- In 2017 we produced our first Fiscal risks report (FRR), an assessment of the shocks and pressures that could threaten our forecast for the public finances over the medium term and fiscal sustainability over the longer term. In this, our second report, we revisit and broaden that assessment in light of recent economic and fiscal developments, including subsequent policy decisions and the Government’s welcome and substantive response to our first FRR.
- Many of the fiscal risks we discussed two years ago remain. That is not surprising, as in many cases the Government can only seek to manage and mitigate them, not to eliminate them. It is also important to remember that the whole point of much government activity is to pool or manage risks that confront society. So taking on fiscal risk can be welfare-improving and attempts to transfer some fiscal risks back to the private sector may simply create different ones that are less imminent, less transparent and potentially more costly.
- That said, the Government has taken useful steps since 2017 to improve the monitoring and management of fiscal risks, including better management of new contingent liabilities, more transparent reporting on the balance sheet and, thanks to the Office for National Statistics, plans to address the pervasive fiscal illusions in the way student loans are captured in the public finances. It has also further reduced the budget deficit and has begun to lower public sector net debt as a share of GDP. In addition, it is reducing its exposure to inflation surprises by relying less on issuing index-linked debt to finance government borrowing.
- But policy risks to the public finances in the medium term are significant and look greater than they were two years ago. In his recent statements the current Chancellor has all but abandoned the Government’s legislated objective to balance the budget by the mid-2020s. And the £27 billion a year NHS settlement announced in June 2018 – unfunded, unaccompanied by detailed plans for reform and outside the normal timetable for spending decisions – has cast doubts over the Treasury’s usually firm grip on departmental spending.
- Medium-term policy decisions will of course depend on the incoming Prime Minister and Chancellor, rather than on the current incumbents. The remaining Conservative leadership contenders have made a series of uncosted proposals for tax cuts and spending increases that would be likely to increase government borrowing by tens of billions of pounds if implemented. So all the signs point to a fiscal loosening and less ambitious objectives for the management of the public finances. (The current Chancellor has urged the candidates at least to commit to keeping net debt falling as a share of GDP, which, all else equal, would allow additional borrowing of approaching £25 billion a year over the medium term.)
- To be clear, it is not the role of the OBR to say what the Government’s fiscal targets should be nor how much budgetary loosening or tightening it should undertake. But it must be understood that additional tax cuts or spending increases would push government borrowing and debt up from the levels expected in our forecasts and that there is no war-chest or pot of money set aside that would make them a free lunch. The Government does have room for manoeuvre against its ‘fiscal mandate’ for structural borrowing next year, but that does not provide an anchor for medium term tax and spending decisions. And the headroom is measured against our central forecast in March – over the next 300 pages we outline some of the many risks that might raise borrowing and debt relative to those figures.
- These decisions will of course need to be taken against the unusually uncertain economic and fiscal backdrop created by different possible outcomes to Brexit. Our March forecast was conditioned on the UK securing a deal and exiting smoothly. Given the leadership contenders’ willingness explicitly to countenance a ‘no-deal’ exit on October 31, we use the ‘stress test’ in this FRR to illustrate the potential fiscal impact of a no-deal, no-transition Brexit scenario set out by the International Monetary Fund (IMF) in its April 2019 World Economic Outlook. This scenario is not necessarily the most likely outcome and it is relatively benign compared to some (for example, assuming limited short-term border disruptions). But it still adds around £30 billion a year to borrowing from 2020-21 onwards and around 12 per cent of GDP to net debt by 2023-24, compared with our March forecast baseline.
- A more disruptive or disorderly scenario, closer to the stress test we considered two years ago, could hit the public finances much harder. (It is important to remember that the economic and fiscal developments over the past three years – as well our and the IMF’s baseline forecasts – already incorporate some impact from the referendum vote, although it is impossible to isolate that from other surprises relative to our pre-vote forecasts. The impact of Brexit itself – once it happens – would also continue to unfold for many years beyond the end of the stress test horizon.)
- As we noted in our previous report, history tells us that the biggest and most frequent fiscal risks in peacetime relate to the economy – even in the absence of specific shocks like Brexit. At the time we finalised this report, these risks appeared to be rising – the latest survey data suggested that growth paused at best in the second quarter. In part, this is likely to be an unwinding of stockpiling by businesses ahead of the previous proposed Brexit date of 29 March, but a more general weakness may persist and intensify as 31 October nears.
- While this may not signal that the economy is currently entering a recession, these occur roughly once a decade in the UK, and are almost always unexpected when they do. Policy can reduce the likelihood of these risks crystallising and their fiscal impact when they do, but the underlying risk cannot be eliminated. In its response to our first report the Government acknowledged the need to seek to reduce debt during more favourable times to ensure that there is room to let it rise when shocks hit, without interest costs rising to undesirable levels.
- Looking at specific risks to receipts and spending points to many ongoing pressures that governments must deal with, while also preparing for inevitable future shocks. There are long-term pressures on revenue from some tax bases, from trends in smoking, drinking and car efficiency, and from the digitalisation of economic activity. And policy is always a source of risk, given repeated decisions to cancel fuel duty increases, although manifesto commitments on the income tax personal allowance and higher rate threshold have now been met. The large, rising and poorly understood cost of tax reliefs poses risks too.
- As ever, there are significant upward pressures on public spending. Over the longer term, the biggest arise from non-demographic cost pressures in health and social care, and the impact of an ageing population on them and the state pension. The near-term fiscal risk from health spending that we flagged in our previous report crystallised with the June 2018 announcement of an NHS settlement more consistent with historical trends in spending. But long-term pressures remain and this might be seen as just the first down-payment on them. And the Government has chosen to retain a triple lock on pensions uprating that ratchets spending higher as a share of GDP – despite acknowledging the fiscal risk that that poses.
- One issue that we did not address in any detail in our first FRR was climate change, which has the potential to inflict both sudden shocks and slower-building pressures on the public finances. Their nature and cost will of course depend hugely on how the climate itself evolves. If global mitigation efforts fail, the risks posed by conflict, mass migration and catastrophic weather events could be severe. But if the targets agreed to in Paris in 2015 are met and there is only modest further warming, the risks would be less severe. In such a world, and when viewed individually, the fiscal risks associated with climate change do not appear especially large relative to others we cover in this report. The effects of extreme weather are not likely to be on the same scale as a major recession – although they might be more frequent. And the cost of adaptation and mitigation measures will probably not be as large as those related to ageing or the cost pressures in health care. But such conclusions might simply reflect the difficulty we all have in foreseeing the full systemic consequences of significant global warming. We intend to draw on the Bank of England’s forthcoming scenario analysis to develop our quantitative assessment of climate-related fiscal risks.
- Throughout this report, we look at the way fiscal risks have evolved partly in the light of the Treasury’s response to our first report – Managing fiscal risks (MFR) – which it published a year ago. Several countries produce fiscal risk reports, but the UK is unusual in having it prepared by an independent body and is, we think, unique in having a Government that has promised in legislation to respond. We welcome the substantive nature of that response and hope that over time both our reports and the Treasury’s responses will help improve fiscal risk management both directly and by facilitating more informed debate and discussion.
Read more in the Fiscal risks report 2019