Rachel Reeves' fiscal headache is getting bigger

New Statesman​

5 hours ago

Photo by Simon Dawson / No 10 Downing Street
The more one looks at last week's Spending Review, the more one appreciates the challenges the economy and the government face.
Health and defence were the two clear beneficiaries from the review, but even here the numbers do not mean that all of the spending pressures have been addressed.
The NHS is going to see real-term increases in its resource budget of 3 per cent, which is much higher than any other department and much higher than economic growth as a whole. It is also lower than the average rate of growth in its budget since its creation of 3.6 per cent and much lower than the last time waiting times were brought down substantially when its budget increased by 5 or 6 per cent a year. If Labour fails to achieve similar progress on waiting times over the course of the parliament, it is in electoral trouble.
As for defence, it got the lion's share of additional capital spending. This makes sense given that our stocks have been depleted by supporting the Ukrainians and that technology is only going to play a bigger role as warfare evolves. But last week's announcement increases overall defence expenditure to 2.5 per cent of GDP, when the government has ambitions to reach 3 per cent, NATO is calling for 3.5 per cent and President Trump is demanding 5 per cent.
So yes, health and defence are the big winners relative to everyone else but there is every chance that, by the time we get to the next election, there will be strong demands for these areas to get more. It is worth reflecting on what the government had to do to enable it to make the announcements on health and defence that it has.
The fiscal rules have been loosened to allow more borrowing, which caused a certain amount of bond market unease at the time of the last Budget and has contributed to us having higher bond yields than most other European economies.
Taxes have gone up very substantially, mostly from an increase in employers' National Insurance Contributions. This is making life difficult for many businesses and will, in time, result in lower pay for employees.
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As for other parts of government, it would be wrong to describe them having austerity imposed upon them, but nor are they living in the land of milk and honey. Departmental settlements for the end of the Spending Review period are tight and leave no scope for additional demands.
Nor is the government generally left with a buffer if matters do not turn out as well as expected. Rachel Reeves gave herself very little fiscal headroom in her autumn Budget or Spring Statement. The Office for Budget Responsibility is a relative optimist when it comes to the growth prospects for the country but if it revises down its productivity assumptions or concludes that President Trump's tariffs or Middle East instability will cause a negative impact on our medium-term growth prospects, Reeves will be on course to breach her 'non-negotiable' fiscal rules.
Reeves argues that nothing in the Spending Review requires her to raise taxes. That is true in that she has stuck to the spending envelope that she set out in October. But what were not included in the spending review are higher debt interest bills or the retreat on winter fuel payment cuts, let alone the abolition of the two-child benefit limit
There must be a better than even chance that some combination of tax increases or spending cuts will be necessary by the autumn if the fiscal rules are to be met. Given that a Spending Review has only just been completed, tax increases are the most likely response. Last year's tax increases landed badly, this year's – if substantial – will be received even less generously.
This gives a sense of the predicament facing the government. Any fair assessment has to acknowledge a very difficult inheritance and some bad luck along the way. When Reeves cleared the way for higher capital investment in her October Budget, she was presumably hoping that she would not need to devote much of it to defence but to improving our economic infrastructure as part of a growth strategy. She would also have hoped that the international trading system would not have been damaged quite so bigly by the new US President. A full-scale war between Israel and Iran disrupting oil supplies would also not have been on her wish list.
The government, of course, cannot be seen as a passive figure here. It is pursuing some economically sensible policies – planning reform, rebuilding our relationship with the EU, encouraging technological innovation – and should seek to be bolder on all fronts. It also needs to be careful not to make growth harder in other areas (expanding employment rights, most obviously).
If taxes have to go up, it makes sense to prepare the ground but this risks weakening consumer confidence. There is then the question of which taxes to increase where there is usually a direct trade-off between what is the least politically unpopular (wealth taxes, anyone?) and the least economically damaging. The government needs to put the economy first. All of this points to a very difficult autumn Budget in which Reeves will likely have to resist calls from within the Labour Party to spend more on welfare, reassure the bond markets by sticking to her fiscal rules and, therefore, find ways to raise revenue without making the country less competitive. For all the talk of having stabilised the economy, there are still some very tough choices ahead.
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