London, Thursday 21 October 2021 – Ahead of the Budget on 27 October, the Chancellor is likely to benefit from upgraded economic forecasts from the Office for Budget Responsibility (OBR) and a consequent fiscal ‘windfall’, according to the EY ITEM Club Budget Preview Report.
However, the EY ITEM Club doubts that the Chancellor will use his much-improved economic circumstances to deliver a significant fiscal loosening. The EY ITEM Club says the Chancellor may need to find a balance between reducing borrowing, tackling rising cost of living pressures, and navigating increasing economic headwinds.
Martin Beck, Senior Economic Advisor to the EY ITEM Club, comments: “The Chancellor certainly has some room for manoeuvre next Thursday given the economy has outperformed the OBR’s March forecast. Likely upgrades to the OBR forecast will mean higher forecast tax receipts, lower future borrowing, and – crucially – much less economic ‘scarring’ from the pandemic than originally expected. This will be on top of the boost to public finances from incoming tax rises and much-reduced spending on pandemic support. The OBR’s forecast will be based on slightly out-of-date data, however, so any upgrades won’t capture the full extent of the economy’s recent rebound.
“That said, this is unlikely to prompt a fiscal loosening. The Chancellor’s September decision to fund extra health and social spending wholly with tax raises suggests deficit reduction is his priority for the time being. And while the economy is much-improved since earlier in the year, the recovery is starting to encounter headwinds.”
OBR forecast upgrades mean a fiscal boost – but there is pressure to tackle the cost of living
The EY ITEM Club’s report says that the OBR is likely to raise its forecast for GDP growth this year from 4% to close to 7%. It also suggests that the OBR could cut its estimate of the pandemic’s long-run ‘scarring’ effect on the economy from 3% of GDP to 1%. The report says that a lower scarring assumption could improve the government’s fiscal position by £25bn annually by the middle of the decade.
The EY ITEM Club’s report adds that a stronger-than-expected economic recovery in the UK has already helped the public finances. The deficit this year is predicted to undershoot the OBR’s £233bn forecast by around £30bn, even allowing for the effect of higher interest rates on government debt. Borrowing of £325bn in 2020-21 was £30bn below the OBR’s forecast.
Peter Arnold, an EY UK Economic Advisory Partner, comments: “Prospects for the UK economy have been looking up over the summer: August’s GDP rise left the economy only 0.8% short of its pre-pandemic size, while, absent any future fiscal loosening, the deficit should fall quite rapidly from 15.5% of GDP in 2020-21 to potentially 1% of GDP by 2024-25. But economic optimism is being increasingly tempered by concerns around rising inflation. The knock-on impact of a global, synchronised recovery in demand, tight labour markets, and pandemic-constrained and disrupted supply chains has led to shortages and significant pricing pressure across a number of sectors – most notably in construction, hospitality and energy.
“These trends do risk cost of living concerns increasing as we head into winter. The Chancellor may therefore look at what he can do to provide additional support for both consumers and businesses, particularly on energy costs.”
Options on energy bills
With rising energy bills adding to cost of living pressures, the EY ITEM Club says the Chancellor has a number of policy options available which could help reduce household energy costs.
The report says that a reduction in the current 5% VAT rate on domestic fuel, or suspending the tax entirely, would be one route open to the Chancellor. Another would be subsidising energy providers to take a fixed sum off every household’s energy bill, mimicking the action taken by the coalition government in 2014 and 2015. A third possibility would be to temporarily transfer the cost of subsidising renewable energy from household and corporate energy bills to the Treasury.
An opportunity to advance Net Zero ambitions and policy objectives around levelling up
The EY ITEM Club says that a number of other policy priorities are competing for the Chancellor’s attention, including furthering the Government’s Net Zero ambitions, increasing investment to support levelling-up objectives, and dealing with the pandemic’s legacy in areas such as education, transport and the court system.
Peter Arnold adds: “With the COP26 meeting taking place in November, the Budget presents an opportunity to advance the Government’s Net Zero ambitions – although the Chancellor will also need to grapple with some of the fiscal contradictions around any efforts to achieve these. Accelerating electric vehicle take-up, for example, will erode revenue from fuel and road duty.
“The Government is also committed to increasing public investment in infrastructure to support its policy objectives around levelling up. However, with totals for public spending over the next few years already confirmed for the forthcoming Spending Review – also due on 27 October – committing more funding in some areas may require cuts in other parts of the public sector.
“As recent EY research found, however, both Net Zero and levelling-up are linked: clean technology investment projects are more likely to be spread around the country than other types of activity. Investment in cleantech and Net Zero means investment in levelling-up too. Either way, the Chancellor has plenty of challenges as he looks to balance deficit reduction, spending demands and taxation.”
Potential detail expected on the Treasury’s longer-term tax strategy
With a number of significant tax rises already in the pipeline, the EY ITEM Club suggests that Chancellor is likely to avoid any further significant increases. And, with the headline rate of corporation tax heading up to 25% in 2023, the EY ITEM Club says there is also a possibility that the current surcharge paid by banks may be cut or scrapped.
The EY ITEM Club report says that the Budget may also provide further detail on the Treasury’s longer-term tax strategy, including reform of business rates and what could replace fuel duty and Vehicle Excise Duty in an electric car future.
Martin Beck continues: “The Government may decide to bring back the three fiscal rules presented in the March 2020 Budget, but which were suspended during the pandemic, to help signal a break from the pandemic-era of fiscal policy. The OBR’s new forecast should also show all three rules being met quite comfortably.”