Higher inflation will improve outlook for Chancellor – but extra headroom is a fiscal illusion founded on implausible spending plans
Stickier-than-expected inflation is leading to higher tax receipts and lower borrowing that will increase the Chancellor’s fiscal headroom to around £13 billion in his Autumn Statement. But this extra headroom is a ‘fiscal illusion’ founded on pretending the higher inflation that boosts tax revenues won’t push up spending too, according to new Resolution Foundation research published today (Monday).
The Foundation’s pre-Autumn-Statement analysis says that while the Office for Budget Responsibility’s (OBR’s) forecast for the UK economic outlook will be for stagnation or recession, the fiscal outlook is likely to improve compared to its forecast in March.
This largely reflects stickier-than-expected inflation and stronger wage growth. The Bank of England now expects CPI inflation will be 6 per cent between 2022-23 and 2023-24, compared to the OBR’s forecast of just 4 per cent in March. Looking over the medium term, the latest Bank forecast has consumer prices rising by around 13 per cent between 2022-23 and 2026-27, compared to around 6 per cent in the OBR’s most recent forecast.
Higher inflation is already flattering the public finances, with tax receipts coming in £15 billion higher than forecast six months into the current fiscal year. This trend is set to continue, with annual receipts around £40 billion higher in 2027-28 than expected in March.
These higher tax receipts will only be partially offset by higher interest rates and debt interest costs, which are expected to rise by around £16 billion in 2027-28, compared to the OBR’s previous forecast.
As a result, overall borrowing will be reduced and the Chancellor’s headroom against his fiscal mandate, of having debt fall as a share of the economy in the final year of the forecast, will increase to around £13 billion (up from £6.5 billion in March).
The Foundation notes that while this level of headroom is still historically low (it’s been £25 billion, on average, since 2010), it is still likely to lead some to believe that there is now space for pre-election tax cuts. Scrapping plans to raise fuel duty next April by 5p, as is very likely, will cost £4 billion.
However, the Foundation cautions that this level of headroom is a fiscal illusion, founded on the idea that higher inflation and wage growth can drive up tax revenues without also pushing up public spending. For example, the government’s current plans have not been changed to reflect recently agreed public sector pay settlements, which would cost a further £13 billion.
Looking ahead, public service spending plans were set in cash terms before the recent inflation surge. This means that per person spending on unprotected departments, such as the Home Office, Transport, Justice, and Levelling Up, Housing and Communities is now set to fall in real terms by 16 per cent, or £20 billion a year, between 2022-23 and 2027-28.
This is up from 11 per cent at the time of the March Budget, and would mean cuts being implemented at a similar pace to those overseen by George Osborne in the early 2010s – when per capita spending on unprotected departments fell by 16 per cent between 2010-11 and 2013-14.
While the Chancellor may choose to allow these fiscal illusions to run until after the next election, that does not remove the fiscal reality of the pressures involved, the authors say.
Other decisions cannot be put off, however. These should include confirming that working-age benefits will rise in line with prices next April (by 6.7 per cent), and carrying out his welcome proposals to reform pension funds in order to encourage greater private investment in UK plc.
The Foundation warns that not uprating benefits in line with prices would worsen an already bleak living standards outlook for nine million low-and-middle income families. Freezing benefits in cash terms would cut the incomes of affected families by nearly £500 on average, and increase absolute child poverty levels by up to 400,000.
James Smith, Research Director at the Resolution Foundation, said:
“As well as causing a huge cost-of-living crisis, Britain’s bout of high inflation is also flattering the public finances, with higher pay growth feeding through into higher tax revenues.
“But while this will give the Chancellor the appearance of extra wriggle room in his Autumn Statement, it is in fact a fiscal illusion founded on the idea that higher inflation will increase tax revenues without also pushing up spending on public services.
“While these fiscal illusions may be parked until after the election, higher public-sector costs and wages cannot be wished away. It’s increasingly clear that spending plans pencilled in for after the next election cannot be delivered. Fiscal forecasts that ignore that reality aren’t worth the paper they’re written on.”