Budget Preview: Safety first - Capital Economics
UK Economics

Budget Preview: Safety first

UK Economics Focus
Written by Ruth Gregory

The new Chancellor Rishi Sunak’s first priority in the Budget on Wednesday 11th March will be to deliver a package of measures to help those areas of the economy likely to be hit hardest by the coronavirus outbreak. He will presumably also get things rolling on delivering the government’s election manifesto by raising investment spending. Anything else will probably have to wait until the next Budget and Spending Review later in 2020.

  • The new Chancellor Rishi Sunak’s first priority in the Budget on Wednesday 11th March will be to deliver a package of measures to help those areas of the economy likely to be hit hardest by the coronavirus outbreak. He will presumably also get things rolling on delivering the government’s election manifesto by raising investment spending. Anything else will probably have to wait until the next Budget and Spending Review later in 2020.
  • It has been over a year since the last Budget in October 2018 and circumstances could hardly be more different. Back then, the Office for Budget Responsibility (OBR) predicted that the economy would expand by 1.4% in 2020 and that the former Chancellor, Philip Hammond, had £26bn to play with without breaching his fiscal rules. This time, the OBR will probably predict that the economy will grow by just 0.9% this year – even before any coronavirus hit – and that Chancellor Rishi Sunak is on course to breach the fiscal rule, to balance the “current” budget (excluding investment spending) by 2022/23, by about £5bn.
  • In reality, though, we doubt that Chancellor Sunak will let the fiscal rules stop him from announcing a fiscal response to the coronavirus and from implementing the Prime Minister’s political agenda to spend big in order to “level up” the regions. After all, it has become clear that fiscal rules place little constraints on the government – there have been 16 fiscal rules in the last decade! As a result, there seems a good chance that the Chancellor either announces some new, less restrictive rules. Or it’s perhaps more likely that he tweaks the current rules. If he were to opt for a ±1% band around the 2022/23 “current” balanced budget target, aiming for -1% instead would provide him with up to £17bn (or 0.8% of GDP) in the target year.
  • That will provide enough fiscal space for the Chancellor to unveil a package of targeted measures to help cushion any damage inflicted by the coronavirus, perhaps amounting to £5bn, broadly the same as the Italian government’s 0.2% of GDP stimulus announced over the weekend.
  • The Chancellor will want to implement the pledges in the Conservative’s election manifesto too. Most notably, the government promised to spend more on the NHS and to lower taxes by raising the NICs threshold for employees and the self-employed from £8,632 to £9,500 in April 2020.
  • We expect the Chancellor will get things rolling on investment spending too. After all, this is one area where there is still plenty of scope within the existing fiscal rules for the Chancellor to significantly boost the economy. Quite how far Mr Sunak will go is not clear. But a package of investment spending worth up to £70bn in total over five years (or around £14bn a year) has recently been talked about.
  • Taking these factors together, we expect the Budget to unveil a fiscal loosening of around £14.5bn (0.7% of GDP) in 2020/21, on top of the £13.4bn of spending announced in the 2019 Spending Round. Most of this will consist of additional investment spending. But a package of measures, perhaps worth £5bn (0.2% of GDP) to help cushion any damage from the coronavirus also seems likely.
  • As this would be tilted towards investment, it has the potential to be particularly effective at boosting GDP growth, adding just over 1ppts to GDP growth in 2020/21. This is the main reason why we anticipate GDP growth will accelerate by more than most expect, from 0.7% in 2020 to 2.0% in 2021.

Budget Preview: Safety first

The new Chancellor Rishi Sunak won’t sit on his hands in the Budget on 11th March in the face of the meltdown in financial markets and growing concerns that the coronavirus is developing into a pandemic. The Chancellor’s first priority will be to unveil a package of targeted measures to help offset any damage inflicted by the virus. His second priority will be to deliver the government’s 2019 manifesto promises and set the wheels in motion on raising investment spending. Anything else will probably have to wait until the next Budget and Spending Review, both due later in the year.

A fiscal response to coronavirus

Admittedly, the economic shock caused by the coronavirus is likely to affect both the supply-side of the economy (through widespread shutdowns and travel restrictions) and the demand-side (due to fewer trips to cinemas and restaurants that reduce consumer spending and weaken demand). And there’s not much that a fiscal stimulus can do to address the former.

But fiscal policy can still target areas of the economy that are hit hardest by weaker demand. Some extra spending on the NHS and other public services to help them prepare for a bigger outbreak seems highly likely. Sunak may also announce policies to provide loans and subsidies to companies in trouble and those involved in the prevention and treatment of the coronavirus.

There has to be a good chance that the Chancellor announces a temporary cut to business rates too, as well as help for the self-employed and employees with flexible or zero-hours contracts. Meanwhile, the government is reportedly preparing for the possibility that more firms struggling due to coronavirus-related cashflow issues use its “time to pay” scheme which allows tax payments to be deferred.

The Chancellor could go further and cut the standard rate of VAT. However, this would be expensive. Reducing it by 2.5 percentage points from 20% to 17.5% would cost about £17bn in 2020/21. And the measure might have a limited impact if shoppers are avoiding the high street.

So we think that the fiscal response to the coronavirus might amount to about £5bn, similar to the Italian government’s 0.2% of GDP stimulus announced over the weekend.

Plenty of scope to increase investment spending

Elsewhere, we expect the Chancellor to set the wheels in motion on raising investment spending. After all, there is plenty of scope within the existing fiscal rules for him to announce a big rise in investment spending over the next five years.

In the 2019 election manifesto, the Conservatives laid out plans to increase public investment by a total of £22bn over the next four years, but pledged to increase public investment by £100bn in total over the next five years. The government might not be able to raise investment spending by quite this much without breaching the current fiscal rule that investment spending cannot exceed 3% of GDP. That rule might leave the Chancellor with close to £85bn to play with over the next five years. Perhaps in response to this, a package of investment spending worth up to £70bn in total (or around £14bn a year) has recently been talked about.

That would eclipse the value of the measures in any of the Budgets or Pre-Budget reports seen since the financial crisis and would take investment spending to a level not seen on a sustained basis since the 1970s. (See Chart 1.)

Chart 1: Public Sector Net Investment (% of GDP)

Sources: OBR, Capital Economics

OBR to revise down growth forecasts again

Aside from spending on investment and funding set aside to mitigate the economic hit from the coronavirus, downgrades to economic growth by the OBR will probably severely limit the Chancellor’s room for manoeuvre.

Admittedly, having finalised its economic and fiscal forecasts a week ago, the OBR is unlikely to have factored in any hit to economic activity from the coronavirus outbreak in the UK – although it will highlight the risks around its headline figures.

And if the Chancellor is lucky, the OBR will assume that the weakness in the economy at the end of last year was temporary, rather than indicating that the economy’s potential growth is weaker than it thought, thereby requiring downgrades in future years.

But the Bank of England accompanied its weaker GDP growth forecasts in January 2020 with a big downgrade to the economy’s growth potential over the next three years, from 1.5% to 1.1% a year due to weak productivity. With productivity having continued to disappoint even the OBR’s more pessimistic productivity forecasts – it fell by 0.6% in the first half of 2019 instead of rising by 0.5% as the OBR thought – the OBR will probably follow suit.

At least the OBR is unlikely to significantly change its forecasts based on the Withdrawal Agreement agreed with the EU in October 2019. In a letter addressed to the Treasury, OBR Chairman Robert Chote suggested that this would not lead to “significantly quantitative difference” relative to the OBR’s March 2019 forecasts.

So we expect the OBR to revise down its forecast for real GDP growth this year from 1.4% to 0.9%, and we think that it will reduce GDP growth a touch in all future years of its forecast. (See Table 1.) That would be a downgrade of 0.8% to the level of GDP by the end of 2023.

Table 1: Real GDP Forecasts (% y/y)

2020

2021

2022

2023

2024

OBR Mar 19.

1.4

1.6

1.6

1.6

OBR Mar. 20 (CE est.)

0.9

1.4

1.5

1.5

1.6

Bank of England

0.8

1.4

1.7

Consensus

1.0

1.5

1.7

1.8

1.7

Capital Economics*

0.7

2.0

1.6

1.5

1.5

Sources: OBR, Bloomberg, BoE, HMT, Capital Economics

And with inflation having run well below the OBR’s expectations, nominal GDP growth, which is more important for the fiscal forecasts, could be even weaker than the fiscal watchdog previously anticipated. That might mean that the level of nominal GDP is about 1.5% lower by 2023 than it was in the OBR’s March 2019 projections.

The OBR’s rule of thumb that each 1% fall in the level of GDP increases public borrowing by 0.5% of GDP in the first year and by a further 0.2% of GDP in the second year suggests that, if we are right, the OBR’s new forecasts could add a whopping £22bn (or 1.1% of GDP) to borrowing by the second year. That would wipe out the Chancellor’s current headroom (of £19bn) against the existing fiscal rule to balance the “current” (i.e. excluding investment) budget by 2022/23. And of course, if the economy were weaker due to the coronavirus then the hit to the public finances could be bigger.

Taken together with the £12bn (or 0.5% of GDP) rise in day-to-day public spending from 2020/21 announced in September’s 2019 Spending Round, that might mean that far from having money to spend on things other than investment, if he wants to stick to the existing fiscal rules, the Chancellor will probably discover he has to increase taxes or cut day-to-day spending to raise some money.

At least a slightly lower starting point for borrowing and lower debt interest payments could provide an offset. Borrowing is now on track to come in at £44.1bn in 2019/20, slightly less than the OBR’s restated March 2019 projection of £47.6bn. And the OBR’s debt interest ready reckoner suggests that the forecast for debt interest payments could be revised down by about £5bn in 2022/23.

Altogether, we think that the OBR will add around £24bn to its estimate of the “current” budget deficit in 2022/23. That would mean that the £18.6bn surplus for 2022/23 predicted in March 2019 would become a £5.1bn deficit, breaching the balanced “current” budget target. (See Chart 2 & Table 2.)

Chart 2: Current Budget Deficit, 2022/23 (£bn)

Sources: OBR, Capital Economics

And as Table 2 shows, our slightly more pessimistic borrowing forecasts, which do factor in a hit from the coronavirus, suggest that the current budget deficit could be larger still in 2020/21 and 2021/22.

Table 2: Current Budget Surplus (+)/Deficit (-) (£bn)

19/20

20/21

21/22

22/23

23/24

OBR Mar. 19

2.5

13.3

15.7

18.6

21.1

OBR Mar. 20 (CE est.)1

-0.5

-6.1

-6.2

-5.1

-4.0

Capital Economics1

-0.5

-7.2

-6.6

-4.3

-3.1

Sources: OBR, CE. 1On the basis of no new policy measures.

The upshot is that the Chancellor will probably announce an increase in investment spending of about £70bn over the next five years. But even before a hit to economic activity from a coronavirus outbreak in the UK, he’s on course to break the existing fiscal rule to balance the “current” budget by 2022/23.

Higher borrowing means new fiscal rules

So he will be faced with a choice between increasing taxes, reducing day-to-day spending, or breaking the fiscal rules.

Given that the Budget is taking place soon after an election, an increase in taxes wouldn’t be too surprising. Indeed, it is typical for the government to get the bad news out of the way early in a new Parliament by raising taxes. Since 1992, tax rises of £13bn on average have been announced after an election year, more than enough to plug the possible £5bn deficit. (See Chart 3.)

Chart 3: Tax Changes (£bn)

Sources: OBR, IFS

In this regard, however, the Conservatives have severely limited their options by pledging in the 2019 manifesto not to raise income tax, VAT or national insurance this Parliament. This has ruled out about 60% of revenues. (The labels of these taxes are shown in red on Chart 4.)

Chart 4: Breakdown of Tax Revenues, 2019/20 (% of Total)

Sources: OBR, Capital Economics

In reality, we doubt that the Chancellor will let the fiscal rules stop him from announcing a package of measures to help those areas of the economy hard hit by the coronavirus and from implementing the Prime Minister’s political agenda to spend big in order to “level up” the regions. After all, it has become clear that fiscal rules place little constraint on the government – there have been 16 fiscal rules in the last decade!

And with the coronavirus outbreak damaging growth, Mr Sunak may try to blame much of the economic weakness on things beyond his control.

As a result, we suspect that Mr Sunak won’t be averse to “adapting the rules” a little to suit his political cause. Indeed, he could buy himself some time by changing the target year for the balanced “current” budget rule from three years’ time (2022/23) to five years’ time (2024/25). That would allow him to announce more spending now whilst postponing any action to get the books back in order until after the next election in 2024.

Perhaps more likely is the introduction of a ±1% band around the 2022/23 “current” balanced budget target. So instead of aiming for 0%, he could go for -1%. If the OBR revises its forecasts as we expect, that would provide him with up to £17bn (or 0.8% of GDP) in the target year.

Admittedly, a potential problem for the Chancellor is that loosening the fiscal rules in this way (or indeed abandoning them altogether) would put government debt (excluding the Bank of England’s quantitative easing programme and the Term Funding Scheme) on a steeper upward path. We estimate that with investment spending at 3% of GDP, even if the government ran a balanced “current” budget, debt as a share of GDP would rise from around 73% now to about 77% by 2023/24. (See Chart 5.) So taxes may eventually have to rise to plug the gap.

But with the markets currently sanguine about the state of the public finances and interest rates very low by past standards, the Chancellor may argue that now is the right time to spend and that these concerns are for another day.

Chart 5: Public Sector Net Debt (Excluding Bank of England, % of GDP)

Sources: OBR, Capital Economics

Some giveaways still in prospect

As a result, we still think that Mr Sunak will announce various other giveaways in the next year or two, although the big decisions may be delayed until the next Budget or Spending Review in the autumn. And in order to head off accusations of fiscal recklessness, they may be largely funded by tax rises elsewhere.

As a bare minimum, the Chancellor will want to implement the pledges in the Conservative’s election manifesto. (See Table 3.) Most importantly, it promised to spend more on the NHS and to cut taxes by raising the NICs threshold for employees and the self-employed from £8,632 to £9,500 in April 2020.

Table 3: Manifesto Promises Cost (-)/Yield (+) (£bn)

20/21

21/22

22/23

23/24

Spending on NHS

-1.2

-1.5

-1.6

-1.6

Cancel corporation tax cut

+3.0

+5.2

+6.0

+6.3

NICs threshold increase

-2.2

-2.2

-2.3

-2.5

Immigration health surcharge

+0.3

+0.5

+0.6

+0.6

Rise in employment allowance

-0.5

-0.5

-0.5

-0.5

Total*

-1.4

-0.1

+0.7

+0.8

Sources: Conservative Manifesto, CE *Only selected measures included.

Meanwhile, the Chancellor will want to show that he is sensitive to the challenges facing the economy. He could announce more money to bolster flood defences, particularly in the Midlands and the North of England. Other business-friendly measures will probably include the setting up of at least ten “freeports”, where corporate tax breaks and tariff and regulatory exemptions could help stimulate local economies.

And while the Budget is not strictly meant to include major changes in expenditure plans, which are usually set out in the multi-year Spending Reviews, there is a strong possibility of extra spending on front-line services such as health and education.

Where might Mr Sunak look to raise some money?

But by clawing back any tax cuts with some green tax rises, the Chancellor may aim to appear generous and relatively fiscally responsible at the same time.

Admittedly, there have been reports that the Chancellor has scrapped plans to raise about £11bn in revenue a year by scaling back pension tax relief for higher earners from 40% to 20%. And the idea of a “mansion tax” has reportedly also been kicked into touch following strong opposition from Conservative MPs.

But the government has already announced it will cancel the corporation tax cut from 19% to 17% planned for April 2020, saving £6.3bn by 2023/24. (See Table 3 again.)

Another possible measure which Mr Sunak may feel might not attract too much adverse attention would be abolish entrepreneurs’ relief in capital gains tax. This allows entrepreneurs to pay capital gains tax at the lower rate of 10% rather than the usual 20% on up to £10m gains and is thought to be overly generous to the wealthy. That would bring in another £2.3bn a year.

Another obvious area to generate some revenue is green taxes. The Treasury has already been consulting on abolishing the £2.4bn “red diesel” subsidy given to users of off-road vehicles and machinery in order to reduce the number of polluting vehicles. Red diesel use accounts for about 15% of total diesel sales in the UK.

And it could increase fuel duty too. Indeed, fuel duty has been kept constant in nominal terms since October 2010 and with oil prices having fallen to close to $50pb that might make it easier for the Chancellor to implement a rise. And fuel duty is certainly a good revenue-raiser, with each 1% increase yielding around £275m per annum.

But again, the recent backlash from Conservative MPs suggests that the potential political costs may be too high. And given that a rise in fuel duty in line with RPI inflation is already in the baseline, it would not actually generate any additional revenue for the government.

Perhaps a more attractive option would be an increase in Vehicle Excise Duty. An average rise in all bands of about £5 would raise about £0.2bn per annum. (Appendix 1 provides a more exhaustive ready-reckoner of the revenue effects of other possible tax changes.) Before the coronavirus outbreak, the Chancellor might have considered raising Air Passenger Duty too. An increase in the reduced rate for both short- and long-haul flights by a couple of pounds might generate about £0.4bn per annum. But with the airline industry having been hit for the spread of the virus, this now seems very unlikely.

Table 4 provides an illustrative example of how a combination of some of these various measures might add up to a net fiscal loosening of about £14.5bn (or 0.7% of GDP) or so in the 2020/21 fiscal year.

Table 4: Overall Possible Policy Package Cost (-)/Yield (+) (£bn)

2020/21 Impact

Election manifesto policies (See Table 2.)

-1.4

Targeted measures to tackle coronavirus

-5.0

Additional investment spending

-12.5

Extra flood defences

-0.5

Abolish entrepreneur’s relief

+2.3

Abolish “red diesel” subsidy

+2.4

Rise in Vehicle Excise Duty

+0.2

Total

-14.5

Sources: IFS, OTS, Resolution Foundation, Capital Economics

Effect on the economy

We had previously anticipated that the Chancellor might announce a giveaway of £11bn (or 0.5%) of GDP of spending mostly on investment in the Budget on 11th March. (See here.) We now think that the Chancellor might go a bit further and unveil an extra package of measures worth £5bn (or 0.2% of GDP) designed to help cushion any damage inflicted by the coronavirus. Admittedly, he might claw back some revenue with some green tax rises. That might mean that the total giveaway will amount to about £14.5bn (or 0.7% of GDP).

Taken together with the additional spending of £13.4bn (0.6% of GDP) announced in the 2019 Spending Round, this amounts to a total fiscal loosening of about £27.9bn in 2020/21 (or 1.3% of GDP).

As this would be tilted towards investment, it has the potential to be particularly effective at boosting GDP growth. Of course, there are big risks around this forecast. We could be wrong about either the size or the timing of the fiscal stimulus, or both. This would have knock on effects on our GDP growth forecasts. But as things stand, we expect the fiscal stimulus to add 0.8ppts to annual growth in 2020 and 0.25ppts in 2021. But this is the key reason why we anticipate GDP growth will accelerate by more than most expect, from 0.7% in 2019 to 2.0% in 2020. (See here.)

Conclusion

We had already expected something big on fiscal policy in the Budget. And in light of the rapid spread of the coronavirus across continents and in Europe, there is a good chance that fiscal stimulus will be even larger. With the headwinds to UK economy growing, that will provide a timely and much-needed boost to economic activity this year and next.

Appendix 1: Tax Ready Reckoner – Direct effects of illustrative changes (£m)

2020/21

2021/22

2022/23

Income Tax

Rates

Change starting rate for savings income by 1p

Neg.

10

10

Change basic rate by 1p

4500

5650

5600

Change higher rate by 1p

940

1350

1300

Change additional rate by 1p:

Increase (yield)

125

240

220

Decrease (cost)

140

265

265

Allowances

Change personal allowance by £100

605

700

680

Starting-rate limit

Increase starting-rate limit for savings income by £100

Neg.

5

5

Basic-rate limit

Change basic-rate limit by 1%

255

300

270

Change basic-rate limit by 10%:

Increase (cost)

2350

3300

3300

Decrease (yield)

2850

4050

4100

Allowances and limits

Change all main allowances, starting and basic-rate limits:

Increase/decrease by 1%:

1000

1200

1150

Increase by 10% (cost)

9750

12000

11900

Decrease by 10% (yield)

11050

13850

13850

Working tax credit

Change basic element by £100:

Increase (cost)

260

255

250

Decrease (yield)

265

260

270

Change 30-hour element by £100:

Increase (cost)

160

160

150

Decrease (yield)

165

160

165

Change element for couples/lone parents by £100:

Increase (cost)

235

250

245

Decrease (yield)

245

230

245

Child tax credit

Change family element by £100:

Increase (cost)

295

275

260

Decrease (yield)

305

285

265

Change child element by £100:

Increase (cost)

640

650

660

Decrease (yield)

660

645

615

Corporation Tax

Increase main rate by 1 percentage point

2000

2800

3100

National Insurance Contributions

Change Class 1 employee rate by 1 percentage point

4200

4300

4450

Change Class 1 employee rate above additional rate by 1 percentage point

1000

1000

1050

Change Class 1 employer rate by 1 percentage point

6150

6350

6550

Change employee entry threshold by £2 per week

300

320

310

Change employer threshold by £2 per week

350

360

360

Continued overleaf

Continued from previous page.

2020/21

2021/22

2022/23

Capital Gains Tax

Increase entrepreneurs’ relief rate by 1 percentage point

10

190

190

Increase lower capital gains tax rate by 1 percentage point

-5

10

5

Increase higher capital gains tax rate by 1 percentage point

-25

55

30

Inheritance Tax

Change rate by 1 percentage point

55

125

140

Increase threshold by £5,000 (cost)

30

65

70

Impact of a 1% change in Excise duties on:

Beer

30

30

30

Wine

40

45

45

Spirits

25

30

30

Cigarettes

10

5

5

Petrol

95

100

100

Diesel

180

185

190

Change insurance premium tax (standard rate) by 1 percentage point

445

445

445

Increase Vehicle Excise Duty by £1 for motorbikes & £5 for other vehicles

200

200

205

Increase air passenger duty (reduced rate) by £1

125

130

130

VAT

Change reduced rate by 1 percentage point

310

325

335

Change standard rate by 1 percentage point

6650

6850

7050

Stamp Duty Land Tax

Cut 2 per cent marginal rate by 1 percentage point

610

650

695

Raise 2 per cent marginal rate by 1 percentage point

575

620

665

Cut 5 per cent marginal rate by 1 percentage point

725

760

865

Raise 5 per cent marginal rate by 1 percentage point

670

680

790

Cut 10 per cent marginal rate by 1 percentage point

50

55

60

Raise 10 per cent marginal rate by 1 percentage point

45

50

60

Cut 12 per cent marginal rate by 1 percentage point

30

25

35

Raise 12 per cent marginal rate by 1 percentage point

25

15

25

Sources: HMRC, Tax expenditures and ready reckoners, http://www.hmrc.gov.uk/statistics/expenditures.htm


Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com