Another fiscal event…
Chancellor Jeremy Hunt’s first full Budget takes place on Wednesday 15 March. One might feel that the UK has been overloaded with fiscal events in recent years. In 2020, for example, there were approximately 20. More recently of course, most of the measures that featured in former Chancellor Kwasi Kwarteng’s ‘mini’ Budget last September were reversed by Mr Hunt less than four weeks later, well ahead of his November Autumn Statement (AS). Other fiscal announcements, such as the introduction of the Energy Price Guarantee, have been made separately too. In this respect, the relative political stability of the past few months should translate into greater continuity in the stance of fiscal policy. Mr Hunt has insisted on several occasions that no unfunded tax cuts will take place this time. This would keep him on course towards a sustainable fiscal position over the longer-term. It is also consistent with the longer-term aim to key taxes down in a year’s time ahead of a possible autumn 2024 election.
The good news is that, in very broad terms, the outlook for the public finances has improved materially. Compared with the Office for Budget Responsibility’s (OBR’s) forecasts at the AS last November, the main measure of the deficit (PSNBx) over the first 10 months of the year is cumulatively tracking around £30bn lower than forecast. This reflects favourable outturns across the board from buoyant tax receipts, softer public expenditure and lower borrowing by public corporations. Part of that is that the cost of the Energy Price Guarantee (and the equivalent for companies, the Energy Bill Relief Scheme (EBRS)) seems to be more modest than forecast as gas usage appears to be less than expected, partly due to the mild winter. In short, while the deficit is on track to have widened this year from last year’s £122bn, the OBR’s PSNBx forecast of £177bn looks too high.
However translating such an undershoot into a margin for tax cuts in subsequent years is not as straightforward as it might appear. One technical issue is that that the Chancellor’s principal rule, the fiscal mandate, is a falling debt-to-GDP ratio in five years’ time, and although this is related to the level of PSNBx, there is no straight read through. Moreover and more importantly, the binding constraint on the narrowing in the deficit over this time horizon is disappointing productivity and low economic growth and so a windfall now will not necessarily translate into a persistent improvement in the public finances. Note too that although in November the OBR concluded that the fiscal mandate would be met with a margin of £9.2bn, this is only the case because Mr Hunt changed the time horizon on the fiscal mandate from three years to five. Absent of this change, the rule would be due to have been missed by £11.4bn.
That said some of the positive effect this year will spill over into next year. Lower wholesale gas prices for example should, if they are maintained, lower the cost of the EPG from July until the end of its life to zero. Our utilities team has calculated that, from then on, the energy price cap will fall towards £2000, well below the prospective £3000 level of the EPG, meaning that it would in effect be redundant. So although widespread tax cuts are off the cards this time, there is some scope for the Chancellor to indulge in a few political quick wins to help prepare the ground for next year’s Budget.
Further help with energy bills but no tax cuts expected as yet
The most obvious quick win relates to ongoing support with household energy price bills. In the Autumn Statement, Mr Hunt announced that the Energy Price Guarantee was to be extended for a further year, to cover the FY to April 2024. But the level of support was to be reduced, so that households would shoulder a maximum energy bill (at average usage) of £3,000 p.a., up from £2,500 currently. The expectation was that this would cost £12.8bn, calculated based on wholesale gas price futures at the time. The latter have since retraced substantially – so much so that the subsidy would only need to be paid in Q2, and cost just £1.8bn. Keeping the EPG at £2,500 instead for Q2 would cost only an extra £2.6bn, and still leave the budgeted EPG cost for £8.4bn lower than estimated in November.
There are alternative, and some might argue better, uses for £2.6bn than a one-size-fits-all subsidy for households; our Utilities team, for instance, has repeatedly called for the introduction of social tariffs. But the clear advantage of a 3m extension of the EPG at £2,500 is that it feeds into CPI inflation, bringing forward the point at which the energy contribution from energy diminishes by 3m. With it, we estimate the contribution utility bills make to headline inflation to fall from 3.1%pts currently to 1.3%pts in April; at a £3,000 EPG, it would be 2.3%pts. Chancellor Hunt could therefore take credit for bringing down inflation sooner.
Less clear is whether the government will choose to offer additional help to businesses facing higher energy bills. Assistance is currently offered through the Energy Bill Relief Scheme. As that expires at the of this month, it is to be replaced by the Energy Bills Discount Scheme, running for one year. That is less generous, offering a set unit price discount for firms at a maximum cost to the public purse of £5.5bn. This new scheme was only been announced in early January, so well after the Autumn Statement, when energy prices had already come down a long way, and the design of the scheme makes it less clear that additional support would be provided by the Chancellor. That said, it is a possibility – especially as press reports suggest Mr Hunt is to maintain the planned corporation tax hike from 19% to 26% that is due to take effects from April, withstanding pressure from some Conservative MPs to scale back or abolish it.
Related to this, firms have benefited until now from the two-year ‘super deduction’ for business loans for investment introduced in the March 2021 Budget, allowing up to 130% of their cost to be deducted from taxable profits. The success of this scheme in having spurred investment is not evident, business investment having only just recovered to pre-Covid levels. That said, it can of course not be observed how much softer business investment would have been without it. With business investment perceived as key to future prosperity, the Chancellor might be tempted to pull further financial levers to incentivise it.
A further issue that will be keenly watched is whether Chancellor Hunt allocates extra resources earmarked to enhance pay for public sector workers. The wedge between public and private sector pay growth, at 6.3% vs 4.2%, is large at the moment, which has contributed to discontent with current and proposed pay for many public-sector workers. Mr Hunt has so far largely resisted pay demands that the unions have been pushing for through widespread strikes, emboldened by labour market tightness strengthening their negotiating position. But the strikes have come at a cost, especially in the NHS. Not only is this a political focus, as a high-priority issue for many voters, but rising waiting lists seem also to have contributed to labour shortages, by reducing labour force participation. Avoiding further strikes could therefore help in several dimensions.
Indeed, the Chancellor may well be thinking of other ways in which fiscal policy could help to alleviate labour shortages and thereby enhance the economy’s growth potential. For instance, pension rules may be tweaked to make it more attractive for older doctors to stay in the workforce. Also in the context of pensions, the government has made it clear it is keen to allow pension money to be channelled into new areas to boost the UK’s infrastructure. Tax incentives to facilitate this, in the context of Solvency II reforms, might therefore feature, despite recent warnings from Bank of England Governor Andrew Bailey.
Where we see relatively little scope for movement, for now, is with regards to personal income tax cuts. Indeed, Hunt opted for ‘stealth’ tax rises through extended freezes in tax thresholds and outright cuts in allowances for dividend and capital gains taxes, the latter of which kick in from this April. The fiscal backdrop has brightened, but not sufficiently for an about-turn now, we judge. As regards the personal income tax cuts that many Conservative MPs have been clamouring for, it is probably both fiscally more prudent and politically more astute to wait until closer to the next General Election to deliver these.
Higher growth and lower inflation now, but the opposite later?
In the tumultuous few years the UK economy has experienced lately, the OBR macroeconomic forecasts changed considerably. 2023 growth was projected at +1.6% in March 2019, +1.3% in March 2020, +1.7% in March 2021 and +1.8% in March 2022, but downgraded to -1.4% in November 2022 (Table 2). To us, this now looks too pessimistic, not least given the fall in natural gas price futures since. It would be surprising if there was no upgrade to this; our forecast is for -0.5% this year. At the same time, the narrative of an economy that struggles under the weight of cost-of-living pressures not fully matched by wage growth and the lagged impact of monetary tightening is likely to remain, even if the projected fall in real household disposable income is reduced.
One reason for the latter is the ongoing resilience of the labour market. It is not that we expect a major downgrade in the OBR’s unemployment rate projection for this year; in fact, our own forecast (4.6%) is higher than theirs. But we see a good chance of an upgrade to their projected nominal average earnings growth, and thus stronger nominal income growth. Moreover, the OBR may make even larger changes to its estimate of real household incomes, by downgrading its projected inflation forecasts for 2023: our latest forecast for 2023 CPI inflation (5.4%) stands a full 2%pts below the OBR’s Autumn 2022 prediction. Similar changes to RPI forecasts would tend to improve the public finance projections, by reducing the amount of revenue that will be absorbed by servicing index-linked gilts.
That said, even if inflation forecasts for this year are lowered, we suspect the OBR may be minded to raise its predictions for subsequent years. The notion that earnings growth will fall to sub-2% rates already next year, and that it will take until 2027 for the output gap to be closed, exerting a persistent drag on prices too, appears less realistic now. And to us it seems optimistic that productivity growth, long an Achilles heel for the UK economy, will average 1½% from 2025 onwards. Any adjustments resulting in a less rosy outlook will act as a constraint on the government’s fiscal room for manoeuvre beyond the upcoming fiscal year.
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