A “Budget for growth” should improve the economy’s prospects – EY ITEM Club comments

• The net fiscal loosening announced in today’s Budget will likely improve the short and long-term economic outlook. However, the Chancellor’s decision to stick with April’s substantial rise in corporation tax and the ongoing freeze in income tax thresholds means fiscal headwinds have far from gone away. And with well-publicised issues in the US banking sector presenting a new source of uncertainty, some unexpected caution may need to be attached to the OBR’s less downbeat forecasts.
• Those forecasts paint a brighter near-term picture for the public finances, with forecast borrowing this year and next £33bn lower than only three months ago, despite the fiscal cost of Budget measures. The OBR has also reined back on its previous prediction of a prolonged downturn, with the economy now expected to avoid recession. A lower trajectory for energy prices has helped on both fronts and given the Chancellor leeway to maintain the energy price guarantee at its current level. This will reduce inflation over the next few months and avoid what would have been another headwind to consumers.
• Supply-side measures around boosting investment and encouraging more people into the workforce should be positive for growth. That said, allowing businesses to fully expense investment against taxable profits may only mitigate the impact of other incoming changes – April’s rise in corporation tax and the end of the super-deduction tax break. The new investment incentive is time limited, while the corporate tax rise is permanent. And the overall tax burden is still headed for a 70-year high, aided by the continued cash freeze in income tax thresholds.
• The OBR thinks the Budget’s measures will boost the economy’s potential, although a steep fall in energy futures prices and higher migration also contribute towards a more optimistic long-term outlook. As a result, the Chancellor is expected to continue meeting his fiscal rules, although the debt goal only marginally.

Martin Beck, chief economic advisor to the EY ITEM Club, says: “Jeremy Hunt’s second fiscal event as Chancellor proved less dramatic, but much more upbeat in tone, than its predecessor. The Chancellor was able to present a package of measures which should boost the economy in the short- and longer-term, while still meeting his self-imposed fiscal rules.

“Underpinning the better mood-music was a less gloomy set of economic and fiscal forecasts from the OBR. Previous predictions of a five quarter-long contraction in GDP has become no technical recession at all. The economy is now expected to shrink 0.2% this year, versus a 1.4% fall forecast last November. A return to growth is expected in 2024, but at a stronger 1.8% compared to 1.3% previously. That said, later years saw some modest downgrades, with a smaller contraction in the short-term meaning a smaller bounce-back later. Meanwhile, helped by more momentum in activity, the fall in wholesale energy prices since the autumn, and a lower expected peak in interest rates, public sector borrowing is forecast at £152.4bn this year, down from November’s £177bn. The forecast deficit in 2023-24 is cut to £131.6bn from £140bn.

“Lower energy prices allowed the Chancellor to change tack on plans to raise the Energy Price Guarantee (EPG) in April from £2,500 to £3,000. As well as avoiding what would have been another drag on households’ spending power, the cancellation also means that inflation should be close to a percentage point lower over the next few months. And falling wholesale energy prices mean household bills may drop below the EPG level from the summer.

“In seeking to boost long-run growth, the Chancellor announced several pillars of supply-side reforms. Two are of particular macroeconomic relevance. One seeks to encourage business investment by temporarily allowing firms to fully offset investment spending against taxable profits in the first year and increased tax breaks for investments made in so-called ‘investment zones’. A second pillar is focused on expanding the size of the workforce against a backdrop of a fall in the supply of workers since 2020. This includes broadening free childcare, imposing greater requirements to look for work and training for those in receipt of out-of-work benefits, and reforming rules around pension contributions to discourage early retirement.

“All these measures should be pro-growth, although whether they will lift the UK out of a long period of slow expansion appears debateable. Policies announced today to raise investment will be balanced against headwinds created by April’s significant rise in the corporation tax rate to 25% (from 19%) and the end of the super-deduction tax incentive, both of which are still going ahead. Meanwhile,100% expensing is only guaranteed for the next three years, with an ‘aim’ to make it permanent. The new tax break might simply bring forward investment to the period where the incentive applies from years when it doesn’t, with little or no long-term effect.

“Moreover, boosting the economy’s supply capacity will only raise growth if extra supply is met with stronger demand. This prospect could be hindered by the fact that the tax burden is still headed for a 70-year high, overall public spending will fall in real terms from the mid-2020s and spending on growth-enhancing public investment is frozen – all while the economy deals with the most significant tightening in monetary policy in over 30 years.

“Nonetheless, the net fiscal loosening of around £20bn per year (0.7% of GDP) over the next three years means the near-term growth outlook has improved. And the OBR has become less pessimistic on the economy’s longer-run potential, with GDP at the end of the forecast period around 0.5% higher compared to November. This partly reflects Budget measures to raise labour supply, as well as higher migration and lower energy prices. Most of the recent unexpected strength of tax receipts is also expected to persist. These factors mean the Chancellor continues to meet his fiscal rules, despite the Budget’s ‘giveaways’. The net debt target is now forecast to be met by a margin of £6.5bn, or 0.2% of GDP, a little down from £9.2bn, or 0.3% of GDP, previously. However, the margin against the deficit target increases to £32.9bn, or 1.3% of GDP, from £18.6bn (0.6%) of GDP.

“Well-publicised issues in the US banking sector and a subsequent substantial fall in government borrowing costs and market interest rate expectations came too late for the OBR forecast. The net effect, if those moves had been included, would have been to mechanically improve the fiscal outlook. But the latest market challenges present economic risks and add an extra degree of caution around the OBR’s latest projections.”