How Hunt and Sunak got boxed into a corner over Britain’s finances
Szu Ping Chan
6 min read
jeremy hunt
Successive economic shocks since the global financial crisis have seen the UK’s debt as a share of GDP rise from around a third of the economy in 2007 to just shy of 100pc today.
A growing debt mountain means interest payments are also getting larger.
In March 2022, the Office for Budget Responsibility (OBR) forecast that debt interest payments would hit £47bn in 2026-27.
That number rose to £89bn in official forecasts as inflation soared and the Bank of England was left behind the curve on interest rates.
It is now likely to hit £108bn when the tax and spending watchdog delivers its latest forecasts next month.
The ratcheting higher of the debt burden is being cranked by inflation and interest rates.
Almost a quarter of UK government debt is “index-linked,” meaning it’s tied to inflation. The protracted battle to contain price rises is keeping payments on these bonds high.
Meanwhile, high interest rates mean the Government must pay rates that would have been unthinkable just a few years ago on newly issued gilts. The Bank of England has taken borrowing costs from 0.1pc to 5.25pc in just under two years.
However, the rising debt burden is only one half of the equation, according to a new analysis by the Institute for Fiscal Studies (IFS). A failure to get the economy growing since the financial crisis means the Government is fighting with one hand tied behind its back. Paul Johnson, the IFS’s director, has called it a “horrible fiscal bind”.
“The price of our high levels of indebtedness, failure to stimulate growth, and high borrowing costs is likely to be a protracted period of high taxes and tight spending.”
The IFS’s latest “green book” – an analysis of the economy akin to the OBR’s “blue book” – shows that Hunt and Sunak have been boxed into a corner where there are no good choices.
With huge debts built up over successive economic shocks and a flatlining economy, the pair have little choice but to cut spending or raise the tax burden to meet debt payments, the IFS argues.
The think tank says: “More economic growth on a sustained basis would help, but this is not something that policymakers or politicians can simply will into existence, and even the best-designed policies would take time to bear fruit.”
For the first time in a generation, interest rates have major implications for public finances.
In a world where interest rates average 2pc in 2026-27, instead of staying above 4pc as financial markets are betting on, debt interest spending would be £12bn lower than the OBR forecast in March at £76bn.
However, the IFS believes higher for longer interest rates means debt servicing costs will settle at the highest sustained level since the mid 1980s. This will be around £30bn above the levels that successive chancellors have become used to.
“That’s £30bn each year that can’t be put to better use. In addition, the growth outlook is poor. Debt as a fraction of national income is set to rise to, and then settle not far below 100pc of GDP.”
The OBR is likely to downgrade its economic growth forecasts next month. In March, it predicted the economy would grow by 1.8pc in 2024.
Its looming downgrade is unlikely to be as severe as the International Monetary Fund’s gloomy prediction of just 0.6pc expansion next year. However, whatever the exact figure, lower growth and higher unemployment has implications for tax revenues.
With a stagnant economy and rising debt costs, Hunt is squeezing more money out of taxpayers to make up the difference. The main mechanism is a stealth raid, relying on a phenomenon known as “fiscal drag” to pull more and more people into higher tax bands.
Rishi Sunak originally announced a four-year freeze on income tax thresholds at £12,570 for basic rate taxpayers and just over £50,000 for the higher rate when he was Chancellor.
This was originally estimated to raise £8bn a year by the end of the parliament.
Hunt extended the policy to a six-year freeze on both income tax and national insurance thresholds.
It is bringing in much more money to the Exchequer than initially anticipated.
Soaring inflation has turbocharged revenues, particularly among the higher paid as employers are forced to give staff bigger pay rises to keep them in a tight jobs market.
This rise is “huge,” the IFS says. It adds: “To give a comparison, the biggest single tax-raising measure in recent history was the June 2010 Budget decision to increase the main rate of VAT from 17.5pc to 20pc, which is estimated to raise £21bn in 2027–28. Or, to put it another way, other ways to raise roughly £52bn of revenue include increasing both the basic and higher rate of income tax by 6p, or increasing the main rate of VAT from 20pc to 26pc.”
The IFS says the policy will lead to 6.5m more income taxpayers and 4.5m more higher and additional rate taxpayers by 2027 than there were in 2020. One in six British adults will be paying higher rate tax by the end of the decade.
The near-term fiscal picture looks brighter as a result, with IFS partner Citi predicting Hunt will borrow £20bn less than previously thought this year to plug the gap between tax revenues and public spending.
The IFS also says that healthier tax revenues mean the UK is on course for the biggest surplus excluding debt interest spending “in a generation”.
“It might feel like there should be room to spend money on tax cuts or spending increases,” the think tank says. “Taxes are heading to their highest ever level.”
However, continued borrowing and higher debt interest payments mean any headroom is likely to be simply eaten up.
Things will only get worse in future unless the economy starts growing faster, the IFS says.
Higher spending on health and state pensions in particular will put further pressure on the public finances.
“The NHS workforce plan alone – to which the Conservative government and the Labour opposition have signed up – will raise spending by 2pc of national income by the mid 2030s. Cutting defence spending is no longer on the cards. We live in a demonstrably risky political and economic environment which could require a big spike in borrowing at any moment.”
The IFS argues Hunt and Sunak therefore have little choice but to be conservative with public finances and chip away at public debt – while also praying that the Bank of England does their bit to lower debt costs.
Benjamin Nabarro, chief UK economist at Citi, which helped IFS prepare its forecasts: “The lesson of the 1970s was to hold rates tight until you can see the ‘whites in the eyes’ of disinflation. In a highly financialised, debt-driven economy, that may turn out to be only half the story.”
In other words, fighting inflation may only be the prelude to a wider battle to get public borrowing back under control.
