Spending And Stability How Much Fiscal Space Does The UK Have?

2nd November 2022

IPPR, the Institute for Public Policy Research challenges the idea that spending cuts are inevitable, and sets out an approach that would stabilise the economy while ensuring that public services are on a secure footing.

After devastating turmoil in markets following the government's mini budget, the key question for the government right now is what its fiscal policy stance should be. The new Chancellor, having reversed course on about two-thirds of the tax cut plans announced in
the mini budget, has said there will be spending cuts to come in the name of macroeconomic stability.

This briefing outlines the current macroeconomic situation and disentangles the binding constraints on fiscal policy in the short term and the medium term. Throughout, we point out some crucial uncertainties that surround policy making at this time of high
macroeconomic risk. We challenge the notion that spending cuts are somehow inevitable for restoring macroeconomic stability. We set out an approach that would both stabilise the economy and ensure that public services are on a secure footing.

We argue the following.
• In the short-term, the binding constraint for fiscal policy is to avoid further fuelling inflation. Inflation risk will likely be an issue through at least 2023. To help contain inflation we argue that the Bank of England should continue to raise interest rates, but more slowly and by less than markets expect, to about 3—4 per cent. This would leave real rates (nominal rate minus inflation) slightly negative,
as they were prior to the pandemic. But, any further tightening by the Bank should be highly responsive to new economic data. Given this monetary policy approach, we argue there is fiscal space for additional spending of between £90—120 billion (beyond a policy baseline of August 2022) within the inflation constraint.

• There is an urgent need for further support measures for households and businesses in 2023, including to maintain spending on public services in real terms, invest in warmer homes, support businesses, and protect households from the rising cost of living.

• Moreover, household and business support measures can help avoid inflation becoming embedded. That is because policies which help absorb the shock of high prices - such as subsidised energy price caps - can avoid businesses from having to increases their prices and workers from requiring wage increases. The government should thus provide bolder policies of this kind to avoid second
round effects from inflation.

• To keep inflation risk in check while supporting households and businesses, taxes will need to play a bigger role, taking demand out of the economy. In our public spending scenario, the inflation constraint on fiscal policy could be exceeded in 2023. To limit additional inflation risk, tax revenues should be increased. We
estimate that about £40 billion in tax increases would be needed to stay within the constraint.

• Tax increases should be focused on the financial ‘winners' from recent years including the pandemic - a time which saw huge windfall wealth gains at the top of the distribution. As well as fully reversing the mini budget cut to NICs (or implementing a similarly sized but more equitable tax rise on income), this could
include equalising taxes on labour and investment income and increasing the windfall tax on energy producers. Taxes on capital and corporations are less likely to be disinflationary than income taxes, and therefore more revenue needs to be raised in order to achieve the same disinflationary effect.

• In the medium term, once inflation ebbs, the key constraint on public spending is the design of self-imposed fiscal rules. Both the Conservative and the Labour parties have committed to the debt-to-GDP ratio falling. There are significant drawbacks to this kind of fiscal rule, including that it is insensitive to macroeconomic conditions.

• With regards to this rule, contrary to how this is reported in the media, there is no single number that tells us ‘how much can we borrow to stabilise the debt?' Instead, we show that this depends on economic conditions and how the spending is used. In the decade preceding the pandemic, interest rates were so low that, counterintuitively, governments could borrow large sums, while still reducing their debt-to-GDP ratio. We illustrate this for the future through simulations.

• Assuming this self-imposed debt-to-GDP rule is in place, we estimate that in 2025, the government could run a primary deficit of £49 billion (2 per cent of GDP) and still have a stable debt burden. This is the case if, in the medium term, the macroeconomic environment returns to one similar to pre-pandemic - with similar interest rates and growth levels. If public spending is used in ways that increase growth (for example via public investment or increasing labour supply through childcare provision) even higher primary deficits can be compatible with stable debt. Under these scenarios the government would not have to cut spending from current projections in order to stabilise debt in the medium term.
This contrasts with often cited numbers that state the UK needs to run a primary surplus which would involve tax increases or spending cuts. We find that such numbers seem to assume what we would call a ‘downside scenario' with regards to macroeconomic conditions, including for example zero per cent growth in the
medium term.

• Finally, we argue that recent market turmoil was mostly caused by surpassing of the short-term inflation constraint, combined with the fact that policies announced did not credibly address key upcoming challenges caused by the cost of living crisis. The mini budget thus gave rise to higher inflation expectations and triggered large policy uncertainty. We do not think that the market reaction was mainly due to long-term debt sustainability considerations.

To read the full paper go HERE
Pdf 29 pages