Rishi Sunak, chancellor of the exchequer, had hoped the fading of the pandemic would deliver a more predictable and stable economy. In reality, it meant supply shortages, soaring inflation and an exceptionally severe squeeze on household real disposable incomes. On top of that has now come the shock of the Ukraine war.
This week’s spring statement has, as a result, become a significant test for Sunak. How should he meet it? Obviously, neither he nor the Office for Budget Responsibility knows what will happen. But they do know the direction of travel. As a net energy importer, the UK may be made as much as 1 per cent poorer by the price changes. More broadly, inflation will be higher (quite possibly well over 8 per cent) and output and real incomes lower than earlier expected. This is a stagflationary shock.
For Sunak, all is not bad news. High inflation brings higher nominal incomes and tax revenues. Meanwhile, cash limits on spending, including lags in the uprating of benefits, mean sharp reductions in real spending. As a result, fiscal outcomes are set to improve dramatically. Borrowing is now expected to be about £23bn (about 1 per cent of gross domestic product) less this financial year than forecast by the OBR in October. The £25bn surplus in the current budget forecast for 2024-25 may now be between £45bn and £75bn. Moreover, as Chris Giles argues, there is also an overwhelming case for a windfall tax on energy producers.
In sum, bar an economic collapse triggered by still bigger shocks, such as an outright energy embargo, the chancellor enjoys room for fiscal manoeuvre. In deciding what to do with it, he has to distinguish adjustments to permanent changes from those to temporary shocks. It is still likely that the jumps in energy and food prices and downturns in activity will be temporary. Thus, temporary cushioning is the right approach.
A first priority is to protect real government spending. There is no obvious reason for an unplanned return to austerity. A temporary upsurge in inflation should be offset by increases in departmental cash limits. Particularly important is raising benefits. According to the Resolution Foundation, the value of most benefits will fall by 4.2 per cent in real terms in 2022-23, equal to a £10bn overall cut. This is largely an unplanned consequence of lags in adjusting for inflation. But it will cause real hardship. It is not just wrong, but foolish, to let many millions fall into destitution.
A second priority is to cushion increases in energy prices, especially on heating. Since the proportion of the spending of the poorest households devoted to energy is roughly three times that of the richest households, help should be concentrated there, most obviously by increasing universal credit. Sunak reportedly hates these benefits. Perhaps, he thinks recipients are wastrels, Labour voters, or both. That may be why his current plans for cushioning energy price increases take the form of a £150 cut in council tax for a large number of households, plus a temporary £200 rebate on electricity bills for all customers. This is grossly ill-targeted. It will also be far from enough, given the impact of the Ukraine war.
A third priority might be to lower fuel taxes for motorists. This may be a political imperative. But it is hard to see it as a high priority use of fiscal resources.
Finally, some permanent increases in spending must be borne in mind. Apart from the well-known priorities of health and social care, the obvious one is defence. UK spending will now surely rise substantially and permanently.
Meanwhile, there is strong backbench pressure on the chancellor to abandon the planned increase in national insurance contributions. It would have been far better to raise income tax more broadly. But there are two strong arguments for going ahead. The first is that this tax rise is at least moderately progressive. The second is that it recognises the reality that taxes must rise permanently, in response to demographic and social pressures. The Tories hate being a tax-raising party. But that was inevitable, at some point. Given this, it might as well be done now.
Yet, while the chancellor is dealing with the huge pressures of today, he also has to look to the long term. The biggest problem for the UK remains its dismal underlying productivity growth. The answers must include higher investment and more dynamic capital markets. One hundred per cent tax credits for investment, along with higher headline rates of corporation tax, should help deliver this, together with a shift to collective defined contribution pension plans.
Crises dominate today’s agenda. But chancellors should never ignore opportunities for longer-term reform.