Budget 2021 – Filling the fiscal hole - Capital Economics
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Budget 2021 – Filling the fiscal hole

UK Economics Focus
Written by Paul Dales
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While most governments are focussed squarely on maintaining or increasing fiscal support for their economies, in today’s Budget the Chancellor, Rishi Sunak, adopted a different two-staged plan for the UK – spend big for the next two years and tax big for the following three. With the bulk of the tax hikes not kicking in until the economy will be much stronger in 2023/24, this shouldn’t derail the economic recovery. In fact, if our forecast that the recovery will be faster and fuller than the OBR expects is right, the Chancellor may be in a position to cancel or reverse some of the tax hikes before the 2024 general election.

  • While most governments are focussed squarely on maintaining or increasing fiscal support for their economies, in today’s Budget the Chancellor, Rishi Sunak, adopted a different two-staged plan for the UK – spend big for the next two years and tax big for the following three. With the bulk of the tax hikes not kicking in until the economy will be much stronger in 2023/24, this shouldn’t derail the economic recovery. In fact, if our forecast that the recovery will be faster and fuller than the OBR expects is right, the Chancellor may be in a position to cancel or reverse some of the tax hikes before the 2024 general election.
  • Stage one of the plan comprises of a long list of extensions to the policies already in place that is worth an extra £53.5bn, or 2.6% of GDP. That includes extending the furlough scheme from the end of April to the end of September, the VAT cut for the hospitality sector in some form from the end of March to the end of March 2022, the £20 per week increase in universal credit payments until the end of September and the stamp duty cut in some form until the end of September. But it also includes a new 130% “super deduction” for business investment, which will cost £12bn in 2021/22.
  • Stage two of the plan includes two pretty hefty tax rises. The freezing of the thresholds at which income is taxed from April 2022 raises £8bn in 2025/26. And the increase in the main rate of corporation tax from 19% now to 25% from April 2023 brings in a cool £17bn in 2025/26. Along with a few other bits and bobs, the net effect of Sunak’s new policy measures is to raise £19bn in 2023/24, £32bn in 2024/25 and £36bn in 2025/26. That makes Sunak the biggest tax-raising Chancellor since Norman Lamont in 1993.
  • These policy measures had a much bigger influence on the forecasts for public sector net borrowing (PSNB) than the economic forecasts of the Office for Budget Responsibility (OBR). The OBR did raise its forecasts for the level of GDP over the next two years compared to its November forecasts. It now expects GDP to return to the pre-pandemic peak in Q2 2022 rather than in Q4 2022. And it now expects the unemployment rate to peak at 6.5% rather than 7.5%. But it still thinks that long-term economic scarring will cause the level of GDP in 2026 to be 3% smaller than it would have been without the pandemic.
  • The net result is that the borrowing forecasts were revised up in 2021/22 and 2022/23 but were revised down significantly thereafter. Borrowing in 2025/26 was revised from £102bn (3.9% of GDP) to £74bn (2.8% of GDP). What’s more, the current budget deficit, which excludes investment, was revised down from £27bn (1.0% of GDP) to just £1bn (0.03% of GDP). On this definition of “balancing the books”, the fiscal hole has been filled and no further tax hikes will be required.
  • That said, while all this goes a long way to prevent the debt to GDP ratio from rising further over the next five years as a whole, it doesn’t do much to reduce it from around 100%. And the government’s debt servicing costs are now twice as sensitive to higher interest rates than before the crisis. But our forecast that the Bank of England won’t raise interest rates until 2026 means the Chancellor has plenty of time to think of some creative ways to reduce the sensitivity of debt to interest rates and/or tweak the Bank of England’s mandate so that it keeps rates lower for longer. That would buy more time for the debt ratio to be reduced by GDP rising rather than another bout of tax hikes.

Budget 2021 – Filling the fiscal hole

In his Budget speech the Chancellor, Rishi Sunak, said he wanted to be “honest” about “how we balance the extraordinary support we are providing to the economy right now, with the need to begin the work of fixing our public finances.” The truth is he’s done much more than “begin” to fix it.

The policy measures

Sunak extended many of the emergency support programmes that were due to expire in March or April with new expiry dates beyond the 21st June date that marks the expected end of the domestic COVID-19 restrictions. This included extending the Coronavirus Job Retention (“furlough”) Scheme to the end of September, with government contributions being tapered from June onwards. This is estimated to cost £6.9bn in 2021/22.

The costliest measure was the fourth and fifth grants for self-employed workers. The recently self-employed are also now eligible to access the Self-Employment Income Support Scheme, which enlarged the pool of potential claimants. This may cost £12.8bn in 2021/22. Businesses will receive an extension to the 100% business rate holiday for another three months and a further 66% relief for the following nine months, costing roughly £6.8bn. And hospitality and accommodation businesses will continue to benefit from a reduced VAT rate of 5% until September and then 12.5% until March 2022.

The Chancellor also added several new measures to bolster the economic recovery. Some businesses will receive Restart Grants worth up to £18,000 per premise. And in a substantial bid to spark business investment, “super deductions” were introduced, which will reduce the tax bills of businesses by 130% of the value of their new investments. This will cost about £12.5bn in both 2021/22 and 2022/23.

But there were also several tax-raising measures. The freezing of the tax thresholds associated with income tax, VAT and inheritance tax from April 2022 will bring in £4.0bn-£8.8bn between 2023/24 and 2025/26. And the increase in the main rate of corporation tax from 19% now to 25% from 2023/24 will raise about £17.2bn in 2025/26. There are also about £4bn of cuts to day-to-day government spending a year pencilled in from 2022/23.

The net effect of the package is £59bn in 2021/22 (2.8% of GDP). This immediate fiscal loosening is followed by a tightening of policy once the economic recovery is entrenched, raising £13bn-£30bn relative to previous plans from 2023/24 to 2025/26. (See Table 1.)

Table 1: Key Measures: Cost (-)/Yield (+) (£bn)

21/22

22/23

23/24

24/25

25/26

Spending measures

Self-employment support

-12.8

+1.7

Super capital deductions

-12.3

-12.7

-2.4

+2.1

+2.8

Job retention scheme

-6.9

Business rate relief

-6.8

+0.1

Restart grants

-5.0

VAT cut for hospitality

-4.7

Universal credit

-2.2

Stamp duty nil-rate band

-1.4

Fuel duty freeze

-0.8

-0.9

-0.9

-0.9

-0.9

Alcohol duty freeze

-0.3

-0.3

-0.3

-0.3

-0.4

Tax credit payments

-0.8

Revenue raisers

Corporation tax rise

+2.4

+11.9

+16.3

+17.2

Income tax threshold

+1.6

+3.7

+5.8

+8.2

Inheritance tax threshold

+0.1

+0.2

+0.3

+0.4

Freeze pension allowance

+0.1

+0.2

+0.2

+0.3

+0.3

Freeze VAT threshold

+0.1

+0.1

+0.1

+0.2

Investment in compliance

-0.5

-0.3

+0.3

+1.0

+1.5

Total Policy Decisions

-58.9

-7.8

+13.1

+25.0

+29.0

Source: HMT. Not an exhaustive list. Numbers may not sum.

The economic forecasts

The new economic forecasts gave the Chancellor a bit of a helping hand. The surge in virus cases over the winter and the current COVID-19 lockdown led the OBR to revise down its forecast for GDP growth in 2021 from 5.5% to 4.0%. (See Table 2.)

Table 2: Real GDP Forecasts (% y/y)

2021

2022

2023

2024

2025

OBR Nov. 20

5.5

6.6

2.3

1.7

1.8

OBR Mar. 21

4.0

7.3

1.7

1.6

1.7

Capital Economics*

5.2

7.2

2.2

1.8

1.7

Sources: OBR, Capital Economics

However, the rapid rollout of vaccines means that the OBR is now more positive on growth in the second half of 2021 and in 2022 than it was in November. Indeed, it revised up growth in 2022 from 6.6% to 7.3%. Much of the boost is driven by an increase in household consumption and business investment as consumers go back to bars and restaurants sooner than expected and businesses take advantage of the “super deduction” for investment.

As a result, the OBR now thinks that GDP will return to its pre-crisis level in the middle of 2022 – about six months quicker than it thought in November. But that is still about six months longer than we think. What’s more, the OBR thinks the initial rapid pace of growth will wear off quickly, meaning that the economy will be roughly the same size in 2024 as the OBR thought in November. (See Chart 1.)

Chart 1: GDP (Q4 2019 = 100)

Sources: Refinitiv, OBR, Capital Economics

Indeed, despite the OBR bringing forward its estimate of when GDP will reach its pre-crisis level, it stuck with its estimate that the impact of long-term economic scarring from the crisis will be to leave the economy 3% smaller in 2026 than it would have been without the pandemic. While the OBR said that the quicker opening of the economy and generous incentives for business investment will ease the hit to the capital stock, it is still concerned about the impact on productivity and the labour market, the latter given the evidence that the population may now be much smaller. (See here.)

In contrast, we doubt there will be much scarring from the COVID-19 crisis. We think that by 2025 the economy may be pretty much back on its pre-crisis path, rather than 3% below it. (See Chart 1 again.)

Since the OBR now expects the economy to get back to its pre-crisis level sooner and as the furlough scheme has been extended from the end of April to the end of September, the OBR has revised down its forecasts for the unemployment rate. It now expects unemployment to peak at 6.5% in Q4 2021 rather than peaking at 7.5% in Q3 2021. That is similar to the 6.5% peak we expect. But our more optimistic outlook for GDP over the next few years means that we expect the unemployment rate to fall faster. (See Chart 2.) So while the OBR’s economic forecasts have moved towards ours, we are more optimistic on the outlook beyond the next two years.

Chart 2: ILO Unemployment Rate (%)

Sources: Refinitiv, OBR, Capital Economics

The fiscal forecasts

The new economic forecasts helped make the public fiscal forecasts look a bit better, but it was the tax hikes that really made a difference. The better-than-expected borrowing figures in recent months and the stronger GDP performance caused the OBR to revise down its borrowing forecast for 2020/21 by £39bn, from £394bn to £355bn. Even so, this is equivalent to 16.9% of GDP and easily the highest peacetime budget deficit on record. (See Chart 3.)

Chart 3: PSNB Excluding Public Sector Banks (% of GDP)

Source: OBR

And the £53.5bn of extra policy support caused the OBR to revise up its borrowing forecast for 2021/22 by £70bn from £164bn (7.4% of GDP) to £234bn (10.3% of GDP). But beyond 2022/23 borrowing was revised down significantly. With the OBR sticking to its assumption that the economy will be 3% smaller in 2026, the downward revisions were entirely a result of the tax hikes and some smaller spending cuts announced in the Budget, rather than changes in the forecasts for the economy. By the end of the forecast period in 2025/26, the OBR now expects borrowing to be only £74bn (2.8% of GDP). That’s £28bn lower than the £102bn (3.9% of GDP) projected in November. (See Table 3.)

Table 3: Changes to PSNB Ex. Forecasts (£bn)

20/21

21/22

22/23

23/24

24/25

25/26

1. Nov. 20 forecast*

394

164

105

100

100

102

2. Economic changes

-47

16

2

4

6

8

3. Pre-policy fcast(1+2)

346

180

107

105

106

110

4. Policy measures**

9

54

0

-19

-32

-36

5. Mar. 21 f’cast (3+4)

355

234

107

85

74

74

Sources: OBR, Capital Economics. *Central Scenario. **Budget measures, plus those previously announced that affect PSNB.

The result is that at 2.8% in 2025/26, PSNB is pretty much back to its 2019/20 level of 2.6%. Rather than reaching £27bn (1.0% of GDP) in 2025/26, the current budget deficit (i.e. excluding investment) now reaches just £0.9bn (0.03% of GDP) by 2025/26. And instead of continuing to trend upwards, the OBR expects the underlying debt to GDP ratio (which includes the Bank of England’s loan facilities) to stabilise at 97% in 2023/24. (See Chart 4.) So the clear message is that the Chancellor doesn’t need to go any further to achieve his two broad fiscal aims set out in the Budget, namely to balance the current budget and to prevent the debt to GDP ratio from continuing to rise.

Chart 4: Underlying Net Debt (% of GDP)

Source: OBR

What’s more, while the borrowing forecasts for this year look reasonable and are similar to our own expectations, the forecasts for 2022/23 and beyond still look pessimistic to us. If, as we think, the recovery is faster and fuller than the OBR expects, the deficit will fall more quickly. We think that borrowing will reach its pre-virus level of £57bn (2.6% of GDP) by 2023/24. (See Chart 5.)

Chart 5: PSNB Excluding Public Sector Banks (£bn)

Sources: OBR, Capital Economics

This suggests that the OBR may eventually lower its borrowing forecasts further, perhaps allowing the Chancellor to cancel/reverse some of the proposed tax hikes before the 2024 general election.

There are two big risks. First, the economic recovery is weaker than we expect due to the virus mutating in a way that makes the vaccines less effective and delays the reopening of the economy. That could cause greater longer-term economic scarring.

Second, if interest rates rise, the debt to GDP ratio would start to climb again. Indeed, government debt servicing costs are now twice as sensitive to any rises in rates than before the crisis. That’s in large part due to the Bank of England’s quantitative easing (QE), which essentially swaps the government’s fixed long-term debt obligations with floating short-term obligations. The median maturity of public debt has shortened from more than ten years before the financial crisis to less than four years now.

But if we are right in thinking the Bank of England won’t raise interest rates until 2026, then the Chancellor has time to come up with more creative solutions to reduce the sensitivity of debt to interest rates and/or tweak the Bank of England’s mandate (i.e. increase its tolerance to inflation) so that it keeps rates lower for longer. That would buy more time for rising GDP to reduce the debt ratio.

Conclusion

Overall, the Chancellor’s two-stage plan should support the economic recovery at its time of need and not hinder it too much once it has got going.


Paul Dales, Chief UK Economist, +44 (0)7939 609 818, paul.dales@capitaleconomics.com
Ruth Gregory, Senior UK Economist, +44 (0)7747 466 451, ruth.gregory@capitaleconomics.com
Thomas Pugh, UK Economist, +44 (0)7568 378 042, thomas.pugh@capitaleconomics.com
Kieran Tompkins, Assistant Economist, kieran.tompkins@capitaleconomics.com