1 November 2018
Is the Chancellor spending a non-existent windfall?
By Frank O’Nomics
Here’s the dilemma. You’ve just won a healthy but not life changing sum of money on the lottery, but know that you are at serious risk of losing your job. Do you blow the money regardless or set it aside for when you are sure that you are safe? Suppose you blow spend the money immediately, only to realise that you have lost your lottery ticket – what do you do then? This may not be a perfect analogy of what the Chancellor has done in the Budget, but the abandonment of any attempt to balance the nation’s finances, while spending what may, or may not, amount to a significant improvement in borrowing numbers since the spring, creates a real risk of the deficit getting out of hand very quickly. In short, Mr. Hammond has pledged to giveaway £103bn that he may not have.
Why has he done this? The first reason would appear to be that the window for introducing a number of the measures (such as adjusting personal allowances) might close very quickly if the tax receipts do not turn out as hoped over the next 18 months. The second, and entirely related, reason could be that the government realises that there is a serious risk of a snap election and they want to be seen to have brought about an “end to austerity” before that happens (even though, once spending for the NHS is stripped out it is hard to argue that austerity really has ended as a result of the Budget). The Chancellor gave us a strong pointer that he knows he has taken some big risks by announcing that, if necessary, the spring statement could become another proper Budget (just when we though that we had escaped the cycle of at least 2 Budgets per year).
In looking at the extent to which Mr. Hammond has taken a risk it is important to realise that the budget deficit is the difference between 2 exceptionally large numbers. While there may be a reasonable degree of certainty on the short to medium term expenditure side of the balance sheet, there is a huge degree of uncertainty on the income side. It is impossible to know the extent to which Brexit (a word only used once in the Chancellor’s speech) will impact economic growth, and hence tax receipts. The better than expected outturn we have seen this year has been due to all key taxes generating more income than expected – income tax, VAT and corporation tax. The level of government borrowing is expected to be £11.9bn lower than forecast in the spring, and over the 5-year forecasting period the deficit forecasts have improved by a whopping £68.5bn. However, even for this fiscal year, there is a danger that the revised forecasts prove to be overly optimistic, particularly if personal spending levels and economic activity fall. While one can argue that fear of Brexit has had little impact yet, there are potentially more important global factors that will slow growth. The escalation of trade wars has already had an impact on growth in China, the key driver of global growth for some time, and the prospects for our (current) key trading partners in Europe are also deteriorating rapidly. Without those external drivers the very modest Office for Budget Responsibility growth forecasts that have generated the source of the Chancellor’s largesse could turn out to look quite optimistic. And then there is the Brexit factor – if the impact of a hard Brexit is, as some are suggesting, the equivalent of a 3% hit to GDP, OBR steady growth forecasts will be negated and government finances will take a huge hit. The Institute of Fiscal Studies has suggested that there is a one in three chance that the Budget finances will come unstuck and that the OBR will revise down its forecasts. It is also worth noting the OBR’s own irritation with the limited time that they were given to incorporate the impact of last minute policy changes into their current forecasts.
Does any of this matter? For many there are strong justifications for allowing government borrowing to increase if it means weathering the economic storm that may be about to develop. If that were to happen, market appetite for gilts would appear to have some scope, given that annual issuance is scheduled to fall below £100bn for the first time in 10 years (having peaked at £227.6bn in 2009/10). For so long the cost of servicing government debt has been exceptionally low – even now the government can borrow for 30 years at less than 2%. The problem is that the low level of long-term interest rates has been the result of low inflation and strict fiscal discipline, and both of these factors will be tested – particularly in a hard Brexit scenario that could generate inflation via a sell-off in sterling and more borrowing due to lower tax receipts.
What the Chancellor has really done is to buy himself some time. He has addressed the issues of NHS funding, universal credit, and the defence budget while even setting aside more money to ease the Brexit transition process. In addition he has managed to achieve the manifesto pledge on personal allowances a year earlier than predicted, while still hitting his two fiscal rules – reducing the cyclically adjusted budget deficit below 2% and ensuring that overall debt is falling. If the borrowing numbers take a turn for the worse, and his fiscal rules are threatened, he has the option of battening down the hatches again with a fresh Budget in the spring, where he can utilise some of the revenue sources, such as pension savings allowances, that he left untouched this time. Much of this will become less relevant if there turns out to be a need to call a general election, and the odds on that seem pretty short.