Spring statement – spending cuts now, tax rises later?

The chancellor’s headroom has most likely been wiped out by a combination of higher interest rates and anaemic growth. The most obvious solution to this is to announce some backloaded spending cuts.

Indeed, we’ve already seen the government announce £5bn worth of cuts to the welfare bill. That will steady the ship for now, but the broader challenge will be how to deal with a significant increase in spending requirements – especially on defence – in an environment of higher interest rates and weak growth. A further rise in taxes at some point therefore seems likely.

Where has all the headroom gone?

In the Autumn Budget, the chancellor left just £9.9bn of leeway against her main fiscal rules. These say the government’s day-to-day spending must be funded by tax receipts and that national debt must fall as a share of the economy by the end of the fiscal year 29/30.

Since then, borrowing has overshot the OBR forecast by almost £13bn in the 24/25 fiscal year. Gilt yields have risen by about half a percent and growth has fallen far short of the OBR’s forecast, meaning more public money tied up in financing the gap between the UK government’s income, borrowing and expenditure.

What matters, though, is how much the OBR expects these recent developments to persist through to the end of the decade. This is when the fiscal rule really bites. Here we think the OBR will downgrade its near-term growth forecasts, but pencil in some catch-up growth later on, leaving the size of the economy at the end of the decade broadly unchanged. 

However, higher interest payments are likely to be more persistent. This alone will probably add almost £9bn to borrowing in the 29/30 fiscal year. Of course, much depends on the OBR forecasts.

Even minor changes to the underlying assumptions can lead to significant changes in borrowing years down the line. 

Our best guess right now is that the OBR will likely add about £10bn to borrowing by the end of the decade. 

What can the chancellor do about it? 

Rachel Reeves broadly has three options. First, would be to rewrite the fiscal rules. Given the current iteration is the UK’s eighth in the last ten years – and the significant changes to the global economic landscape since January – the chancellor’s constraints arguably don’t have to be set in stone. 

But, rewriting the rules so soon after having announced them would significantly undermine their credibility in financial markets. What’s more, the chancellor and the Treasury have been adamant they will not change the fiscal rules. 

The second option is to raise taxes. The obvious option here would be to freeze the income tax and National Insurance Contribution thresholds for another two years. This would raise an additional £10bn a year by 29/30, according to the IFS. It would, however, be breaking the very sensible pledge to only have one fiscal event a year and would drag more people into paying tax – an issue that is becoming more politically contentious. 

The third option is to reduce future spending commitments. We have already seen curbs on welfare payments that should save about £5bn a year by the end of parliament. Recent press reports suggest another £5bn will be shaved off department budgets. The chances are these will be unspecified cuts backloaded toward the end of the decade. This wouldn’t have much impact on the economy or the Bank of England over the next couple of years. However, it would bring into question the “gaming” of the fiscal rules and whether the government’s spending plans are credible. Even so, this seems to be the most likely choice.

The bigger picture

The risk is that this is another exercise in kicking the can down the road. The OBR will, eventually, be forced to cut its heroic productivity growth forecasts, which will have a huge impact on borrowing. What’s more, defence spending will have to rise to 3% of GDP or higher. All of this will happen in an environment where gilt yields are likely to remain elevated. 

The inevitable conclusion is that there will have to be either much bigger cuts in welfare spending or higher taxes at some point. The government may be able to continue gaming the fiscal rules for a while yet, but eventually those hard decisions will have to be taken. 

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