Good afternoon from New Economy Brief.
Weeks of speculation about how the Chancellor would respond to the OBR’s widely expected productivity downgrade ended yesterday as Rachel Reeves delivered her second Budget. But all the focus on tax rises, spending cuts and ‘headroom’ continues to obscure the question at the heart of the UK’s economic woes: why is productivity so low as to have warranted a downgrade in the first place?
This week’s New Economy Brief goes a little deeper than your usual post-Budget summaries and asks: why are we in this mess, and how do we get out of it?
What did the Chancellor announce?
Tax ‘smorgasbord’. The Chancellor increased a variety of taxes without breaking the government’s manifesto pledge not to increase taxes on ‘working people’, raising £26bn of additional revenue by 2029/30. The House of Commons Library provides a useful summary of all of the changes, including freezing National Insurance and income tax thresholds for another three years after 2028, a ‘mansion tax’ on expensive properties, increasing taxes on gambling taxes and on investment income like property, savings and dividends, and more.
Action on the cost of living. The Chancellor also scrapped the two-child limit on means-tested benefits, froze rail fares, took levies off energy bills and into general taxation and raised the minimum wage. Interestingly, the government is actively using what some economists have termed ‘unconventional fiscal policy’ to reduce inflation, traditionally the role for the independent central bank – the OBR predicts these measures will reduce inflation by 0.3 percentage points next year.
Zooming out: why did taxes rise?
The run-up to the Budget was dominated by months of speculation about a downgrade to the OBR’s forecast for UK productivity growth. It was generally expected that the combination of this productivity downgrade and new pressures on spending would put the Chancellor on track to breach her ‘stability’ rule, which requires the government’s tax receipts to cover current spending in 2029/30.
In the event, the impact of the productivity downgrade was unexpectedly counteracted by higher inflation and wage growth. This meant that the Chancellor’s tax rises largely served to increase the size of the buffer (the so-called ‘headroom’) against the ‘stability’ rule, rather than to stop her from breaching it. These changes also financed some increases in spending, including the action on the cost of living explained above.
We can draw a number of lessons from this. First, that media and political speculation about a ‘black hole’ in the public finances has been as baseless as it is ceaseless. Second, that we still risk missing the real story: whatever its impact on ‘headroom’, the productivity downgrade matters. In revising its trend productivity forecast down, the OBR is moving closer to other forecasters. This reflects the UK’s dismal productivity growth since the Global Financial Crisis, with much larger slowdowns than other nations.
Underinvestment and austerity economics.
We have previously covered how underinvestment has been putting the brakes on economic growth and harming debt sustainability for decades.
And the Chancellor’s recent speech setting the scene for the Budget acknowledged underinvestment as a key reason for the UK’s ‘productivity puzzle’: “it’s not a puzzle. The causes of our economic underperformance are well understood. The chronic stop-go cycle of public investment has left us with roads full of potholes, high energy prices and unstable conditions for vital business investment in skills and technology.”
It is important to remember the role that the OBR played, and still plays, in incentivising this underinvestment. Its first assessment in 2010 formed the basis for then-Chancellor George Osborne’s spending cuts, and drew criticism from the IMF’s then-Chief Economist Olivier Blanchard.
Public investment was repeatedly cut in an effort to meet fiscal rules that debt should be falling as a percentage of GDP, but we now know that government spending cuts harmed GDP in every advanced economy that tried them. Even Osborne has admitted he wishes he had not cut public investment as much.
Lower productivity growth has serious implications for long-term debt sustainability. The OBR previously estimated that if productivity returned to growing at its average rate from before the 2008 financial crisis, public debt could remain well below 100% of GDP for the next 50 years. Conversely, if productivity growth stays at its average rate since then, debt could spiral to almost 650% of GDP.
They can’t tinker their way out of this one.
A ‘smorgasbord’ of tax rises to build up more ‘headroom’ against breaking the rules doesn’t get to the root of the problem. In fact, the excessive focus on headroom is infantilising the fiscal policy debate.
The OBR’s most recent external review noted the “short-term focus” of fiscal debate in UK politics and media, with its incessant discussions of ‘headroom’. It said this was “unhelpful, as it threatens to obscure broader assessments of UK fiscal sustainability.” The Chancellor took a step in the right direction today, using the political space provided by the IMF to move to one OBR assessment of the fiscal rules each year. But although we will now only face the carnival of media speculation before one fiscal event a year, rather than two, this does not solve the underlying problem – the media fixation on ‘headroom’.
Solving the productivity puzzle with more investment. If low productivity is harming debt sustainability, the rational thing to do would be to improve productivity with more growth-enhancing investment. This government has taken a step in the right direction, committing an extra £120 billion to public investment so far over this parliament. But that was only enough to reverse the cuts planned by the last government. And the additional investment was frontloaded, meaning overall public investment will actually fall towards the end of this Parliament.
Furthermore, the UK underinvested £550bn relative to OECD nations over the 30 years prior to the last election. This means workers in the UK’s factories, hospitals, construction sites, warehouses and offices often rely on out-dated infrastructure, machinery and software compared to their counterparts abroad.
A new briefing from Invest in Britain includes economic modelling to show how the government can close this gap within the next ten years with an additional £60bn of public investment per year (+2% of GDP). This would boost growth, wages and improve long-term debt sustainability, as higher GDP growth increases employment and tax receipts while reducing demand for social security spending.
Exercising austerity economics from the fiscal framework.
The OBR has started to appreciate the benefits of public investment for long-term growth, but they are still required to assess compliance with fiscal rules that require debt to be falling within three years – far too short to capture the benefits of public investment on fiscal sustainability. So when the UK economy needs counter-cyclical stimulus, the current fiscal framework incentivises consolidation – a self-defeating attempt to reduce the debt to GDP ratio that ends up doing the opposite by limiting economic growth.
Root and branch reform of the fiscal framework. With the move to one OBR assessment a year, the government will have to amend the Charter for Budget Responsibility that enshrines the OBR’s mandate, the government’s fiscal rules and how they are assessed. Perhaps this time there will be a more enlightened debate about previous and ongoing fiscal policy mistakes that have led to chronic underinvestment and poor debt sustainability.
How to tame the bond markets. NEF’s Dominic Caddick explains why “more austerity won’t placate the bond markets”. Instead, he argues the government should stop relying only on monetary policy to tackle inflation and use targeted fiscal measures to address the root causes of price rises and so lower inflation expectations.
Cost of living is more important than immigration. A new report from the Joseph Rowntree Foundation finds growing economic insecurity is eroding Labour’s 2024 electoral coalition. They argue this is a “broader explanation for Labour’s losses than are immigration-related grievances”, and suggest a political strategy that delivers an “economic feel-good factor” for the national economy and households would have more electoral benefits than chasing votes lost over immigration.
Bringing down rail fares though public ownership. Common Wealth argues that freezing in rail fares, while providing welcome relief, is only the start of making rail more affordable. Sarah Nankivell says the government should also nationalise rolling stock companies to reduce costs and “embed passenger representation and worker participation” to make the most of public ownership and build the political case that it can serve the public interest better than private ownership.
Windfall tax on banks. Responding to an FT article arguing that a windfall tax on banks would reduce investment and growth, Positive Money’s Simon Youel argues that “Banks waste far too much on payouts to shareholders”. He defends the case for a windfall tax on banks that can “claw back windfalls from higher interest rates made at the expense of the British public, without unduly affecting competitiveness in other parts of banks’ business.”
