This piece is by our Senior Consultant Economist, Matthew Latham.
It’s Autumn Statement season once again and, while we’re not in as fraught circumstances as we were in the aftermath of the short-lived Truss administration, the stakes are high for the Chancellor. There is of course the prospect of an election next year and with the Tories 20 points behind in the polls, Mr Hunt would normally be wanting to give away a number of goodies. His tone in the press over the past few weeks, however, has suggested that we may have a rather more restrained budget, with him ruling tax cuts as being out of the question. Unsurprisingly, this has left many other party members cold, with them already incensed by the country’s record breaking tax burden.
At the centre of much of the debate of what we can expect to see in the upcoming budget is ‘headroom’ and how much of it the Chancellor has to play with. Here, we’ll take a little tour of what the word means and dive into the factors affecting both it and the Chancellor’s decision making in the upcoming budget. Much of the conversation around the Statement’s likely measures thus far has been focussed on households and the likely settlements for different public services. To add a counterpoint, we’ll provide some discussion of some policies businesses might see affecting their bottom lines.
Figure 1: headroom pressures in a nutshell
For those of you looking for the headlines: (see the diagram above) the Autumn Statement must, according to OBR forecasts, set the country on the track to see net debt as a % of GDP to be falling by 2027/28 and for net borrowing to not exceed 3% of GDP in that year either.
While at the time of the Spring Statement, the country was seeing expectations of its growth performance upgraded and expectations were set for interest rates to have peaked by Q3 of this year. Growth projections are now being downgraded and inflation and interest rates have remained high (even with reports of inflation dropping to 4.6% in October, that’s still orders of magnitude higher than has been the norm this decade). Lower expected growth puts downward pressure on government receipts, whilst higher interest rates increase debt servicing costs towards 2027/28. Higher inflation on the one hand increases the cost of pension and welfare spending, but increases the size of the cash economy, boosting revenues in nominal terms. The size of the Chancellor’s ‘headroom’ and thus, his willingness to give away goodies will depend on the relative sizes of these effects reflected in the OBR’s forecasts.
Thus far, we’ve seen projections of tightening headroom, as pointed to by the IFS on multiple occasions, but other forecasts, produced by NIESR, for example, expect headroom to the tune of £90bn for the funding of tax cuts. Which forecaster is right ultimately doesn’t matter for the budget, it’s what the OBR predicts that’ll determine what the Chancellor has to play with.
It is also (very) likely that Mr Hunt’s grim tone is being taken now to create a greater sense of excitement around whatever goodies he does decide to give away.
What determines how much ‘headroom’ we have?
Much of the gossip surrounding the upcoming Autumn Statement centres on the issue of ‘fiscal headroom.’ This refers to the degree to which the Chancellor can take actions which will loosen the public finances in some way (by either cutting taxes or increasing spending somewhere), whilst still meeting the fiscal rules set out in last year’s Autumn Statement. These fiscal rules are:
for public sector net debt (excluding the Bank of England) as a % of GDP to be falling by the fifth year of the OBR’s forecast, i.e. 2027/28.
for public sector net borrowing to not exceed 3% of GDP by the fifth year of the OBR’s forecast.
to ensure that spending on welfare is contained within a predetermined cap set by the Treasury.
The first two are the most pressing for both the Chancellor and the country more widely, dictating a more broader set of decisions than the third.
The first rule means that, based on the decisions made at the Autumn Statement, the OBR’s forecast values for public sector net debt as a share of GDP must be falling in 2027/28. In simpler terms, it translates to ‘the country’s level of indebtedness relative to its income should be falling in the medium term.’
The second rule means that by 2027/28, public sector net borrowing must be at or below 3% of GDP, essentially meaning that in the medium term, we should expect the government to be keeping a ‘disciplined’ budget. This leaves room for governments to respond to short term crises, where we would expect to see high levels of spending and potentially low tax revenues, but for these to be brought in line by the time the crisis in question is recovered from.
As will become clear from the discussion below, it is the first rule which will be binding for the Chancellor in the current budget, driven in part by the costs of servicing the country’s debt increasing over the medium term.
How much room for manoeuvre is there?
At the time of the Spring Budget, a whole 8 months ago, the government was forecast to meet all three fiscal rules, with the OBR forecasting public sector net debt as a share of GDP to fall by 0.2 percentage points between 2026/27 and 2027/28, public sector net borrowing to be at 1.7% in 2027/28. This budget came at a time when, as it is now, the tax burden was at its highest level since the end of the second world war, after a decade of attempted budget cuts and record-low capital expenditure, as well as record levels of public debt. Even so, ‘headroom’ was found for a number of new spending commitments and tax cuts in areas like childcare and pensions.
The ‘headroom’ found for these extra commitments, came in large part due to improving prospects for the UK economy. Forecasts had in the months prior upgraded expectations about the UK’s growth performance in the short term from a recession to some stagnation. It was also expected that the inflation which had been driven by increased fuel costs would fall steadily throughout the year, standing at 5.4% by now, which would in turn lead to a reduction in the Bank of England base rate, which was expected to peak at 4.25%. The avoidance of a recession and the eventual calming of price and interest rate rises provided enough wiggle room for the Chancellor to offer some loosening of fiscal policy in certain areas.
Many of those factors which, in the short to medium term, were set to provide some relief for the government’s coffers either have not materialised on the upside or have begun to dissipate.
Inflation has remained higher than was expected at the start of the year, reportedly sitting at 6.7% for quarter three of 2023, with the price shock generated by the energy crisis feeding through into more persistent core inflation via salary increases. This in and of itself would actually have a positive impact upon the revenue-side of government finances. With high inflation, especially when driven in part by pay growth, the government is able to bring in more in cash terms via taxation, an effect enhanced by the freezing of income tax thresholds. These increased revenues and cheaper-than-expected energy supports have led to borrowing for the fiscal year actually being around £10bn below expectations.
Given that both increases in salaries and the price level tend to be permanent, the benefits of these changes for the government’s coffers is likely to persist over the course of the 5-year forecast period, potentially reducing the value of the numerator of the all important net debt to GDP ratio. The larger economy in cash terms, which we can expect after a period of inflation and salary adjustments, will also help to chip away at the denominator.
‘So what’s the problem then?’ I hear you ask. The problem is not in inflation’s effect this year, but over the next 5 or so years.
In response to this above forecast (and more importantly, above target) inflation, the Bank of England has increased its base rate to 5.25%, a whole percentage point above what was expected at the time of the Spring Budget. This has two very important effects. The most significant is that of increasing government borrowing costs in the medium term. An increase in the bank’s base rate today increases the amount the government will have to pay back when the debt it issues today comes to maturity a few years down the line. It is estimated that compared to what was expected when Rishi took up office in number 10, the government’s interest payments on its debts in the final year of the OBR’s forecast will be £40bn higher thanks to increases in the base rate. This seriously squeezes the Chancellor’s ability to meet the requirement to see debt as a share of GDP fall in 2027/28.
A further consequence of the higher inflation and interest rates is the likelihood of us seeing lower growth rates than we were expecting at the beginning of the year. While over the course of 2022, the below-expected energy price rises and the support measures from government kept the economy more robust than many forecasters expected, those tailwinds have run out. The above expectation inflation is showing signs of eating into disposable income, especially when taken in combination with the fiscal drag imposed by tax threshold freezes.
The base rate increases are also starting to bite. On the side of households, those with floating rate mortgages have seen their budgets pinched. Slightly less well promoted have been the dampening effects of rate rises on asset prices more widely, which have led to deteriorations in both the balances of households and businesses. Further, more recent data has also begun to show slowdowns in borrowing and investment more widely. These factors are beginning to be taken into account by forecasters, with the Institute for Fiscal Studies reporting expectations of a recession next year.
This lower growth will mean downgrades in expectations for future tax revenues and expectations of higher spending, all meaning more debt being taken on at a period where interest rates are high, increasing the cost of servicing every pound borrowed and making it increasingly difficult for the government to hit its targets by the end of the OBR’s forecasting period.
Finally, in periods of inflation, coffers come under pressure from the upgrades made to pension and welfare payments, adding further pressures to those created by potentially lower revenues and higher interest payments.
The real uncertainty surrounding the degree of headroom will lie in expectations of the relative size of the effect of a larger economy in cash terms helping to shrink the net debt to GDP ratio and the potentially higher borrowing costs, contracting real activity and higher spending on welfare and pensions. On this point, we see a wide variety of analyses, with the IFS suggesting that the picture is almost certainly worsening for the prospect of a fiscal loosening, but other analyses, by NIESR or The Resolution Foundation (see figure 2 below) predicting that the growth of the cash economy will more than offset any negative drag driven by interest rates or inflation (worth noting they do not wade into the debate around growth in the run up to 2027/28). The real deciding factor here is not, however, which forecaster is correct, but what the OBR predicts will be the case.
Figure 2: Resolution Foundation estimates of the impacts of inflation and interest rate changes on government borrowing
Regardless of where the OBR lands amongst the other forecasters, headroom is certainly tight - we should not forget the longer term context we are in, after a decade of poor growth, crises and record debts. Some sweeteners are still almost inevitable, especially with an election just around the corner - it is very likely that the Chancellor’s tone thus far has been to increase the wow factor of any positive announcements made in the Statement.
Which measures might we expect to see?
For the most part, the rumours spreading throughout the press on which measures might appear in the budget have focussed on measures for households. Here we’ll focus on factors more relevant to businesses.
Full expensing: with an economy significantly underperforming with regards to business investment, many eyes will be on the government’s full expensing policy, which allows companies to deduct 100% of the cost of spending on certain plant and machinery investments between 1st April 2023 and 31st March 2026. In past interviews, Jeremy Hunt has stated that if there is room in the budget, he would make full expensing a permanent fixture. However, now with him emphasising the tightness of headroom in the run up to the Autumn Statement, this relief may be phased out on schedule, allowing for a little more room for manoeuvre towards the end of the forecast period.
VAT registration thresholds: much of the talk around fiscal drag has centred on income tax thresholds, but VAT registration thresholds have also been frozen at its £85,000 level since 2017/18, bringing more small businesses over the edge and footing them with both the cost of paying VAT and the processes required to go through to register. While the policy has brought in further revenue, analysis by the OBR has shown that a number of businesses appear to be stalling in terms of their incomes just below the £85,000 threshold, pointing to some disincentive effects on business growth. The Chancellor may take the decision to raise the threshold.
Living wage increases: with inflation continuing to stick around, there are a number of calls on government to further increase the living wage from its current £10.42 level. This would not immediately cost the Treasury anything, and may score some points in the minds of some voters. The labour market, however, appears to be entering a different phase from what we have seen in recent months, with a slowdown in economic activity likely and mounting pressures from existing salary pressures, the eyes of many businesses have turned away from the issue of skills shortages and may increasingly be concerned with the matter of covering their current staffing costs.
Incentives to hire the long-term sick: a big theme of the Spring Budget was the Chancellor’s attempts to increase labour force participation, with measures targeting pensioners, as well as increasing levels of childcare support. One of the core issues facing the UK economy, especially in the aftermath of the pandemic, has been increases in the numbers of workers leaving the labour force as long-term sick. In response to this, it would not be foolish to expect extra measures at some point to coax employers into hiring those from this group who want to re-enter the workforce. Again, the broader contractionary direction of the economy not expected by a number of commentators may dampen the effectiveness of such measures - if businesses are not concerned with filling gaps or expanding for the time being, such policies are unlikely to do an awful lot.