Headroom

Duncan Weldon writes:

The budget may be six weeks away but the internal debate within the Conservative party over its contents has already spilled out on to the front pages. One might reasonably question whether weeks of briefing, counter-briefing and leaks are the most rational way to set fiscal policy at a precarious economic moment, but this is simply how things are done in Britain, especially in an election year.

Over the next few weeks there will be much talk of the chancellor’s “fiscal headroom” and how it should be deployed. The most important thing to keep in mind is that the entire concept is essentially nonsensical on multiple levels. It is easy to fall into the trap of thinking of this supposed headroom as a pot of money that the chancellor can choose how to spend or even, to use a favoured analogy that will crop up an awful lot between now and March, as a “pre-election war chest”. In reality, what is called headroom is simply the gap between the government’s tax and spending plans and what would be allowed under the fiscal rules, which the government itself sets and which have been changed almost annually over the past decade. Essentially, the chancellor gets to decide how much headroom he has.

The government manufactured itself even more of that fiscal space in the autumn statement last November. The story the chancellor told was that Britain’s economy had turned a corner, that the difficult decisions of recent years had paid off and now, because of that, he had the space to cut national insurance rates, handing the average worker a tax cut worth about £450 a year. But as the Office for Budget Responsibility (OBR), the government’s independent forecaster, made clear at the time, this politically useful story does not quite fit the facts.

What actually happened was that the OBR revised up its view of the likely course of inflation over 2024 and 2025. Higher inflation, and the accompanying faster wage growth, boosts expected tax receipts but also reduces the real value of public spending. The chancellor chose to bank the gains from the former while ignoring the impact of the latter. The £18bn of tax cuts announced two months ago were effectively paid for by pencilling in deep real-terms cuts in public spending in the coming parliament rather than through some unexpected fiscal bonanza.

The government seems determined to double down on this approach in the budget, with yet more tax cuts, in the hope of generating a pre-election feelgood factor. With the overall tax burden at its highest level in decades and with workers having undergone a deep squeeze in their real incomes after inflation, the argument for cutting taxes is obvious. But sadly for the chancellor, it is not convincing.

The real priority should be Britain’s increasingly threadbare public services. The current fiscal plans imply that departments outside health, education and defence will suffer the kind of cuts last seen in the early 2010s during the first wave of austerity. Even the most zealous small-stater would surely agree that after 14 years of tight spending there is little in the way of fat to cut. And even in the “protected” areas of the state such as health and education, current spending plans are hardly adequate. The NHS waiting list in England alone stands at 7.6m and more than 40% of incoming patients are waiting more than four hours in accident and emergency departments. Teacher recruitment is running at 38% below its target level as real-terms pay cuts bite.

If the chancellor has any fiscal wriggle room at the next budget, the clear priority should be reversing the planned real-terms cuts in public spending rather than broad-based tax cuts. If he has managed to carve out £20bn then that is a considerable amount of money to plug some very large holes. To put it in context, that is a third of the annual schools budget. Not only does this make more economic sense, it makes more political sense too. Polling suggests that the public are more concerned with the dire state of public services than with their tax bills.

Growth is expected to be weak this year and unemployment to rise. It is hard to see how a cut to income tax would generate much in the way of a consumer upswing. What it can do, though, is make the job of whoever is presiding over the next budget in the spring of 2025 that much harder. But that is unlikely to be a problem that concerns Jeremy Hunt.