Five ways Kwarteng can reduce UK debt

Kwasi Kwarteng drafts a debt reduction plan to reassure the feverish financial markets that Liz Truss’s government can be trusted with the UK’s public finances. Planned for November 23, according to his staff, the chancellor wants to bring this forward to this month if possible.

The Chancellor’s tax-cutting “mini” budget had investors demanding higher interest payments on UK assets, both because they expected the Bank of England to raise borrowing costs to keep inflation under control — and because they had confidence in the ability the Chancellor had lost to reducing the UK budget deficit and national debt.

It will be difficult for the Chancellor to get the government books to balance and reduce debt over the medium term as she must choose one or more of the following five paths to fiscal discipline.

Undo more tax cuts

The chart showing UK government debt is now expected to be much higher than when the OBR last forecast

After two reversals in two days, it’s no longer impossible to believe that Kwarteng could reverse some of the other permanent tax cuts to bring the books back closer to balance. This would be very much a last resort.

With Labor backing the property tax rate cut and reversal of the Social Security increase in April this year, the most likely action here would be to reintroduce the previously planned corporate tax rate hike from 19 percent to 25 percent cents in 2023-24. That would bring in £17 billion a year.

However, this would undermine Kwarteng’s commitment to boosting the UK’s economic growth through lower corporate taxes and undo a promise made by Truss during the Tory leadership contest. Although economists don’t think a lower corporate tax rate would have much of an effect, most believe it could slightly boost growth.

Stuart Adam, Senior Economist at the IFS, said: “The repeal of the corporate tax hike will encourage investment in the UK and therefore contribute to economic growth – if businesses believe it will last.”

Cut public spending

By reducing public spending compared to current plans and projections, Kwarteng could reduce borrowing and balance the books.

Neither Kwarteng nor Truss have committed to adjusting welfare benefits for non-pensioners for inflation in April 2023, which the Resolution Foundation estimates could save £11billion a year. But those proposals drew sharp criticism on Tuesday, including from Penny Mordaunt, leader of the House of Commons, who said she thinks benefits should rise with inflation.

“We’re not trying to help people with one hand and take away with the other,” she said.

Bar chart of income losses in 2024-25 if Universal Credit is increased by income rather than inflation (£pa) over the next two years (£pa), showing that no increase in UK benefits is in line with inflation Would save money but would be politically controversial

The Chancellor could also target banks. With rates rising so much, lenders are getting much higher returns on the over £800bn they have parked with the BoE since 2009 as a result of quantitative easing programmes.

Instead of paying interest on these “reserves” at the bank’s official rate, the government could instead choose to force banks to hold the money at the central bank at a lower – or even zero – interest rate.

Frank van Lerven, senior economist at the New Economics Foundation, said £200bn in interest would be paid to commercial banks by the end of 2026-27. “Instead of looking for funding cuts in public services. . . it [the government] could stop paying interest altogether,” he said.

A third option would be to set extremely tight spending plans for the years after the current spending review period, which ends in 2024-25. Kwarteng could simply tell the Office of Fiscal Responsibility that the government would freeze spending after the next election and drastically lower borrowing projections. Even if the spending plans weren’t credible, the OBR has an obligation to use them.

Simplify fiscal compliance

Kwarteng laid out an “iron-clad commitment to fiscal discipline” in his speech to the Conservative Party conference, but he has been able to move the goalposts and set new fiscal rules that tie his hands less.

The Chancellor has stated that he wants to reduce the debt-to-GDP ratio in the medium term in order to extend the period over which the debt reduction criteria are measured. The current rule is “three years in advance,” which equates to 2024-25. But if that period were extended by five years – as expected – it would mean 2027-28.

An extension of the rule would allow the chancellor to make spending cuts later in the period after a general election. For that to help Kwarteng, he would also have to abandon the current by-law that obliges the government to balance the “current budget” and ensure day-to-day expenses are funded from tax revenues without capital investments. This is likely to become the more binding restriction over a five-year period.

“Three years is an odd amount of time anyway,” said Julian Jessop, a fellow at the Free Market Institute of Economic Affairs. “Five years also gives more time to reap the benefits of supply-side reforms.”

Convince the OBR to forecast higher growth

If Kwarteng could convince the OBR that the government’s policies would boost sustainable economic growth, it would generate more tax revenue, reduce borrowing and help reduce debt.

In December 2013, the fiscal watchdog produced simulations of both higher and lower growth scenarios for the supply side of the economy. It found that higher sustainable growth ensured that “the underlying fiscal position is stronger given the increase in future output potential”.

However, since its inception in 2010, the OBR has overestimated the potential for productivity growth and would therefore be reluctant to raise it.

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It would be “better if the chancellor and the OBR could agree on the growth prospects” resulting from the government’s new plan, Jessop said. “I can already see the headlines as the government’s own tax watchdog questions the economic assumptions on which policies are based,” he added.

Accept disagreements with the OBR

There is no legal obligation for the government to produce a budget that conforms to its budgetary rules according to the OBR. The law simply states that the fiscal watchdog will provide a forecast and “an assessment of the extent to which the fiscal mandate has been or is likely to be achieved.”

It is fully consistent with the system for the Chancellor to allow the OBR to say it is likely to break its budget rules, but respectfully disagrees. This has happened fairly regularly in the past but would be a challenge to present given the current market turmoil.

One way to alleviate the difficulties would be for the OBR to create a scenario of what public finances would look like if the government achieved its target of a sustainable annual growth rate of 2.5 percent.

But as Torsten Bell, director of the Resolution Foundation, pointed out, historically, fiscal trickery and a lack of rules have not caused market turbulence because “it was not a time of rising interest rates, so attention was far less acute.”

https://www.ft.com/content/a848eee2-71de-477c-acdb-38e0e2fc790a Five ways Kwarteng can reduce UK debt

Adam Bradshaw

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