Chancellor of the Exchequer Rachel Reeves has pledged to have one main fiscal event per year in the autumn, and no further tax rises – at least on companies. However, these pledges may prove unrealistic given recent developments in the gilts and foreign exchange markets and accumulating evidence of weak economic growth.
Amid such febrile market and political conditions, the successful management of the UK economy will involve both making the correct policy choices and – almost as important – making them at the right time. Policy changes must be announced within the Office of Budget Responsibility forecast on 26 March, or even sooner if market developments worsen.
Looking further ahead, the government intends to complete the public expenditure review for the years from 2026-27 by mid-year, but without an OBR assessment. This is unrealistic unless economic prospects remain exactly as previously forecast by the OBR. To maintain financial market calm, an OBR assessment of the spending review will be essential and some corrective changes to tax and spending plans might also be necessary.
Loosening fiscal rules – to borrow more for either current spending and investment – would risk unnerving financial markets. Efforts to increase growth and government efficiency may have modest effects in the near term. As a result, the government will be forced to consider service cuts or a temporary, broad-based income tax hike, which stands to be the least damaging though still unpalatable option. Within such fiscal tightening, there might have to be some relief for companies and for low-wage workers.
The main economic challenge lies in fiscal policy, though rising consumer price inflation may follow recent exchange rate weakness and higher world energy prices. Typically, the Bank of England would respond by slowing short-term interest rate cuts or even raising rates if the exchange rate weakened markedly. However, this would not be a fitting response to inflationary pressure caused primarily by a loss in confidence in fiscal policy. Instead, a coordinated fiscal response from the Treasury and Bank, possibly involving tax rises for individuals, would be preferable. At a time of difficulty in the markets, the Bank should pause the rundown of its gilt holdings as part of its quantitative tightening policy.
The Treasury policy timetable
Treasury policy-making appears not to be fully adjusted to the OBR’s requirements to publish two forecasts a year. When economic developments are unstable, it is fanciful to expect a published OBR forecast not to require some policy changes, particularly if the forecast shows a breach of fiscal rules or guidelines. Rising gilt yields seem likely to have removed the bulk of the previously estimated headroom within the Chancellor’s fiscal rules and weak activity following the budget’s tax increases is expected to be another factor diminishing the fiscal outlook. With markets jittery ahead of the OBR’s 26 March forecast, delaying any tax or spending changes until later in the year is impractical.
Figure 1. British borrowing costs surge as investors sell gilts
Source: London Stock Exchange Group, Reuters
There is another complication. The planned mid-year public spending review – almost three months after the 26 March OBR exercise – risks creating uncertainty if it doesn’t align with one of the two statutory OBR assessments for 2025-26. Since the 1970s, there has justifiably been parliamentary pressure to publish medium-term public spending plans alongside forecasts of government revenues. Anything less would produce considerable uncertainty about the feasibility of the new plans. To avoid such uncertainty would require another full-scale OBR update.
The Treasury has a choice to make: either hold a third OBR exercise in financial year 2025/26 coinciding with the planned mid-year spending review or advance the date of the public spending review to coincide with the late March 2025 OBR exercise. Allowing too generous a timetable for the public spending review could hinder rather than help ministerial agreement as positions become more entrenched. If an earlier announcement is ruled out, the OBR should instead be involved in assessing and presenting the medium-term spending plans.
What policy changes are needed?
The nature and timing of policy changes will depend crucially on financial market conditions. The government’s hope is that no changes will be necessary before at least the 26 March OBR assessment, but a rise in gilt yields and a weakening pound more severe than other European economies may prompt action.
A simultaneous weakening of the exchange rate and difficulty in selling gilts would put the Treasury in crisis mode of a nature not experienced since the 1960s or 1970s, except in the brief episode under former Prime Minister Liz Truss. This would require a significant fiscal response. Overreliance on the Bank raising interest rates would not address underlying fiscal problems and would unfairly and inefficiently concentrate the pain of adjustment on mortgage holders.
The fiscal options are not attractive either. Loosening or abolishing the Chancellor’s fiscal rules would be of no help in current circumstances and weakening the commitment to fund current spending with revenues would increase borrowing. The government is right to focus on public spending efficiencies, but reversing productivity declines since the pandemic will take time.
Any gains from a growth strategy will similarly have little effect on government revenues in the next few years. The government is likely, therefore, to be forced to contemplate a combination of cuts in the funding of services or – more likely – tax rises unless public sector efficiencies turn out to be much larger and to occur sooner than expected.
Any tax rises must avoid the corporate sector which may even need some relief, for instance by moderating the lowering of the National Insurance threshold announced in the budget. Fear of financial market turmoil could put on the table such options that have hitherto been firmly ruled out. Yet a broadly based surcharge on income tax could be the least damaging option for boosting revenue. Whatever decisions are made, they should be fully costed and their effects assessed by the OBR.
Finally, to put macroeconomic policy on a firm footing, the government should make realistic provision for known future pressures on public spending in the later years – even if these imply higher taxes. The practice of this and the previous government of presenting a falsely reassuring public spending picture should end, replacing them with more credible projections to enhance fiscal policy credibility.
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
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