Reforming Lawson or austerity Osborne: how will Sunak’s budget go?

For the past 20 months Rishi Sunak has been fighting to limit the economic damage from Covid-19. This week marks the chancellor’s first real opportunity to set out proposals for the rest of the parliament, and demonstrate to backbench Tory MPs that the Treasury’s tax and spending plans support the ambitions of his neighbour in No 10.

There is a danger for Sunak that many of his supporters will turn on him if a harsh, joyless budget is seen as crushing much of the goodwill the Tories are still enjoying from the speedy rollout of vaccines earlier this year. In the summer Boris Johnson threatened to demote his chancellor as punishment for daring to challenge the government’s handling of the pandemic. With no replacement on hand, it was an empty threat, but Liz Truss, newly promoted to foreign secretary, is ready to fill the chancellor’s shoes should he stumble. These are the issues now facing Sunak as he looks forward, and back over his shoulder.

A reforming chancellor

Sunak is an admirer of Nigel Lawson, who for all the criticism he received over the boom and bust of the late 1980s, made a significant mark on the incentivisation of businesses to invest and people to work. Tax codes have, however, become unwieldy, and tackling that appeals to the chancellor’s nerdy side.

Tax reliefs designed to encourage saving are a Conservative totem, but most were put in place when deposits were desperately needed to fund investment. These days, the world is awash with savings. Pensions tax relief alone costs the exchequer about £40bn a year, with most of that going to higher-rate taxpayers, who gain 40p for every £1 saved. The Bank of England estimates better-off households have accumulated more than £150bn from not spending during the pandemic, so now could be the time to limit the subsidy to the standard 20p tax rate. A long-awaited reform of business rates is also under consideration, though details look likely to be delayed again as Sunak tries to reconcile retailers’ and factory owners’ calls for a simpler system and rate cuts with his need for revenues.

Taxes – how high can they go?

With No 11 hemmed in by manifesto commitments to cap income tax, VAT and national insurance (NICs) – and having already broken one of those promises with the 1.25% increase in NICs next spring – MPs are not expecting any major tax rises on Wednesday. Plenty of Tories are already concerned about a tax burden that is at its highest sustained level in peacetime. Any more and there might be a revolt.

The party is in danger, according to many supporters, of throwing away its primary electoral weapon if taxes continue to rise, as they will in 2023 when a corporation tax increase is due. Sunak can say his super-deduction tax break on investment spending, which offsets 130% of spending on machinery against tax in this financial year and next, demonstrates his willingness to kickstart private sector activity. However, the budget will show that from next April, virtually all government support for the economy will have been withdrawn – in contrast to the US, Japan and the rest of Europe, where post-pandemic stimulus policies will still be in place.

Can Whitehall and councils take more cuts?

Sunak wants to prevent government borrowing from topping 100% of GDP. By the UK’s official measure (others already show it above 100%), the debt-to-GDP ratio is 95.5%. Last year’s 15% spending deficit is expected to fall below 10% this year after a strong bounceback in economic activity over the summer. The chancellor wants to maintain this downward trend so that he’ll have room to cut taxes ahead of an election expected in 2024.

He has pencilled in a 3% real-terms rise in departmental spending, but rising inflation is eating into the value of cash spending. And most of the extra money was already expected to be hoovered up by health and schools, both badly hit by the pandemic. That leaves only crumbs for other departments and local government. Sunak is likely to stand accused of being closer to George Osborne than any of his predecessors, and known for another 10 years of austerity.

Is climate aid on the block?

Sunak has cut the foreign aid budget by around £4bn to £10bn this year after ministers agreed to lower the UK’s commitment from 0.7% of GDP to 0.5%. It is understood he is planning to go further in the budget by using an “accounting trick” to rebadge funds for developing countries from the International Monetary Fund (IMF) as if they were from the UK. According to the BBC, government climate change advisers have warned Boris Johnson against further foreign aid cuts that could amount to £1bn ahead of the Cop26 summit. Johnson is also under pressure to ramp up subsidies to support the UK’s transition to low-carbon technologies, but has met opposition from Sunak. In response to Johnson’s net zero strategy last week, the chancellor produced a long analysis of the resultant tax losses. A move to electric cars threatens £37bn of revenue from fuel duty and road tax.

The economic outlook

What the Office for Budget Responsibility (OBR) says about the long-term impact of the pandemic and Brexit on the UK economy will play a crucial role in the budget. The government’s independent forecaster said at the time of the last budget, in March, that the scarring effects of the pandemic would permanently knock 3% off Britain’s GDP. This estimate is contradicted by the Bank of England, which says the success of the furlough scheme and business loans will mean the economy emerges largely unscathed. It puts the hit from scarring at around 1%.

If the OBR adopts the Bank of England’s view, it will be saying to Sunak that he can expect to see tens of billions of pounds rolling on over the parliament thanks to higher tax receipts and lower welfare bills. The Treasury could bank that money and save it for tax cuts in two years’ time, or use it to ease the pain the chancellor is planning to inflict on international aid and Whitehall departments. Figures last week showing consumer confidence sliding, retail sales falling for the longest period on record and the manufacturing sector slipping - all in response to rising Covid infections, and shortages of components and labour – makes a radical revision by the OBR unlikely.