In each Economic and fiscal outlook we publish a box that summarises the effects of the Government’s new policy measures on our economy forecast. These include the overall effect of the package of measures and any specific effects of individual measures that we deem to be sufficiently material to have wider indirect effects on the economy. In our October 2021 Economic and fiscal outlook, we adjusted our economy forecast to take into account plans to loosen fiscal policy from 2022-23, as well as for several specific measures, including the impact of the HSC Levy on earnings.
To estimate the effect of discretionary fiscal policy changes on economic activity, we use multipliers drawn from the empirical literature. These capture the wider effects of the fiscal policy measures over and above their immediate effect on demand, through raising private incomes and spending. These effects diminish steadily to zero by the forecast horizon, as the Bank of England is assumed to respond to the upward pressure on wages and prices with a somewhat tighter monetary policy response in order to keep inflation at its 2 per cent target.
Overall, the Budget increases the level of GDP in 2022-23 by 0.4 per cent, with growth slightly weaker thereafter as the direct effect of discretionary easing fades. Our estimate of the fiscal impulse excludes the cost of raising the overseas aid budget back to 0.7 per cent of gross national income that is likely to have negligible impact on domestic demand. One risk to our estimates is that the prevalence of labour shortages and supply bottlenecks could mean that the effect of the Budget on output could be less than usual, with more of the effect felt in higher inflation instead.
As increased activity adds to inflationary pressure and the full extent of discretionary easing is unlikely to have been anticipated by market participants when we closed our pre-measures interest rate forecast on 15 September, we have incorporated into our post-measures forecast an additional monetary policy response above that reflected in the path of market expectations for Bank Rate. This takes Bank Rate up to 0.75 per cent by the fourth quarter of 2023, 0.2 percentage points above our pre-measures forecast assumption in that quarter, and it remains at that level thereafter. This is consistent with inflation returning to the target in the medium term based on our post-measures forecast (see paragraph 2.15).
The temporary increase in NICs followed by its replacement by the new health and social care levy leaves labour supply unchanged, with income and substitution effects assumed to offset. While the statutory incidence of employer NICs and the equivalent element of the levy is on businesses, we assume the economic incidence of the tax is passed through entirely to lower real wages in the medium term, with 80 per cent of the increase passed through to workers via lower nominal wages and 20 per cent to consumers via higher prices. The pass-through does not take place immediately, however, with firms absorbing 20 per cent of the cost in lower profits in the first year. This leaves nominal earnings 0.5 per cent lower and prices 0.1 per cent higher from 2023-24 onwards.
We have made several other adjustments to our economy forecast for the measures announced in this Budget:
- The discretionary fiscal easing and the pass-through of higher payroll tax costs push up CPI inflation in 2022 and 2023, although the customary fuel and alcohol duty freezes offset these effects in 2022. That leaves the price level up 0.3 per cent at the forecast horizon. On top of this, the latest rises in the council tax adult social care precept increase RPI inflation by less than 0.1 percentage points a year from 2022-23 to 2024-25.
- We assume that the effect of measures to boost business investment (via the latest temporary increase to the annual investment allowance and a reduction in the bank surcharge) is small in the context of the super-deduction that was announced in March, and as such makes no material difference to the path of business investment.
- We have not made an adjustment in the economy forecast for the universal credit taper rate reduction and the increase in work allowances. These changes can be expected to increase the labour supply of those affected – with evidence suggesting the most significant effects are likely to be in bringing non-working mothers into the labour market (either lone parents or second earners in couples).a But any induced employment among these groups is likely to be at relatively low numbers of hours a week and at relatively low hourly pay, so while they could be material to the incomes of affected households, we judge that they are negligible relative to the economy as a whole.
This box was originally published in Economic and fiscal outlook – October 2021