UK economic budget preview: levelling up the regions?

06 Mar 2020

Phil Shaw and George Brown

Investec Economics

The new UK Chancellor of the Exchequer, Rishi Sunak, will present his first budget on 11 March. A more expansionary stance is expected, especially since the ramping up of the coronavirus threat. We crunch the numbers in what may be a difficult debut for Mr Sunak.

There has not been a UK budget since October 2018. One had been planned for November last year under the previous chancellor, Sajid Javid, but it was postponed due to December’s general election. As a result, Britain has just had the longest period without a budget since at least the 19th Century.
 
The emphasis of the budget will be the delivery of the government’s election promises. Most significantly, this involves “levelling up” the economic discrepancies across the various parts of the UK. Prime Minister Boris Johnson has spoken of the need for everyone to be able to “get a fair share of future prosperity.” A key intention here is to raise spending, both on national infrastructure and in specific areas in less prosperous regions of the country. In practice, though, this will be more of a medium-term process, rather than being the result of one budget. Indeed, next week’s budget will be the first of a trilogy of fiscal events, which will include a Spending Review later this year and a further budget in the autumn. Given the likely expansionary stance of the budget, Mr Sunak will no doubt also bill his budget as an exercise in tackling the downside risks from the coronavirus. 

The first rule is...

We expect the new aggregate medium-term plans for public spending (the expenditure “envelope”) to be published in the budget, with the breakdown across different areas determined in the Spending Review. A key question here is how much room exists to raise spending and for a wider fiscal giveaway. Ahead of the election, Sajid Javid outlined three fiscal rules, which were included in the Conservative Party manifesto. These are:
 
  • the current budget position should be in balance (i.e. the government should only spend to invest) by 2022/23
  • public sector net investment should not exceed 3% of GDP
  • debt service should not exceed 6% of government revenues
There was also a commitment for outstanding debt to GDP to be lower at the end of the Parliament.

Table 1

The principal constraint is the current budget position. The most recent official forecasts from the Office for Budget Responsibility (OBR) were published at the March 2019 Spring Statement. These showed a current budget surplus of £36.8 billion in 2022/23. However, in the intervening period, accounting changes have resulted in higher borrowing estimates. Adjusting for these results in the surplus being restated £18.2 billion lower, at £18.6 billion.
 
Also, in his 2020/21 Spending Review in September, Sajid Javid signalled a material increase in public expenditure such that the real rise in day-to-day spending would total 4.1%, a 15-year high. This is equivalent to £11.7 billion in cash terms next year. Simply uprating by inflation, this becomes £12.2 billion in 2022/23.
 
The next factors to consider are forecast changes. Data for the first 10 months of 2019/20 so far suggest that the current budget could show a small surplus this year, bettering the OBR’s restated estimates by £1.4 billion or so. We have used this better starting point as a base for the projections. 
budget table 2
On top of this, the OBR’s borrowing forecasts will reflect shifts in the economic outlook (as well as budget changes). Here the March GDP forecasts of +1.4% for 2020 and +1.6% for both 2021 and 2022 look somewhat hopeful, particularly given the backdrop of likely economic disruption arising from the coronavirus. However, on the (optimistic) grounds that the new projections are the same shape as those in September, the chancellor has £7.9 billion to spend while still leaving the first of his fiscal rules intact. Of course, this is separate from the government’s capacity to raise investment. Even so, Mr Sunak may want room for an even more generous giveaway, especially given the current risks.

If we didn’t have rules, where would we be?

One way to avoid breaking the new fiscal rules would be to change them or even to ditch them. We would note that these have not been enshrined in any sort of Fiscal Responsibility Act, as done previously. However, we would guess that the government is inclined not to abandon them altogether, given the loss of credibility that would ensue. Moreover, Mr Javid’s rules were spelt out in the Conservatives’ manifesto. Dropping them would also be reversing an election pledge.
 
A possibility would be to tweak them. For example, Mr Sunak could commit to balancing the current budget position at the end of the Parliament (2024/25) instead of 2022/23. Alternatively, he could target a cyclically adjusted version of borrowing, as his predecessors did. Both of these options would give the chancellor some cushion in the event of a COVID-19-based downturn in the economy.
 
We judge that Mr Sunak (possibly with necessary support from the prime minister) will not scrap the fiscal rules. Instead, modest changes to them seem likely. What he could also do is limit the specific giveaways this time to give him more flexibility over policies later this year. In other words, fiscal easing announcements are spread around the trilogy of events this year.

What will Mr Sunak give away?

With negotiations of the UK-EU trading relationship still ongoing, we suspect that any significant spending decisions will be postponed until later this year. Instead, the chancellor is likely to focus on delivering the Conservative Party’s key manifesto pledges. Its flagship pledge is to lift the employee National Insurance contributions threshold from £8,632 to £9,500, at the cost of £2.2 billion. Other tax giveaways may include increasing the Employment Allowance for SMEs (£0.5 billion) and reforming business rates (£0.3 billion). The manifesto also commits to more NHS spending on nurses, GP appointments and free parking at the cost of around £1.3 billion.
 
The outbreak of the coronavirus is also likely to put additional demands on the public purse. At the very least, it should see the chancellor allocate emergency funding to aid efforts to contain the spread of the pathogen and potentially some compensation for consumers and businesses most acutely affected. But we would not rule out a more comprehensive stimulus package, possibly as part of a coordinated effort with other G7 finance ministries.
 
But as the chancellor gives with one hand, he is set to take away with the other. For one, the corporation tax rate will be maintained at 19% rather than being cut to 17% as previously planned, delivering a windfall of around £6 billion. Reports also suggest that Entrepreneurs’ Relief is in for the chop, which cost the Exchequer £2.7 billion in 2018/19. Moreover, Mr Sunak is said to want to abolish the “red diesel” subsidy to unlock £2.4 billion. Similarly at risk is the fuel duty freeze that has existed since 2010, with an inflation-linked rise of 2 pence a litre raising some £1 billion.
 
Beyond day-to-day spending, we similarly expect that any significant infrastructure commitments will be held back for the time being. The manifesto has earmarked £3.3 billion of investment for 2020/21, rising to £8.1 billion by 2023/24. Most of this has been allocated for R&D (e.g. dementia research, a new DARPA-style agency). While £0.8 billion has been pledged for next year, this will quadruple by 2023/24. Other investments include fixing potholes and reversing the Beeching cuts to railway routes, which will cost £0.5 billion each. Despite these pledges, the chancellor should still have scope to raise investment by at least £12 billion a year based on our analysis of the fiscal rules outlined earlier.

Economic forecasts

Another factor determining the amount of fiscal headroom will be the OBR’s updated projections. Though 2019/20 should be modestly improved (as detailed above), the amount of cash available in subsequent years will hinge on how the OBR’s macroeconomic outlook evolves. As previously mentioned, its UK GDP forecasts for the next three years look overly optimistic even before considering the impact of the coronavirus. A downgrade, therefore, seems to be on the cards, presenting the Exchequer with a less favourable fiscal backdrop.
 
Reports suggest that the OBR finalised its forecasts in late-February before the rapid spread of coronavirus outside of Asia. This may well present an added motivation to delay any significant fiscal decisions until later this year. Note though that the OBR will publish a limited forecast update two days after the budget (13 March) so that it can meet its obligation to produce at least two forecasts in each fiscal year. The OBR has indicated that this will not encompass any new data or market developments.
Budget table 3

Monetary Policy Committee remit reconsidered?

Separately, Mr Sunak will also be obliged to specify the definition of price stability and the government’s economic policy objectives under the terms of the Bank of England Act 1998. Since 2003, the inflation target has been defined as an annual rate of 2% for the Consumer Price Index. We see little reason for this to be altered next week. However, we would not be surprised if the chancellor elected to launch a review of the Bank of England’s strategy to run alongside those at the Federal Reserve and the European Central Bank.

Conclusion

Mr Sunak’s first budget was already going to be a challenging operation. The election manifesto pledges and subsequent commitment to “levelling up” are expensive. At the same time, there is not much cash available. Also, the effects of the COVID-19 potentially make the fiscal arithmetic more difficult. That said, the chancellor seems to have identified several measures to raise tax revenue which will help to fund his favoured measures. While fiscal credibility may not be as visible on the government’s list of priorities as seen previously, it will still be there. Borrowing at record-low interest rates does depend on this remaining intact. While we will not know the exact breakdown of planned expenditure further ahead until the Spending Review, the spending envelope will give us the total for both current and capital spending. Hence we should know the overall fiscal stance of policy. That is, until the next budget this autumn.