Sunday, November 13, 2022
Where did our £50 billion black hole suddenly come from?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

You will have heard a lot about the “black hole” in the public finances that the chancellor, Jeremy Hunt, is grappling with, alongside the prime minister Rishi Sunak, in the run-up to the autumn statement this Thursday. That is not a sentence I expected to be writing a few weeks ago.

I am aware in doing so that it is likely to make anybody who knows anything about science wince. The black hole in this context is the gap, the space, between future tax revenues and public spending, which if wise enough to bust the government’s fiscal rules has to be tackled.

But, as every schoolboy and schoolgirl probably know, and as a useful description from NASA reminds it, that is not what a black hole is at all. As it puts it: “Don't let the name fool you: a black hole is anything but empty space. Rather, it is a great amount of matter packed into a very small area - think of a star ten times more massive than the Sun squeezed into a sphere approximately the diameter of New York City. The result is a gravitational field so strong that nothing, not even light, can escape.”

Anyway, I cannot get out of the habit, but there is another puzzle, not quite as big as the mysteries of the cosmos, that I wanted to tackle today. How did we get into a fiscal mess so serious that Hunt and Sunak have been looking for between £50 billion and £60 billion of annua tax hikes and spending cuts to put the public finances back on track?

There was no hint of it when Sunak was campaigning for the Tory leadership over the summer, merely and rightly pointing out that Liz Truss’s unfunded tax cuts would create such a mess. I shall come back to that.

More importantly, there was little hint of it when the government’s economic and fiscal watchdog, the Office for Budget Responsibility (OBR), assessed the public finances as recently as March. Then, as chancellor, Sunak was able to announce two significant tax cuts. One was to raise the threshold at which people start paying national insurance (NI) to just over £12,500, matching the personal income tax allowance, and thus significantly softening the blow of the increase in NI rates.

The other was a fully costed cut in the basic rate of income tax from 20 to 19 per cent, to take effect in April 2024. That, you may recall, was brought forward to April next year in Kwasi Kwarteng’s mini budget on September 23 but has now been postponed indefinitely, pending what we might hear this week. In the leadership context Sunak promised further cuts in the basic rate, beyond the 2024 reduction.

He was able to do so because, on the face of it, the public finances were in good shape. The two main fiscal rules, government debt falling as a percentage of gross domestic product and the government only borrowing to invest (balancing the current budget), each in the third year of the forecast, 2024-25, were met with a margin to spare.

The debt rule was met by a margin of £27.8 billion, or 1 per cent of GDP, while the current budget rule was met by a margin of £31.6 billion, 1.2 per cent of GDP.

Now, it seems, taxes need to be increased and public spending cut significantly to meet a softer fiscal rule, one in which debt is falling as a percentage of GDP in five years’ time, not three, at which time we could well have a different party in government.

There were health warnings attached to the OBR’s forecast in March, compiled while the implications of the Russian invasion of Ukraine were still unfolding. It noted that the chancellor’s fiscal headroom was no greater than that used by previous chancellors and “could be wiped out by relatively small changes in the economic outlook”.

That is one clue to how things have changed so dramatically. In March the OBR predicted 1.8 per cent growth next year and 2.1 per cent in 2024. Those forecasts look to have been blown out of the window by recent events. The OBR will not necessarily replicate the Bank of England’s economic forecasts, for various reasons, but those forecasts, a 1.5 per cent drop in GDP next year and a further 1 per cent in 2024, show the extent to which things have changed.

Instead of reasonable growth there is recession. On the Bank’s forecasts the economy will be smaller at the end of 2024 than it was at the time of the last election in December 2019.

The big reasons for the shift in the OBR’s assessment of the public finances are, however, inflation and interest rates. In March inflation was predicted to average 7.4 per cent this year and 4 per cent next. Official interest rates were projected to peak at 1.9 per cent next year, in line with market expectations.

That has now changed very substantially. Bank rate is already at 3 per cent and the Bank has not finished hiking it yet. The Bank expects inflation to be 10.75 per cent at the end of this year and 5.25 per cent at the end of 2023. A sustained increase of 1 percentage points in inflation and interest rates adds roughly £20 billion to the annual debt interest bill, according to the OBR. Its new projections for the government’s debt interest payments will make eyewatering reading.

The OBR’s forecast is not the only one in town. You will have seen reports, from think tanks and others, that tax increases and spending cuts are not necessary, either to avoid the errors of post-2010 austerity, or because relatively small variations in forecasts would render them unnecessary.

The National Institute of Economic and Social Research (Niesr), in a pre-autumn statement assessment on Friday, predicted that in the absence of further tax hikes and spending cuts, the economy could grow by 0.7 per cent next year and 1.7 per cent in 2024, avoiding a recession.

It also said that the key measure for the government, debt falling as a percentage of GDP, will begin to occur roughly now, rather than at some distant point in the future, negating the need for further action.

Such alternative views are important, but the only one that matters for the chancellor at present is the one from the OBR. After the drama that greeted the Truss-Kwarteng mini budget, which did not benefit from an OBR assessment, the last thing Hunt could afford to do would be to ignore the OBR. Whether it is right or wrong, it has never been more powerful.

The Truss-Kwarteng episode, most of which has already been binned, will continue to have an impact. It has meant, not only that a thumbs-up from the OBR is essential this week, but also that the new prime minister and chancellor have to bend over backwards to satisfy the markets. Any repeat of the reaction to the September 23 event, even an echo of it, would be disastrous.

Can this week’s measures be delivered without inflicting what I described last week as a triple whammy on a weak economy – higher interest rates, tax increases and spending cuts? The best hope is that enough of this week’s measures are slow-burn enough for their impact to come through only gradually. The virtue of a five-year debt target and stealth tax increases by such means as freezing allowances is that most of the impact comes later.

Hunt and Sunak are determined to fix the public finances and to help the Bank out by bearing down on inflation. They would hope to do that without crashing the economy.