How will Reeves plug the UK's fiscal black hole?

Paul Diggle

Hello and welcome to Macro Bytes, the economics and politics podcast from Aberdeen. My name is Paul Diggle.

Luke Bartholomew

And I'm Luke Bartholomew.

Paul Diggle

The UK budget is about two months away. It's scheduled for very late in the year, for 26th of November, but already speculation about what will be in that budget is increasing in earnest – from the size of the so-called ‘fiscal black hole’ that the chancellor will be required to fill, to the spending cuts, or, more likely, tax increases that will be announced. And markets are, of course, trying to price all of this in already, including with upward pressure on long-term UK gilt yields. So, Luke and I are joined today by Lizzie Galbraith, senior political economist here at Aberdeen, to discuss the chancellor's tough choices, the outlook for fiscal policy and the state of the UK economy more broadly. Welcome, Lizzie.

Lizzie Galbraith

Hi Paul.

Paul Diggle

So, Lizzie, at the time of the spring statement earlier this year, Chancellor Rachel Reeves took various measures to restore roughly 10 billion pounds of headroom against her own fiscal rules. And as a reminder, the chancellor set itself [sic] no less than three fiscal rules. But the binding one against which this headroom is measured is the so-called ‘stability rule’ [which] requires the government to run a balanced budget for day-to-day spending by 2029/30, as measured by the Office for Budget Responsibility in its forecasts. Now, since restoring this sort of theoretical headroom, various things have happened, as they have, the want of doing, that appear to have eroded again. So, Lizzie, what are those things that have eroded UK fiscal space, and what do we think that means in terms of the size of the black hole come November?

Lizzie Galbraith

Yeah. So, there's three main buckets, I think, that we can ascribe to that erosion of fiscal headroom. So, the first is government policy decisions, and more accurately government policy U-turns. So, the government had planned to pass a bill that would have cut benefits spending and they had to U-turn on that – they actually had to scrap it entirely. That cost the government about 4.8 billion relative to their previous plans. And we also had the restoration of winter fuel payments, which proved to be one of the most unpopular aspects of the previous budget, and that cost the government just over a billion pounds as well. So, policy decisions have had an impact here. They've taken around about two-thirds of that original fiscal headroom with them. But we've also had some other things happen as well. So, the first is that gilt yields have been rising, and have risen relatively considerably since the autumn budget. That has increased the cost of borrowing for the government. And indeed, government borrowing has been running slightly higher than the OBR had expected as well. So that has further eroded that headroom. And then the final factor to consider here is that it looks really quite likely that the OBR will downgrade its productivity forecasts. They've been relatively over-optimistic, pretty much since Covid and even a bit further back than that, over productivity growth in the UK. And they're likely to revise their forecasts down. And that will, again, quite considerably erode the fiscal headroom, as a result. So, all of that is likely to leave Rachel Reeves in a position where she's a negative against her fiscal headroom and she's likely to need to find an additional 20 to 30 billion pounds at this autumn budget in order to get back in the black.

Luke Bartholomew

So when we talk about that 20 to 30 billion pound ‘black hole’, as it's sometimes referred to, and what's going on there, I guess, is that you're missing the fiscal rules and then you're consolidating to get back to zero, as it were, just meeting the rules, and then restoring the 10 billion pounds or so of headroom that existed previously. And it's not obvious why that 10 billion pounds is being chosen as the magic number of headroom that the chancellor wishes to have. It's not like that number has, in fact, served her particularly well. It has turned out to be a pretty small number that gets blown out of the water with relatively small moves, but that seems to be the number that everyone's assuming she will target this time as well. But are 20 to 30 billion that we're talking about there, Lizzie, I mean I think that that's a number that's broadly in line with consensus as well. But it is worth saying that there are some estimates out there for a much bigger black hole. And the National Institute of Economic and Social Research has talked about a 40-to-50-billion-pound black hole. And I think, where those more pessimistic numbers coming from, those bigger numbers are coming from, is on different productivity numbers. As you talked about, the OBR is likely to be revising its productivity numbers down. They quite famously had productivity estimates that are considered quite optimistic. 1.1% is the productivity estimates that they have in whereas the National Institute is talking more about a 0.2% productivity growth and that's basically in line with the UK's performance post-financial crisis. So, a really really dire productivity outlook – assuming that we don't pick up productivity growth at all. I suspect the truth, or at least where the OBR’s going to land – whether that's true or not is a different matter – is somewhere between that 0.2 and 1.1. So that will be revised down. But it is hard to see the OBR doing a cut of that magnitude in one go. And sort of to put it in perspective, what these kinds of numbers mean – every 0.1 percentage point reduction in productivity estimates cost about 9 to 10 billion pounds on the fiscal rule. So, you start cutting that number considerably and you can see where 40-to-50-billion-pound black holes come from, and yeah, the kind of headache that that would create for the chancellor. The OBR of course is an independent institution, but it's not entirely immune, I suspect, to some of the political considerations that would be involved in changes that have those kind of implications.

Paul Diggle

Okay. And there are basically three ways, I think, out of this fiscal bind. One is to loosen the fiscal rules. But that could potentially run into the gilt market, which, after all, was actually the binding constraint on the UK fiscal stance rather than the rules themselves – the rules are there really to keep the government onside with the gilt market. Ultimately it is the market that will decide at what rate the UK can borrow and at what point it thinks that [the] size of debt and deficit are too much and that a much higher borrowing costs are therefore required for the increase in risk. The specific structure of the rules that does, I think, cause some problems around the choreography of the fiscal events and leads to some uncertainty, some sub-optimal policy decisions. So a move, say, to one fiscal event a year could be a welcome change to the rules at the margin. The second way around this bind is to reduce spending. But as you were talking about, Lizzie, the government has found it very politically difficult to do that. We’re, of course, heading into party conference season and all the pressure is going to be in the opposite direction – to actually increase spending. Things like dropping the two-child benefit cap, figuring out how to fund the NATO defence spending increase, which is not currently, actually fully budgeted for. And then the third is raise taxes. Maybe there is a fourth that we will get on to a sort of ‘get out of jail free’ card, which is – pull the growth lever, in some way. But Lizzie, it's going to be mainly a tax-rising budget. Therefore, why don't you walk through what the most likely measures that you expect the chancellor to announce in the budget, and how much they could plausibly raise?

Lizzie Galbraith

Yeah. So, no one obviously enjoys hearing about tax increases at budgets. But there are some options that are less politically challenging for this government than others. So, there are options like refreezing income tax bands beyond 2028. Rachel Reeves at the previous budget made the decision to unfreeze those. Now, you could simply just reverse that decision and let fiscal drag do some of the work here. Previous governments have done very similar things, and it's a relatively politically cost-free measure when you consider that it raises around about 10 billion pounds – so a fairly considerable sum given the options that we're looking at elsewhere. Another option that we think the government is going to be very seriously considering is a reform of gambling taxation and increases to other so-called ‘sin taxes’ – so alcohol duty, tobacco duty, possibly taxes on flights as well, things like that. Collectively, that could raise up to 5 billion pounds depending on the exact mechanisms involved. And the other option that we think the government is going to be very seriously considering is, increases to taxes on banks. There's a couple of options here that are most talked about. The first is a QE reserve levy that could raise up to 5 billion pounds, depending on exactly how it's implemented, and then increasing the bank surcharge from its current 3% back to 8%. That cut was a relatively recent change so it would simply be reverting back to what had been its previous level. So, all of that would net you up to 20 billion pounds. After that, we think the trade-offs, the political considerations and the way they interact with the future economic growth get a little bit more challenging. But there are ways that we think the government can get to a figure of around about 20 billion pounds without necessarily needing to really go for some of the harder political choices that some have speculated.

Luke Bartholomew

And on the QE reserves levy thing, I think it is worth dwelling on that a moment because it perhaps is a little bit complicated. It's a feature of the way in which the UK's monetary policy, since the financial crisis, is interacting with fiscal policy and perhaps some unfortunate ways, and certainly creating some unfortunate optics. Because the big policy innovations that the Bank of England introduced following the financial crisis to try and put more stimulus into the economy involve several things, one of which was, of course, quantitative easing – large purchases of gilts, which were financed by the creation of reserves which necessarily have to sit within the banking system. So, it created these reserves out of thin air and used those to pay for the gilts that it purchased under QE – the idea to push down long-term interest rates. And the second innovation related to that is that these reserves started to pay interest. There’s always been bank reserves but they were relatively scarce, and they never paid interest. Post-QE, [a] huge number of bank reserves in the system and to, sort of, keep control of interest rates in that system, they had to pay interest rates at bank rate. And so, for much of the post-financial crisis period, where interest rates were around 0%, these reserves were paying around 0%, and they were being used to finance the purchase of gilts, which were yielding, let's say, 3% or so, on average. So, for a long time, that's a pretty profitable trade for the Bank of England and, in turn, Treasury, where the money is being remitted to, you know, they're financing the purchase of something that yields 3%, with something that they have to pay, call it half a percent or so –nice and profitable. But since the pandemic, the increase in inflation and the big increase in interest rates, bank rate is now 4%. So again, reserves are paid at bank rate, so they're now paying 4%. And indeed, that has been higher. Of course, bank rate has been coming down over the last year or so – so paying 4%, at the moment. And all those gilts that were purchased, as I say, were maybe yielding 3%, 2.5%. So at this point, what used to be a very nice trade is now [a] quite unfortunate trade for the Bank of England and Treasury. They are financing something that's paying two-and-a-half, 3%, with something that pays 4%. So they're losing money on that trade. And in effect, it feels like it's going to the banks because, as I say, reserves have to sit within the banking system. Now, there is a sense in really what's going on here, it's just that the government has shifted its financing from gilts that pay a fixed interest rate to reserves that are a variable interest rate. And it turns out that hasn't been a particularly profitable trade for the government over the last couple of years. But that's really what's going on – it's a change in its financing mix. But the optics of it are pretty unpleasant. It looks like these banks are being paid out and at a time of serious fiscal constraints. No one, I think, sheds too many tears if banks are taxed. Now, one thing you might think is, well, why not just abolish this interest on reserves if this is the cause of the problem? Well, as I say, that's sort of necessary to keep control of money markets, interest rates, given the current way in which monetary policy is conducted. So instead this tax, this surcharge is, sort of, seen as a way of clawing the money back. So that's the context in that. And yeah, we are talking reasonably large amounts, perhaps 5 billion or so. But as you said, Lizzie, this maybe gets us to 20, 25 billion, these measures. And if the OBR’s productivity downgrades are a little bit bigger than we're suggesting, if we get perhaps not all the way to the National Institute’s, 40-to-50-billion-pound black hole, but somewhere in between, what are some of the less pleasant measures that the government might turn to in terms of raising extra revenue?

Lizzie Galbraith

So, we've seen a lot of speculation over whether or not the government is going to really look at things like pensions, taxation, looking at inheritance tax again, looking at closing some of the current exemptions that exist around certain assets, as an example. They would come with probably quite serious political costs, if we take the political risk reaction to the measures taken at the previous budget – changes to things like pension benefits and inheritance tax tend to be very unpopular. And indeed, we saw the government walk back some of those measures, after the last budget as well. So, they come with serious political costs. But there have been suggestions from, you know, many think tanks over the past 12 months that there is money on the table there if the government wishes to go for it. So, things like introducing a flat rate of pensions relief at 30%, for example, would raise about 3.5 billion pounds. So, you know, nothing, not huge amounts in the scale of the black hole we're talking about. But if we're in a position where every little helps could very much be on the table. The most radical option that I think is reasonable to consider is something like a new social care levy, or a defence levy, something that is effectively a one-off income tax increase that goes to a nominal cause that has broad-based political support, something that is hard for the opposition to necessarily argue against. So, you might say: ‘this is to help us meet our NATO defence contributions’. You might say: ‘this is to help us, you know, reform our social care system’, which continues to really struggle and, of course, puts a lot of pressure on the NHS as well. It could raise quite significant sums of money. Of course, it does come with very serious political trade-offs and potentially puts the government in a position where you could say that it has violated its manifesto commitments around not raising the main personal taxes, as well.

Luke Bartholomew

And then another consideration for the government outside of these political constraints is that they want to avoid measures which might push up on inflation. They face a lot of criticism that the last budget did lead to a pickup in inflation, through the increase in national insurance contributions for employers and the increase in the national living wage that this pushed up on, on wage pressure and so price pressure, and then that kept interest rates higher than they otherwise would have been. And then, indeed, that fed back into the government's fiscal problems because gilt yields ended up higher than they otherwise would have been. The government's financing costs were higher. So that I think, is quite a significant thing weighing on their thinking as well. And where that really bites is with considerations around the fuel duty escalator, because of course, notionally and in the OBR forecast, the fuel duty escalator will kick in – that fuel duty should pick up. But that, of course, would then be inflation and inflationary in ways in which, the Bank of England seem to be worrying about quite a lot at the moment, which is to say that it will push up prices on things which, are quite important to households, consumers when they set their inflation expectations – so food prices, petrol prices, you might imagine are very important in people's perception of inflation. And the Bank is worried that higher prices in those areas might be causing inflation expectations to ramp up a little bit. So yeah, were the fuel duty escalator to be allowed to return to work, that could potentially be inflationary and cause concerns about what it would mean for the bank rate. And again, you know, it doesn't necessarily raise any revenue versus the OBR’s rules, given that it's assumed that that's what's going to happen anyway. But it does, it does raise real [xxxx], which might be worth having.

Paul Diggle

Okay. Well let's talk about this potential fourth option, this sort of ‘hail mary’ of growth. Because that, of course Lizzie, was the number one priority of this government when they came to power. It was the way in which this gordian knot was going to be cut. So, whatever has happened to Labour's growth agenda?

Lizzie Galbraith

Yeah. So Labour talks a lot in the run up to the last election about leading a sort of a mission-driven government, if you will, and this government was going to have these key missions that were going to really define its agenda. And the overarching theme of them all was trying to generate economic growth – primarily through a supply-side reform agenda. And I think really what has happened there is that that ambition has collided with the reality of being in government. Things take longer than you want them to. Plans get watered down as they come into contact with the realities of no longer being in opposition. And the government also has had a rockier start to this, its time in office, than it certainly would have wanted. And that has slowed things up as well. So, we have seen progress made against that reform agenda. But arguably, expectations were set incredibly high about the speed and ambition with which this government would move. And that means that the progress that has been made so far, looks like a relatively disappointing set of results when you consider what Labour were talking about when in opposition. So the Planning and Infrastructure bill has been watered down slightly but is due to be given royal assent towards the end of this year. And I think arguably you do still see signs that the government hasn't really moved away from wanting to prioritise growth. The recent government reshuffle that we had in early September is arguably about restoring focus on that sort of mission-driven government. We saw a lot of changes at the ministerial level across housing, Treasury, ministerial positions and in the business department as well. Quite broad-based changes to personnel there arguably to try and restore that focus and try and get things moving. So, I don't think it's that the government has abandoned it. I think that it is becoming far harder than they anticipated while in opposition and the economic realities, as well, are also colliding with that growth agenda in sometimes unhelpful ways. They're having to make more trade-offs than they necessarily had anticipated, or alluded to, while they were in opposition.

Paul Diggle

Yeah, we are speaking in the week in which a second runway at Gatwick has been approved. I mean, before that, the government did do its mini reset of relations with the EU, which maybe, at the margin, is helpful for growth. We've seen the national wealth fund, GB Energy, like things have happened. There are still very ambitious home building targets. But I think, precisely as you say Lizzie, this realisation that political trade-offs exist between on the one hand, say, energy deregulation and climate goals, or between planning reform and environmental charities; conservation interests; NIMBYs; between immigration and [xxxx] politics, which is increasingly unfriendly to large-scale net migration. The Bank of England, itself, has opposed some of the government's proposals to deregulate parts of the financial system. So, it's really running into these trade-offs. I think it's been a big part of the story.

Luke Bartholomew

Or talking of the Bank of England, maybe that's the place to finish up. Talking about the interaction between this budget and how it might affect the path of monetary policy. And I think one quite superficial way, but nonetheless, worth mentioning is that just the timing of the budget potentially impacts the kind of meetings that interest rates are more or less likely to be changed this year. So, the budget is now going to be the 26th of November. So quite late. And notably, that is after the Bank's meeting in November, which is on the sixth. So, I think given that context, it probably makes a lot of sense for the Bank of England to wait now until the budget is announced. So, it fully has the information to hand before it sets policy. And there are a variety of reasons why an interest rate cut in November would become less likely. But I think the timing of the budget is another factor, which, you know, means that a cut in December is probably the earliest timing for such a move, if not next year. But then, more fundamentally, I think the ways in which it could impact monetary policy are several. One, on inflation, as we talked about, it's quite possible that the budget does include measures that push up inflation, and particularly in areas which are quite important to how the bank is thinking about the inflation process at the moment, to the extent to which the budget did push up on inflation, and all else equal, that would keep interest rates higher. But I think perhaps the more important channel is actually the one in which the budget is likely to weigh on growth, at the margin. One for it [xxxx] hit animal spirits and sentiment. Here we are speculating about black holes and various tax increases that are coming. We are not going to be the only people doing that. There's no doubt, you see very clearly that does weigh on things like consumer sentiment, business sentiment and the speculation about these measures in the run up to the announcements themselves. And then, yeah, the tax increases are also likely to weigh on growth, although it is worth saying that, you know, the kind of fiscal drag that you talked about, Lizzie, the freezing of income tax thresholds several years down the road. Now, that is fiscal tightening, but, you know, the growth multiplier, if you like, on that, and indeed, some of the other measures that we've talked about is likely to be much smaller than the hit to growth that occurred from, say, the increase in the national insurance contribution, which immediately hit the demand for labour after it was announced. That is, labour as in workers rather than Labour, the party, although perhaps both of those things were hit by the announcement. But anyway, the point is that, all else equal, I think the most likely impact of the budget is that it further increases the case for monetary easing next year. And we do continue to expect bank rate to come down further, which, you know, perhaps also does help the government out in due course if it brings down gilt yields. But perhaps they'll be falling for the nasty reason of weak growth. So, we will see how much of a help that is.

Paul Diggle

Great. Well, I think that's about all we have time for this week. Thank you, Lizzie, for joining us. Thank you to you for listening. Please don't forget to like and subscribe to Macro Bytes on your podcast platform of choice. But until next time, goodbye and good luck out there.