Despite a significant fall in the UK deficit, the Chancellor will have limited opportunities to deliver significant tax cuts or spending increases in the Budget unless he loosens the fiscal rules set out in the Conservative Party’s manifesto, says the EY ITEM Club.
The EY ITEM Club’s Budget Preview Report says that net borrowing has come down from 10.2% of GDP in 2009/10 to 1.8% of GDP in 2018/19. Nevertheless, the Chancellor is only likely to have around £5bn at his disposal to deliver net tax cuts or day-to-day spending increases if he maintains the fiscal commitment to balance the current budget in three years. This could become even more problematic should the Office for Budget Responsibility (OBR) downgrade its UK growth forecast.
Budget surplus could be further eroded by GDP downgrades
According to the EY ITEM Club, adjustments made to the OBR’s forecasts for Public Sector Net Borrowing excluding banks (PSNBex) and the extra spending in last September’s Spending Review would cut the current budget surplus to around £5bn (0.2% of GDP) in 2022/23 - when the Government would need to achieve a balanced current budget.
This margin could be eroded further if the OBR markedly reduces its GDP forecast of 1.4% for 2020, which now looks highly likely (although the OBR’s new growth forecasts are likely to have been produced before the escalation in the coronavirus outbreak). The OBR’s forecasts will be important in defining exactly what funds are available to the Chancellor, but there seems little prospect of any fiscal windfall. The EY ITEM Club believes the OBR could cut its 2020 GDP growth forecast down to 1.0% at best, which would have negative implications for the public finances and mean that a current budget deficit would be likely in 2022/23. The EY ITEM Club has recently trimmed its own 2020 growth forecast to 1.0% (down from 1.2%) while the Bank of England cut its projection to just 0.8% in the January Monetary Policy report.
As such, the EY ITEM Club says the Chancellor is likely to loosen the approach to fiscal policy in the forthcoming Budget. The report says that the Chancellor could aim for a balanced current budget over five years rather than three, which would be more achievable. Alternatively, he could adopt some flexibility in the balanced current target by having a +/-1% band around it. Other options for the Chancellor to consider include capping Government borrowing at 3% of GDP in any year, including both current spending and Government investment, or introducing a rule that would see borrowing levels reduced by the end of this Parliament compared to the start.
Howard Archer, Chief Economic Advisor to the EY ITEM Club comments:
“There has been positive momentum in the UK economy at the start of 2020, but the near-term outlook now looks more challenging with the escalation of the coronavirus outbreak.
“The Chancellor has indicated that the Budget will provide more support for families, businesses and the public services affected by coronavirus. This is likely to include more money for the NHS which could put further strain on the public finances in 2020/21. However it won’t have a permanent impact on the fiscal accounts, so it shouldn’t ultimately affect the big picture fiscal decisions.
“The Chancellor may choose to flex the UK’s fiscal rules to provide more headroom to spend, but his flexibility on current spending seems limited and he will have to work carefully to maximise the benefits of the money he has at his disposal.”
Capital spending set to rise to 3% of GDP
The EY ITEM Club says the centerpiece of the Budget is likely to be a substantial uplift in debt-financed government investment, aided by low borrowing costs. While he was Chancellor, Sajid Javid had proposed a rule permitting net investment to rise to a limit of 3% of GDP per year. This would permit an extra £15bn-20bn of capital spending per annum compared to existing plans.
The focus of this extra investment is likely to be aimed at ‘levelling up’ the economic performance in struggling towns. The Government has indicated that it will commit £100bn in infrastructure over a five-year period, however the EY ITEM Club says the scale of the task should not be underestimated.
To achieve these targets, the Chancellor would need to lift public investment to 3% of GDP each year. The long-term average is 1.8% of GDP and it has only averaged 1.3% of GDP over the past 30 years – so this is a marked step-up.
Mark Gregory, EY’s UK Chief Economist comments: “This is a bold ambition that will require Government and business to work quickly to define detailed long-term programmes and to ensure that there are the resources and capabilities available to deliver them. More than doubling the share of GDP invested over the long-term average is a major uplift in activity to manage.”
Potential policy changes
The EY ITEM Club says that the scope for policy changes in the Budget will largely depend on the choices made on the fiscal rules. However, measures that have a good chance of being cited include: raising the threshold for National Insurance from £8,632 to £9,500; increasing research and development tax credits; and more generous capital allowances for investment. In terms of revenue raising initiatives, EY ITEM Club says the Chancellor could look at reforms to pensions tax, inheritance tax, capital gains tax and entrepreneur’s tax relief. The introduction of a ‘mansion tax’ is also a possibility.
However, with the change of Chancellor occurring less than a month before the Budget, EY ITEM Club says that major strategic decisions may well be delayed until the Spending Review and a second Budget towards the end of the year. The Chancellor could also choose to launch some policy reviews in this Budget (such as on pension reform) and then look to incorporate the findings into the autumn Budget. For example, the Government has indicated that it will launch a “fundamental” review of business rates in next week’s Budget.
Mark Gregory, EY’s UK Chief Economist comments: “Confidence has started to pick up across the economy, following the decisive general election result and greater clarity on Brexit. The new Chancellor has the opportunity to catch the mood and convince the country that there is a deliverable vision in place. To do this, it’s vital that he articulates a clear picture of economic policy and aligns all parts of the Government on delivery to avoid any policy conflicts.
“There is little doubt that more investment in skills and infrastructure and support for higher spending on research and development will be required. But transformative change requires more than resources and the Budget provides the opportunity to begin the explanation of how the Government plans to deliver its economic policy. Ambition is necessary but the ability to deliver is key.”
For more Budget insights from EY, please visit ey.com/budget.