Fiscal outlook isn’t as bad as it looks - Capital Economics
UK Markets

Fiscal outlook isn’t as bad as it looks

UK Economics Update
Written by Ruth Gregory
  • The Chancellor, Rishi Sunak, was right to say today that now is not the time to tighten fiscal policy. But given the OBR’s downbeat forecasts, the biggest danger is that the government is lured into withdrawing its support too much too soon. That could lead to a slower economic recovery, cause greater long-term scarring and thus magnify the scale of future fiscal challenges.
  • The Chancellor’s spending spree looks set to continue for some time yet. He announced a further £55bn (2.4% of GDP) of COVID-related spending in 2021/22 on top of the total £280bn (14.5% of GDP) of policy support already announced this year. Admittedly, he clawed some revenue back, saving £10bn a year from departments’ non-COVID budgets and £4bn per annum from reducing the overseas aid budget from 0.7% of GDP to 0.5% of GDP. But non-COVID day-to-day spending is still set to increase by an average of 3.8% a year from 2019/20 to 2021/22 in real terms, the fastest rate in 15 years.
  • However, the Office for Budget Responsibility’s (OBR) forecasts suggest that the government may not remain in this support phase for long. In its central forecast in which an effective vaccine becomes widely available in the second half of 2021, the OBR expects the economy to be about 3% smaller in 2024/25 than if the pandemic never happened. The OBR forecasts that the government will still be running a budget deficit of £102bn (3.9% of GDP) by 2025/26, well above the deficit in 2019/20 of £54.5bn (2.5% of GDP). And underlying public debt (excluding the Bank of England’s funding measures) is expected to continue to rise from 91.9% in 2020/21 to 97.5% by 2025/26.
  • On these numbers, if the government wanted to get the deficit back to pre-virus levels in 2025/26, it might have to tighten fiscal policy by about £48bn (2.1% of GDP) a year. If it wished to stop debt rising relative to GDP, then a fiscal tightening of £21bn (0.9% of GDP) a year would be required. And all this is based on relatively conservative spending assumptions in the medium term. Indeed, the government has pencilled in no further COVID-related spending beyond 2021/22 and a reduction in departmental spending of between £10bn and £12bn a year in the medium term relative to the plans published in the March Budget.
  • But things aren’t that bad as the OBR’s forecasts exaggerate the weakness in the economy in two ways. First, we think the projections are underplaying the effect of vaccines on economic activity. Indeed, in our vaccine forecast, rather than return to its pre-virus level in late-2022 as the OBR expects, we suspect the economy will be able to do so by early 2022. Second, and much more importantly, it is not necessarily the case that there will be a fiscal hole anyway if the economy eventually gets back to its pre-virus level as we think it will. (See here.) We think the economy would be around 1% smaller in 2024/25 compared to if the pandemic had never happened. That’s closer to the OBR’s upside scenario. (See Chart 1.) That would allow the deficit to return to close to its pre-virus levels by 2024/25. (See Chart 2.) Moreover, we expect the economy to get back to its pre-virus trend later in the decade. And low borrowing costs means that the government can take time to let economic growth fill the hole.
  • This doesn’t mean that taxes won’t rise at all. But the danger is that they are raised too much too soon to fill a perceived hole in the public finances caused by the crisis that never materialises. That could be self-defeating if it prevents the economy from getting back to pre-pandemic levels and could mean that any eventual fiscal consolidation would have to be greater.

Chart 1: Real GDP (Q4 2019 = 100)

Chart 2: Public Sector Net Borrowing (As a % of GDP)

Sources: OBR, Capital Economics

Sources: OBR, Capital Economics

Ruth Gregory, Senior UK Economist, +44 (0)7747 466 451,