Ready for a shot in the arm? Back in July, we highlighted the upside risks to medium-term UK economic growth from a likely fiscal stimulus. Two weeks ago, we made this our base case and raised our 2020 forecast to 1. 8% (from 1. 3%) and our 2021 call to 2.1% (from 1.8%).
 | Latest polls continue to point to a victory for Prime Minister Boris Johnson at the 12 December election. His Conservatives maintain a c11-point – five-poll average – lead over Labour after the first week of campaigning. The Conservatives are currently polling at 40%, up from c38% before the campaign started. The sustained lead after the first week is significant. Polls often change quickly once elections are called and voters begin to consider the issues more carefully. Separately, Brexit Party leader Nigel Farage has pledged not to field any candidates in constituencies that the Conservatives won in 2017. That reduces the risk that the Conservatives could lose marginal seats. |
| Johnson continues to pledge an orderly Brexit on 31 January 2020 based on his renegotiated deal. His party, including the hardline eurosceptics, continues to back him and his deal for an orderly Brexit. Reduced uncertainty and a rise in confidence following an orderly Brexit is a necessary condition for any material uptick in U.K. economic activity, in our view. |
| Recent data suggest that the downturn in global production and trade seems to be bottoming out. Survey measures of expectations have turned up. More importantly, the two big risks to the outlook – an escalation of the US-China trade war and a hard Brexit – seem to be contained. The UK is a medium-sized open economy and is thus highly exposed to global headwinds and tailwinds alike. Even with a big fiscal stimulus at home, the UK would struggle to rebound to above its potential growth rate for a while if the global backdrop remains soft. |
Johnson and his Chancellor Sajid Javid turned on the spending taps as soon as they entered office in July. Real government spending is now accelerating at its fastest rate since before the financial crisis (Chart 1). For the first time in a decade, government spending is rising as a percentage of GDP. This uptick marks the end of austerity in the UK and is a sign of what is around the corner. In the Spending Round 2019 on 4 September, Javid announced the biggest rise in real day-to-day government spending in 15 years. For fiscal years 2019/20 and 2020/21, real government spending will rise at an average annual rate of 4.1%, with planned increases in health, social care, education, crime and policing. Public sector gross investment is set to rise by an average annual rate of 5.6% over the same period.
Shifting the goal posts (and making them bigger)
Javid has scrapped his predecessor Philip Hammond’s fiscal rules. Whereas the old rules included keeping public sector borrowing below 2% of national income in 2020-21, and balancing the budget by the mid-2020s, the new rules give much more scope to borrow for spending and investment. Javid plans to:
| 1. | balance the current budget (ie ex-net investment) by the middle of next parliament (2022/23); |
| 2. | limit borrowing for investment to 3% of national income; and |
| 3. | keep costs of debt servicing below 6% of tax revenues. |
Whether Javid will manage to stick to his rules remains to be seen. It is normal for UK chancellors to set such rules and then later break them or change them whenever it seems politically convenient. In our view, the so-called “rules” merely signal the direction of fiscal policy, which Javid plans to loosen significantly to allow for more borrowing. Javid thus marks a major change from the previous two Conservative Chancellors – Hammond and George Osborne before him – who set much stricter limits on borrowing while bringing down the public sector deficit gradually. After falling from a peak of 10% in 2009, the public sector deficit dropped to below 2% since 2018. Under Javid, we expect the deficit to begin moving towards 3% again.
More investment spending and modest tax cuts
We cannot yet be certain about the precise mix of potential spending and tax cuts under a new Conservatives government. For that, we have to wait for Javid to present his first budget – probably in spring 2020. For now, our projections are based on the policy pledges announced so far and our best guesses of what else could be in store given the new fiscal rules.
Last week, Javid announced plans for an extra £20bn per year in investment spending over the next parliament. Earlier this year, Johnson pledged in his Conservative leadership campaign to increase the higher-rate threshold for income taxes to £80,000 and to raise the threshold for national insurance (NI) insurance, which currently stands at £8,632. The IFS calculates that the change to income tax would cost £9bn pa. It also calculates that raising the threshold for NI to the current personal allowance level for income tax (£12,500) would cost £11bn pa.
While we expect the announced investment spending to come through, based on the Office for Budget Responsibility’s (OBR’s) estimate back in March of a current budget surplus of £37bn by 2022-23 (ie the middle of next parliament), the scope for tax cuts looks more limited.
The IFS calculates that the latest Spending Round measures will reduce the projected 2022/23 surplus by £15bn. Separately, reclassifications and methodological changes that will apply to the next budget calculations will reduce the projected current budget surplus in 2022/23 by a further £18bn.
Probably, the OBR will upgrade its economic forecasts at the next budget if Brexit is sorted by then and the Conservatives win the election. The March projection for average real GDP growth of 1.5% through to 2023 is a little on the low side (say, by 0.1-0.2ppt), in our view.
Given the likely cash constraints, Johnson will only manage to put through one of his tax cut pledges. In our view, he will probably look to raise the threshold for NI. First, it is politically advantageous – raising the NI threshold would help the least well-off in work by much more than raising the threshold for the higher rate for income tax. It is among the low-income groups that the Conservative Party tends to struggle for support. Second, it makes more economic sense if the aim is to stimulate spending and growth. As low earners have the highest propensity to consume, raising the national insurance threshold will have a higher multiplier than tax cuts for high earners. It would stimulate demand by more. Tax cuts for the well-off could simply lead to higher savings.
Relative to our initial expectations, on balance the plans look slightly better
The proposed size of the planned fiscal stimulus is roughly in line with the assumptions we made when we upgraded our economic calls on 30 October. However, the stimulus is likely to be more focused on investment than we had initially anticipated and will probably include less in terms of tax cuts. On balance, this would be positive.
The UK is in dire need of more investment spending to deal with its persistently weak productivity growth over the past decade (Chart 2). The stagnation of private business investment since the Brexit referendum has further weighed on productivity gains (Chart 3). As the UK economy is already close to full capacity, adding to supply and capacity rather than simply lifting demand can help to contain the inflation risks from a pro-cyclical stimulus. And critically, unlike debt-financed tax cuts that would simply raise current demand, spending borrowed money on public investment raises the asset side of the public sector balance sheet – this partly makes the borrowing more sustainable.
Stronger growth for a while? Yes, but at a price
In our view, a fiscal stimulus at this stage of the economic cycle is misguided and raises the existing risks to the UK’s long-run fiscal sustainability. The UK economy will likely rebound nicely anyway once Brexit is sorted. With less uncertainty, rising confidence would likely lift private spending and investment above trend for a while. There is no need for a big stimulus.
Instead of wasting the already limited fiscal headroom on a pro-cyclical stimulus, the UK would be better off saving that borrowing capacity for a genuine downturn and instead focus on supply-side reforms and other regulatory measures to improve its competitiveness as it exits the EU.
The OBR’s long-run forecasts highlight the risks to the fiscal outlook. It projects that the public sector’s primary balance will fall from -0.5% of GDP in 2023 to -8% of GDP by the 2060s, as debt as a percentage of GDP rises above 250%. The expected explosion in borrowing is mainly the result of a likely sharp rise in healthcare costs and other spending linked to the UK’s ageing population. As the OBR does not project that the costs will really begin to accumulate in a major way until the 2030s, there is still time to set fiscal policy on a sustainable course. However, the Johnson/Javid stimulus would bring these challenges to the fore.
Currently, financial markets do not worry much about UK fiscal sustainability. Long-term gilt yields even declined in June 2016 following the EU referendum, despite the Brexit-related risks to the UK’s long-run growth potential – and thus the fiscal outlook. The fall in yields reflected the market’s lower expectations for GDP growth and anticipated rate cuts by the Bank of England (BoE). If markets had genuinely believed that the risks to the UK’s fiscal position had increased materially, long-term bond yields would have risen instead. Meanwhile, the trends that have driven bond yields lower in recent years are set to reverse.
Rising fiscal sustainability risks, along with a likely pick-up in nominal GDP growth (partly due to a likely rise in inflation) and the prospect of further rate hikes by the BoE, suggest that gilt yields are too low across the curve. We expect 10-year gilt yields to rise from the c0.8% currently to 1.7% by end-2020. Of course, if we are wrong about the election and Jeremy Corbyn with his left-wing policy agenda and even bigger spending and borrowing pledges comes into power, then gilt yields are much too low.
Kallum Pickering
Senior Economist
Phone +44 203 465 2672
Mobile +44 791 710 6575
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