While policymakers in the US are wrangling about how much additional stimulus is required, the debate in the UK is more about what tax rises are needed to repair the damage to the public finances caused by the pandemic. Admittedly, in next week’s Budget the Chancellor, Rishi Sunak, appears intent on extending some of the temporary support for the economy for another few months. But the risk is that over the next two years he will be tempted to pull the rug out from under the feet of households and businesses by reducing the budget deficit at a faster pace than is currently scheduled. Not only would that undermine the economic recovery, but it could also cause more problems for the public finances than it solves.
- While policymakers in the US are wrangling about how much additional stimulus is required, the debate in the UK is more about what tax rises are needed to repair the damage to the public finances caused by the pandemic. Admittedly, in next week’s Budget the Chancellor, Rishi Sunak, appears intent on extending some of the temporary support for the economy for another few months. But the risk is that over the next two years he will be tempted to pull the rug out from under the feet of households and businesses by reducing the budget deficit at a faster pace than is currently scheduled. Not only would that undermine the economic recovery, but it could also cause more problems for the public finances than it solves.
- Given the vast £285bn (13.7% of GDP) direct fiscal cost of the COVID-19 policy support and the Office for Budget Responsibility’s (OBR) projection of a lasting hit to the public finances, it is easy to see why the Chancellor might be tempted to use his Budget on Wednesday 3rd March at 12.30pm to try to raise some cash. What’s more, this would achieve his political desire to underline the Conservative Party’s fiscal discipline and distinguish it from the Labour Party.
- After all, it seems unlikely that the OBR will change its assumption that the economy will be 3% smaller than its pre-pandemic trajectory by 2026 and that there will still be a budget deficit of about £100bn (3.9% of GDP) in 2025/26. Taken at face value, this suggests that if the government wants to reduce the budget deficit back to pre-virus levels of £57bn (2.6% of GDP) by 2026, then it might have to tighten fiscal policy by about £45bn (2.2% of GDP) a year.
- Add in a desire by the government to raise taxes sooner rather than later so that tax rises don’t happen just before the 2024 general election, then it’s entirely possible that the Chancellor takes the first steps to claw back some revenue in this Budget.
- But until the COVID-19 restrictions come to an end after 21st June, the immediate priority will be to do everything possible to ensure that the crisis does not lead to long-term economic scarring. So while we wouldn’t rule out Mr Sunak announcing a 1% rise in the main rate of corporation tax from 19% to 20% in the autumn and laying out plans for a further increase to 23% or 25% by 2024/25, for the most part, we think the Chancellor will be content to just express his intention to make savings at future fiscal events.
- This means that anything Mr Sunak takes away in the form of tax hikes in the Budget on 3rd March will probably be more than offset with higher spending. Indeed, we expect the Chancellor to announce a loosening in fiscal policy relative to current plans amounting to about £25bn (1.2% of GDP) in 2021/22.
- But the real risk is that at the next big fiscal announcement, perhaps in another Budget in the autumn, the Chancellor puts political aims before economic sense and begins a major discretionary tightening in fiscal policy over and above current plans, mainly driven by higher taxes. That would get some bad news out of the way before the next general election in 2024. But if it puts the economic recovery on shaky ground, the risk is that it could cause precisely the fiscal hole the Chancellor is aiming to fill.
- As we have pointed out before, we believe that a faster and fuller economic recover than the OBR expects will mean that by 2023/24 the budget deficit will have returned to its pre-crisis levels. The implication is that major tax rises may only be required if the government wants spending to stay significantly higher than before the pandemic. (See here.)
Spring Budget 2021 – Preview
The Chancellor, Rishi Sunak, will present his Budget on 3rd March under mounting pressure to do more to support the economy. So how much fiscal support will the Chancellor unveil? What policy measures will be announced? And will the Chancellor’s desire to repair the damage to the public finances caused by the pandemic prompt him to raise taxes in the Budget or will he use his statement to prepare the ground for tax hikes later this year or in 2022?
The cost of the crisis so far
There is no denying that the cost of the crisis so far has been vast. Before the COVID-19 crisis, we had thought that the budget deficit in 2020/21 would be £68bn (3.3% of GDP). We now expect the deficit to soar to about £370bn (17.8% of GDP). That would far exceed the peak of £158bn (10.1% of GDP) in 2009/10 after the Global Financial Crisis (GFC) and would be the highest budget deficit since the Second World War. (See Chart 1.)
Chart 1: PSNB Excluding Public Sector Banks (% of GDP)
Sources: OBR, Capital Economics
This deterioration reflects two factors. First, in no fewer than 13 big fiscal announcements since the 2020 March Budget, the Chancellor has unveiled direct policy support worth £285bn in total, or 13.7% of GDP. The majority of that support has been devoted to spending on public services and the government’s job furlough scheme. (See Table 1.) To put this into context, the fiscal support provided in the wake of the GFC was equivalent to 2% of GDP. So no one can accuse the Chancellor of penny pinching!
Second, the indirect economic effects of the downturn have further increased welfare payments and reduced tax revenues. We estimate that this has added an extra £18bn (0.9% of GDP) to the budget deficit in 2020/21. Table 2 shows the upward pressure on the budget deficit from these two sources.
Table 1: Sources of Fiscal Support in 2020/21
% of GDP
Self-Employment Income Support
Support for businesses
Loans and guarantees write-offs
Other tax support
Sources: OBR, UK Gov’t
Table 2: Budget Deficit, 2020/21
% of GDP
Budget Deficit (CE, pre-pandemic)
Budget Deficit (CE, Forecast)
Sources: OBR, Capital Economics
Meanwhile, public debt reached 97.9% of GDP in January 2021 and we think that it will climb to a peak of 108% of GDP in 2021/22, a level not seen since the early 1960s. (See Chart 2.)
Chart 2: Government Net Debt (As a % of GDP)
Sources: Bank of England, Capital Economics
The economic forecasts
However, the sky-high budget deficit in 2020/21 is only a concern if the COVID-19 crisis results in a permanent reduction in economic activity such that tax receipts are permanently lower and the deficit is therefore persistently higher. So the key question is whether the Office for Budget Responsibility (OBR) will retain its downbeat view that the economy will be 3% smaller than its pre-pandemic trajectory by 2026 in its new forecasts published alongside the Budget. (See Chart 3.)
Chart 3: Real GDP (Q4 2019 = 100)
Sources: Refinitiv, BoE, Capital Economics, OBR
Admittedly, the economy has outperformed the OBR’s November forecasts. Instead of remaining 12% below its pre-virus level in Q4 2020 as the OBR had projected, it was 7.8% below its pre-virus level. Against this background, the OBR will incorporate the better outcome for GDP growth in 2020, but as the economy does not have as far to recover, it will probably pull down its 2021 forecast. (See Table 3.) The OBR’s key judgement, though, will be whether it thinks that stronger growth implies that less damage has been done to the economy’s supply potential than it previously thought.
Table 3: Real GDP Forecasts (% y/y)
OBR Nov. 20
OBR Mar. 21 (CE est.)
Bank of England
Sources: OBR, BoE, Capital Economics
But we find it difficult to imagine the OBR changing its view about potential longer-term scarring effects in just three months. What’s more, the government’s roadmap for the easing of England’s current lockdown gradually from March and to give all adults their first vaccine dose by the end of July suggest there is no obvious need for the OBR to change its assumption in its central scenario that the COVID-19 restrictions would be gradually eased from the spring and vaccines become widely available from mid-2021. (See here.) So we expect the OBR to stick to its key forecast that the economy will be 3% smaller in 2026.
The fiscal forecasts
Meanwhile, the monthly borrowing figures for the 2020/21 fiscal year have so far followed a markedly lower path than that predicted by the OBR in November. Assuming that borrowing is in line with the OBR’s borrowing forecast for the remaining two months of the year, then public borrowing on the PSNB excluding public sector banks measure would come in at £325bn. That would be about £70bn lower than the OBR’s November 2020/21 forecast of £394bn. (See Chart 4.)
Admittedly, the borrowing undershoot is unlikely to be as big as that. Write-offs associated with the various government-backed loan schemes have yet to be captured in the official figures. That could raise public borrowing by about £30bn in 2020/21. But the OBR’s borrowing forecast of £394bn for 2020/21 will still probably be revised down. Before any new measures are included, a figure of about £360bn looks plausible.
Chart 4: PSNB Excluding Public Sector Banks (£bn)
Sources: Refinitiv, OBR
The medium-term projections for PSNB, however, are unlikely to change markedly. Our best guess is that the OBR may still project a budget deficit of around £100bn (3.9% of GDP) in 2025/26. That would be almost double the £57bn (2.6% of GDP) seen in 2019/20. Chart 5 shows the rough path of borrowing we expect the OBR to publish on 3rd March.
Taken at face value, this suggests that if the government wants to get the deficit back to pre-virus levels of £57bn (2.6% of GDP) by 2026, then it might have to tighten fiscal policy by about £45bn (2.2% of GDP) a year.
Chart 5: Pre-Measures PSNB ex. Banks (£bn)
Sources: OBR, Capital Economics
But now is not the time to do it
Given the vast cost of the crisis so far and the OBR’s projection of a lasting hit to the public finances, it is easy to see why the Chancellor might be tempted to use the Budget on 3rd March to try to raise cash. However, we think that such concerns are for another day.
The government’s response to the COVID-19 crisis can be divided into three phases. (See Chart 6.)
Phase 1 – Crisis mode while the COVID-19 restrictions remain in place.
Phase 2 – Supporting the recovery.
Phase 3 – Raising taxes to achieve the government’s fiscal aims.
Chart 6: Economic Timeline
Source: Capital Economics
While just a few months ago the Chancellor might have hoped the March Budget would be a chance to move away from crisis mode and towards achieving his fiscal aims, Boris Johnson has said that the COVID-19 restrictions will remain in place until at least 21st June. Until those restrictions come to an end, the immediate priority will remain doing everything possible to ensure that the recession does not lead to longer-term scarring effects.
Even once the economy recovers and we move into phase 2, it will be important for the Chancellor to commit to sufficient spending to support demand and entrench that recovery. The government might try to ensure that some of the £125bn of involuntary savings households have built up in 2020 are spent. Meanwhile, the $600 of stimulus cheques sent to US households is a good example of a policy that has boosted retail spending there. (See here.)
Even without tax increases or spending cuts, the key point for macro-economic prospects is that fiscal policy won’t provide anything like the support to the economy over the next few years as the government’s emergency policy measures start to expire. So at the very least that will mean that the government should withdraw the fiscal stimulus only gradually, to ensure that GDP and the unemployment rate return relatively quickly to their pre-crisis levels.
If the Chancellor does want to recoup some money, then it only makes economic sense to do it in phase 3 of our economic timeline. (See Chart 6 again.) And that may not be until 2023. This has the added advantage that by then it will be easier to see whether the OBR is right in thinking that there is a hole in the public finances to fill.
On our forecasts, in which we do not expect there to be big long-term scarring effects, there may not be one. Indeed, we think there is a good chance that five years down the road, the UK economy will get broadly back to its pre-virus path and that the deficit will return to its pre-virus level by 2023/24, although the government will still need to accept higher government debt. (See here.)
If we are right, that may mean it is a question of raising taxes to fund the government’s spending aims, rather than to pay for the crisis. Indeed, even before the crisis, the government had ambitious spending plans on green infrastructure and “levelling up” the regions. The extra public investment planned was already likely to take public investment spending to its highest level as a share of GDP since the 1970s. (See Chart 7.)
Chart 7: Public Sector Net Investment (As a % of GDP)
And in the wake of the crisis, the government may have an even greater desire to raise spending to tackle rising income inequality caused by the crisis, help the economy adjust to its new normal and increase the economy’s productive capacity.
The Budget measures
But with the Budget falling at the end of phase 1 and the beginning of phase 2, the case for further fiscal policy support is, in our view, a solid one. And more importantly, the government now appears to be fully signed up to the idea, with Boris Johnson in his speech on 22nd February saying that the government will “continue to do whatever it takes to protect jobs and livelihoods across the UK”.
So what key measures might the Chancellor announce? The Chancellor will probably allocate extra funds to the NHS to fund the rollout of the vaccination programme and testing capabilities, perhaps worth an extra £5bn.
And he is likely to extend many of the existing fiscal support schemes. Indeed, with 3.9 million people still furloughed at the end of December and little chance that the indoor hospitality and leisure sectors will be open before 17th May, support for the labour market is likely to feature prominently in the Chancellor’s speech. That may include an extension to the government’s job furlough scheme from 30th April perhaps until the end of June, costing about £0.5bn (0.02% of GDP). There may also be the return of the £1,000 Job Retention Bonus for employers who take their employees off furlough, which could cost up to £6bn (0.3% of GDP).
Meanwhile, the Chancellor has come under pressure from businesses to reduce the burden of business rates. But wholesale changes are unlikely, given the review of business rates and consideration of an online sales tax is now not due until later this year. Instead, the Budget will probably include an extension to the business rate relief already in place for certain sectors from 31st March perhaps until the end of July, costing a further £3.9bn (0.2% of GDP). An extension of the 5% reduced rate of VAT for hospitality and tourism from 31st March until the end of July is also possible. It would cost about £1.3bn (0.1% of GDP).
There is also a strong chance that Mr Sunak will delay the start for VAT deferral payments and the deadline for new applications for the government’s three guaranteed loan schemes (BBLS, CBILS, CLBILS) beyond 31st March.
Finally, Mr Sunak may also extend the stamp duty holiday for properties worth less than £500,000 from 31st March perhaps to the end of June. This would cost the Treasury about £1.0bn (0.1% of GDP).
The Conservatives may also feel a political imperative to take the wind out of the Labour Party’s sails by keeping the £20 a week uplift to Universal Credit for another six months beyond the existing expiry date of 5th April. That would cost about £3.0bn (0.1% of GDP).
New measures, rather than the extension of existing ones, are not out of the question either. An option that has been bandied around in the past few weeks is to reduce employer NICs by 1ppt, which would cost a hefty £6.2bn (0.3% of GDP). The costs of other possible tax changes are set out in the Tax Ready Reckoner at the end of this document.
Could Sunak do a Biden?
Of course, the Chancellor could follow in the footsteps of US President Joe Biden and go even further, choosing to spend big on the recovery as well as stemming the immediate crisis. And while private sector demand is depressed, there is certainly a good economic case to do so. After all, the risks to providing too much fiscal stimulus (i.e. causing the economy to overheat and inflation to take-off) are perhaps less worrying currently than those associated with providing too little stimulus (i.e. a slower economic recovery and possible longer-term scarring effects).
But there seems little political appetite for it in the UK. In fact, quite the opposite, given the UK is the only major economy considering raising taxes. Far from providing additional support, Mr Sunak has suggested that he might only be prepared to wait until “the economy begins to recover” before returning “the public finances to a more sustainable footing”. According to our forecasts, that might be as soon as the second half of this year. So the real risk is that the Chancellor won’t wait until the third phase in 2023 on our timeline to try to claw back some revenue.
Taxing businesses and the rich?
That is likely to have one aim and one aim only – to ensure that the government distinguishes itself from the Labour Party’s reputation of loose fiscal management to win the next general election currently scheduled for 2024. (See Chart 6 again.) And raising taxes sooner rather than later means that the Chancellor won’t have to raise taxes just before the election. Ideally, Mr Sunak would not raise taxes in 2023/24. After all, few Chancellors have dared to announce major tax increases just ahead of an election even if they don’t actually kick in for several years.
So it’s entirely possible that the Chancellor takes the first steps to claw back some revenue in the Budget on 3rd March. Media rumours suggest that the government might phase in a rise in the main rate of corporation tax from 19% to 23% or 25% gradually between now and 2024, with a 1% rise in the autumn raising about £2bn this year.
Talk of a reduction in higher rate tax relief on pension contributions is pretty much a staple of every Budget these days. And given that this is the most obvious and perhaps a politically painless source to tap as the Chancellor would be able to claim that it affects only the well-off, the government may finally go down this route. Restricting tax relief on pension contributions by high earners to the basic rate of income tax would net the Treasury more than £10bn a year, so it could also raise a significant amount.
But the Chancellor might be wary about going too far. After all, an overall fiscal consolidation could be self-defeating if it undermines the economic recovery. So while there may be a few tax rises in the Budget on 3rd March, it seems likely that they will be more than offset by a loosening elsewhere. And the Chancellor will restrain himself to saying how savings might be achieved further ahead.
The review of business rates which will consider the case for an online sales tax is due in the autumn. In addition, the Chancellor may return to the possibility of some sort of wealth tax which keeps on rearing its head. The latest variant of this idea is a one-off 5% levy of those with assets in excess of £500,000. The Chancellor might also return to the issue of whether to align capital gains tax with income tax, which could raise about £14bn.
Another option would be to pre-announce an increase in taxes. That would not be unprecedented given that in the past major changes unveiled in the pre-cursor to the Budget, the “Pre-Budget Report”, did not come into force until at least the following April. And it would allow the Chancellor to claim that he is sensitive to the challenges facing the economy but is not abandoning the action required to put the “books back in order”. And for the time being, there would be a net fiscal loosening, so this would not hurt the economy.
Table 4 brings together what we think is a plausible combination of measures, leading to fiscal policy being about £25bn (1.2% of GDP) looser in 2021/22 than under current plans.
Table 4: Possible Policy Package in 2021/22
Revenue (-)/ Cost (+)
% of GDP
Reduce employer NICS by 1ppt
£1,000 Job Retention Bonus
Extra funds for the NHS
Extend business rates relief to end-July
Extend £20 a week Universal Credit uplift for 6 months
Extend VAT cut for hospitality, tourism until end-July
Extend stamp duty holiday until end-July
Extra funds for schools
Extend furlough scheme to end-June.
Extend the loan schemes deadline
Delayed start for VAT deferral payments
Rise in Main Rate of Corporation Tax from 19% to 20%
Total Fiscal Package
Source: Capital Economics
Our forecasts for the public finances
We had already pencilled in an additional net spending of £15bn (0.7% of GDP) in 2020/21 and £10bn (0.5% of GDP) in 2021/22 in our forecast. So this would not materially alter our forecasts for economic growth.
But in our view, we think that the OBR’s new economic forecasts will still be too pessimistic about the outlook for economic growth and therefore the ability of borrowing to fall naturally in future years. Our own prediction for stronger economic growth means that by 2023/24 borrowing will have returned to pre-crisis levels. (See Chart 8.) As we have pointed out before, this means that major tax rises are not necessary to reduce the budget deficit. (See here.)
Chart 8: PSNB Excluding Banks (£bn)
Sources: OBR, Capital Economics
This doesn’t mean that taxes won’t need to rise eventually to put the public finances on a sustainable footing. There is still the medium-term issue of how to pay for increases in age-related spending. But it suggests that over the next few years, taxes only need to rise if the government wants spending to be higher than before the crisis, not to fill a hole in the public finances.
Overall, it seems likely that on 3rd March the Chancellor will announce a further fiscal stimulus, possibly amounting to about £25bn (1.2% of GDP). But the real risk is that at the next big fiscal announcement, perhaps in another Budget in the autumn, the Chancellor puts political aims before economic sense and begins a major discretionary tightening in fiscal policy over and above current plans, mainly driven by higher taxes. That would get some bad news out of the way before the next general election in 2024. But if it puts the economic recovery on shaky ground, the risk is that it could cause precisely the fiscal hole the Chancellor is aiming to fill.
Appendix 1: Tax Ready Reckoner – Direct effects of illustrative changes (£m)
Change starting rate for savings income by 1p
Change basic rate by 1p
Change higher rate by 1p
Change additional rate by 1p:
Change personal allowance by £100
Change personal allowances by 1 per cent
Change personal allowances by 10 per cent
Increase starting-rate limit for savings income by £100
Change basic-rate limit by 1%
Change basic-rate limit by 10%:
Allowances and limits
Change all main allowances, starting and basic-rate limits:
Increase/decrease by 1%:
Increase by 10% (cost)
Decrease by 10% (yield)
Working tax credit
Change basic element by £100:
Child tax credit
Change child element by £100:
Increase first child rate by £1 per week (cost)
Decrease first child rate by £1 per week (yield)
Increase subsequent child rate by £1 per week (cost)
Decrease subsequent child rate by £1 per week (yield)
Increase main rate by 1 percentage point
National Insurance Contributions
Change Class 1 employee main rate by 1 percent point
Change Class 1 employee additional rate by 1 percent point
Change Class 1 employer rate by 1 percentage point
Change Class 2 rate by £1 per week
Change Class 4 main rate by 1 percentage point
Change Class 4 additional rate by 1 percentage point
National insurance contributions limits
Change employee entry threshold by £2 per week
Change employer threshold by £2 per week
Change lower profits limit by £104 per year
Change upper profits limit by £520 per year
Change upper earnings limit by £10 per week
Capital Gains Tax
Increase Business Assets Disposal Relief rate by 1 percentage point (yield)
Increase main lower Capital Gains Tax rate by 1 percentage point (yield)
Increase main higher Capital Gains Tax rate by 1 percentage point (yield)
Increase Annual Exempt Amount by £500 for individuals and £250 for trusts (cost)
Change rate by 1 percentage point
Increase threshold by £5,000 (cost)
Impact of a 1% change in Excise duties on:
Beer & Cider
Climate change levy
Carbon price support
Insurance premium tax
Change standard rate by 1 percentage point
Change higher rate by 1 percentage point
Increase Vehicle Excise Duty by £1 for motorbikes & £5 for other vehicles
Increase air passenger duty (reduced rate) by £1
Change reduced rate by 1 percentage point
Change standard rate by 1 percentage point
Stamp Duty Land Tax
Cut 2 per cent marginal rate by 1 percentage point
Raise 2 per cent marginal rate by 1 percentage point
Cut 5 per cent marginal rate by 1 percentage point
Raise 5 per cent marginal rate by 1 percentage point
Cut 10 per cent marginal rate by 1 percentage point
Raise 10 per cent marginal rate by 1 percentage point
Cut 12 per cent marginal rate by 1 percentage point
Raise 12 per cent marginal rate by 1 percentage point
Increase £125,000 threshold by £10,000 (Cost)
Decrease £125,000 threshold by £10,000 (Yield)
Decrease Higher Rates of Duty on Additional Dwellings by 1 percentage point (Cost)
Increase Higher Rates of Duty on Additional Dwellings by 1 percentage point (Yield)
Ruth Gregory, Senior UK Economist, +44 7747 466 451, firstname.lastname@example.org