Questions facing the government in autumn 2021

IfG INSIGHT | SEPTEMBER 2021

Tax and spending

Questions facing the

government in autumn 2021

Thomas Pope, Gemma Tetlow

and Graham Atkins

Summary

Rishi Sunak faces a crucial autumn that will set the course of public spending and

taxation for the rest of the parliament. He will announce departments¡¯ budgets for the

next three years at the first multi-year spending review since 2015. He also faces big

decisions over the future of social care, which the prime minister has pledged to ¡°fix¡±,

and Universal Credit. This Insight paper looks at how the public finance forecasts are

likely to change and how much room for manoeuvre this will give the chancellor.

The good news for Sunak is that the economy has recovered more quickly than the

Office for Budget Responsibility (OBR, the government¡¯s official independent forecaster)

expected back in March. Most other forecasters, including the Bank of England, are now

more optimistic about the economy in the medium term too. If the OBR upgrades its

outlook for the economy in line with the Bank, the forecast for borrowing in 2025/26 ¨C

the end of the OBR¡¯s current forecast horizon ¨C could be reduced by around ?25 billion.

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AUTUMN 2021 TAX AND SPENDING

The chancellor has not yet put in place any new fiscal rules to replace those he ditched

to allow flexibility in the government¡¯s pandemic response, but he has stated that the

government should not borrow for day-to-day spending in normal times. If he adopts

that as a formal rule, he might ¨C like his predecessors ¨C want to build in around 0.5%

of GDP headroom against it. Even allowing for that, the better outlook for the economy

would allow him to spend an additional ?12bn over and above his March 2021 plans.

Ordinarily, an extra ?12bn would give a chancellor an easy autumn. However, the March

forecast was based on several tight spending assumptions that mean ?12bn will not be

enough to avoid difficult decisions. Pressures include:

?

The state pension triple lock: Average earnings growth ¨C one of the three measures

against which the triple lock is set ¨C has been higher this year than anticipated, but

the increase is artificially high because so many workers were furloughed last year.

If the chancellor sticks to the letter of the triple lock, he would have to spend ?4bn

per year more.

?

Universal Credit: The ¡®temporary¡¯ ?20-per-week uplift is set to stop at the end of

September, but this may prove difficult politically. Cancelling the cut would cost

?6bn a year.

?

Social care: The prime minister has pledged to ¡°fix¡± social care ¨C an objective

successive governments have failed to address ¨C and reports suggest he intends to

introduce a cap on care costs. To do so and meet social care pressures could cost

?10bn per year.

?

Spending review: Provisional plans laid out in March include barely enough money

to meet demographic-related demand pressures. They allow for no extra spending

to deal with coronavirus-related costs beyond this year (such as continued test and

trace, and vaccination programmes) or backlogs created by the pandemic. More

money will be required if the government wants to meet these spending needs.

If the chancellor wants to address these pressures, while remaining committed not

to borrow for day-to-day spending, he would need to raise taxes or find cuts to

spending elsewhere. If he does decide to increase taxes ¨C for example, to pay for

social care ¨C he should:

?

Raise taxes in a way that does not make the UK¡¯s already imperfect tax system

worse. Increasing National Insurance contributions (NICs) to pay for social care

would worsen the bias in the tax system away from employees and towards the selfemployed. It would also ¨C inappropriately ¨C fall only on those under 65, who use the

social care system least. An additional income tax levy on over-40s would not suffer

from these problems but would complicate the tax system further.

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?

Package tax increases with the additional spending they help pay for. In the past,

chancellors have failed to deliver tax reforms because spending increases were

announced first, making a standalone tax increase appear less justified to the public

when later announced, making it more difficult to deliver. Any announcement should

happen simultaneously to stop Sunak making his predecessors¡¯ mistake.

Introduction

In the March 2021 budget, Rishi Sunak allocated a lot of extra money to allow the

government to continue tackling the short-term impact of the pandemic. But he laid

out tight fiscal plans for the years up to 2025/26 to help reduce borrowing ¨C including

a large corporate tax rise and a freeze to income tax thresholds to bring in more money,

and tight limits on day-to-day public spending from next year onwards.

So far, Sunak has not set out any firm fiscal rules. But he did, in March, state that ¡°in

normal times, the state should not be borrowing to pay for everyday public spending¡±

and that ¡°we cannot allow our debt to keep rising¡±.1 More recently, the ¡®compromise¡¯ that

Sunak struck with Conservative rebels over controversial cuts to overseas aid spending

¨C that he will return aid spending to 0.7% of gross national income (GNI) when the

government is no longer borrowing for day-to-day spending and when debt is falling 2 ¨C

further underlines the government¡¯s commitment to getting to that fiscal position.

The fiscal forecasts in March were (just) consistent with the chancellor¡¯s ambition not

to borrow for day-to-day spending in 2025/26, as Figure 1 shows. But there was no

leeway in those forecasts for tax giveaways or extra spending. This paper looks at how

the outlook has changed since then. The economy has rebounded more strongly than

was expected and many forecasters now think the long-term economic damage from

Covid will be less severe. This makes the fiscal sums easier. However, we also highlight

the many areas in which the March budget was predicated on future actions that will

be very difficult for the government to deliver. This means Sunak still faces some very

tough choices in the autumn as he prepares to present his multi-year spending review

and potentially also a new budget.

Figure

1 Net borrowing and current budget deficit, March 2021 OBR forecast, ? billion

400

350

300

250

200

150

100

50

0

2019/20

2020/21

2021/22

2022/23

PSNB

2023/24

2024/25

2025/26

Current budget de?cit

Source: OBR Economic and Fiscal Outlook: March 2021. PSNB = public sector net borrowing.

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AUTUMN 2021 TAX AND SPENDING

How has the economic and fiscal outlook changed since

the spring?

The economy is bouncing back strongly

The last time the Office for Budget Responsibility (OBR) published any official economic

and fiscal forecasts was in early March 2021. At that time, the coronavirus vaccine rollout was in its early stages but since then it has gathered pace and consumer confidence

and spending have rebounded as the economy has reopened. The economy has

recovered more quickly than most forecasters (including the OBR) expected in the near

term. The OBR forecast in March predicted that GDP would be 7.8% below its 2019 Q4

level in the second quarter of this year. However, the initial estimate is that it was only

4.4% down.3

Most forecasters predict that this stronger performance in the short term will translate

into a stronger medium-term outlook as well. Taking the average of the most recent

projections by independent forecasters shows that they now expect that the UK

economy will grow more over this year and next than the OBR thought in March. As

Figure 2 shows, while independent forecasters were on average more pessimistic than

the OBR at the start of the year, the average of independent forecasts is now for the

UK economy to be 12.8% larger in 2022 than in 2020, compared to the OBR¡¯s latest

forecast of 11.6%. The Bank of England (BoE) also now expects the economy to grow

more quickly and get closer to its pre-pandemic growth path in the medium term than it

did at the start of the year (Figure 3).

Figure 2 OBR and independent forecasts for real economic growth in 2021 and 2022

14

12.8%

+11.6%

12

+10.4%

10

8

+6.9%

+5.7%

6

4

+7.3%

+4.0%

+5.5%

+4.4%

2

0

2021

OBR, March 2021

2022

Independent forecasters, February 2021

2021 & 2022

Independent forecasters, July 2021

Source: OBR Economic and Fiscal Outlook: March 2021 and Treasury survey of independent forecasters.

Earlier in the year, forecasters were relatively more concerned that workers would have

lost skills and become detached from the labour market during lockdowns and that

businesses would have cancelled investment, harming productivity. But these concerns

have been calmed by a quicker than expected recovery ¨C and, in particular, a stronger

labour market with lower-than-expected unemployment.

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AUTUMN 2021 TAX AND SPENDING

Forecasters are now more optimistic about the medium term because they think

Covid will leave fewer permanent ¡®scars¡¯ on the UK economy than they previously

expected. It is this medium-term outlook that will affect the public finance position

in the mid-2020s, when the chancellor has indicated he wants to stop borrowing for

day-to-day spending.

That said, the extent of pandemic ¡®scarring¡¯ remains highly uncertain, and some

forecasters ¨C such as Citi 4 ¨C still expect scarring to mean the economy will be 3%

smaller than it otherwise would have been. This is in line with the OBR¡¯s March forecast.

However, the BoE and others¡¯ more optimistic outlook means the OBR is likely to follow

suit when it produces its next forecast, to be published on 27 October.5

If the OBR were to revise its forecast for the economy in the medium term in line with

the BoE¡¯s August 2021 forecast, higher GDP would translate into much higher tax

revenues and therefore reduce the forecast for borrowing. We would expect this to

reduce borrowing in 2025/26 by ?32bn (1.2% of GDP).*

Figure 3 Real GDP forecasts from OBR and Bank of England (2019 Q1 = 100)

OBR, March 2020

110

BoE, August 2021

105

OBR, March 2021

BoE, February 2021

100

95

90

85

80

75

2019Q1

2020Q1

2021Q1

2022Q1

2023Q1

2024Q1

2025Q1

2026Q1

Source: OBR Economic and Fiscal Outlooks, March 2020 and March 2021; Bank of England monetary policy reports,

February 2021 and August 2021.

But higher interest rates on government debt will increase public spending¡­

A stronger economy would be good news overall for the public finances. Additional

economic activity means more income, consumer spending and profit, which in turn

means higher tax revenues. However, it would also increase some aspects of public

spending, which would partially offset the gain in tax revenues.

The better outlook, as well as higher inflation (covered below), means that interest rates

are now expected to be higher than in the OBR¡¯s March forecast. This is because the BoE

is more likely to increase the base rate if inflation is higher and the economy is stronger,

while higher economic growth also makes other assets more attractive to investors and

so the government needs to offer a higher return on its debt.

*

5

We calculate the effect of higher GDP on the public finances by taking the difference in borrowing and GDP

between the ¡®central¡¯ and ¡®upside¡¯ OBR scenarios in the November 2020 Economic and Fiscal Outlook and

assuming that the same relationship between the two will apply to the next forecast revision.

AUTUMN 2021 TAX AND SPENDING

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