The chasm between the recent big changes in the world order and the small changes in UK fiscal policy announced by the Chancellor yesterday can’t persist for long. And it’s hard to see how the gap can be closed without higher taxes for UK households.
When the Chancellor, Rachel Reeves, yesterday said during her Spring Statement that the “world is changing before our eyes” she was referring to the need for Europe to defend itself. But she was silent on how the UK was going to pay for it.
Admittedly, the scheduled rise in defence spending from 2.3% of GDP now to 2.5% by 2027 is being funded by cuts to overseas aid. But we don’t know where the money for the government’s ambition to raise defence spending to 3.0% of GDP by 2029-2033 will come from. This isn’t pocket change either as it will cost £17bn.
What’s more, 3.0% might not be enough. Germany has pledged to spend 3.5% of its GDP on defence and America already does the same. Raising the UK’s defence spending to 3.5% of GDP would cost £35bn.
It is hard to see such changes happening while the Chancellor is boxed in by three restraints.
The first restraint is her own fiscal rules. In some ways, these rules are already self-defeating. They are designed to ensure fiscal stability and promote economic growth. But to avoid breaking them, yesterday the Chancellor had to announce a tightening in fiscal policy of £9.7bn (0.3% of GDP) that will crimp economic growth.
The second restraint is the Chancellor’s pre-election pledge not to raise taxes for households. This may or may not have been necessary to win last year’s election. But it has certainly tied her hands since. It explains why she announced big increases in National Insurance Contributions for businesses at last October’s Budget (those tax rises take effect on 6th April). And it explains why the tightening in fiscal policy announced yesterday was paid for by cuts to welfare and other government spending.
The third restraint stems from the financial markets and the UK’s dire fiscal position. The UK has outstanding public debt that is almost equal to its income (i.e. a debt to GDP ratio of almost 100%), its income has grown by an average of 4.4% over the past ten years and it has to pay an annual interest rate of 4.8% to borrow for the next 10 years. If this continues, the extra income the UK is earning each year won’t be enough to cover the interest it needs to pay each year on its debt.
As a result, if the UK were to try to borrow more to pay for defence spending, the markets may charge a higher interest rate to compensate for the extra risk of the debt not being repaid. That would make the UK’s fiscal arithmetic worse or even unsustainable.
The solution in the long term is for income growth (i.e. GDP growth) to be higher and/or interest rates to be lower. Both may happen eventually. But the Chancellor can’t just sit back and hope.
Instead, big changes in the world order require big changes in fiscal policy. Something is going to have to give. As playing hard and fast with the markets has resulted in previous Chancellors losing their jobs, it is probably the fiscal rules that will have to bend and the government’s tax pledges that will have to break.
Overall, it feels as though bigger changes to fiscal policy lie ahead and higher taxes for households seem inevitable.
Paul Dales is chief UK economist of research consultancy Capital Economics.
