CNBC's UK Exchange newsletter: No easy answers for Reeves

CNBC

a day ago

It says much about the current state of U.K. politics that today's spending review has taken on such importance.
What should be a relatively straightforward event, in which Rachel Reeves, the chancellor of the Exchequer, sets out the government's spending plans for the next three financial years, has even been billed by some commentators as the defining moment of this parliament.
This is because, little under a year after being handed a landslide majority by the U.K. electorate, Prime Minister Keir Starmer's government is deeply unpopular and thrashing around for ways to appease a surly and resentful public.
It is important, at the outset, to make clear what won't happen today. This is not a fiscal event — Reeves is committed to just one of these a year and the next will be her Autumn Budget.
So there will be no forecasts from the Office for Budget Responsibility and no details on how the government plans to raise money during the next financial year. There will also be no changes to tax policy announced; nor, unless something remarkable happens, will there be any changes to the overall sums the government expects to spend.
That is because those figures are already in the public domain: Reeves set out last October the "spending envelope" for the next three financial years, with day-to-day spending (such as salaries for public sector workers) set to rise by an average of 1.2% in real terms over the next three years and capital spending (such as transport infrastructure) set to rise by an average of 1.3% in real terms over the next four years.
That spending envelope, the tightest for many years, has been dictated by Reeves' much-vaunted fiscal rules — that day-to-day spending must be covered by tax revenues, not borrowing, and that debt, as a proportion of GDP, should be falling by the end of this parliament. Most economists think she is in severe danger of breaking those rules, though, having set herself wiggle room of just £9.9 billion ($13.4 billion) in her last Budget — since when the economic outlook has deteriorated and yields on gilts (U.K. government bonds) have risen, implying higher-than-expected government borrowing costs in the coming years.
All of which adds to the significance of today's spending review which is, as the independent Institute for Fiscal Studies (IFS) points out, "the first multi-year spending review since 2021 and the first to happen outside of a pandemic since 2015."
And, despite it not being a fiscal event, the bond markets will be watching for hints on what to expect regarding taxation and borrowing in the autumn.
We received one such hint when, on Monday, the Treasury announced a humiliating U-turn on one of the government's first big decisions. Shortly after being elected in July last year, Reeves announced that the winter fuel allowance — a bung to pensioners of either £200 or £300 a year introduced in 1997 by one of her Labour predecessors Gordon Brown — would henceforth be means-tested, effectively stripping it from 10 million pensioners. However, after a political backlash, the Treasury said on Monday the benefit would be restored to all but the wealthiest 2 million pensioners in a move that will cost the government £1.5 billion annually. No indication was given on where that money will come from.
There have also been plenty of other leaks concerning the spending review. The Times reported on Saturday that the National Health Service (NHS) will receive a 2.8% increase in real terms to its day-to-day budget over the three-year period, roughly equivalent to an extra £30 billion in cash terms by 2028. The question here (with leaders of the doctors union already agitating for industrial action) is how much of that will actually go toward improving patient services and how much will be handed to doctors in pay awards to stave off strikes.
The other big winner looks to be defense which, as the IFS has noted, seems to have been implicitly allocated all of the increase in capital spending over the spending review period.
The government has already set out plans to raise defense spending from the present 2.3% of GDP to 2.5% of GDP by 2027 and to 3% by the early 2030s — and it is under pressure to go further. The Trump administration has made clear it thinks NATO members should be spending 5% of GDP on defense and, in a speech on Monday, Mark Rutte, the NATO secretary-general, said the same. Reeves would need to find an extra £24 billion to take defense spending to just 3% of GDP.
These big spending commitments — particularly for the NHS, which already consumes £2 in every £5 of day-to-day government spending — will mean real-term cuts in other departments. Many of these have already been stretched by years of austerity following the global financial crisis, from which the U.K. emerged with a deficit-to-GDP ratio of 10%.
Britain's justice system, from courts to prisons, is under huge pressure. So is local government which, at a time of rising costs due to an ageing population, must pick up the tab for a lot of social care. The country's schools also face a squeeze; while some new money has been allocated, schools have been told to fund around a quarter of the 4% pay rise awarded to teachers this year from existing budgets. Anecdotally, stories abound of teaching assistants — many of whom work part-time — being laid off or having their hours reduced.
Elsewhere, newspaper reports have prominently covered rows within the cabinet. Ed Miliband, the energy secretary, faces cuts in his department in order to protect his cherished home insulation program, while Angela Rayner, the deputy prime minister and housing secretary, is said to have clashed with Treasury officials as she sought to protect her plan to build more affordable homes. The biggest arguments, though, are said to have been between the Treasury and Yvette Cooper, the experienced home secretary and a veteran of the last Labour government, over the policing budget.
At the center of all this is the urgent need for great swathes of the British state to do more with less.
As Sanjay Raja, senior U.K. economist at Deutsche Bank, said in a note to clients last week: "Markets will be keeping an eye on any fallout from the spending review, while we will also be looking at the sustainability of spending policy. What do we mean by sustainability? For one, sustainability in maintaining such tight spending envelopes, via ambitious cost-saving measures. And two, sustainability in sticking to existing spending envelopes despite diminishing headroom from higher interest rates, potential downgrades to productivity growth, global trade tensions, and a looser labour market."
And this speaks to the heart of the U.K.'s problem: the dreadful productivity record of its public sector and particularly the NHS. As an example, it emerged at the weekend that the NHS spent at least £102 million sending letters by post last year — causing countless missed appointments due to slow deliveries — despite promising to go digital in an era in which nearly every patient now has email access.
Poor NHS productivity is not a new phenomenon. As long ago as March 2010, during the dying days of Brown's government, the Office for National Statistics reported that, from 1995 to 2008, NHS productivity fell by an average of 0.3% per year, with the decline accelerating after 2001 when Brown, as chancellor, unleashed a huge increase in spending on the service.
In the absence of productivity improvements or economic growth, future spending increases will have to be met by increased borrowing or taxation. Given Reeves' devotion to her fiscal rules, she is unlikely to opt for the former. Strikingly, during interviews on Monday to discuss the winter fuel climbdown, she conspicuously failed to rule out tax increases come the autumn.
Many economists now think that is almost inevitable, among them Raja, who wrote: "Perhaps even more difficult decisions lie ahead for the Chancellor. On our estimates, we see a fiscal hole of near £10-15 billion emerging ahead of the Autumn Budget. Tax rises, we think, are inevitable as spending cuts are pushed to their political limits. It could be a noisy few quarters as we move closer to the Chancellor's second budget."
Another reason to expect tax increases come the autumn is the government's seeming inability to make even modest spending cuts, as shown by the winter fuel U-turn.
As Simon French, the chief economist and head of research at stockbroker Panmure Liberum, put it: "Whilst not macroeconomically significant, it speaks to a problem that if Chancellors/PMs can't find it politically intolerable to find a saving of £1.5 billion (1% of this year's PSBR) then bond markets are going to be unconvinced on the decisions (regarding the cost of aging, supply-side reforms) necessary to keep public sector debt on a sustainable path."
This being a political event, Reeves is bound to try and produce at least one rabbit from her hat, even though most spending decisions have already been announced or leaked. Labour MPs would love her to abolish the cap that restricts child benefit to the first two children in a family — a move that would cost £3.5 billion.
The biggest surprise of all would be an increase in the overall spending envelope, perhaps justified by the fact that the economic outlook has been altered by unforeseen events, chiefly U.S. President Donald Trump's tariffs.
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