High inflation rather than the scale of flexibility provided by fiscal “headroom” is the key challenge facing John Healey, economists said as they warned against a “steady-as-she-goes” Budget.
Analysis by the Institute for Fiscal Studies (IFS) found that while the war in the Middle East means inflation will be higher than expected in the coming years, rising prices will also boost tax revenues.
This means the fall in the financial buffer available to the Chancellor will be smaller than widely anticipated.
The most pressing problem for the Chancellor identified ahead of the Budget on October 28 is that inflation will erode the budgets of Government departments, creating the need for either large cuts to some public services or potential top ups to spending plans totalling tens of billions of pounds.
The IFS said Mr Healey must clarify the ceiling for spending he is “willing to live within”, warning that his plan to meet the fiscal rules, including day-to-day spending paid for by taxation and borrowing coming down by the end of this Parliament, would only be plausible if it is based on “credible spending totals”.
Higher interest rates on Government debt will push up borrowing by about £10 billion in 2029-30, the IFS said.
But inflation would increase tax revenues, probably by more than it automatically boosts spending on benefits, and therefore borrowing would fall in 2029–30, it added.
The Office for Budget Responsibility (OBR) forecast is expected to show higher borrowing across the next five years than was anticipated in March, but with it still decreasing in the coming years and the fiscal rules being met.
In what the IFS described as “a plausible scenario”, the fiscal headroom would be around £20 billion in 2029–30, compared with £24 billion forecast in March.
However, the IFS stressed there is a “very high” degree of uncertainty, with the precise figure largely dependent on how the OBR expect inflation to impact on wages.
Changes to the earnings forecast alone could leave headroom around £10 billion higher or lower, while the OBR’s assessment of employment, migration and health-related benefits will also be a key factor, the IFS said.
Higher inflation is set to reduce the spending power of departments’ budgets.
The analysis found that maintaining the real-terms spending plans at its March level could require a £12 billion top-up at the end of the decade, with £3 billion more needed to maintain the level of capital spending plans.
Departmental budgets have already been squeezed by more generous pay settlements and a requirement to make productivity improvements.
Under current plans, growth in spending on public services is forecast to slow in coming years, with some departments potentially vulnerable to funding reductions.
In a scenario that health spending increased at 2.7% per year in real terms and plans to increase defence spending remained unchanged, this would imply real-terms cuts to other departments.
Increasing defence spending to 3% of GDP by 2030 is forecast to cost £11 billion in 2030–31.
Forecasts of higher inflation than in the spring would reduce the generosity of budgets further.
These pressures mean avoiding cuts to departments’ budgets could require a combined top-up to day-to-day and investment spending of around £25 billion in 2030–31, the IFS said.
It added: “A choice to leave spending totals unchanged would implicitly be a choice to cut some budgets and allow the quality and/or quantity of some public services to fall.”
“On the other hand, increasing spending to avoid cuts to budgets and fund higher defence spending could require tax rises or benefit cuts of around £35 billion.
“The Chancellor must decide where to land on that spectrum.”
The think tank said the Chancellor’s plan to reduce borrowing in order to meet the fiscal rules will be predicated on the spending totals he sets out.
“If John Healey sets out spending envelopes for public services that he would not be willing to live within, his plan for meeting the fiscal rules will not be credible,” it added.
The IFS also stressed that “now is not a good time to substantially increase borrowing” as debt remains historically high, with interest costs having more than doubled as a share of GDP since 2019.
This now accounts for £1 of every £13 the government spends, meaning any significant increase in day-to-day spending “should be met through tax rises or spending cuts elsewhere”.
Director of IFS Helen Miller said: “John Healey likely faces a forecast in which borrowing is still expected to fall in coming years and the fiscal rules are still being met.
“Despite that, a ‘steady-as-she-goes’ Budget is not an option available to the Chancellor.
“Choosing to stay the course with the inherited tax and spending plans would mean allowing inflation to blow departments’ spending plans off course.
“It would be a choice to tolerate chunky cuts to the quantity or quality of some public services – cuts that would be larger if defence spending was increased within existing totals.”
Ms Miller added the Chancellor does not have to set out detailed spending plans at the Budget, with an option to scale back ambitions for defence or other services, or make the plans contingent on an improvement in the economy by the time of next year’s spending review.
She said: “If he chooses the path of squeezing public spending, he should be transparent that there are tough years ahead for some public services.
“Simply pencilling in implicit cuts that he has no intention of delivering would make the Budget a work of fiction.”
Mr Healey is set to visit Bangkok for the IMF annual meetings this week, where he will tell international counterparts that major economies need credible plans to get borrowing under control.
“The consequences of conflict in the Middle East and Europe are hitting countries worldwide, leading to higher prices at the pumps and more expensive mortgages at home, but Britain and our allies can face up to these challenges together.
“I will work with our international partners to keep trade moving, support families and businesses, and make Britain’s economy stronger and more resilient to deliver good growth in every postcode.
“My Budget will build on this approach with fiscal discipline helping to deliver economic resilience. This means breathing space for today, and hope for the future.”
Shadow chancellor Andrew Griffith (Jacob King/PA)
PA Wire
Shadow chancellor Andrew Griffith said: “Higher borrowing costs and Andy Burnham’s unfunded spending commitments have swallowed up his headroom and created upward inflationary pressure.
“Labour raised taxes by £66 billion in its first two budgets. Families cannot afford to be lumbered with even more tax rises at this Budget. Labour should cut welfare instead of dumping on working people as they have already done.”
Green Party leader Zack Polanski said: “Economists are telling the Chancellor today that a steady-as-she-goes budget ‘is not an option’.
“With three in five families already cutting back on spending, and many about to see a £300 increase in their bills in January, we’re challenging the Government to take bold and immediate action on the cost of living.
“For a start, this means moving more costs off energy bills, properly funding a national home insulation scheme, clamping down on profiteering by energy companies and rapidly scaling up cheaper, cleaner energy.”