Speculation is at fever pitch around what might be coming in the Chancellor’s Autumn Budget at the end of the month. So, rather than joining in, this week we’re going to look at what a ‘good’ budget might look like. Obviously, I’m using the word ‘good’ in its most relative sense here. There will be belt tightening, which will be painful. But, if it's necessary, there are better and worse ways of doing it.

To be classed as ‘good’ in this context, the Autumn Budget would have to satisfy three main conditions.

First, it would have to abide by the fiscal rules the government has already set out and has repeatedly said are “iron clad”. Breaching the fiscal rules this early in the parliament with no obvious crisis would send a strong signal to financial markets that the government’s commitment to fiscal discipline was weak and that more borrowing would follow. The result would be a further rise in gilt yields and the interest-rate curve, which in turn would push up financing costs and lead to even more future borrowing.

Second, it should be credible. This means financial markets believe the government can and will follow through on the fiscal plans it sets out. The Chancellor therefore can’t pull every chancellor’s favourite trick of increasing spending in the near-term, followed by promising steep spending cuts or tax rises, which may or – more likely – may not, happen in later years. It also means most of the belt-tightening burden will have to come from tax rises. The government has been unable to get even minor spending restraint through parliament, despite its majority. Unfortunately for all of us, that means a ’good’ budget would result in significant tax rises next year and not at some distant point in the future.

A good budget would also involve increasing the Chancellor’s headroom from the measly £10bn currently to £15bn or even £20bn. For context, previous chancellors left an average of £30bn. A credible budget that signals the government is serious about reducing borrowing would have the advantage of lowering gilt yields, giving a further boost to future headroom.

Third, it should fill the fiscal hole in the least economically damaging way. Given we’ve already established that large spending cuts are pretty much out of the question, that means tax rises. But, not all taxes are created equally. A ’good’ budget would focus on disinflationary taxes. Those are taxes that take demand out of the economy without pushing up inflation.

It would also aim to avoid taxes that disincentivise employment or investment. In practice, that means focusing on taxes like on income and property, and staying away from big increases in duties, employers’ National Insurance Contributions (NICs) and VAT. This is important because disinflationary taxes, which lower demand and inflation, allow the Bank of England (BoE) to cut interest rates. This would offset some of the hit to demand in the economy, lower the government’s financing costs and increase fiscal headroom further. Indeed, the recent fall in gilt yields is partially due to rumours that the Autumn Budget will be disinflationary this time.

Stagflationary tax rises, on the other hand, lower demand in the economy and push up inflation. That increase in inflation costs the Exchequer and also might prevent the BoE from cutting interest rates. That would result in a weaker economy and higher expenditure, offsetting some of the increases in taxes.

What taxes could rise in a 'good' Autumn Budget?

So, in practice what might a ‘good’ budget look like this time? Our latest analysis puts the fiscal hole at around £30bn (see chart below). Taking the above points into account, something like a significant rise in income tax next year, combined with reformed property tax, would be the least economically damaging way of raising the required sums.

There is some scope for increased ‘sin’ taxes, as long as the inflationary effects are offset elsewhere. The Chancellor should also go above and beyond filling the £30bn black hole and increase her fiscal headroom by £5bn to £10bn. This means that the total package could approach £40bn. That would avoid another policy-induced surge in inflation and would show credibility to financial markets at the cost of slower growth next year.

Of course, this would be a breach of the manifesto commitments not to raise income tax, NICs or VAT. But, the Chancellor will have to choose between doing the economically sensible thing this time around or putting politics ahead of economics again. As former European Commission President and former Prime Minister of Luxembourg Jean-Claude Juncker said of politicians: “We all know what to do, but we don’t know how to get re-elected once we have done it."

Get it right, though, and the result could be some short-term pain that is offset by lower interest rates, lower gilt yields, a drop in inflation and a significant increase in future headroom that means an end to the constant confidence-sapping speculation about future tax rises. That would set the stage for a sustained recovery in 2027. Get it wrong and this won’t be the last major tax-rising Autumn Budget this parliament.

MPC: rates on hold in November, but cuts to come

We think the Monetary Policy Committee (MPC) will vote 6-3 to keep interest rates on hold in November as it moves away from its recent path of cutting rates at every other meeting. There are a few key reasons for this.

First, inflation is still 3.8%, which is almost double the MPC’s target. We think the MPC will want to play it safe and ensure inflation comes down a little further before pushing ahead with further rate cuts.

Second, the MPC will be watching the upcoming Autumn Budget just as closely as the rest of us. Members will want to see what it has in store before pushing ahead with rate cuts.

The good news is that the government seems to have learnt lessons from the last Autumn Budget when a range of stagflationary tax hikes, such as employer NICs and duties, pushed up inflation. It will likely instead focus on deflationary tax hikes, which will help to take the sting out of inflation.

What’s more, inflation remained stable at 3.8% in September instead of peaking at 4% like the MPC, analysts and commentators had expected. This will help to reassure the MPC that the disinflationary process continues.

With inflation undershooting the MPC’s forecast, signs that private sector pay will do the same and with talk of a more disinflationary Autumn Budget than we’d previously expected, we grow increasingly confident that future rate cuts are on the way.

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