UK Autumn Statement signals further fiscal tightening to come

This week’s Autumn Statement provided few surprises. Despite the modest tax cuts that it contained, fiscal policy overall will continue to tighten going forward, the result of the tax raising measures that are already in place, and as such will present a headwind to growth next year. The scale of this tightening can be seen in the estimate by the Office for Budget Responsibility (OBR) for the primary surplus (current government spending less current income from taxation, and excluding interest paid on government debt) next financial year, where it is now forecasting a cyclically-adjusted surplus of 0.3% of GDP compared to the 1.3% deficit expected for the current financial year. This overall fiscal consolidation of 1.6% GDP is more than double the 0.7% tightening that is expected for this year and will deliver a considerable impediment to growth, all other things being equal. Accordingly, the Statement has kept open the door for the Bank of England (BoE) to begin cutting interest rates next year as an offset to this fiscal drag.

The main tax cut announced in the Statement – the 2% reduction on employees’ National Insurance contributions from 12% to 10% – will in practice have little real impact on the UK economy. It is estimated that it will boost aggregate household disposable income by approximately £8.75bn, or just 0.5%. Further, the OBR estimates that tax changes have a first-year multiplier of just 0.33, given that some of the extra income is saved and some is spent on imports. So of this £8.75bn, only approximately just under £3bn may actually end up as additional spending on domestically produced output. Overall, it implies a boost to GDP of only around 0.15%, not enough to offset the continued fiscal tightening that remains in the pipeline. As such, the Statement in itself is unlikely to alter the BoE’s own forecasts on the UK economy and materially shift when it might deliver the first interest rate cut, which we continue to expect to be at end H1.

However, the government has a general election ahead of it, to be held by the latest January 2025, and the temptation for it to loosen fiscal policy ahead of this will almost certainly be too much to resist, particularly given its current poor standing in opinion polls. The Treasury now has approximately £13bn of headroom available to it for meeting its target of the debt-to-GDP ratio being on a downwards trajectory in five years’ time – over twice the figure estimated in the March Budget – and a figure that looks set to increase further given the reduction we have seen in gilt yields since the OBR fixed its market assumptions on 11 October for input into its latest projections. This suggests that the Budget next March may well contain further tax reductions as the government seeks to improve its chances of winning the election, with the result that the fiscal consolidation expected in 2024/25 is likely to be softer than currently forecast. These measures may be sufficient to persuade the BoE against loosening monetary policy next year as much as planned, potentially translating into one fewer 25bps cut than the market currently expects.

Going forward, there are two main risks to the government’s fiscal projections which may yet derail much of the above. Firstly, the strength of the OBR’s growth forecast looks unduly optimistic, being very much at the more optimistic end of the spectrum. The BoE’s own forecast shows growth to be around 3% lower than the OBR is forecasting by end-2026, which if realised would wipe out all of the fiscal headroom above that for ensuring the debt-to-GDP ratio is falling in five years’ time and removing the capacity to cut taxes any further. And second, the outlined plans for government spending as a share of GDP to fall going forward may be politically difficult to deliver, particularly as the ‘unprotected’ departments will be facing the bulk of this falling spending in order to protect departments such as the NHS.

With the BoE itself projecting a 50% chance of the UK economy actually falling into recession next year, if the OBR’s growth forecasts do not come to fruition then the next administration may find itself facing some tough decisions: either implement further spending cuts, raise taxes further, or risk credibility and potentially the support of the markets by changing the fiscal framework.