoE) to raise rates by more, cancelling out any positive benefit to the economy.
Sunak and Johnson have reportedly disagreed over the right way to run the country’s finances and support the economy over the past year. While Johnson has wanted to provide more support to the economy through the cost-of-living crisis, Sunak has reportedly wanted to prioritise getting the fiscal deficit under control and was concerned that additional spending would result in higher inflation and faster interest rate rises, which would widen the deficit even further. Indeed, in his resignation letter to Boris Johnson, Rishi Sunak stated that ‘our approaches are fundamentally too different’.
Just this morning, Zahawi stated that his main priority was to ’rebuild and grow the economy’, which suggests he may be more amenable to lower taxes or higher spending. While it is much too early to know how big any fiscal loosening might be, there are three areas the new Chancellor is likely to focus on.
First, more cost-of-living support. Inflation is set to hit 10% or even 11% in October, as households experience another sharp rise in their energy bills. Even taking account of the £37 billion of support the government has already announced, we think the hit to real incomes will push the economy perilously close to recession this year. While we expect the economy to avoid a technical recession, which is two consecutive quarters of contraction, GDP is unlikely to rise between 2Q and 4Q.
Second, corporate tax strategy. Business investment in the UK has lagged behind other similar for years. The uncertainty ushered in by Brexit is partly to blame, but even before that the reduction in corporate taxes failed to deliver the rise in business investment many expected. Johnson has made clear he wants to cancel the rise in corporation tax (from 19% to 25%) and it’s possible the new chancellor shares the same view. Indeed, Zahawi hinted at cuts to corporation tax, saying: ‘I want to make sure we’re as competitive as we can be while maintaining fiscal discipline.’
Third, income and national insurance tax. Johnson has made it clear that he wants to cut taxes. Sunak had already promised to cut the basic rate of income tax to 19%, from 20%, in 2024-25, after raising national insurance taxes this year. We wouldn’t be surprised to see that the cut in income tax brought forward.
Looser fiscal policy would be a welcome support to an economy on the brink of a recession. But if the BoE thinks that additional support will just stoke inflation then it will be more likely to raise interest rates more quickly, which could cancel out any broader economic benefit. We’re currently expecting interest rates to peak at between 2.5% and 3.0% in the middle of next year. More government spending would make the upper end of that range more likely.