UK: CAUTIOUS BUDGET SETS STAGE FOR PRE-ELECTION BOOST

Today Chancellor Rishi Sunak unveiled a mostly cautious budget. Following the better-than-expected economic performance since his previous big announcement in March, the government is on course to hit its updated fiscal rules despite a net increase in spending of c£21.bn (c0.8% of nominal GDP) next year that fades over the medium-term. By not fully spending the windfall from the better economic backdrop, and due to the fact that the OBR based its projections on outdated GDP data (see below), Sunak has ample scope for fiscal easing ahead of the next election to be held no later than May 2024. He signalled this already towards the end of his speech in the House of Commons ‘by the end of the parliament, I want taxes to be going down’.

The broad strokes of the budget are in line with our preview. Sunak has turned his attention towards the government’s longer run economic objective – to lift UK growth potential by ‘levelling up’ laggard regions. The plan involves a sizeable increase in taxes as a percent of GDP to return borrowing to a sustainable level while funding a much-needed multi-year programme of public investment as well as higher current expenditure as a % of GDP. The government seems to be betting that higher taxes will be less of a drag on demand and on the incentive for businesses to invest than the additional public investment may add to growth. A risky bet, in our view. Since most of the policies announced today had been trialled in the press in recent days, the market reaction to the speech was muted – most of the news had been priced in ahead of the speech.

Economic upgrades – significant near-term upgrades, but no change to longer run outlook (Table 1)

The OBR has sharply revised up its expectations for 2021 growth following the better-than-expected performance since its previous projections in March – Chart 1. The OBR now expects real GDP to expand by 6.5% in 2021, versus 4.0% in March. Despite the various announced measures to raise public investment, encourage higher private investment and to support R&D, the OBR has not upgraded its still pessimistic view on the UK’s longer run economic prospects. Growth remains at around the 1.6-1.7% rate by the end of the forecast. The OBR’s detailed forecasts can be found here OBR Economic and Fiscal Outlook – October 2021.

The OBR has cut its estimate of the long-term scarring effect of the COVID-19 crisis on real GDP from 3% to 2% - Chart 2a. Interestingly, the OBR has revised up its projection for the size and trend of nominal GDP to its pre-COVID March 2020 projection. The lower projected level of real GDP over the forecast horizon now looks entirely due to a higher projected price level. The OBR now looks for inflation to peak at close to 4.5% early next year, more than double its previous projection – 3a. In line with other global policymakers and central banks, the OBR still expects the current inflation surge to be transitory. Headline inflation returns to its previous projection of 2% by 2024. With little change to its medium-term call, the OBR also projects a smaller peak and shallower near-term profile for unemployment following the end of the furlough scheme on 30 September – Chart 3b.

IMPORTANT TECHNICAL NOTE

According to the OBR ‘both outturn and forecast are based on the vintage of nominal GDP data that was available when we closed the pre -measures forecast, so do not reflect upward revisions in the latest Quarterly National Accounts.’ Discussing the impact, the OBR notes ‘The latest Quarterly National Accounts, released after our pre-measures forecast closed, revised up cumulative real GDP growth since the pre-pandemic peak by 1.1 percentage points’.

Fiscal outlook – a return to sustainable borrowing, and a new set of targets

Big picture unchanged: today’s announcements reiterated the UK government’s plan to raise public expenditures as a % of GDP to levels not seen since the 1980s. This rise will be financed by sizeable tax hikes plus modest borrowing. Roughly 1/3 of the planned rise in total expenditure from c39% of GDP in 2018/19 to c42% over the medium-term will go towards a much-needed rise in public investment while the remaining 2/3 will go towards financing higher current expenditure. As the OBR shows, unlike after the Financial Crisis, the UK is not on track for any serious austerity based on current plans – Chart 5. Virtually all of the improvement in public borrowing comes from the economic recovery.

The budget did not involve any big announcements that materially change the economic outlook for the UK. Instead, the chancellor offered a smorgasbord of modest but mostly sensible giveaways. These included reforms to welfare to ease the cost of living crisis from higher energy prices, cuts to business rates for the retail, hospitality and leisure sectors and increased R&D expenditure. The full list of policies can here found here - HM Treasury Autumn Budget and Spending Review 2021.

Today’s announcements - Table 2 – should add to borrowing by less the economic improvements mechanically improve the government’s fiscal position via higher tax revenues less lower automatic spending on welfare and the like. As a result, the OBR forecasts lower borrowing (Chart 4a) and debt (Chart 4b) as a % of GDP – Table 3. The OBR projects that borrowing peaked in 2020-21 at a peacetime high of 15.2% of GDP (£320bn). For this fiscal year it expects borrowing to fall to 7.9% of GDP. Thereafter, the OBR projects borrowing to decline to 3.3% of GDP in 2022-23, with gradual sustained falls thereafter – to 1.5% by 2026-27. After peaking at 98.2% of GDP this year, the OBR projects that public sector net debt will fall to 88% by 2026-27.

The Chancellor has proposed a new set of fiscal rules

They will take legal effect only after they are debated and voted on in parliament. The proposals are as follows:

A new mandate:

‘To have public sector net debt excluding the Bank of England as a percentage of GDP falling by the third year of the rolling forecast period’;

With three supplementary targets:

‘To balance the current budget by the third year of the rolling forecast period.’

‘To ensure that public sector net investment does not exceed 3 per cent of GDP on average over the rolling five-year forecast period’

‘To ensure that expenditure on welfare is contained within a predetermined cap and margin set by the Treasury. (The cap continues to exclude the state pension and payments that are most closely linked to the economic cycle.)’

On the whole, the new dynamic rules make sense. By setting rules based on the three-year forecast of the independent budget watchdog, instead of setting fixed targets at a given date as some previous chancellors had chosen to do, the new rules provide scope for fiscal policy to temporally adjust to gyrations in the business cycle. As a result, they are less likely to be scrapped or revised if and when economic performance disappoints.

Guaranteed upside at the next budget

The OBR projects that the government will meet all of its newly proposed rules – Table 4. However, as mentioned, the forecasts do not include the latest upward revision to GDP. If the OBR scored the government’s policies versus the latest vintage of GDP it would show that the government is on track to easily hit all of the its target with room to spare. Unless the economy really disappoints over the next year, the next set of projections by the OBR (which will include the latest GDP vintage) virtually guarantee rosy upgrades to the fiscal outlook which can create the space for pre-election giveaways in 2023.

Kallum Pickering
Senior Economist, Director

Mobile +44 791 710 6575

Phone +44 203 465 2672

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