- Rising gilt yields and falling inflation shrink the government’s ‘headroom’ to near-record lows
- Economists warn giveaways could make the BoE more cautious about cutting interest rates
After months of speculation about the abolition of inheritance tax and sweeping income tax cuts, the Spring Budget was a rather restrained affair. A further 2p cut in national insurance contributions and an extension to the fuel duty cut were the headline measures in an economically restrained – but politically important – Spring Budget.
Chancellor had limited room for manoeuvre
The government is bound by two self-imposed fiscal rules, which place limits on debt as a proportion of gross domestic product (GDP) and government borrowing on a five-year rolling basis. The gap between the forecast level of debt in five years and the figure that would break the rule is described as the chancellor’s ‘headroom’. Since 2010, governments have enjoyed an average of almost £30bn but, as the chart shows, Hunt had only £8.9bn to work with today.
One reason is lower expected tax receipts. Over the past few years, the government has frozen tax thresholds at the same time that inflation has pushed incomes upwards. The chancellor has benefited significantly as millions have been pulled into higher tax bands. The watchdog now expects inflation to fall below 2 per cent in a matter of months, a year earlier than forecast at the time of the Autumn Statement. As inflation drops, so will the additional revenues raised from this 'fiscal drag'.
Rising gilt yields have also worsened the public finance position. A big fall in market rate expectations brought down the 10-year gilt yield (seen as a proxy for government borrowing costs) to under 3.5 per cent at the end of last year. Economists calculate that this helped to increase the chancellor’s headroom to almost £30bn before Christmas. Since then, yields have rebounded above 4.1 per cent, increasing the cost of servicing government debt and reducing headroom even further.
Following ‘the letter but not the spirit’
Because the chancellor’s fiscal rules look at borrowing and debt on a five-year horizon, forecasts for inflation, growth and interest rates in 2027-28 and 2028-29 determine how much headroom he has today.
Given the rapidly changing economic backdrop, analysts are sceptical about the credibility of forecasts so far out. Analysts at Capital Economics think that Hunt can only meet his fiscal rules by pledging “implausible” cuts to real department spending from 2025, as well as increases to fuel duty which have not, in practice, been implemented since 2011. They describe this as “a classic case of kicking the fiscal can down the road”.
Paul Johnson, director of the Institute for Fiscal Studies think tank, says that “everything is being bent to meet the letter of the rules while their spirit, the reason for having them in the first place, is effectively being ignored”.
He called the current set-up “patently ridiculous”, adding that “gaming fiscal rules is no way to make budget policy”. Economists at the Resolution Foundation think tank warned that voters could find themselves in a “tax sandwich”, enjoying a brief period of tax cuts now, before rises follow after the next election.
What the Budget means for the next election
The current fiscal rules were introduced in the aftermath of Liz Truss’s short-lived premiership, and (despite their flaws) have helped the government to restore some fiscal credibility. Matthew Ryan, head of market strategy at global financial services firm Ebury, said that “the government has a difficult balancing act on its hands as it attempts to bring voters on-side while preventing another collapse in UK bond markets”.
Analysts at Capital Economics said that modest tax rises might help to bring the economy out of recession, and probably won’t lead to any market ructions. But they added that giveaways today “may mean that whoever wins the election later this year has to work harder to keep the bond market onside”.
In a report released after the announcement, the Office for Budget Responsibility warned that “the fiscal position remains very challenging due to high debt, subdued economic growth, and the highest interest rates for over a decade”.
Kallum Pickering, senior economist at private bank Berenberg, said that today’s giveaways have come as the economic situation for households is already improving. He added that “if the Bank of England judges that tax cuts add to inflationary pressures, policymakers may be inclined to cut rates by less this year – defacto neutralising the impact of tax cuts”.
