A year ago, Chancellor Rishi Sunak was enduring a baptism of fire. Having been in the post for just 27 days, he delivered his first Budget. This was against a background when the coronavirus pandemic was beginning to take hold and about to wreak havoc on the economy. Also, financial markets had become dysfunctional, requiring support from the Bank of England and coordination with HM Treasury. It was not a case of fixing the roof whilst the sun was shining, as former Chancellor George Osborne once quipped. It was more akin to pouring in concrete reinforcements just before an earthquake.
Fortunately, his second budget, due on Wednesday, will not be quite as challenging. Nevertheless, it will be far from a mainstream budget. The chancellor is treading a fine line. On one side, he needs to provide the economy with continued support, in particular, to prevent business closures and significant increases in unemployment.
But at the same time, he needs to look closely at the public finances. Concerns 12 months ago about the scale of deficit financing have disappeared. Even so, Mr Sunak needs to avoid a medium-term burden of debt that either risks spooking investors or requires a substantial fiscal adjustment. We judge that his strategy will be to keep fiscal policy expansionary in the very near term while signalling a serious intent to deliver budgetary sustainability further ahead.
It seems likely that Mr Sunak will introduce some higher taxes now. The present frontrunner is an increase in the main corporation tax rate, currently 19%. However, it should be remembered that this budget has been delayed from the autumn when the economic outlook was even murkier than now. Therefore, the next budget will be scheduled relatively quickly, in October or November, enabling the chancellor to defer decisions for a relatively short space of time if he wants to. A further point is that we have had 14 fiscal announcements over the past year. Against this background, it is impossible to rule out an adjustment to next week’s budget before autumn’s exercise.
While the UK’s impressive vaccine rollout should enable the planned easing of social restrictions between now and June, downside risks from different Covid-19 variants remain. Mr Sunak has proved himself to be pragmatic and is likely to remain so. Accordingly, we would expect him to meet new risks with new policies.
It is also important to recognise the international background. In particular, both the US and the EU are undertaking highly expansionary fiscal policies. In the US, for example, the package passed late last year, plus US President Joe Biden‘s Covid relief bill, together provide stimulus to the tune of 13% of gross domestic product (GDP). Of course, no-one expects the UK to replicate this. It is a sign of how various finance ministries are looking at the desired direction of travel. In these cases, tightening the fiscal screws will not be on the policy agenda for a while.
Many proclaim austerity to be dead. Indeed, in terms of political scope to cut UK public expenditure, we agree. The government here is committed to levelling up prosperity levels across the country, which will require higher public spending in many areas. But what has not fundamentally altered is the arithmetic governing fiscal sustainability. And if it has changed at all, it has moved the wrong way. Trend growth is now lower than before the financial crisis, which aggravates the dynamics of how economies can shake off high public debt levels.
In summary, the chancellor has to ensure that the downside risks are covered and look after the public finances in the longer term. We expect him to plan for recovery, look to righting the fiscal ship, but to be prepared for the worst.
Economic outlook – positive but uncertain?
Relative to when the Office for Budget Responsibility (OBR) last put together its projections in November, the news on the economy has been mixed. Firstly, it had not been anticipated that the emergence of a new Covid-19 variant would force the economy into a fresh lockdown since the start of 2021. However, GDP growth performed better in the fourth quarter than expected in the OBR's most optimistic scenario. There were upward revisions to previous quarters, giving a better starting place than previously factored in. More importantly, the rollout of vaccines has been highly successful and swift, which could allow for a full opening up of the economy from late-June, according to the government’s roadmap. On top of that, bank deposits illustrate that households have accumulated substantial excess savings – we estimate to the tune of £93 billion as of December – which could unleash pent-up demand once social restrictions end: if all of it is spent in 2021, this would add 7.6% to consumer spending.
Altogether then, despite a likely poor first quarter, the economy looks most closely on track regarding the OBR’s previous upside case playing out. That had activity returning to pre-virus levels by the end of 2021 rather than its central case forecast of late-2022. In terms of growth rates, revisions to the OBR’s forecasts could go either way, though, depending on the magnitude of the first-quarter fall and the second-quarter rebound pencilled in. For the public finances, however, levels of GDP arguably matter more than growth rates.
As far as the unemployment rate is concerned, the starting point for the OBR’s projections will be less favourable than it had expected in November - the unemployment rate moved up rather than sideways during the fourth quarter, so in line with its downside case rather than the central scenario. The link between unemployment and GDP growth, which is indirect and loose in normal times, is, of course, deliberately severed for the time being through the furlough schemes. So for as long as these measures remain in place, the unemployment rate will be much lower than it would otherwise be.
Much more uncertain and important for the medium-term outlook for public finances is what will happen to the unemployment rate once the schemes expire. In November’s central case, the OBR’s forecasts pointed towards a jump to a peak of 7.5% in the unemployment rate, followed by a gradual decline to 4.4% by late 2024 (see Table 1). In its upside case, the peak was just 5.1%, the level it is now, and the long-run unemployment rate at 4.1%, indicating less scarring; in its downside case, unemployment climbed to a peak of 11% before gradually falling back to 5.2%. We suspect that the OBR will now pencil in a baseline case that is slightly more optimistic, falling between its previous central and upside scenarios, albeit starting from a somewhat higher rate of unemployment.
Regarding inflation, the OBR’s baseline forecasts had previously factored in a prolonged rise in inflation, from 0.8% in 2020 to the Bank of England’s 2% target only by 2025. This time, the forecasts could be nudged up a little, bringing forward the point at which inflation is expected to be up to 2% if spare capacity is seen to be used up slightly faster than previously thought. But the overall picture of inflation pressures staying muted for some time is set to remain as before.
Public finances – needing to deal with the medium-term?
Of course, the fiscal metrics are as eye-catching as the figures on the economy. In November, the OBR forecast that borrowing would reach £394 billion in 2020-21 (see Table 2). The watchdog pointed out that £280 billion of this total was due directly to the cost of the pandemic measures. Thereafter, as the economy begins to recover and the pandemic measures are withdrawn, the focus will move towards borrowing resulting from higher unemployment and business failures. So while public sector net borrowing excluding bank interventions (PSNBx) is projected to fall from this year’s peak, it is expected to be stubbornly high over the remainder of the forecast horizon. Indeed, it is envisaged to remain at £100 billion or so in 2024-25, just below 4% of GDP.
In terms of the high-frequency data, the recent run of deficit figures has been better than expected. On current trends, our calculations suggest that borrowing for this year will be in the order of £325 billion, not the near-£400 billion indicated by the OBR. Against this, new pandemic measures have been introduced and existing programmes extended since the November forecasts were compiled (see Table 3). Moreover, the deficit's official numbers do not include possible effects from individual programmes, such as government-guaranteed lending schemes, which could result in higher borrowing needs.
But whatever the detail on the figures, the policy-relevant point is that the medium-term borrowing profile needs to be addressed. Admittedly government borrowing rates have been at historic lows over the past year. But quantitative-easing programmes, which have been instrumental in keeping a lid on rates in various jurisdictions, will be wound down at some stage. Moreover, the US's recovery prospects, tied in with President Joe Biden’s fiscal plans, have resulted in a sharp increase in global sovereign yields so far this year. Hence if anything, the cost of financing looks set to become more expensive over the next year or two. Importantly, the chancellor is aware that debt dynamics need to be sustainable, and of the risk - however small - that investors lose patience with a set of adverse fiscal metrics. A gradual tightening in the government’s fiscal plans starts this year and, in all likelihood, in a limited way next week.
Policy measures – near-term versus medium-term focus
Looking to the concrete steps the chancellor may announce, the near-term focus is likely to remain on supporting businesses and individuals through the tough times caused by the crisis. In practice, the most significant – and costly – measure that has been touted is an extension of the job support programmes, both for employees - known as the Coronavirus Job Retention Scheme (CJRS) - and for the self-employed - known as the Self-Employment Income Support Scheme (SEISS). With the CJRS alone estimated to cost more than £4 billion a month in January, this is not a step that will be taken lightly. But a roadmap to exit social restrictions is now in place. Hence pushing out the end date of the job support schemes to the end of June, aligning with the anticipated end date of the social restrictions, seems sensible economically and politically.
Also on the cards, for much the same reason and the same duration, is an extension of the business rates holiday for retail, hospitality and leisure, and the VAT cut for hospitality and tourism. Similarly, the Stamp Duty Land Tax (SDLT) holiday, which has been highly successful in bolstering housing transaction volumes last year, may well be extended through the second quarter too.
Additional Covid-related spending measures could also be announced that focus on education to accelerate catch-up for pupils after the extended periods of homeschooling. Also, the vaccination drive may require further resources beyond those earmarked already.
Moving beyond the pandemic's impact, the chancellor is also likely to give further support for the green agenda, which is an important priority in its own right to the UK government and fits in neatly with policy priorities elsewhere, such as the Biden administration in the US. It can also be targeted to dovetail with the ‘levelling up’ agenda. Exactly which measures will be put forward remains to be seen; one example put forward is the extension of the initiative to exempt electric company cars from benefit-in-kind tax beyond April.
That said, press reports indicate that the fuel duty freeze is likely to continue for the tenth consecutive year. That sits a little uneasily with the green agenda itself. Still, Mr Sunak is cognizant that car usage has been important in the pandemic as a means of limiting social contact on public transport and being keen not to discourage this at this particular moment.
Turning to these measures' funding side, as explained above, it is probably too early as yet to expect major tax rises at this stage in the pandemic, when the focus is firmly on amplifying demand in the economy. However, the chancellor may well choose to announce a corporate tax hike. Currently, the corporate tax rate is, at 19%, low internationally, and there is talk it could be raised to 23% or even 25%, phased in over a number of years. That would still only bring corporate tax rates to the lower end of the spectrum in developed economies. That the Biden administration is leaning in a similar direction in the US would give the UK some cover and comfort regarding such a move.
The introduction of an online tax has also been mentioned in the press as a possibility. Generally, though, the government may well choose to hold off on introducing such measures until the next opportunity naturally presents itself at the Autumn Budget. By that point, if all goes to plan, Covid-19 should be under control and the economy firmly on a recovery path.
Still, even then, a number of measures that have been mentioned in the press seem unlikely to be put into place. Top among those is a wealth tax; this may well be a step too far for a Conservative government to take. We also expect that pension tax relief measures for higher earners are unlikely to be modified, at least for the time being.
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