How Hunt and Sunak found themselves backed into a corner over Britain's finances

Successive economic turmoil since the global financial crisis has seen the UK's debt as a share of GDP rise from around a third of the economy in 2007 to just under 100% today.

A growing mountain of debt means interest payments are also getting larger.

In March 2022, the Office for Budget Responsibility (OBR) forecasts that interest payments debt will amount to £47 billion in 2026–27.

The figure has risen to £89 billion, according to official forecasts, as inflation soared and the Bank of England remained behind the interest rate curve.

Tax and Spending will now deliver its latest forecasts next month. it is likely to reach £108 billion.

The increased debt burden is caused by inflation and interest rates.

>Almost a quarter of UK government debt is “indexed”, that is, linked to inflation. The protracted struggle to contain price increases has kept payments on these bonds high.

Meanwhile, high interest rates mean the government must pay rates that would have been unthinkable on newly issued gold bonds just a few years ago. The Bank of England has increased borrowing costs from 0.1% to 5.25% in just two years.

As a result, Jeremy Hunt will face “difficult decisions” in his autumn statement. Last week the Chancellor said: “We are likely to see between £20bn and £30bn of increased interest payments on debt and that is a huge problem.”

However, a rising debt burden is only half the problem, according to new analysis from the Institute for Fiscal Studies (IFS). The failure to grow the economy after the financial crisis means the government is struggling with one hand tied behind its back. Paul Johnson, director of the IFS, called it a «terrible financial hardship».

The cost of our high debt levels, failure to stimulate economic growth, and high borrowing costs will likely be long term. high taxes and limited spending.»

The latest IFS Green Paper — an analysis of the economy similar to the OBR Blue Book — shows Hunt and Sunak backed into a corner with no good choices.

With huge debts. As a result of successive economic shocks and a stagnant economy, the couple has no choice but to cut spending or increase the tax burden to pay off debt, says IFS.

The think tank says: “Increasing economic growth on a sustainable basis could help , but this is not something politicians or politicians can simply achieve, and even the best-laid policies will take time to bear fruit.”

For the first time in a generation, interest rates are having a major impact on public finances.

In a world where interest rates average 2% in 2026-27, instead of remaining above 4% as financial market rates do. Going forward, interest costs on debt will be £12 billion below the OBR's March forecast, at £76 billion.

However, the IFS believes higher interest rates mean debt servicing costs are stabilizing high sustainable level since the mid-1980s. This would be around £30 billion above the level to which subsequent chancellors have become accustomed.

“That's £30 billion a year that cannot be put to better use. Moreover, growth prospects are poor. Debt as a share of national income will rise and then reach levels just below 100% of GDP.”

The OBR is likely to cut its economic growth forecasts next month. In March, he forecast that the economy would grow 1.8% in 2024.

The looming downgrade is unlikely to be as severe as the International Monetary Fund's gloomy forecast of economic growth of just 0.6% next year. However, whatever the exact figure, lower economic growth and higher unemployment will have implications for tax revenues.

With the economy stagnating and the cost of debt rising, Hunt is squeezing more money out of taxpayers to make up the difference. The main mechanism is a stealth raid, based on a phenomenon known as «fiscal drag», to pull more and more people into higher tax bands.

Rishi Sunak initially announced a four-year freeze on income tax thresholds in £12,570 for basic rate taxpayers and just over £50,000 for higher rate taxpayers when he was Chancellor.

This was originally expected to be £8 billion a year by the end of Parliament.

Hunt extended the policy to a six-year freeze on both income tax and national insurance thresholds.

This is bringing much more money into the Treasury than originally expected.

Rising inflation has led to a sharp increase in incomes, especially among high-income earners, as employers are forced to increase employees' wages to keep them in a tight labor market.

The stealth raid is now expected to generate an extra £52 billion a year. year in tax revenues by 2027–2028

The growth is “enormous,” according to the IFS. It adds: “By comparison, the biggest tax rise in recent history was the Budget decision in June 2010 to increase the main VAT rate from 17.5% to 20%, which is estimated to raise £21 billion in 2027. -2028. Or to put it another way, other ways to raise the estimated £52 billion in revenue include increasing basic and higher rates of income tax by 6p, or increasing the basic rate of VAT from 20 to 26 per cent.»

The IFS says the policy will result in 6.5 million more people paying income tax by 2027 and 4.5 million more people paying higher and additional tax rates by 2027. By the end of the decade, one in six UK adults will pay higher rates of tax.

As a result, the short-term financial picture looks brighter, with IFS partner Citi predicting Hunt will borrow £20bn less this year than previously thought to plug the tax gap gap and government spending.

The IFS also notes that healthier tax receipts mean the UK is on course for its biggest surplus, excluding interest costs on debt, «in a generation.»

«It might seem that there should be room to spend money to cut taxes or increase spending,” the think tank says. “Taxes are approaching their highest levels.”

However, continued borrowing and higher interest payments on debt mean any stock is likely to be eaten up.

The situation will only get worse. in the future, if the economy does not begin to grow faster, IFS believes.

Higher health care costs and state pensions in particular will put further pressure on public finances.

“The NHS staffing plan alone, which the Conservative government and Labor opposition have signed up to, will increase spending by 2% of national income by the mid-2030s. Cutting defense spending is no longer on the table. We live in a clearly risky political and economic environment, which could require a sharp increase in borrowing at any moment.»

The IFS therefore argues that Hunt and Sunak have no choice but to be conservative about public finances and cut costs. government debt, while praying that the Bank of England will do its part to reduce the cost of debt.

Benjamin Nabarro, chief economist at Citi in the UK, who helped the IFS prepare its forecasts: “The lesson of the 1970s was to keep rates at high level until you see the «white eyes» of deflation. In a highly financialized, debt-driven economy, this may be only half the battle.”

In other words, fighting inflation may be just a prelude to a broader fight to bring government borrowing back under control. control.