28 October 2021

Rishi Sunak may yet have to raise taxes again, not cut them

If the Chancellor’s economic optimism proves misplaced, he will have to raise taxes or cut spending to meet his fiscal rules.

By David Gauke

This was a Budget for a “new age of optimism”, said Rishi Sunak. And indeed it was. The Chancellor announced a series of measures that became possible because the Office for Budget Responsibility (OBR) is more optimistic about growth, employment and the public finances than it was at the time of the previous Budget in March. It also appears to be the case that the Chancellor is more optimistic than the OBR. If he is correct, he will have a chance to deliver another giveaway Budget this side of a general election.

Before turning to that, it is worth reminding ourselves of the fiscal approach the government has taken in recent months. In March, when the OBR predicted that the pandemic would scar the economy by 3 per cent, the Chancellor announced a hefty increase in corporation tax (from 19 per cent to 25 per cent) plus the freezing of allowances and thresholds in the personal tax system. This was to reduce debt following the pandemic.

In September, National Insurance rates were increased to fund social care, although the money has largely been allocated to the NHS and the breaking of a manifesto commitment was attributed to the pandemic.

In yesterday’s Budget (27 October), the OBR downgraded the scarring impact of the virus on the economy to 2 per cent, meaning that the public finances were in a much better state. (It is also the case that, taken in the round, a bit of inflation can be rather helpful in boosting tax receipts.) Borrowing for 2021-22 was revised down from £234bn to £183bn but even further out there were significant reductions. Add to that the additional tax revenue that Sunak will reap, and the OBR expects us to be borrowing less in 2024-25 than it forecast prior to the first lockdown in March 2020.

In those circumstances, the Chancellor had a choice to lower taxes, increase spending or focus on deficit reduction.

Of the three options, it was tax cuts that missed out even though towards the end of his speech, Sunak made an impassioned case for limited government and lower taxes that sat uneasily with everything he had announced. Next time I have something to give away, he implied, it will be used to cut taxes.

That is all very well but the combination of measures announced this year demonstrates a move towards a larger state. To a great extent, this was inevitable. Post-2010 levels of spending restraint were never going to be indefinitely sustainable – demographic pressures increase demands on the state, a changing coalition of Tory support demanded higher spending and the Prime Minister is naturally predisposed to say yes to new projects. Covid catch-up, levelling up and the net-zero emissions target all require higher levels of public expenditure.

In recent months, there has been a sense that the Treasury has been winning the argument on fiscal responsibility. Higher spending announcements on health and social care have been funded by tax rises, a supposedly difficult decision was made to suspend the pension triple lock, the temporary uplift in Universal Credit (UC) ended and the flow of ad hoc spending announcements staunched.

Whether the OBR’s forecasts reduced the Chancellor’s concerns or whether the Prime Minister’s instincts proved more influential is not clear, but the Budget involved a more relaxed approach to fiscal discipline. It was always likely that some of the windfall would go to ensuring that no department faced real-term cuts and, given the cost of living challenges and the row over the UC uplift, cutting the UC taper rate made a lot of sense and was predictable (and, indeed, predicted). It fits with the government’s emphasis on the working poor and although it is a spending increase, many on the right think of it as a tax cut so it keeps nearly everyone happy. But on both departmental spending and the taper rate, the Chancellor went further than he might.

The cut in the taper rate was, in the words of the Chancellor, a “first step” in “reducing taxes”. What would it take for Sunak to deliver actual tax cuts? If everything else remains equal, a further reduction in the OBR’s estimate of economic scarring caused by the pandemic would give a further boost to the public finances that would give the Chancellor the opportunity to deliver the tax-cutting Budget he very obviously aspires to deliver. That is his optimistic vision.

He will also have his pessimistic vision. What if the economy does not perform so well? The Chancellor often talks of the threat of higher interest rates and higher debt servicing costs to the economy but that is, I suspect, a convenient catch-all for a range of uncertainties facing the economy. There is evidence of an economic slowdown as supply constraints bite, lower trade intensity caused by Brexit is reducing productivity, David Frost is still trying to provoke a trade war with the EU and we have not yet seen off Covid-19.

With the increased levels of spending announced in the Budget, the Chancellor has a very small margin – approximately 1 per cent of GDP – to meet his fiscal rules. It is a calculated gamble that the economy will grow at least as well as the OBR forecasts, but Sunak will be conscious that it is a gamble nonetheless. If his optimism is misplaced, much to his frustration and embarrassment, he may be forced into raising taxes again, not cutting them.