As he prepares for tomorrow’s Spring Statement, the chancellor faces a huge dilemma. Does he do nothing with taxes and leave the pre-announced rises to come in as planned? In that case, with households already facing a squeeze on their incomes on account of rising energy prices and inflation more generally, and the Russia-Ukraine conflict acting to raise uncertainty and lower confidence among both households and businesses, he risks the country falling into recession. Or does he move to cancel the planned tax rises? He will then be left in the unfortunate position of possibly missing his fiscal targets for 2024-25 unless he raises taxes towards the end of the parliament: not something he’ll want to do just before an election.
Given the tax increases that the chancellor has previously announced, the Office for Budget Responsibility forecast back in October that the overall tax burden would rise to 36.2 per cent of GDP in 2026-27—the highest percentage since the 1950s. This results from the increase in corporation tax in March 2021, the freezing of personal allowances for five years from March 2021 and the new Health and Social Care Levy that will, on current plans, start this April.
But in his October budget, the chancellor also announced his intention to cut taxes before the end of the current parliament. Given how much has changed since then, should he do this? And could he?
Economic theory suggests that when setting taxes, you first decide how much spending you want to finance and then set taxes to raise that money in the least bad way for households and firms. Having done that, you aim to keep taxes stable so that people and businesses can make long-term decisions, safe in the knowledge that they won’t be penalised for doing so by sudden changes in the system. Announcing large rises in taxes today, while promising lower taxes in the future, creates uncertainty—not what the UK economy currently needs.
Households are facing a squeeze on their real incomes, given the rise in energy prices and general inflation. This is likely to worsen as the ongoing Ukraine conflict leads to even higher food and energy prices. Ands the National Institute of Economic and Social Research showed in its recent analysis, this affects the poorest households the most, because they spend more of their income on food and fuel, and such households are heavily concentrated in some of the poorest areas of the country. If the government is serious about “levelling up,” it will need to address this through higher spending. Further, there is a question over whether the government will now need to increase spending on defence, which has fallen from roughly 5 per cent of GDP in the early 1980s to 2.3 per cent of GDP in 2020. Taken together, this suggests that the chancellor has much less room, if any, to cut taxes.
But if he is determined to cut taxes at some point, how might we assess that room?
Public sector borrowing in 2021/22 is now expected to be £30bn lower than forecast in October. But more than the immediate term, it may be instructive to look at the chancellor’s own fiscal targets, which he announced in his last budget. Sunak wanted public sector net debt as a share of GDP to fall by the third year of the rolling forecast period. The OBR October Forecast suggested that, in the current target year of 2024-25, the rule would be met by a margin of 0.6 per cent of GDP (£17.5bn) and the surprisingly high tax revenues since October are likely to raise this by a further 1 per cent. But the OBR also made clear that lower-than-expected GDP growth or higher-than-expected interest rates or inflation could easily wipe out that headroom. And this was assuming spending remained unchanged.
This approach, though, is arbitrary, since the chancellor can always change the targets. What we need is a framework that makes sure that governments reduce debt when times are good, so that they can increase borrowing when they have financial crises or pandemics (or even armed conflicts) to deal with. In a recent NIESR paper, the authors argue for introducing just such a fiscal framework. I will simply note one of their key points: when setting fiscal policy, what matters more than arbitrary targets is the concrete impact on people’s everyday lives.
Given the dilemma facing the chancellor just now, this maxim could be a very useful guide.
