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Britain has spent recent weeks preparing for the new Chancellor to plug a so-called “fiscal black hole”, estimated at around £55bn.
This fiscal hole has resulted in a double threat: a round of spending cuts on public services and a wave of tax rises, which Jeremy Hunt will implement today.
Virtually every tax imaginable is rumored to increase in the run-up to the Fall Statement, and while it’s unlikely that all of them will, we can be sure that some will.
But what is this fiscal black hole? Why is it bad enough to justify it? Is it true that if you modify the figures in the forecasts a little, it disappears?
How did we go from Rishi Sunak as Chancellor with a £30bn cushion to hit his targets, to Rishi Sunak as Prime Minister with a supposed black hole twice as big?
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Rishi Sunak’s tax rule
The first thing to keep in mind is that it is Rishi’s goals that underlie this so-called black hole.
A year ago, as Chancellor, you introduced the UK’s latest tax rules, designed to show that we were prudent and would not continue to borrow money and spend it on things.
To put this in the context of how good Britain is at adhering to such rules, before the announcement the Institute for Fiscal Studies noted that the UK had eleven fiscal targets over the past seven years.
However, many would appreciate the sentiment that we should try to live within our means and not borrow money for daily expenses.
Sunak told parliament that his tax rules would apply over a three-year time horizon and were:
“Underlying public sector net debt, excluding the impact of the Bank of England, should be falling, as a percentage of GDP.”
AND
“Secondly, in normal times the state should only borrow to invest in our future growth and prosperity.”
Earlier this week I spoke to Carl Emmerson of the IFS about this and asked him to explain what was going on with the tax rule and the black hole.
He said that, as fiscal targets go, this was not a bad thing: the three-year period was arbitrary, but it allowed for reasons in bad years to increase debt, while recognizing that it cannot increase as a proportion of income. national. forever.
Instead, the rules aim to use good years to reduce debt as a percentage of GDP and state borrowing is fine for investing in our future, but not for filling gaps where we can’t balance the books.
Where did the fiscal black hole come from?
In March, when Sunak presented his Spring Statement, the accompanying Office for Budget Responsibility report said there was room of around £30 billion to meet the fiscal target. But Emmerson says “the outlook has clearly gotten much worse since then,” with higher spending combined with lower growth meaning lower taxes.
The OBR forecasts emerged before Russia’s invasion of Ukraine sent energy and food prices soaring and inflation soaring.
This has caused interest rates to rise more than expected and increased the cost of government borrowing and servicing our debt, with investors demanding higher rates to hold gilts, as UK bonds are known. .
To meet the fiscal target, UK debt growth must be slower than GDP growth, but forecasts have changed abruptly.
A Financial Times report this week suggested that the OBR has told the Treasury that a previously forecast budget deficit of £31.6bn in 2026 to 2027 could now be almost £100bn, with about half of the increase being due to increased interest on the UK’s £2 trillion. pile of debt.
Bond yields had already risen over the summer, but soared after Kwasi Kwarteng’s poorly delivered mini-budget, which cut taxes in hopes of growth without any OBR report alongside.
After that, a few days before Kwarteng was sacked as Chancellor, the IFS assessed the state of Britain’s finances and said the margin had evaporated and we were currently about £60bn short.
Other forecasters made similar estimates and this is where the £55bn black hole figures come from.
However, Emmerson added that we have since seen the reversal of almost all of those tax cuts – except for National Insurance and stamp duty – and we may now only have £30bn left.
It is true that by changing the figures on projected growth, inflation and interest rates it is possible to make this go away, but that also applies to any longer-term forecast and the OBR will propose a range of outcomes, but The government generally tends to use the central one.
In the meantime, while this may mean things are not as bad as reported, the Treasury will want some headroom to hit its targets.
It appears that Hunt wants to go further than necessary to try to calm already calm markets and give the government room to maneuver in the future. But doing that in an already expected deep recession is a risky move.
Is it wise to raise taxes until we reach a recession?
Hunt would likely prefer to spread all the bad news at once rather than have to come back with more tax increases in the future.
Politically, Sunak and Hunt would also prefer to achieve those unpopular tax rises now rather than closer to the general election, and they only have two years to play with.
Hunt risks going too far. Now that markets have calmed down thanks to the stern schoolteacher approach of Sunak and Hunt, rather than Truss and Kwarteng’s children on a school trip, a sense of credibility and caution has already been restored.
Assessing the situation, Emmerson said Hunt has to weigh the extent to which he has to implement tax increases now to appear credible, versus whether he could take a more agile approach and plan some for years to come.
The advantage of the latter is that they won’t hurt the economy now and can be canceled later if things go a little better than planned.
“There are risks of both over-tightening and under-tightening,” Emmerson said.
Hunt risks going too far is a message that has been echoed elsewhere, as with markets now calmed by Sunak and Hunt’s stern approach as a schoolteacher rather than the sons of Truss and Kwarteng in a school trip, a much greater sense of credibility and prudence has been reestablished.
Government borrowing costs have fallen, with 10-year bond yields falling to 3.29 percent compared to 4.5 percent at the end of September.
Meanwhile, the pound has risen to a three-month high: it is trading at $1.19, the same level as in mid-July.
There is concern among many in the financial world that the Chancellor risks implementing the second austerity measure unnecessarily and that the problems in the bond market have to do with Truss and Kwarteng and their delivery of the mini-budget, rather than a Britain’s desire to put on his hair shirt.
Speaking to people outside the financial world, I keep hearing a similar question about whether raising taxes and eliminating any remaining traces of optimistic consumer sentiment in the face of a recession is really a smart move.
Hunt’s version of the mini-Budget is expected to include a commitment to maintaining the triple lock and a benefit increase in line with inflation to protect the poorest, but it won’t bring much joy to others.
Households are already struggling with much higher mortgage costs, rapidly rising rents, 15 percent food inflation and skyrocketing energy bills.
That will be enough to damage growth.
Let’s hope there isn’t a harsh round of tax rises coming that will make the recession much worse, because that’s what I fear Jeremy Hunt is about to do.
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