The public and the press send the chancellor their Christmas letters, and watch with bated breath, but are often left disappointed.
It is the numbers which are read out by the chancellor, Rishi Sunak, at the beginning of his speech that are worth concentrating on. These represent the government’s own forecasts on which budget arithmetic is based; and also, the more detailed tables at the back of the "Treasury Red Book" which anoraks like me will scrutinise for hidden tax booby traps or concealed cuts. In addition, the independent Office of Budget Responsibility (OBR) provides an honesty check that the government isn’t making up numbers to flatter itself.
At the heart of the budgetary arithmetic the most important of the big numbers is the growth forecast, which leads – among other things – to forecasts of government revenue and the sustainability of debt. There is currently massive uncertainty around growth because of the rapid but uneven post-Covid-19 recovery. After a probable 6 per cent growth in 2021/2, anything less than 5 per cent in the next financial year would be disappointing and leave the economy more than 3 per cent smaller than before the pandemic.
The second of the big numbers is the projected budget deficit. The data is likely to show that after a record budget deficit in 2020/21 – of around 14 per cent of gross domestic product (GDP) – this year’s number may be around 8 per cent. Not as big as the US (nearer 12 per cent), close to France but still more than Germany (around 6 per cent). We are recovering from the economic equivalent of a war and – rightly – borrowed vast sums to keep the economy alive. A key question for the Budget will be how quickly the balance of tax revenues against spending returns to “normal” – Sunak seems to have opted for the middle of the decade.
But what is normal? Successive governments have adopted a rule that governments should normally aim to balance day-to-day spending with tax receipts. Since governments typically spend around run a deficit of 2 per cent to 3 per cent to finance longer term public investment, the overall deficit will have to be cut by around a further 5 per cent. Economic growth will help by bringing in more tax revenue, but government cannot just switch on economic growth. The critical bit of budgetary arithmetic will be how much of the deficit also has to be squeezed out by unpopular austerity (higher taxes and spending curbs), and when.
In addition to making a judgement on the speed of return to a “normal” budget cycle, the chancellor has to decide on the level of public investment which requires government borrowing but doesn’t impinge on day-to-day spending. That is the money for new railways and infrastructure seen as key to the “levelling up” agenda. The problem here is that things we regard as “investing in the future” like skill training for adults or more teachers in schools do not count as “investment” in public sector accounting terms. I recall from the Conservative/Liberal Democrat coalition bitter quarrels with the Treasury about what was allowable as “public investment”.
It is partly to escape these definitional ambiguities, and to focus on the overall impact of government borrowing, that attention has shifted to a third important number: the ratio of public debt to GDP. The British ratio (net of government assets) has crept up from a target of 40 per cent before the financial crisis, to around 90 per cent after it and now to more than 100 per cent.
There is no right or wrong level but there is wide variety of international experience to draw on. Japan has a very high ratio of around 240 per cent in part because citizens will lend to their government (by saving) at derisory interest rates. The USA has a ratio close to 110 per cent, and rising, and Americans rely on the seemingly insatiable appetite of the rest of the world to lend to its government and to hold dollar assets. Germany is more cautious; the ratio there is 60 per cent.
Britain saw its debt ratio climb to well above 200 per cent after the Second World War, and fall back to under 40 per cent before climbing back up in response to recent crisis borrowing. But British governments cannot rely on patriotic savers to lend cheaply, and the world no longer has a big appetite for sterling. So, British governments rely on the “generosity of (overseas) strangers” to finance borrowing and the strangers need to be reassured that Britain is credit-worthy.
It was this reliance that led then-chancellor George Osborne to insist that maintaining market confidence required commitment to a maximum debt ratio of 90 per cent, to be reduced gradually. The figure owed something to an academic article, subsequently discredited, which suggested that debt crises may be triggered by breaching this limit. Chancellor Sunak appears to have decided that 100 per cent is the new magic number.
However, the situation is very different from 2010 when the obsession with this began for the Conservatives. Then, the cost of borrowing – in the form of 10-year bonds – was around 4 per cent and could have risen if international confidence was lost due to the exceptionally bad deficit position of the UK. Now the borrowing rate is 1 per cent and the UK is in good company with the rest of the world, much of which is in a far worse position. A simple rule-of-thumb for countries worried about their indebtedness is that debt is on a sustainable path if the economy is growing (in real terms) faster than the borrowing rate. At present, it clearly is.
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I am pleased to see that some leading Conservatives recognise this difference in context and are telling Sunak not to be too exercised about the debt ratio if it were to lead him towards unnecessary and inappropriate “austerity”. Now is the time to spend (and borrow) to treat social wounds (by reversing cuts in universal credit) and to attend to the needs of those “left behind” in Britain and to our international obligations (restoring foreign aid).
His answer is that interest rates and the cost of borrowing may soon rise adding to the cost of debt service, squeezing out other spending. Yet the arithmetic does not suggest that this is a serious or imminent problem.
Conservatives are also exercised over a fourth number: the share of the economy accounted for by the state. In 2020, tax revenue accounted for around 37 per cent of GDP which was closer to the low tax economies of the USA (30 per cent) Switzerland (34 per cent) and Singapore (18 per cent) – where traditional Tories want to be – than it is to those of the European Union (Germany 47 per cent; Sweden 49 per cent; France 52 per cent) or even Liberal-run Canada. (42 per cent). As Britain tries to return to more normal budgetary conditions, there is a tension between the aim of keeping taxes down, by cutting spending, or raising taxes to finance more generous spending.
The public appears to want good public services but without European-level taxes to pay for them. Some higher taxes are to come in the form of the national insurance contribution increase and a corporate tax rise. So are some further real cuts in spending, mostly hidden for the moment but due to hit local government especially. But the chancellor may need more of each to meet his self-imposed fiscal targets.
On Wednesday, Sunak has a three-way choice: relax his debt and deficit targets, risking accusations of irresponsibility from his party’s fiscal hawks; lean towards spending cuts, risking the wrath of No 10 and many colleagues; or lean towards more tax increases, risking his reputation as a Tory.
All the popularity he has fostered as Father Christmas may soon disappear back up the chimney.
Sir Vince Cable is the former leader of the Liberal Democrats and served as secretary of state for business, innovation and skills from 2010 to 2015
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