By Dr Andrew Sentance, Senior Adviser – Cambridge Econometrics & Former MPC Member
Across the world, governments have found that the need to support their economies in the face of the global pandemic leading to a massive surge in government borrowing. The OECD’s most recent Economic Outlook projected general government borrowing would reach 11.5% of GDP across the OECD countries as a whole in 2020, around 3% of GDP higher the peak in the Global Financial Crisis (2009).
Finance ministers are now having to judge how far they need to go to continue to support economic activity in 2021 and beyond, and what changes might be required to put public finances on a more sustainable footing in the medium term. That was the balancing act facing UK Chancellor of the Exchequer Rishi Sunak in delivering his 2021 Budget.
Further Short-Term Stimulus To Aid Recovery
In the short-term, the Chancellor has provided stimulus to recovery by rolling forward many of the support measures he had announced for 2020/21 into the early months of 2021/22. This includes an extension of the furlough scheme for employed workers and additional help for the self-employed. In addition, for the next two years there will be an enhanced regime of capital allowances which will enable businesses to claim 130% of their total investment in plant and machinery. Taking all these measures together, Rishi Sunak announced a short-term fiscal boost of nearly £60bn, or 2.6% of GDP, in 2021/22.
The Pace of Fiscal Consolidation
Looking further out, however, the Budget is much less generous – as Chart 1 shows.
First of all, the short-term support provided to businesses and employees through the current lockdown will fall away. Second, the main corporation tax rate will be raised from 19% to 25% from April 2023. Third, personal income tax allowances will not be indexed from 2022/23, creating a “fiscal drag” effect which also helps bring borrowing down. The combined impact of these two tax-raising measures, however, amounts to less than 1% of GDP. So these measures cannot be regarded a drastic tax rises, and they will only take effect as the recovery gathers momentum.
This approach to raising taxes is very different from the approach taken by Chancellor George Osborne as the UK economy recovered from the 2008/9 recession. Then, consumers were hit by 2 successive rises in VAT, taking the headline rate from a reduced level of 15% to 20% in the space of just over a year. By focussing on corporation tax and freezing personal tax allowances, Rishi Sunak is using “stealth taxes” which consumers and households are less likely to notice. The risk is that the corporation tax rise could hit investment, but that issue could be addressed by keeping a more generous system of investment allowances in place for longer.
By introducing these modest tax rises, the Chancellor hopes to bring down the public sector deficit to around 3% of GDP and stabilise the ratio of public debt to GDP at just over 100%. While this sounds a relatively high figure, it is worth noting that the average ratio of UK public debt to GDP since 1700 has been around 95% (See Chart 2).
With interest rates at historically low levels, this level of public debt is easily manageable for a country like the UK which has a good track record of managing government finances. It is also worth noting that if the debt to GDP ratio is projected to peak at around 97% if the Bank of England’s debt holdings and other financial activities are excluded from the calculation.
How Much Support for Green Recovery?
The UK government put great emphasis on “building back better” as the economy recovers from the pandemic, including investment in a “green recovery”. A green recovery plan announced last November. But the investment funds which were put behind this plan before the Budget were modest. The green recovery plan committed £12bn of public investment over 10 years, with the hope this will lever in a further £36bn of private sector investment, Putting this all together we are talking about around £5bn a year in terms of the injections of public and private “green investment” in the decade ahead – just 0.25% of GDP.
The 2021 Budget provided mixed signals on how far the Chancellor was prepared to augment these funds. He announced a £15 billion programme of “green bonds” to support the financing of environmentally friendly investment projects. But the new green schemes announced in the Budget were costed in millions, not billions. It remains to be seen how much the new “green bonds” will genuinely boost investment or whether they will simply represent a source of finance for projects already in the pipeline.
Long-Term Tax Restructuring and Reform
Another source of disappointment in the Budget was the lack of any serious focus on tax reform, which has been largely neglected by UK Chancellors since Nigel Lawson in the 1980s. Reform and restructuring taxation is politically difficult, because it can create losers as well as winners. But there are many aspects of the UK tax system where it is badly needed, including National Insurance, VAT and property taxes.
The 2021 UK Budget did well to provide support for investment and recovery in the short-term. But its longer term impact is more uncertain. The fiscal tightening planned for the mid-2020s is s relatively modest and focussed around “stealth taxes”. But plans for supporting a “green recovery” need further development and fundamental tax reform was largely ignored by Rishi Sunak.