02 July 2019

Fiscal headroom doesn’t mean that Jeremy Hunt and Boris Johnson can make straightforward public spending promises – especially in the event of a no deal Brexit, says Thomas Pope

The two candidates to be the next Prime Minister have announced multiple tax and spending policies in the course of the Conservative leadership campaign. If delivered, these policies would lead to a substantial increase in government borrowing – a notable change in tone on the Government’s finances from the ‘austerity’ of the last nine years.

So how have we gone from famine to feast? Both Boris Johnson and Jeremy Hunt have cited ‘headroom’ in the public finances that will allow them to deliver on their commitments. But while there may be some capacity to adopt a looser fiscal approach than that pursued by current Chancellor Philip Hammond, extra borrowing would not be risk free.  

Possible headroom in the short-run but not in the longer run

The ‘headroom’, or ‘war chest’, to which the candidates refer is the £27bn difference between the Chancellor’s self-imposed ceiling for borrowing in 2020–21 (2% of national income) and the OBR’s Spring Statement forecast for borrowing in that year. This ‘headroom’ is not set in stone. If the public finances were to worsen – for example if a no-deal Brexit led to a deterioration in the economy – then the ‘war chest’ could rapidly shrink or disappear entirely.

Even if the short-term ‘headroom’ persists, the new Prime Minister will still need to make difficult choices to address the longer-run public finance challenge. The anticipated spending pressures associated with an ageing population means that some combination of spending restraint and tax rises will be necessary to keep the Government’s finances on a level footing. These trade-offs will be even more difficult if a no-deal Brexit led, as most economists expect, to the economy being smaller than it would otherwise have been.

Nor are the public finances starting from an ideal place to address this challenge. While annual government borrowing is now below pre-financial crisis levels, national debt still stands at over 80% of national income – the highest level since the mid-1960s.

There is a case for a looser fiscal stance, but more borrowing is not risk free

Given that governments are currently able to borrow at very low interest rates, considerably below the rate of economic growth, some have argued that they could borrow more without needing to offset this with future tax increases or spending cuts. This argument suggests the new Prime Minister could borrow somewhat more than Theresa May and Philip Hammond did last year without worrying about any long-term fiscal consequences.

But extra borrowing would not be entirely without risk. While interest rates are low now, it cannot be guaranteed that they will remain low in the future. A government that borrows more is more exposed to the risk of interest rates increasing. This would mean a greater share of tax revenue is spent on financing debt rather than on spending that benefits current and future generations.

The public finances also need to be robust to the possibility of bad economic shocks that will lead to increases in debt, with the OBR calculating that the UK has a 50/50 chance of experiencing a recession in any five-year period. This suggests that, to keep the public finances on a sustainable path, governments should at the very least aim for debt to be falling as a share of national income during ‘normal’, non-recession times.

If they increase borrowing then the next Prime Minister must spend wisely

If the next Prime Minister does intend to borrow more then policies that are well designed to boost the supply-side of the economy, and so encourage economic growth, are more likely to represent money well spent. This is the type of policy that would be particularly appropriate in a ‘no-deal’ scenario, where the prospects for the supply-side of the economy are likely to be dampened.

The proposals of the two candidates represent, at best, a mixed bag on this front. Many of the spending commitments – for example on police and defence – primarily concern day-to-day spending rather than the types of capital spending that might be expected to boost growth. Likewise, income tax and National Insurance giveaways are unlikely to boost economic growth appreciably.

The swathe of tax-cutting and spending promises made by Boris Johnson and Jeremy Hunt over the past few weeks seem detached from the reality of the UK’s economic and fiscal prospects. While low government borrowing costs means there may be scope to adopt a somewhat looser fiscal stance than Mr Hammond was aiming for, the needs of the UK’s ageing population would more than use up any additional fiscal wiggle room. The likely negative economic consequences of leaving the EU without a deal would add further difficulty.

Future governments will face difficult choices about how to prioritise public spending and where to fund it from, and how public policy can best support UK economic growth – particularly in the event of no deal.  It is a reality which the Conservative leadership contenders don’t appear to be facing up to, but it is one which the next Prime Minister will not be able to avoid.