Key Takeaways
- Wednesday sees the much-anticipated UK Budget. Much of the policy mix has been flagged in advance and a £25-30 billion fiscal black hole is anticipated.
- A rollback from manifesto-breaking tax hikes means we are set to see a raft of smaller moves away from the likes of income tax, VAT and national insurance. Will these be able to generate sufficient revenue?
- The government faces a tricky task. They are not in a politically strong position and need to keep markets on side. At the same time, they do not want to implement significant cuts in spending.
- Will the Budget solve the UK’s financial problems? Likely not, but we expect to see a little more fiscal headroom achieved and, with it not being inflationary in nature, the Bank of England will have room to cut rates in December.
This week we focus on Wednesday’s UK Budget. The date was announced back on 4 September and that feels like a long time ago. In the intervening period we have heard much around the soon to be unveiled policy mix, fiscal black holes and the Office for Budget Responsibility (OBR) and their forecasts around productivity. A £25-30 billion fiscal black hole is widely anticipated.
£20-30 billion is a big hole to fill given the state of the government’s finances. We have heard lots of policy speeches from Chancellor Rachel Reeves (and others) with potential ideas being floated to address financial issues. Tax hikes have been mooted and a big decision for the government has been around whether they break manifesto pledges on income tax, VAT and National Insurance, or go for the so-called ‘smorgasbord’ approach of smaller hikes. The latter will mean it is generally harder to achieve fiscal goals because smaller tax rises don’t generate as much revenue as expected. The government has no appetite to cut spending, nor any backing from their backbenches to do so.
People have been watching the gilt market closely and things were calm overall until the U-turn on proposing to increase income tax a couple of weeks ago. When we think about the market backdrop, it is obviously one of difficult debt dynamics for the UK (although many international peers are in a similar situation). The UK does appear to be suffering a period of low growth and, more recently, high inflation, and we think back to various economic shocks over the past 15 years or so. The global financial crisis, leaving the EU, the pandemic and energy price shock have all impacted a UK economy characterised by soft confidence, low investment and lacklustre productivity. The UK is vulnerable to higher debt levels, and inflation picking up with corresponding rate hikes has had a significant impact on debt servicing costs. The UK has a potent mix of short-dated and index-linked debt, which means that when inflation picks up and interest rates are raised you get significantly higher debt service costs. In terms of the government finances, it means that over 7% of their budget is now going on interest payments – this equates to over £100 billion a year.
This Budget is a tough assignment for the government. They are not in a position of political strength and, while they obviously want to address the issues on the fiscal side (to keep markets on side), doing so means they need to increase taxes and/or cut spending. However, the taxpaying public does not see any benefit – quite the opposite, because that money is going to be spent on increased interest payments rather than improved public services. This leaves the government politically unpopular and vulnerable.
So, will this Budget be a fix? Probably not – the Chancellor will go for as little fiscal headroom as she can get away with, but that will mean the government remains vulnerable to future shocks. We could be heading into a cycle of the government trying to do just enough to keep everybody onside, but finding out later that their efforts weren’t enough. There is clearly no appetite to address the unsustainable spending, but they want to ease worries about fiscal stability, and I think some of this fiscal pain will be pushed back within parliament. A small silver lining is the fact that this Budget won’t be inflationary, and it won’t have a huge amount of impact on growth, which will give the Bank of England room to lower interest rates in December.
