The Chancellor will have some tough decisions to make when dishing out the cash in next week’s Spending Review. But handing out money is usually easier than raising it.
And raising money later in the year will be the bigger challenge and will probably result in the Chancellor announcing some tax hikes.
When the Chancellor, Rachel Reeves, announces the details of her Spending Review next Wednesday, it will sound as though she’s increasing the amount of money the government is spending on public services and future investment projects.
But the total amount of government spending was already set in the Chancellor’s Spring Statement in March. Back then, she decided the government would spend £1.4 trillion on average in each of the next five years.
That’s equivalent to 44% of GDP, is higher than the average of 40% of GDP in the five years before the pandemic and is unlikely to be increased in the Spending Review.
Incidentally, these numbers are bigger than the average tax receipts of £1.3 trillion, or 41.5% of GDP, anticipated over the next five years. That explains why the government is expecting to borrow an average of £90bn each year, or 2.8% of GDP, to fill the gap.
Instead of altering the total amount of money the government will spend, the Spending Review will determine what the money is spent on. This means the Chancellor has to make some tricky decisions on how much to spend on the NHS, defence, welfare and all the other public services.
Given the sheer size of the NHS budget and the growing importance of defence, increases in those areas will result in meagre increases elsewhere.
The Spending Review won’t, however, address the bigger issue, which is that the Chancellor will probably have to find more money later in the year.
The pressure to increase total amount of government spending has grown since it was set in March. The recent public sector pay deals, the plans to restore some winter fuel payments and soften other benefit cuts, and the clamour to scrap the two-child benefit cap could mean that government spending needs to be £8bn higher than currently planned in five years’ time.
And the government’s new migration policy (which may mean fewer people are paying taxes than previously expected) and the recent rise in the government’s borrowing costs may result in the gap between government spending and tax receipts being an extra £10bn bigger in five years’ time.
That’s an additional £18bn that may need to be found from somewhere. That would rise to £36bn if the government needed to meet its “ambition” to raise defence spending from 2.5% of GDP to 3.0% of GDP before 2030.
And it could rise to £46bn should the Office for Budget Responsibility judge that the UK’s rate of productivity growth will be a bit lower than it currently believes. That would mean the economy doesn’t grow as fast as expected and, as a result, tax receipts would be lower than projected and government spending would be higher.
In other words, to avoid breaking her own fiscal rules and to maintain the current buffer against those rules, in the Budget this autumn the Chancellor may need to raise an extra £18bn to £46bn.
She can do this in three equally unappealing ways. First, she could cut other forms of government spending, although this will jar with the government’s aims to improve the provision of public services.
Second, she could bend her fiscal rules to allow her to borrow more, but this may just increase government spending if it results in the financial markets charging the government a higher interest rate.
Third, she could raise taxes, but to fill a hole as large as £18bn to £46bn the Chancellor may need to break her pre-election pledge to not raise income tax, VAT and National Insurance for employees. To limit the fallout, the Chancellor may opt for a bit of all three.
It's unclear what this would mean for the economy as it would depend on the mix of the changes in spending, taxes and borrowing. But it is clear that the hardest decisions for the Chancellor lie further down the line and may involve raising taxes for households.
Paul Dales is Chief UK Economist of research consultancy Capital Economics.
