The week ahead: Spending Review to spotlight tough fiscal position

The Spending Review, launched on Wednesday, will be the focus of this week. To be clear, the job of the Spending Review is to distribute the cash that was announced at the Autumn Budget back in October. We’re very unlikely to get any new announcements on additional taxes until after the summer. But, the announcements will shine a spotlight on just how tight the fiscal position is. It will probably provoke even more speculation about future tax hikes and could cause a spike in gilt yields if the markets take it badly.

To recap, the government announced a significant increase in government spending at the last budget. Day-to-day government spending will grow at about 1.8% on average in real terms (adjusted for inflation) over the next five years. That’s about twice the rate the previous government planned.

However, those funds won’t be distributed evenly, either by department or over time. After a 4% splurge in spending growth this year designed to clear some significant backlogs in the NHS, justice system and elsewhere, spending will rise by a more sedate 1.3% on average over the rest of the parliament.

Once we factor in the plans we already know about, such as big increases in health spending and raising defence spending to 2.5%, the outlook for those “unprotected” departments such as policing and transport looks much tougher and may even result in real-term budget cuts.

A tight balancing act on when and where to spend

One of the biggest questions is whether Chancellor Rachel Reeves will put a date on the government’s ambition to raise defence spending to 3%. Given the fiscal pressures we think this issue will probably be kicked into the next parliament, but any increase in defence spending will have to be paid for either by cuts elsewhere or higher taxes because the headroom against the fiscal rules she set is too tight to allow for more borrowing.

The risk here is that if the future budget cuts for unprotected departments look too large, then the markets will view them as undeliverable and assume that taxes will have to rise, or worse, higher borrowing. That could cause gilt yields to rise further.

Assuming the chancellor announces no extra cash on Wednesday, redistribution between government departments doesn’t have much short-term economic impact. The biggest impact, over the longer term at least, will come from how the government allocates investment spending. Indeed, capital spending is now set to rise by an average of 2.2% over the next five years, although, again, these are heavily front-loaded. That’s important for the economy because academic literature suggests a 1% increase in capital spending can boost long-run GDP by 2% as better infrastructure boosts productivity growth. We’ve already seen a raft of announcements on new transportation projects and housing.

However, the focus on defence spending poses a risk here. Whereas building a new road, railway or even housing provides economic benefits long after the building is finished, new tanks or more munitions does not.

It is not always the case that defence investment offers no productivity gains. Spending on new technology that makes its way into the civilian sector can offer a substantial boost to productivity and is often cited as a reason why productivity growth in the US has been so much stronger than elsewhere. But, the recent defence review made it clear that a substantial amount of investment will have to go to standard military hardware. That means the surge in investment spending may not have the same positive multiplier effect on the economy as it might normally do, although it does offer huge potential for a flagging UK manufacturing sector.

Overall, we aren’t anticipating that the spending review will alter our forecasts for economic growth over the next few years. However, it will shine an even harsher spotlight on the chancellor’s tough fiscal position, especially since the recent U-turns on benefits spending and rising gilt yields. There is a chance that if the spending plans look unbelievable, then gilt yields will rise further. Indeed, with no adjustments on the spending side, Reeves could be forced to find another £20bn to maintain the current headroom against her fiscal rules come the autumn.

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