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The Autumn Statement: Damaging, incredible, and suicidal

s960 Doc GOV UK
Written by Harry Western

The government’s Autumn fiscal policy statement marks a low point in the UK’s recent history of economic policy making. It is based on false premises, particularly the idea that fiscal tightening is needed to bear down on inflation. It is not credible, being badly designed and centring on measures that are unlikely to raise significant revenues. It is almost certain to damage long-term economic growth as well as worsening the imminent recession. Finally, it is electorally suicidal – it is hard to imagine a package that could damage the government’s credentials more with key sections of the electorate.

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The UK government’s Autumn fiscal policy statement of November 17 marks a low point in the UK’s recent history of economic policy making. The consequences of it are likely to be dire for short-term and long-term economic growth and almost certainly fatal for the political fortunes of the government.

The fiscal package in the Autumn Statement was ostensibly designed to appease financial markets after the fiasco of the September mini-budget put forward by the previous government. But far from being a well-designed package that will shore up the UK economy, it is fundamentally flawed and is likely to unravel badly in the months ahead. There are three main problem areas – misdiagnosis of the fiscal situation, a lack of credibility of the fiscal measures and damaging consequences of the package for growth.

Misdiagnosis of the fiscal situation. There is no question that the mini-budget introduced by the Truss government in September went down badly with markets. But it was not the only factor behind the sharp rise in UK bond yields over the few weeks that followed, perhaps not even the main one.

Importantly, UK bond yields also rose due to several other factors:

  • A global rise in yields,
  • The Bank of England raising rates more slowly than markets expected and announcing a large programme of bond sales (adding to gilt supply),
  • The decision by the UK government to enter an open-ended fiscal commitment to cap household and business energy prices,
  • A scramble for cash by UK pension funds, which had leveraged derivative positions that made them very sensitive to rising gilt yields. This factor greatly exaggerated the rise in gilt yields in a thin market.

Given that all these factors were in the mix, it is unclear that a large fiscal tightening was the right response to the surge in UK bond yields. Indeed, it is not obvious that investors were seriously concerned about the UK’s creditworthiness. UK credit default swaps (a measure of the cost of insuring against a debt default) did rise from around 20 basis points to 55 basis points, but this was way below the level of 160 seen in the global financial crisis and also lower than in 2016 (Chart 1).

Defenders of the decision to tighten policy may point to the marked decline in UK gilt yields that has occurred since mid-October as fiscal policy plans shifted, but this decline is surely due in large part to other factors such as Bank of England intervention in the bond market to cap long-term yields and the halving in European gas futures prices since the mini-budget. The latter has dramatically reduced the implied fiscal costs of the government’s energy price guarantees – probably by more than the supposed savings generated by the fiscal measures in the Autumn statement.

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Source: Datastream

The case for fiscal tightening was also based on two further misdiagnoses. First, much fuss was made about the mounting ‘cost’ of government interest payments. But the supposed spike in interest payments to £120 billion this year is not what it seems. Over half of it represents the effect of higher inflation on the principal value of inflation-linked debt – this is not cash interest that will be paid this year, but rather a sum that will be paid out over many years as the bonds mature.

Second, the government argues that tighter fiscal policy is needed to fight inflation. This is wrong. UK inflation is the result of monetary and fiscal excess during the covid pandemic plus some global supply factors, both of which have eased markedly this year. Based on trends in UK broad money growth and global commodity prices, UK inflation is likely to drop sharply over the next year and this would have been the case without any fiscal tightening (see Chart 2). Indeed, it is quite likely that the fiscal tightening in the Autumn statement represents overkill in this regard.

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Source: Bank of England, ONS, CRB

 

Lack of credibility of the fiscal package. The design of the fiscal package in the Autumn statement lacks credibility, for three main reasons:

  • Most of the fiscal tightening occurs some time in the future. There is no net tightening in 2022/2023 to 2023/2024. Instead, all the adjustment, worth a total of just under 2% of GDP, comes in later years – after the next general election. There must be very real doubts that this will ever actually occur, and the lack of any upfront measures also leaves the UK potentially vulnerable to shifts in international financial sentiment.
  • The split between tax rises and spending cuts is wrong. The international evidence suggests that fiscal tightening has the best chance of success if it focuses mostly on spending cuts, ideally cuts to current spending like the government wage bill. A share of 70-75% for spending cuts is often seen as a good benchmark. The fiscal measures in the Autumn Statement, by contrast, are only around 55% spending cuts. And in the near-term, to 2024/2025, over 100% of the planned fiscal tightening is tax rises (Chart 3). The historical evidence suggests a very high chance that a package structured like this will fail and be reversed. This is especially the case given that the cause of the UK’s large budget deficit is a very large rise in public spending as a share of GDP since 2019 – the package is not tackling the key problem area head on.

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Source: OBR

 

  • The planned tax rises are unlikely to raise the revenue claimed. The Autumn Statement package relies heavily on increased taxes on business, including higher taxes on energy firms and the sharp rise in corporation tax from 19% to 25%. The latter is supposed to raise some £19 billion in extra revenues by 2027-28 but this is very unlikely to materialise. It is more likely that UK firms will take action to reduce their tax liability, including potentially shifting activity to non-UK locations. In this regard, it is notable that the previous UK policy of significantly reducing the headline corporation tax rate did not reduce the yield from the tax, either in money terms or as a share of UK GDP (the onshore tax yield was 2.5% of GDP in 2007-08 and 2.8% in 2021-22). Similarly, other tax rises in the Autumn Statement aimed at getting more from dividends and capital gains are likely to yield far less than planned as behavioural changes shrink the tax base.
  • Dubious growth forecasts. The OBR expects the UK to enter recession next year but for growth to recover relatively strongly to over 2.5% per year in the later years of its forecast. But this recovery in large part reflects a decline in inflation to very low and even negative levels in 2024-2026 – a questionable forecast. If this growth recovery fails to appear, the fiscal savings planned will also not come through.

Damaging consequences for growth. Fiscal policy, as Patrick Minford has recently argued, should have two aims: to smooth fluctuations in output and promote long-term growth. The Autumn Statement package fails on both grounds. It is welcome that the fiscal package implies a slight net loosening of policy in 2023/2024, but that will not offset other factors pushing the UK towards recession (e.g. high energy prices and higher interest rates). In addition, it is quite likely that the fiscal package will still have a negative impact on short-term growth due to the damage it has done to economic confidence, particularly in the business sector where the package has been badly received.

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Source: OBR

Longer term, the Autumn Statement measures are potentially very damaging. The damage comes from several sources:

  • High tax levels. The fiscal problems of the UK government have resulted from a surge in public spending since 2019, but rather than concentrating on bringing spending back to pre-pandemic levels as a share of GDP, the government is instead intending to raise taxes significantly. Based on OBR projections, government revenues will rise to 41.7% of GDP by 2025, up from 37.1% of GDP in 2018. This will be the highest level since 1970. Within this, tax revenues are projected to rise to 37.5% of GDP from 33.3% in 2018. This will be the highest level since the second world war (Chart 4).
  • Loss of tax competitiveness. The Autumn Statement tax increases threaten to push the UK further down the international league table of tax competitiveness. The decline in the UK’s tax competitiveness has been quite striking in recent years. In 2015, the UK ranked a respectable 11th out of 34 OECD economies in the Tax Foundation’s International Tax Competitiveness Index, but by 2020 the ranking had fallen to 22nd and after the Autumn Statement tax rises it is estimated that it will collapse to 33rd of 38 OECD economies (Chart 5). This matters because attracting foreign investment has been a very important part of the UK’s economic success over the last four decades, but such investment is sensitive to tax burdens. The Autumn Statement is a massive threat to the UK’s position as Europe’s leading location for greenfield FDI.

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Source: Tax Foundation

  • Blunting of incentives to work. The Autumn Statement will damage work incentives across the income spectrum, an extraordinarily short-sighted policy at a time when the UK is suffering from a rise in economic inactivity in the workforce. The combination of frozen income tax thresholds with benefits indexed to inflation will reduce work incentives at the bottom end of the income scale, while the extension of the higher 45% tax rate will damage incentives at the upper end, where a variety of distortions such as progressive withdrawal of the personal allowance, the child benefit charge, and tax charges on pension contributions are already causing labour supply issues. Many taxpayers on incomes of £50,000 and above face effective marginal tax rates of over 60%.
  • Damage to investment. The Autumn Statement measures threaten to be particularly damaging for business investment. The OBR projects that capital spending will be lower by 8% by 2027-2028 but things could easily be worse than this. There is a risk that the step change higher in UK corporate taxation will lead to ‘non-linear’ effects on investment as UK firms shift activity to friendlier overseas jurisdictions. The recent announcement by Shell that is reviewing its planned investments in the UK energy sector following the Autumn Statement may be a straw in the wind here. If so, the OBR estimate that potential output may be lowered by 0.3% in the long term by corporation tax rises could prove an underestimate.

There is a section of the Autumn Statement devoted to supposedly pro-growth measures, but it is a pretty unimpressive set of proposals, rightly termed a ‘damp squib’ by the CEBR. Most of the measures outlined are either restatements of existing policies or low-impact proposals. There is a promise to rapidly review EU regulations in five growth industries but given the government’s recent record of procrastination and giving in to vested interests we should probably not expect too much from this. Even in areas crying out for reform such as Solvency II, nothing has yet been done.

Moreover, the Autumn Statement does nothing to tackle perhaps the most serious structural problem the UK economy now faces – the collapse of productivity in public services. While productivity in the market sector of the economy has recovered from the Covid slump to a level 2% above the 2019 level, in public services, productivity is still around 7% below 2019 levels (Chart 6).

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Source: ONS

What this means is that more and more resources are being transferred from the productive sector to the public sector, while the output of the latter is actually falling. This is in fact the key cause of strain in the public finances. The CEBR estimates that public spending is £71 billion higher than it would have been had public sector productivity maintained its (modest) pre-pandemic improvements in productivity. This number is larger than the whole of the Autumn Statement fiscal tightening. In addition, the government is continuing with public sector projects – notably the HS2 rail scheme – which are not only expensive but represent an appalling waste of scarce resources.

Conclusion – economically damaging, politically suicidal

The UK’s public finances need a longer-term shoring up, but the Autumn Statement represents an unnecessarily large fiscal adjustment which is badly designed and has a high chance of failing by depressing growth and investment. It is quite likely that some of its provisions will need to be revisited within the next six months as their damaging impact becomes clear.

Most seriously, the Autumn Statement threatens to entrench a downward spiral of low growth and ever-rising taxes that will sap the UK’s international competitiveness. The government is not tackling the problem of excessive public spending and the collapsing productivity of the public sector that is at the root of the country’s fiscal issues. Instead, it is following an ‘anti-reform’ agenda that will damage incentives to work and invest across all income groups and drive away international investors. This trajectory, if unchecked, threatens to push government into even more damaging tax rises and return the UK to the state it was in at the end of the 1970s, when Sir Peter Hall famously dubbed it ‘a land without opportunity’.

The current economic policies of the UK government also look politically suicidal. Even though the fiscal tightening in the Autumn statement is back-loaded, the OBR estimates UK household incomes will fall at a record pace in the next two years, by 4.3% in 2022-2023 and 2.8% in 2023-2024, thanks in large part to soaring energy prices (Chart 7). Disposable income declines on this scale are likely to prove an extinction-level event electorally, based on past form. The Truss government recognised the threat to its position from the coming slump in household incomes and tried to ameliorate it, but the new government has instead chosen to worsen it and inflict substantial long-term economic damage as well – a politically suicidal as well as economically damaging approach.

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About the author

Harry Western