The demand- and supply-side effects of policy measures

Our economic and fiscal forecasts are conditioned on the latest announced Government policies. This always includes estimates of the direct fiscal costs or savings from policy measures and their near-term demand-side impacts on the economy. Where evidence suggests that measures will have a material, additional, and durable impact on potential output, we also take their supply-side impacts into account.^a This box details our estimates of the demand and supply impact of policies announced since the Spring Statement in March.

Demand impact of new policy measures

To estimate the effect of discretionary fiscal policy changes on economic activity, we normally use multipliers drawn from the empirical literature. These capture wider effects of fiscal policy measures over and above their immediate effect on demand, through changes to private incomes and spending. We review these estimates periodically.^b

In 2022-23, £40 billion is being spent to support households via May’s cost-of-living measures and September’s energy price guarantee. The £15 billion cost of the former supports incomes directly, while the latter’s £25 billion cost in 2022-23 and its further £13 billion cost in 2023-24 supports real incomes by lowering energy prices, reducing consumer price inflation by almost 3½ percentage points at its peak impact (and by 2 percentage points in the second quarter of 2023 when the generosity of the scheme is reduced). In the medium term there will be no direct impact on the price of energy. The equivalent six-month scheme for firms (the £18 billion energy bill relief scheme in 2022-23), has a smaller, but still significant, effect on CPI inflation by limiting the need for firms to pass on the costs of higher energy bills.

The measures announced since March 2022 total £64 billion in 2022-23 and £40 billion in 2023-24 (2.6 and 1.6 per cent of GDP). This boosts real incomes, supporting household consumption, so the 2.1 per cent peak-to-trough fall in GDP is a little over 1 percentage point shallower than it would have been in the absence of these policies, and the unemployment rate is 3.6 per cent in 2022-23 and 4.3 per cent in 2023-24, around 0.2 percentage points (around 70,000) lower than it would have been otherwise. Per pound of support provided, we expect the targeted cost-of-living payments to have a modestly larger impact on spending than the untargeted EPG (since it also benefits those on higher incomes who tend to save more of any
boost to real incomes). And we expect the EPG to have a larger impact again than support to businesses (as this is more likely to be saved rather than invested in the current highly uncertain economic conditions). Combined, these measures result in a less negative output gap in 2022-23, so less downward pressure on wage and price growth. As a result, the measures directly lower prices significantly in the near term, while the indirect effect from the fiscal stimulus raises
them modestly in future years (when the price subsidy is no longer in effect). Box 2 discusses how the combined effect of the measures announced in 2022 (both alongside and since our March 2022 forecast) support real household disposable incomes (RHDI) on a per person basis (relative to what would otherwise have occurred).

Over the medium term, the net effect of measures announced since our March forecast is a structural tightening that builds to over 1 per cent of GDP (£39 billion) in 2027-28, driven mainly by lower departmental spending. This outweighs the smaller fiscal impulse provided by cancelling the introduction of the health and social care levy and weighs on activity from 2025-26. The effect of all these policies on the level of real GDP via the demand channel diminishes to zero by the forecast horizon. This is because, as usual, we assume that the Bank of England responds to changes in wages and price pressures by adjusting monetary policy to keep inflation at its 2 per cent target, so that output evolves in line with the economy’s supply capacity.

Supply impact of new policy measures

As described in a briefing paper alongside this Economic and fiscal outlook (EFO), our forecasts also reflect the supply-side impact of policy measures that we expect to affect the economy’s potential to generate GDP over the longer term.^a The potential output of the UK economy is determined by the volume of two large stocks – the stock of labour (the number of hours that can be sustainably worked across the economy without generating inflation) and the stock of capital (the volume of infrastructure, equipment, and other past investments available to those in work) – as well as the efficiency with which these two ‘productive factors’ are combined, known as ‘total factor productivity’.

The fact that these stocks are large relative to the annual flows of new workers, enhancements to skills, investments, and new technologies that are typically the focus of government policies (and the fact that such policies are subject to frequent modification and sometimes reversal) means that the supply-side effects of some policy measures will be too small to warrant an explicit adjustment to our potential output forecasts (outside our periodic stocktakes). We therefore explicitly adjust our forecasts only for those new measures that we judge to be of sufficient size, additionality, and duration to have material effects on these stocks, or the efficiency with which they are combined, over the medium term.

The net effect of the new measures announced since March on potential output is neutral over the forecast period, reflecting several small changes in both directions that offset over time:

• We expect the effect of policy changes on labour supply to be neutral over the forecast period. The scrapping of the health and social care levy, on its own, provides some modest support to the supply of labour. As a tax whose incidence would have fallen on real wages, we would have assumed that the substitution effects from lower marginal tax rates modestly outweighed their income effects and that its elimination would, in isolation, increase incentives to work.^c But we expect this positive labour supply effect to be offset by the growing disincentives to work provided by frozen tax thresholds in an environment of higher and more persistent inflation than assumed in our March forecast and the reversal of the cut to the basic rate of income tax.
• Policy measures have also resulted in no material net adjustment to our capital stock forecast. The extension of the £1 million annual investment allowance announced in the Growth Plan has a small positive effect on the level of business investment over the forecast period, raising it by around 0.1 per cent on average.^d Numerous other measures
  announced since March could also have either small positive impacts on whole economy investment (the investment allowances in the energy profits levy, and the increase in generosity of the R&D expenditure credit, predominantly used by large firms) or small negative ones (the electricity generators and energy profits levies, and reduction in the generosity of the R&D scheme for smaller firms). These measures’ combined effects are judged to be small and offsetting. The net effect of two other announcements would have been more material – the Growth Plan decision to simultaneously not raise the corporation tax rate from April, while increasing the bank surcharge – had they not subsequently been reversed.^e
• The reductions in departmental capital budgets from 2025-26 reduce public investment by 8 per cent by the final year of the forecast and the public sector capital stock by 1 per cent in 2027-28. This could eventually reduce the level of potential output by 0.1 per cent (using our March 2020 approach of an output elasticity of 0.1, drawn from a survey of the literature).^f But given the long lags between public investment projects beginning and affecting the productive capacity of the public and/or private sectors, we assume any material impacts on potential output would occur outside our five-year forecast horizon.