Proactive cuts, reactive cuts
This week, everyone’s favourite government agency, the Office of National Statistics (ONS), announced that inflation had hit a new 10-month high of 3 percent in January – well above the Bank of England’s forecast. Meanwhile, GDP growth in the three months to December 2024 came in at a meagre 0.1 percent, which might as well have been -0.1 or 0 percent, given that measuring GDP is actually not that easy even if we ignore the ONS’s recent track record of downward revisions.
By now, it looks like the Chancellor’s upcoming Spring Statement may bring some combination of further tax rises and budget cuts.
Mind, the Autumn Budget already contained £40bn in new taxes, including the much-discussed introduction of VAT on public school fees, which has contributed significantly to the recent surge in inflation, as per the ONS.
To further complicate the situation, the Chancellor's new fiscal rules only allow borrowing if it is used for capital investment. Any slowdown in the economy putting a squeeze on public finances will result in the Chancellor having to either cut spending or raise taxes to balance the books.
Labour being Labour, adjustment will come in the form of higher taxes rather than cuts. Yet, if the economic situation does not improve soon, and with the tax screw already tightened to the max, severe budget cuts will have to happen eventually, no matter how much the government dislikes them. The question is under what conditions.
Option 1 is to continue the current policy of reacting to predictably deteriorating situation as we go along. Of course, this approach only ever goes so far as to accommodate exactly what is needed to ride out the latest wave of bad news. Just reacting to the ever-worsening state of public finances means riding the spiral to the bottom.
Option 2 is to be proactive and start freeing up fiscal space before we need to: make the cuts now, and either use the money to help the economy grow or keep the additional legroom as a buffer for the future.
The difference between Option 1 and Option 2 is that, by making the same-sized cut while fiscal conditions are still relatively strong, a smaller portion of its proceeds needs to go toward plugging budget holes. In other words, the payoff from budget cuts diminishes as the economic situation worsens.
To give the government its due, many of its recent big investment announcements are a step in the right direction. Unfortunately, however, the benefits will only start to materialise in the medium run – if the government ever actually gets these projects on the road.
In the short run, budget cuts will have to happen. The question is whether the government is willing to be proactive and make some tough choices now when the returns are still relatively high.