How the economic rebound saved Sunak's Budget

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Economic rebound Budget Sunak

The economy will reach its pre-pandemic peak at the end of this year, the fiscal watchdog has said, in a significant boost for Rishi Sunak as he fights to repair the country's post-pandemic finances.

Richard Hughes, chairman of the Office for Budget Responsibility (OBR), acknowledged he had been too pessimistic back in March’s forecasts at the previous Budget, when the economy was starting to move on from lockdown.

Hughes has now ramped up growth predictions dramatically for this year, propelling Britain to the fastest expansion in the G7, which means more taxes flowing into Treasury coffers and welcome breathing space for Rishi Sunak, the Chancellor.

Back in March officials thought the economy would grow by 4pc in 2021. Instead, growth is booming at 6.5pc. Compared to the UK’s major economic rivals, that is ahead of France’s 6.3pc, the US’s 6pc, Italy’s 5.8pc, Canada’s 5.7pc, Germany’s 3.1pc and Japan’s 2.4pc.

The UK will follow up its 2021 spurt with another healthy 6pc in 2022, followed by a more ordinary looking 2.1pc the following year and then 1.3pc in 2024 and a 1.6pc advance in 2025.

It means all the damage to the economy since the crisis hit will have been undone by the end of December – several months before previously expected.

“We overestimated the fall in output associated with the last lockdown,” Hughes said. “This has been part of a pattern of underestimating the adaptability of the UK economy to pandemic conditions.”

The country coped better than expected with the second lockdown as businesses and consumers applied the lessons learnt when Covid first hit. The rebound once restrictions were lifted was faster too.

However, this has unleashed a wave of problems across the economy as Covid-battered UK and world supply chains struggle to cope with booming demand.

It means the economic picture is better than previously thought, and so the public finances are stronger. But there are serious threats, too, which will make life tough for families and businesses and could cost the Chancellor dear in the years ahead.

“The rollout of the vaccines and lifting of public health restrictions unleashed a stronger than expected rebound in demand that took output to 1.1pc below its pre-pandemic peak in August 2021, rather than the 4.9pc shortfall we had expected in our March forecast,” the OBR said.

Unemployment

Such strong growth has consequences for the public finances. With more people in work – unemployment is now 4.5pc, compared with the 5.6pc the OBR forecast for the year as a whole – more tax revenues are coming in.

Unemployment will peak at 5.2pc, the forecaster believes, a little more pessimistic than the Bank of England. Joblessness will then fall to 4.3pc in 2023 and 4.2pc from 2024 onwards. This indicates the jobs market will not fully recover to 2019’s unemployment rate of below 4pc.

Tax receipts

The Treasury is set to rake in £862bn this financial year, up from the £819.3bn predicted in March 2021. Receipts will climb to £962bn next year then break the £1 trillion mark with a haul of £1.02 trillion in 2023-24, £1.06 trillion, £1.1 trillion in 2025-26 and £1.15 trillion in 2026-27.

Income tax will raise £213.2bn this year, rising to £229.6bn next year, £240.5 the year after, and £253bn in 2024-25. By 2026-27 it is set to rake in £284.3bn. Before the pandemic, it brought in just under £200bn in 2020-21.

That is not all workers are paying. National insurance – across employers and employees – will bring in £157bn this year and £182bn next year, when it is enhanced by the new health and social care levy.

After that levy is fully established as a standalone tax from 2023-24, national insurance drops back to £168.1bn, then £171.7bn the following year and £176.5bn in 2025-26.

Meanwhile the new health and social care levy will raise £18.3bn in its first full year, £18.7bn in 2024-25, £19.3bn in 2025-26 and £20.1bn in 2026-27.

VAT’s haul will climb from £131.9bn this year, £155bn next year, £159.1bn in the following 12 months, £163.1bn in 2024-25, £167.4bn and finally £172.1bn.

Corporation tax will jump from £52bn this year to £56.6bn next year and £75.6bn when the rate rises from 19pc to 25pc in 2023-24. It will keep climbing to £85.2bn, £89.3bn and £91.5bn in 2026-27.

Council tax will bring in £40.1bn this year, rising to £41.8bn next year, then £43.6bn, £45.4bn, £46.9bn and £48.4bn.

Public spending and debt

Meanwhile spending is a touch lower at £1.045 trillion, around £8.3bn below earlier forecasts.

UK public spending stands at 45.1pc of GDP, having hit 53.1pc last year. It will fall to 41.6pc by 2024–25, the OBR said, but at that level spending will still represent the “largest sustained share of GDP since the late 1970s”.

Current spending will drop from 40.1pc of GDP to 37.1pc next year, 36.8pc and then 36.6pc from 2024-25 onwards.

The number of furloughed workers at the end of the Coronavirus Job Retention Scheme in September was 1.3m, significantly fewer than the 2m the OBR anticipated, saving money.

It leaves Sunak with a deficit of £183bn for this financial year, extremely high by pre-Covid standards – borrowing in the financial crisis peaked just below £158bn – but down from almost £320bn last year.

It is more than £50bn smaller than was expected in March.

The national debt is set to rise to £2.37 trillion this financial year, £134bn less than expected. As a share of GDP it should peak this year at 98.2pc of GDP, rather than rising for years to close to 110pc as previously thought.

On Sunak’s preferred measure of underlying debt excluding the Bank of England, the deficit is due to peak at 85.7pc of GDP in 2023-24 after rising by 10.2 percentage points in the first year of the pandemic.

There is more good news. Last financial year the Chancellor borrowed less than he realised at the time. The deficit was thought to be £354.6bn but instead, it turned out to be £319.9bn.

This is still a record high, and at 15.2pc of GDP it is the biggest borrowing ever incurred in peacetime. But all contributions are welcome and a drop of almost £35bn is not insignificant.

Meanwhile the stronger economy puts the finances on a better footing for future years.

In 2022-23, the deficit was expected to come in at almost £107bn. Now the OBR anticipates £83bn.

This same picture is repeated for subsequent years: to £61.6bn in 2023-24, £46.3bn in 2024-25 – lower than projected before the pandemic – £46.4bn in 2025-26, and £44bn in 2026-27.

The gap between these forecasts and the previous ones effectively gives the Chancellor an extra £98.6bn of fiscal headroom between now and the next election.

Unemployment is set to peak at 5.25pc compared to the previous prediction of 6.5pc, equating to around 500,000 fewer jobseekers.

It means economic “scarring” – the shortfall in the economy over the long-term relative to pre-Covid forecasts – will be around 2pc, not the 3pc as previously thought.

But not all is well. Scarring might be less bad than feared, but it still represents a permanent hole in the economy.

The OBR estimates the workforce will be 160,000 smaller than previously expected, with less migration and more early retirements.

Business investment

Some business investment was lost last year and will not return. Cumulative investment over the coming years will be 7.3pc lower than was anticipated before Covid.

Business investment slumped from £217.3bn in 2019 to £195bn in 2020. It will fall further this year to £190.3bn before rebounding to £220.2bn in 2022, £230.6bn in 2023, £228.7bn in 2024, £239.7bn in 2025 and £253.5bn in 2026.

That shortfall compared to previous expectations undermines productivity. By the start of 2025, output per hour worked will be more than 1pc below what was expected before Covid struck, hitting future growth and prosperity.

Public sector net investment jumped from £41.8bn in 2019-20 to £72.7bn 2020-21 when the pandemic struck. This year it dropped back to £60.1bn, but should rise again to £67.2bn next year and £74.1bn in 2023-24 before hovering around that level in subsequent years.

Ultimately, despite the improvement in recent months, the deterioration in Britain’s finances caused by the pandemic has been stark – underlining the urgency of the repair job for a Chancellor who considers protecting the public purse a “sacred duty”.

In March 2020, just as the OBR was warning with masterly understatement that Covid would have a “significant adverse effect” on the public finances, the forecaster was expecting debt as a share of GDP to stand at just 75pc this year – compared to more than 98pc in its latest updates.

Costs of Covid and the debt burden

For all the cheer over borrowing, in the pre-pandemic world the deficit was expected to be a far more modest £66.7bn.

It is not only the smaller economy which is to blame. Those gaping holes in the finances reflect the sheer scale of Covid policies, including test and trace, vaccinations and the furlough scheme.

Covid spending has hit £315bn so far. Furlough accounts for £69bn. The self-employed income support scheme racked up a £28bn bill. Loan guarantee schemes are set to cost £23bn.

The saving grace for the Chancellor’s creaking debt burden is that interest rates remain low for now. In March last year, debt interest for 2021-22 was expected to be £60.1bn. Despite the swollen debt burden, that bill has merely edged up to £60.4bn.

This may not last. The OBR forecasts the annual cost of servicing debt to remain roughly stable, but there are key risks from inflation – which drives up borrowing costs as one-quarter of the debt is linked to retail prices – and interest rates, as the Bank of England is expected to raise its base rate next week or in December.

A one percentage point rise in both inflation and interest rates would cost the Treasury £23bn, wiping out the Chancellor’s headroom above his new fiscal targets.

The result is that taxpayers are on the hook for more, despite the recovery.

Frozen tax thresholds mean higher prices and higher pay result in higher tax bills, even if workers are no better off in real terms.

Rising inflation makes the economy bigger in cash terms, which along with the “five-year freeze in the income tax thresholds, makes the additional GDP particularly tax rich given the high effective tax rates on labour income and consumption,” said Hughes.

At the same time taxation is climbing. The tax burden is to rise to more than 36pc of GDP, the highest since Labour’s Clement Atlee was in Downing Street in 1950-51 and the nation was struggling to recover from the Second World War.

It might not feel like a booming rebound when the bills come in.

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