IFS: Recent fiscal improvements welcome but might not last, making permanent Budget tax cuts or spending increases harder to justify

Ahead of the Budget on 15 March, there is some welcome good news for the Chancellor. The UK can now expect a shorter, shallower economic downturn than expected in the autumn, and borrowing this year and next could come in around £30 billion lower than previously forecast, owing largely to lower energy prices and interest rates than previously expected, and stronger-than-expected tax revenues.

Unfortunately, this improvement might not last. Savings on energy support can only be temporary. The indications are that a downgrade in the OBR’s medium-run growth forecast is possible, which could easily offset much, if not all, of any enduring fiscal improvements elsewhere (such as a reduction in forecast debt interest spending, or an increase in the ‘tax-richness’ of growth). The Chancellor will doubtless also need to find £6 billion a year to freeze fuel duties. In any case, any improvement in borrowing since November will still represent a deterioration on the forecast from a year ago.

Debt may well remain on course to fall very slightly by the end of the forecast horizon, as the government’s new fiscal rules stipulate. Or, forecast revisions could put debt on a slightly rising path in five years’ time. This judgement is extremely sensitive to the OBR’s assumptions about growth and inflation five years hence. It would not be desirable for the government to take immediate policy action in response to a minor forecast change that puts it on track to miss the letter of its fiscal rules – not least due to the uncertainty involved. Stepping back, the case for permanent tax cuts or spending increases that are not offset elsewhere is no stronger now than in the autumn.

Unlocking public sector pay disputes will almost certainly require extra funding from the Treasury: as it stands, departments can ‘afford’ pay awards of at most 3.5% in 2023–24, when both inflation and private sector awards are expected to run considerably higher. Providing a CPI-matching 5.5% pay award across the entire public sector in 2023–24 would add around £5 billion to the pay bill, relative to the 3.5% or so already apparently budgeted. That would more-or-less match expected settlements in the private sector in the coming year, but would mean locking in the real-terms pay cuts of 2022–23. Going further and acting to undo that year’s reduction vis-à-vis the private sector would cost a further £9 billion or so. And even this would still leave public sector workers worse off (on average) than in 2020–21.

The public finance outlook means that extra Treasury funding for higher awards will likely mean higher taxes or spending squeezes elsewhere. Consolidated pay awards would represent permanent increases in spending – increases which could not be financed from any short-term savings on the Energy Price Guarantee. The Treasury’s £13–14 billion spending ‘Reserve’ could be the key to resolving disputes in the near term, but this would not alter the long-term calculation. One-off pay awards, or awards backdated to the start of 2023, would pose fewer fiscal challenges but would leave public sector staff permanently worse off.

This parliament has seen a decisive break with austerity: public service spending is set to have grown by 2.8% a year between 2019–20 and 2024–25, well above the long-run average. The plans for after 2025, pencilled in at the Autumn Statement, would see funding grow by just 1% per year. Coming after the funding increases of this parliament, that might look manageable. However, given the inevitable demands from the NHS, sticking to those plans would almost certainly mean cuts to some other budgets. And while the ‘peace dividend’ from lower defence spending has historically allowed for greater spending on the welfare state, we may now be facing a world where the government feels the need to increase health and defence budgets at the same time. That points to an enormously difficult couple of years for other areas, such as local government, prisons, further education and the courts – services which faced deep cuts over the 2010s and which face deep-rooted challenges of their own.

With poor economic growth and elevated debt interest payments, even currently planned tax increases may not be sufficient to meet the accumulated demands on public spending.

Isabel Stockton, Senior Research Economist at IFS, said:

‘It is difficult to see an end to public sector pay disputes and industrial action that does not involve the Treasury providing additional funding to departments. Short-term improvements in the borrowing outlook could allow for one-off bonuses or backdated pay awards for public sector workers. But it is far from clear that these improvements will last and, if the Bank of England is right, the UK’s medium-term growth outlook may have deteriorated. Short-term savings cannot finance permanently higher spending – which is what a higher consolidated pay rise for public sector workers would entail. The Chancellor likely has less fiscal room for manoeuvre than recent headlines might suggest.’