New fiscal rules could pose a risk to UK’s economic growth, warns EY ITEM Club


06-07-2015

The Chancellor’s new fiscal rule, expected to be announced alongside the Summer Budget, could intensify the fiscal squeeze and hit economic growth, warns the EY ITEM Club in its special report released today (Monday).

 
  • Chancellor’s new surplus rule could lead to deeper public spending cuts
  • Impact of new rule will depend on its time horizon – at worst it could see an extra £12bn of spending cuts and tax rises by 2017/18
  • Ambitions rather than actions are likely to be the order of the day on 8th July

The EY ITEM Club’s Summer Budget preview says that the time span over which the Chancellor chooses to meet his new rule of a budget surplus in “normal times” will have a major bearing on the extent of the fiscal squeeze and the performance of the UK economy. The EY ITEM Club warns that a worst case could see an additional £12bn of spending cuts and tax rises over the next two years.

The Government has already committed to £30bn of extra fiscal consolidation over the next two years. The big question is whether the Chancellor’s new rule will define “normal times” as being when spare capacity in the economy has been eliminated – something which the OBR believes will happen in 2017/18, - or whether he will retain the three-year timespan of the existing fiscal mandate, which will allow for additional breathing space.

Martin Beck, senior economic advisor to the EY ITEM Club, comments: “The Chancellor’s new fiscal rule could entail an even tighter fiscal squeeze and even greater departmental cuts may be on the cards if he seeks to achieve his surplus target within the next two years. And with the Bank of England in a limited positon to respond with looser monetary policy, the result could be weaker growth.”    

The EY ITEM Club says that since saving by one sector has to be offset by borrowing by another, the ease or otherwise of achieving a budget surplus will depend upon the behaviour of households and firms.

Martin continues: “The Government can only achieve a surplus on the public finances if another sector of the economy runs a deficit. The OBR’s view is that households will oblige, predicting a substantial rise in household indebtedness over the next few years. But households have persistently shown little appetite for more borrowing and we are doubtful that this will change anytime soon. In that case, achieving a fiscal surplus is likely to depress the economy.  

“We would like to see the Chancellor opt for a growth-friendly definition of his new framework, setting out to achieve a surplus over a five-year period. This would minimise the impact on the economy as well as giving more time for monetary policy to return to a position where it can offset the fiscal squeeze.”


Ambitions rather than actions likely to be the order of the day

With deficit reduction set to remain centre stage and in light of previous immediate post-election Budgets –which have typically seen overall tax rises – the EY ITEM Club says that any ‘giveaways’ in the Summer Budget are likely to be set out as “ambitions rather than actions”.

The report predicts that the Chancellor will make some baby-steps towards meeting the Conservative Party’s manifesto pledge to increase the personal tax-free allowance from the current £10,000 to £12,500 by 2020/21.The Summer Budget may also see some modest moves towards raising the 40% higher-rate threshold from the current £42,386 to the goal of £50,000 by the end of the Parliament.

In light of the continued dismal performance of productivity, The EY ITEM Club also expects the Chancellor to focus on measures that could boost business spending on investment, which would also help him achieve his surplus target without hurting the economy. The Annual Investment Allowance (AIA) currently stands at a temporary £500,000 and is due to fall back to £25,000 next April. The Chancellor is likely to announce a new higher permanent level.   

Martin adds: “Although the Chancellor has limited room for manoeuvre when it comes to boosting productivity, promoting investment could help him meet his surplus target while imposing less pain on the economy. A higher AIA, albeit only scratching the surface, would be helpful in this regard. The Chancellor may also come up with some off-balance sheet wheezes to encourage spending by larger companies looking to make major investments in sectors such as infrastructure.”

In terms of ‘takeaways’ the EY ITEM Club expects the Chancellor to put some flesh on the bones of the £12bn cuts in welfare spending supposed to kick in by 2017/18. Savings in this area should help to eliminate the worst of the departmental spending “rollercoaster”. The Budget may also provide some hints on where the departmental savings will come from and how these can be reconciled with the Conservative Party’s manifesto pledge to raise NHS spending by an additional £8n a year by the end of the Parliament, although we will have to wait until Autumn’s Comprehensive Spending Review for the full details.

Finally, the Government’s ‘tax-lock’ commitment rules out any increase in the headline rates of income tax, VAT or National Insurance Contributions, but a reduction of the pension tax relief for those with an income above £150,000 a year is on the cards, according to the EY ITEM Club report. The Chancellor may also choose to reduce or eliminate some tax reliefs under the banner of further ‘simplification’ of the tax system.

Stuart Wilkinson, tax partner at EY in Cambridge comments: “Freed from the balancing act of a Coalition Government, the Chancellor can be expected to stick to his path of deficit reduction, while saving any giveaways for future Budgets nearer the next election. However, as this is the first Conservative Budget since 1996, you couldn’t fault the Chancellor for wanting to make his mark. He can be expected to focus on revenue raising measures, while setting out his plans for the future direction of the UK’s tax system.”

Martin Beck concludes: “Regardless of which path of deficit reduction the Chancellor opts for, the reality for many government departments is likely to be one of sizeable spending cuts. The Chancellor has made up his mind to achieve a fiscal surplus despite increased global uncertainty and the limited ammunition available to monetary policy in supporting the economy. In our view, a policy geared more towards growth would be sensible but, for now, that goal looks set to play second fiddle to fixing the public finances.”

Read the full EY ITEM Club report here


About EY ITEM Club

The ITEM Club is the only non-governmental economic forecasting group to use the HM Treasury’s model of the UK economy. Its forecasts are independent of any political, economic or business bias and this independence is underpinned by the untied sponsorship of Ernst & Young LLP.

 ITEM stands for Independent Treasury Economic Model.  HM Treasury uses the UK Treasury model for its UK policy analysis and Industry Act forecasts for the Budget. ITEM’s use of the model enables it to explore the implications and unpublished assumptions behind Government forecasts and policy measures.  Uniquely, ITEM can test whether Government claims are consistent and can assess which forecasts are credible and which are not.  

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