The 30 October budget will be the first by a Labour government since responsibility for forecasting and the costing of policy changes was transferred from the Treasury to the independent Office for Budget Responsibility in 2010.
It will also be the first time since the International Monetary Fund programme in 1976 that Labour will propose significant tax increases or public spending cuts. It was widely known before this year’s election campaign that the former government’s fiscal plans were unrealistic. The infamous £20bn ‘black hole’ for 2024/25 was not a complete surprise, but more important were the known fiscal gaps in future years which will necessitate tax increases, service cuts or additional borrowing. The budget will be announced against the backdrop of a sharp rise in government bond yields in recent weeks, reflecting adverse capital market reaction to uncertainty over UK borrowing plans.
The new government escalated its problems by ruling out increases in the most important tax rates and keeping the recent cuts in National Insurance contributions. The resulting focus has been on raising taxes that do not affect ‘working people’, the effects of which are more difficult to assess.
Unrealistic forecasts
There are already signs that the OBR’s assessments of the effects of changes in these taxes will differ from the new government’s original hopes. After the sidelining of the OBR during the disastrous Liz Truss premiership, there will be no overt attempts to diminish its role or to pressurise it unduly to modify judgments and produce more optimistic forecasts. But the relationship between Treasury ministers and the official forecasters could be fraught once again.
When ministers had the final decision-making powers on published forecasts, both main political parties would publish forecasts and use assumptions for public spending plans that were too optimistic or lacked the meaningful detail on which official forecasts and fiscal prospects were based. Sensitivity grew around prospects for inflation, unemployment, the exchange rate and interest rates. It was assumed that market-sensitive variables stayed at the most recently recorded levels, even where to do so was unrealistic.
Not many commentators took such assumptions seriously and the effect of using unrealistic assumptions damaged the presentation of government policy. Gradually, the Treasury was forced by parliamentary pressure over several decades to publish more forecasts and supporting analysis that covered the whole period of its public spending plans.
Healey and Lawson clamp down
The legal obligation for the Treasury to publish forecasts following the Industry Act of 1975 increased the tensions. The most vitriolic attack on forecasters was by Denis Healey, chancellor of the exchequer from 1974 to 1979, who wrote that he ‘decided to do for forecasters what the Boston Strangler did for door-to-door salesmen – to make them distrusted forever’. His claim that he would not have had to seek an IMF loan in 1976 if the Treasury’s forecasts had been correct was self-deception. By mid-1976, the financial markets had lost confidence in the government without knowing the recent Treasury forecasts – the bulk of which were never published.
Nigel Lawson, chancellor of the exchequer from 1983 to 1989, was as critical as Healey of Treasury forecasts. However, his claim was correct that the forecast fall in gross domestic product published with the Thatcher government’s first budget in 1979 was more accurate after ministers had adjusted the internal Treasury forecast for excessive pessimism.
Lawson frequently claimed that policy was not based on forecasts. What neither he nor Healey explained was how macroeconomic policy – and fiscal policy in particular – could be presented coherently without taking a considered view of the economy’s future path and the effect of their policies on it.
Both Healey and Lawson would have been horrified at the creation of an independent OBR in 2010, a move that all previous governments, including the last Labour administration, had resisted. Ministers have not only reduced control over the published figures, but they are now also likely to be extremely reluctant to make fiscal changes if the OBR shows the results to be less favourable than hoped.
Repairing public finances
In the absence of new external shocks, such as a substantial rise in world fuel prices, the immediate prospect is for UK growth and inflation that compare reasonably well with European economies. A priority for the OBR will be assessing measures to repair public finances – filling future ‘black holes’ – while making some progress towards the economic and social aspirations of the new government.
Much of the public discussion has been about possible changes to the fiscal rules to allow more borrowing for public investment. The government would be wise not to take any risks with the gilts market given the existing high volume of gilt issuance plus the sales of gilts by the Bank of England as part of quantitative tightening.
The difficult and controversial forecasting judgments will be about the extent and speed with which investment (particularly in infrastructure) will be stimulated by budget decisions, the size and timing of any increase in growth due to extra investment, and the effect on government revenues and economic activity of tax measures designed to increase fairness (such as changes in inheritance tax, capital gains tax, pension tax arrangements, the rules for non-doms and the tax rate for carried interest). Changes in these could reduce enterprise and drive business or taxpayers overseas.
The OBR may forecast modest effects for these and as a result, some modification or even withdrawal of proposals could occur before the budget. If the forecast yield of such tax changes proves less than hoped for, the government will have difficult decisions to take on overall borrowing and public spending.
It is unlikely that it will change its approach at this late stage. The government should however bear in mind one key precept. It would be better policy to raise necessary extra revenue by changing one of the broad-based taxes such as income tax or VAT. Reforming other taxes, such as CGT and IHT, should be carried out over a longer period and without using them as sources of higher short-term revenue. Given the unpropitious economic background and the warnings already on the bond market, the government must be greatly concerned about getting the policy mix right. Any missteps bring the potential of punishment by the markets.
Peter Sedgwick was a senior UK Treasury official, Vice President of the European Investment Bank from 2000-06, Chair of 3i Infrastructure PLC from 2007-15 and Chair of the Guernsey Financial Stability Committee 2016-19.
Image credit: Number 10
