Better days ahead?

As Rachael Reeves unveiled the budget, she faced an impossible trinity: Deliver the funding to fix public services that many voted for, maintain the sufficiently low-tax environment to make the UK economy an attractive place to do business, and, at the same time, keep the markets onside. So how did she do?

Fiscal credibility is hard won, but easily lost – just ask Liz Truss. As the markets digested the details over the next day, sterling and UK equities have fluctuated and gilts have underperformed. Initial market reaction was small, but sentiment can be fickle and negative momentum potentially self-reinforcing. Good intentions are sometimes not enough to calm markets.

It helps that the Office for Budget Responsibility (OBR) is independent and was properly consulted this time, while there’s also been no fudging of future growth prospects. Potential growth and net migration estimates are essentially unchanged, though they remain at the more optimistic end of forecasters.

Overall, the fiscal loosening has been more front-loaded than expected. However, while the extent of the inherited ‘£22bn black hole’ can be debated, the loosening is not as large as the 1% of GDP shown relative to the March 2024 budget in the OBR chart below and it largely offsets the previously announced tightening.

The changes to the fiscal rules required delicate handling to avoid upsetting the gilt market. It was well leaked that the Chancellor would create more space for future public investment spending. Without fiscal rules, however, this risked driving up interest rates and crowding out private-sector investment.

Debt must still be falling as a proportion of GDP. But the definition of debt has changed from Public Sector Net Debt excl. BoE (PSND ex BoE) to Public Sector Net Financial Liabilities (PSNFL). PSNFL is slightly broader than PSND and includes a wider range of financial assets and liabilities, such as the student loan book and assets held by funded public sector pension schemes. It now must be met by 2029-30 (until 2029-30 becomes the third year of the forecast period, from which point the mandate applies to the third year).

More binding in the short run is the introduction of a main fiscal rule that day-to-day spending will be matched by revenues. We now have clarity that this rule is to be met on the same timetable as the debt rule.

To meet the fiscal rules and prevent some of the previously announced real-term spending cuts required £40bn of tax rises. In the central forecast, the current budget target is met two years early and by a margin of £10bn in the target year. The Chancellor will be keen to avoid being forced to raise taxes or cut spending in future, but she has not left herself much room for error. The rule could be vulnerable to either a revenue shortfall or an unexpected rise in interest rates.

In terms of the main revenue raising measures, many of those floated in the media have been delivered:

·         Increase National Insurance Contributions for employers as well as reduce the threshold for when these are paid

·         An increase in capital gains tax

·         Raising the rate on carried interest

·         Changes to the inheritance tax regime, but not the rates

·         An increase in stamp duty due on purchases of second homes

·         VAT on private school fees

·         Changes to the energy profits levy regime

·         Increases to HMRC resource aimed at achieving a greater level of tax compliance

Two areas of speculation which did not materialise were ending the freeze on fuel duty (extended for another year) and to not extend the freezing of income tax allowances beyond the previously announced 2028.

The increase in NICs is the largest revenue raiser at around £25bn and is likely to have indirect impacts as employers look to pass these on at the next round of pay reviews. This is likely to contribute to further loosening pressure on the labour market as companies may cut back on hiring due to the additional cost pressures.

While the impact to the gilt remit in the current fiscal year is not too significant at an additional £19bn (close to consensus expectations), the impact on the Bank of England might be to marginally slow the pace of rate cuts given there is less fiscal tightening over the next year than it is likely to have been anticipating.

Alongside the budget announcements, there has been some strengthening of the UK’s fiscal framework which enhances transparency and scrutiny from the OBR and commits to a single fiscal event a year, alongside regular spending reviews. Much now hinges on whether the government can deliver growth enhancing investment and efficiency savings in public services.