The UK's tax-led consolidation

A personal view from Debapratim De, Deloitte’s Chief Economist in the UK. To subscribe to this weekly newsletter, click here.

Last week the UK's chancellor, John Healey, unveiled his first budget. Here are some thoughts on the measures announced and on recent UK fiscal policy.

First, as most analysts had predicted, this was no blockbuster budget. With limited scope to borrow and a commitment to not raise income tax, national insurance or VAT - the three biggest revenue raisers - the chancellor had little room for dramatic increases in spending. Instead, the budget contained a raft of small measures.

Second, policies seeking to help households with their energy bills should soften the blow to consumers from sharply higher energy prices. But the support provided will only offset a fraction of the rise in living costs since the war in Iran began. The Resolution Foundation estimates that the poorest half of households stand to gain £145, on average, from the cost of living measures in the budget, compared to an expected £600 increase in typical household energy bills over the 12 months to January.

Third, like his predecessor, the chancellor announced an easing of policy in the short term to be offset by tightening later. This adds to the significant fiscal squeeze already pencilled in for the end of this parliament following previous budgets. Two-thirds of the deficit reduction promised over this parliament is to come in its last two years - between 2027 and 2029 - and is contingent on deep cuts to departmental spending. Delivering that over the potential run up to an election is likely to be politically challenging.

Fourth, the fiscal headroom - the margin by which the government meets its fiscal rules - has reduced to £15bn. The Office for Budget Responsibility (OBR)'s calculations for it assume a rise in fuel duty next year, which successive governments have struggled to implement since 2011. Given the current Labour government's focus on the rising cost of living and the risk of elevated inflation, the duty seems likely to remain frozen throughout this parliament, which would amount to a further reduction in the headroom of £4bn, leaving a narrow buffer. This makes fiscal policy more vulnerable to external shocks and subject to uncertainty.

Fifth, this Labour-led parliament is presiding over a fiscal consolidation programme relying almost entirely on tax rises. As the chart of the week below shows, this is the sharpest tax-led retrenchment the government has undertaken since the second world war. Bigger consolidations have relied predominantly on spending cuts.

In fact, several studies show that successful fiscal consolidations tend to place more weight on reductions in public expenditure than on raising taxes. There are risks to relying solely on taxes to fix public finances. A study of fiscal retrenchments by Harvard economist Alberto Alesina and co-authors in 2018 found that tax rises tend to have a greater dampening effect on growth than spending cuts.

As the briefing above explains, the current Labour-led parliament is presiding over a period of significant fiscal retrenchment. According to estimates from the Office for Budget Responsibility (OBR), between the beginning and end of this parliament, national taxes as a share of GDP will have risen by 3.8 percentage points while spending will have increased by 0.8 percentage points.

Together, that will amount to a consolidation worth 3% of GDP, the biggest tax-led fiscal retrenchment since the second world war. Consolidations such as this are rarer than those driven by cuts in public expenditure because tax rises tend to be a bigger dampener of activity than austerity.

What we're looking out for this week?

This week, we’ll be looking out for the results of the US midterm elections set to be held on Tuesday. All 435 seats of the currently Republican-controlled House of Representatives are up for election, as well as roughly one-third of the seats in the Senate. 36 states, including California and Florida, will also be electing governors.

Currently, the Republicans have a slim majority in both the Senate and the House of Representatives. According to pollster Nate Silver's and The Economist's prediction models, the Democrats are favourites to win the House. But the race for the Senate is tighter, with the Economist's model giving the Democrats a slight edge in it. 

If Democrats secure a majority in either the House or the Senate, they are likely to impede Republican legislative action. This will leave the current Republican administration heavily reliant on Mr Trump's executive powers to advance core elements of its policy agenda, over the remaining two years of this presidency.

In the UK, we’ll be looking out for the Bank of England’s interest rate decision on Wednesday. With inflation accelerating to 3.5% in September and some very early signs of higher energy prices starting to diffuse through the inflation basket, markets expect the Bank to raise rates by 0.25 percentage points, to 4%, this week.

And finally...

A new study by the University of Oxford found that migratory seabirds can suffer from jet lag. Due to the mismatch between local time and the migrating birds’ internal body clocks, many of the birds studied found the sun to be farther around the sky than expected when flying to the UK from across the Atlantic Ocean, resulting in them drifting off course – tern-ing back time.