Predictions from the country’s budget office paint a grim picture for Britain’s next government, suggesting limited flexibility in terms of tax cuts or spending increases.
However, in the event that the economy exceeds expectations by a small margin, the victorious candidate in the upcoming election could potentially have a significant increase in fiscal flexibility, amounting to hundreds of millions of pounds.
In that more optimistic situation, Prime Minister Rishi Sunak’s Conservatives may have a smoother path to reducing the heaviest tax burden since World War Two, all while fulfilling their debt commitments.
If the Labour Party, which is in opposition, were to assume power, it would have greater flexibility to finance its ambitious annual investment plan of 20 billion pounds ($25 billion) for achieving net zero emissions.
Undoubtedly, economic forecasting is widely known for its lack of precision, and the Office for Budget Responsibility (OBR) has previously demonstrated an overly optimistic outlook on the economy’s potential.
If circumstances deteriorate beyond expectations, the subsequent administration may encounter an even more stringent financial constraint.
Parties Commit to Cutting Debt
The Conservatives and Labour both pledge to reduce the public debt burden in the UK, keeping in mind the impact of the significant tax reductions proposed by former Prime Minister Liz Truss, which had a detrimental effect on bond markets in 2022.
The level of debt has reached a significant proportion of the economic output due to extensive public spending during the COVID pandemic and the recent surge in energy prices in 2022, in addition to the substantial expenses incurred from the financial crisis of 2008-09.
Dealing with debt becomes more challenging as the economy remains stagnant, while the need for public services, like healthcare for the growing elderly population in Britain, keeps increasing.
The finance minister, Jeremy Hunt, has committed to reduce the debt as a percentage of the gross domestic product within five years.
According to the latest predictions, he is expected to barely achieve that goal, leaving him with limited flexibility compared to those who came before him.
However, the “fiscal headroom” is expected to undergo alterations, considering the multitude of factors that contribute to the OBR’s perspective. The issue at hand is whether the available space increases or becomes more constricted.
The Wildcard of Productivity
An unpredictable factor is the impact on productivity growth, which has decelerated, putting pressure on the economy and tax revenues.
According to the OBR, if the government can increase productivity to match its pre-2008 rate of 1.5% per year instead of the expected 1.0%, the potential for meeting Hunt’s target would increase to 72 billion pounds in five years.
That would greatly surpass the current estimated value of 13 billion pounds and come close to the magnitude of Britain’s public education budget of 82 billion pounds for this fiscal year.
However, efficiency may decline. If the growth rate remains at 0.5% per year, which is consistent with the previous decade, the government is projected to fall short of its debt target by over 40 billion pounds, according to the OBR. This would necessitate potential options such as tax increases, additional spending cuts, or further accumulation of debt.
The OBR has consistently overestimated the likelihood of a productivity enhancement in previous assessments. However, according to corporate leaders, Hunt’s announcement in November regarding the permanent establishment of tax incentives for business investment is seen as a positive development. The emergence of artificial intelligence is also fueling expectations of increased productivity.
The behavior of inflation is a crucial factor to consider, not only due to the costly payouts associated with Britain’s extensive collection of index-linked government bonds.
According to the OBR, if there is a future surge in inflation caused by the rise in import prices, particularly oil and gas, it would negatively impact the public finances.
However, in the event that the surge in prices is a result of increased wages and corporate profits, it could lead to a boost in tax revenues. This has the potential to contribute towards reducing debt. Nevertheless, the Treasury may encounter demands to raise spending in order to keep up with inflation.
There Is a Tendency for Interest Rates to Decrease
Yet another significant presumption made by the OBR pertains to the anticipated trajectory of interest rates, which the Bank of England has recently elevated to a level not seen in 15 years, reaching 5.25%, in an effort to combat inflation.
In 2022, Britain allocated a more significant portion of its GDP towards debt interest compared to most other Group of Seven countries, with the exception of Italy. This was primarily due to the substantial sale of inflation-linked bonds.
In November, the OBR predicted that net interest expenses within three years would reach a staggering 109 billion pounds per year, which is more than twice the amount they had estimated less than two years ago.
According to the Institute for Fiscal Studies think tank, the government’s debt interest bill was on track to increase by approximately 2% of GDP, which is equivalent to the entire defense budget.
However, rate expectations have declined rapidly since November.
Investors are now anticipating a potential decrease in Bank Rate to 4% by December, which is three years earlier than what the OBR had previously assumed.
According to Carl Emmerson, the deputy director of IFS, a decrease of one percentage point in bank rates and government bond yields would result in an annual saving of approximately 15 billion pounds for the Treasury. This amount is projected to increase to 19 billion pounds within the next five years.
For perspective, in 2022, Britain allocated a staggering 12.8 billion pounds towards international assistance.
“They’re quite substantial figures,” Emmerson remarked.
Hunt has the potential to transform a portion of the decline in anticipated future debt expenses into tax reductions, possibly as early as March 6, when he is scheduled to deliver what is likely to be his last budget announcement before the election.
The Regulations Are Often Changed
Arguably, the most significant factor is the fiscal regulations that the upcoming administration chooses to implement.
Although both major parties express their intention to reduce debt as a percentage of GDP, Labour has not provided specific details. At the same time, if they win the election, the Conservatives may introduce a new regulation.
Since 2011, various Conservative-led administrations have implemented six distinct fiscal guidelines.
Emmerson emphasized the importance of ministers refraining from utilizing positive changes in the fiscal outlook as an opportunity to reduce taxes or increase spending, mainly when any negative changes result in increased bond sales.
“If every time the situation deteriorates, you find yourself resorting to increased borrowing, but every time the situation improves, you opt for tax cuts, you will consistently end up borrowing more than your initial projections,” he remarked.