From the Desk of the Chief Economist  Strap in: it’s going to be a bumpy ride...

When you dig into the detail of our data, it’s clear the pessimistic tone amongst business leaders has hardened. There’s significant frustration with government policy, tax uncertainty, and rising costs (driven up mostly by employment costs, with supply chain inflation and energy also featuring prominently). And while concerns over global growth have diminished, they’re rising for the UK economy. Companies’ planning horizons are shortening to mitigate risk, with reports of going for more flexible or shorter contracts and diversification, while costs are being tightly managed, with downsizing, outsourcing and automation being reported. Meanwhile glimmers of positivity – from better opportunities overseas and more certainty over government spending priorities – have fallen away amidst frustration over ongoing slowness in government procurement. And the outlook is challenging. Some of the tailwinds supporting the UK economy appear weaker: interest rates don’t have much further to fall, high inflation (which won’t be back to target until 2027) is significantly eroding real income gains and unemployment is on the rise. And persistent uncertainty affecting businesses is damaging investment incentives and growth.

How the Autumn Budget is shaping up

Amidst a pretty choppy economy, we’ve unfortunately got another fiscal hole to deal with. The OBR are set to reveal a fiscal rules miss in the tens of billions. Driving this will be a downward revision to their growth forecasts for the UK – every 0.1% point off their medium term growth forecasts adds £10 billion to the fiscal hole. Government borrowing costs have also risen, which will add further. They’ve already got more than £5 billion to find from aborted attempts to cut welfare and winter fuel payments, and another freeze in fuel duty would cost £5 billion as well, while public sector borrowing so far this year is £11.4 billion above forecast. So if the Chancellor has to find £20-50 billion, what are the options on the table?

Change or abandon the fiscal rules to enable more borrowing? This would cause a significant market reaction which would push up government borrowing costs further, increasing the fiscal challenge – speculation by Andy Burnham has already had an impact. The fiscal rules aren’t the only feature required to provide evidence that the UK is managing its public finances prudently. But they are a necessary one, and to change them after only a year – particularly when they’re set to get looser in the Spring anyway – would come with a high cost.

Reduce public spending? There’s a balance to be struck here. Yes, public sector productivity is lower than pre-pandemic, public spending is therefore high to sustain public services and productivity improvements are desperately needed. But we do need to ensure public service provision at the same time as engaging in widescale reform. Keeping departmental budgets stable in the near-term – and capital budgets for the longer term – is important for delivering the very policy stability which business leaders told us was their number one priority for unblocking growth when we surveyed them in July 2024. But the other half of public spending – which includes benefit and pension spend – needs looking at, as significant components are on unsustainable trajectories. With the numbers receiving incapacity or disability benefit increasing at double the number of disabled people, there’s a clear need to reform the system. But system reform needs to be well-designed, which will take time. And short-term measures have already proven politically difficult to deliver. Even tackling benefit fraud more firmly (estimated at £8 billion) couldn’t yield very much in the near-term. So ultimately this isn’t an area that can deliver significant sums quickly.

We’re left with tax to plug much of the gap. And the reality is that if you exclude the manifesto commitments on income tax, employee national insurance and VAT (more than two thirds of the tax base), you have to raise the remaining taxes by larger amounts, which pose greater risk to the economy through damaging incentives. We’re already living the damage to the labour market from significant rises in employment costs at the last Budget. Even speculation over some of the other options has had economic cost. Worries over changes in housing taxation have damaged market confidence, stalled transactions and reduced inquiries. Concerns that pensions may be subject to higher taxation risk pushing households to making snap decisions with long-term consequences. The literature suggests a wealth tax only works if it’s credibly one-off, i.e. implemented during a crisis, which we are not currently in. It makes sense to look more broadly at how we tax assets, but this needs to be done over time, and so doesn’t really work as a quick way to raise significant amounts.  “Sin” taxes on sugar, salt and gambling can be considered, but are likely to raise less than £5 billion all-in, and risk adding to already high food inflation.

Income tax: the best of a bad bunch… So we are left with looking at income tax, VAT and employee NI. With inflation already high, it would be difficult to engage in VAT reform (namely widening the tax base) or increasing the rate in the near-term, as it would risk exacerbating inflationary pressures. Of the two remaining big taxes, income tax is paid by more people, so smaller moves yield larger revenues, thus minimising the burden on any one individual. Raising the basic and higher income tax rates by 1p gives £10.3 billion, and a further threshold freeze another £10 billion.

Change is needed: from tactics to strategy

The fiscal rules are necessary, but meeting them by fudging the semantics of manifesto commitments, ever more creative definitions of “working people” and targeting the few parts of the tax system left does not give you a credible fiscal and growth strategy. To properly stabilise the public finances in the near-term, we unfortunately need to rely on tax. But today’s decisions must be credibly growth-supportive, minimising pressures on any one group. We’ve already got some elements of what’s necessary to support growth further out: long-term strategies across infrastructure, industry, trade and corporate tax; a plan to improve the performance of HMRC and enhance its customer focus; and more money for infrastructure investment. What’s missing is coherence, completeness and genuine commitment – there’s little point having a corporate tax roadmap which excludes a large proportion of the tax paid by business, for example. The challenges the UK faces are solveable, but we don’t need to make a difficult situation worse.