How should the Chancellor escape her headroom bind?

It is only four months since Rachel Reeves ‘shocked’ Britain by doing what every Chancellor does after an election – jacking up taxes. We have now been told the Government will make the “politically difficult” choice to cut welfare. It is safe to say that no political choices are walks in the park. The “bravest” of them all would be to return to tax. Can (and should) the Chancellor duck that on 26 March?

Potential escape route 1: fingers in the ears and miss the rules?

Last week the Office for Budget Responsibility sent their final verdict on the outlook, prior to any policy decisions. They very likely concluded the Chancellor would be missing her target to cover day-to-day spending with taxation in five years’ time (known as “balancing the current budget”).

We can be pretty sure of this because of what’s been going on with debt interest. The OBR takes forecasted government borrowing costs from market expectations – which have risen. We are left guessing at exactly which moment the OBR gauged the market view, but there will certainly be a big increase in the debt servicing bill, with Resolution Foundation estimating a roughly £9bn increase. Given the Chancellor had only £9.9bn of room for manoeuvre in the autumn, the OBR would have to take a singularly sunny read on the predominantly gloomy news since last Autumn for a hole to be avoided. Admittedly, higher than expected inflation (good for tax receipts) could somewhat offset weaker growth in fiscal terms, but it would be a surprise if the numbers did not worsen overall.

If the OBR deems the fiscal rules breached, then Rachel Reeves’s vaunted ambition of one fiscal event each year is out the window. Simply ignoring the rules that the Chancellor only set herself in October, and legislated for just last month, would be embarrassing: like chowing down on cream cakes the day after you’ve announced your diet. Reeves is on the record suggesting it would damage precious credibility. Stability means sticking to the constraints you set yourself, much more than rationing Budgets. (Important caveat – it doesn’t mean tightening into a downturn, but the fiscal rules bind in five years’ time so there’s no need for that).

While we’re on stability, let’s not forget how enormous the changes in recent fiscal events have been. In the 2010-2015 Parliament total policy in fiscal events, whether a cost or a saving, was on average worth 0.2% GDP a year. Since the 2015 election they have averaged three times that at 0.6% GDP. And in practice, bigger has meant more expensive too. As the chart below shows, not since 2016 has a Chancellor actually announced policies that on average tighten the fiscal position. All told, this is not a backdrop to recommend Reeves sticking her fingers in her ears.

Nine years of pain deferred: fiscal tightening is a distant memory

Potential escape route 2: Die Regeln ändern?[1]

The decision by the incoming German Chancellor to reform the fiscal rules baked into the German constitution is profound. Faced with our own tricky trade-offs this escape slide looks especially tempting. But for the UK it could be a trap door.

For starters, we set out from a very different place. The UK’s debt-to-GDP is around 40 percentage points higher than Germany. Last year we borrowed more than twice as much. Moreover, German fiscal rules are much tighter to start with, so they can be loosened quite a bit before they are looser than the UK’s. If your sober friend turns up to your birthday and has a drink, it doesn’t mean it’s sensible for you to have another if you’re already drunk.

More generally, while I love a fiscal rule more than most, I have to acknowledge they are a terrible way to judge the public finances. They are self-defined targets. Obsessing about the margin by which you meet them is like judging a race not by who actually got the fastest time, but by who most outpaced their personal target – it rewards the unambitious.

Very much unlike the Germans – whose rules bite on an actual year, not a forecasted year – the UK rules are focused on the current balance several years out. While the current budget hasn’t been in balance for a long while, it has often been forecast to be so a few years later, as the chart below shows. Britain’s long history of brighter tomorrows is another caution against borrowing more today.

Lord make me balanced-but not yet: budgets are often in surplus a few years out 

Potential escape route 3: Spending cuts and welfare

This looks like this is the Chancellor’s chosen life raft. It will not be easy to steer, and it has potential to sink.

The rising cost of working-age health-related benefits (up £13bn in real terms by the end of the Parliament), a system that doesn’t currently work particularly well for anyone, is firmly in the spotlight. To the extent that strategic reforms can curb those costs, by addressing perverse incentives to claim one benefit rather than another and supporting people into work, that is welcome.

But the Government’s savings efforts seem to be focused on the Personal Independence Payments that are paid the same to people in and out of work. The fiscal rewards for even careful reforms would be slow and uncertain. The alternative (banking early savings by crudely reducing entitlements) risks burning political capital without achieving fundamental change. The history of welfare reform is chastening – changes sold as cost savings have often turned out to be much less so. The introduction of PIP itself was meant to be cost saving (of £1.4 billion a year) but has not proved to be so (delivering savings of just £100 million).

Welfare reforms don’t always work out as planned

Turning to public service spending, the Chancellor might feel she should have some scope to pare things back, after boosting day-to-day departmental budgets in 2025-26 by £45bn in the autumn. Her difficulty, though, is that the jam only lasted a couple of years. Prospective settlements for the three subsequent years covered by the current Spending Review are already tight. On the autumn numbers, we estimate that real spending per person in departments other than health, defence, ODA and education would need to fall by around £10bn by 2029-30.

Stepping back, the new plan to expand defence to 3 per cent of GDP by the end of the next Parliament would cost an extra £21bn. By then, the OBR projects an additional £47bn of pressures on health spending. There must come a point when further squeezes to “unprotected departments” will become impossible to square with the prime minister’s vow of “no return to austerity.” Some departmental spending cuts may well be needed, but in the longer run politicians who want a smaller state will need to start telling us what the state should stop doing.

Are there any alternatives?

My expectation is the Chancellor is aiming to squeak through this Spring doing as little as possible. Welfare reductions, spending cuts, and some OBR optimism could just mean she doesn’t have to return to tax in any serious way this time. That, though, is a gamble. Rushed benefit cuts may undermine efforts for more fundamental reforms – and more significant savings – later. After this spending review, departmental spending will be set, and so much harder to cut, for all but one of the years before the fiscal rules bite. The OBR forecast for growth is more optimistic than most.

There is a further reckoning to come at some point on the tension between the government’s commitments on tax, spending and borrowing. This brings us back to the T-shaped elephant in the room (no, not the orange one…). Tax. The Chancellor’s reluctance to return to tax is understandable– but risks creating huge problems for the public finances, which are more likely than not to get worse. And there’s an (economically) straightforward lever to pull – fiscal drag (I’ve still got HMT in my soul…). Extending the freeze on personal tax thresholds for another two years to 2030 (as the past two Chancellors have done) would raise around £8 billion. Sometimes the obvious solutions, are the best ones.

[1] Change the rules?