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How a last-minute forecast could save Jeremy Hunt’s dream of tax cuts

Jeremy Hunt
Jeremy Hunt hopes to annOunce further tax cuts in the Budget in a bid to gain votes in the general election - Carl Court/Getty Images Europe

The email that sunk Treasury hearts dropped at around midnight on Tuesday.

For weeks, the economic numbers which will determine how much money Jeremy Hunt has to play with for next month’s Budget had been moving away from the Government.

The Chancellor and Rishi Sunak want to follow up November’s announcement of a 2p reduction in workers’ National Insurance payments with another tax cut in the hope that grateful voters will reward them at the general election.

But, as Treasury sources tell it, any flicker of hope that a surprise haul of extra cash was coming was extinguished when the Office for Budget Responsibility’s (OBR’s) latest round of forecasts pinged into inboxes.

The fiscal headroom – the amount of money the Government can spend without breaking its promise to get debt falling within five years – is understood to have been roughly where it was last autumn.

Back then it was £13 billion, an unusually small amount compared to past years. It remains hovering around the same level, give or take a few billion, according to Whitehall sources.

However, there may yet be hope after all.

This view of the public finances is entirely at odds with that of economists outside the Treasury who believe the OBR may instead just have handed Hunt the lifeline he needs for tax cuts.

The OBR is basing its forecasts on interest rates in financial markets in the 10 working days to Jan 23. Borrowing costs were significantly lower last month than they were in the run-up to the Autumn Statement – so that should hand the Chancellor more room for manoeuvre than feared.

The population is also bigger than previously realised. If the OBR accepts the latest projections from the Office for National Statistics, the country has almost 750,000 more people of working age than was previously realised.

More people means more work, more spending and more tax revenue.

So who is right? The fate of critical tax cuts – which Conservative MPs are banking on as a game-changing moment before the election – hangs in the balance.

To understand what Downing Street hoped to do, and why it may now be in jeopardy, the wider story which the Tories are trying to tell must be appreciated.

Sunak’s strategists have put regaining economic credibility and getting the reward for a gradually improving situation at the centre of their dreams of an almighty comeback victory.

“The election will be won or lost on the economy,” said one who has the Prime Minister’s ear. And that has led to the leadership falling back in love with action on the T word: taxes.

The gear change in economic strategy came last autumn, when the Prime Minister pressed Hunt to switch the focus from reducing inflation and shoring up the finances, to boosting growth via slashing tax.

It resulted in £20 billion of tax cuts being unveiled, the biggest giveaway of any fiscal event since Nigel Lawson’s famous 1988 Budget – though not nearly enough to stop the overall tax burden rising.

Half of those reductions came in business taxes. This spring, it was meant to be time for personal tax cuts.

The debate has boiled down to how big the Government can go on two specific items: income tax and National Insurance.

A reduction in the basic rate of income tax is deemed more popular than one for National Insurance, with public polling cited as proof. Plus pensioners also benefit from such a move – “our people”, as the Tories see it.

National Insurance, though, has its own appeal. A cut here would more directly be linked to work, since only individuals in employment pay it. That means potentially a larger boost to growth – important, with the economy in recession last year. It also costs less than reducing income tax.

Then there is the issue of size, summed up with a Shakespearean misquote. “2p or not 2p” is the question being asked, over and over, in the corridors in No 10 and No 11.

A reduction of not one percentage point but two in the rate of either tax is what Downing Street has long wanted.

A 2p cut in the basic rate of income tax would cost £13 billion, the Treasury estimates. A 2p cut in National Insurance employee contributions would cost £9 billion. Economists in the City think this should be doable.

Falling inflation

Martin Beck at the EY Item Club – which uses the Treasury’s economic model to gain an insight into the data which Number 11 will be watching – says lower debt interest will save the Chancellor £7 billion, with the bigger population boosting the coffers by another £15 billion.

Even after considering knocks to the finances from weak growth and a fall in inflation, “overall you are probably talking about headroom of £30 billion rather than £13 billion, so that creates decent room for tax cuts,” he says.

Andrew Goodwin at Oxford Economics agrees. “Treasury briefings that the Chancellor won’t have any extra headroom look a little odd,” he says.

“We think this is largely expectations management for Conservative MPs hungry for large tax cuts.”

It would not be the first time the Treasury has engaged in a little misdirection before big announcements. Budget Day is renowned for rabbits pulled out of hats, as Chancellors always want to generate positive headlines and a feel-good atmosphere with surprise tax cuts or spending giveaways, regardless of the dire state of the economy and the public finances.

But unless the spin is just a ruse to squash expectations to generate a bigger surprise on the day itself, a big Budget squeeze is underway.

The Treasury argues it is penned in by tighter than hoped money constraints and by Labour’s copycat strategy.

Contrary to economists’ forecasts of favourable borrowing costs and population growth, the mandarins are focused on falling inflation.

The Government had relied on spiralling prices to supercharge its tax receipts, with VAT growing as prices increase and the income tax rate rising in line with pay rises. But as inflation has fallen more quickly than previously expected, this bonanza may be over.

If the net result is that the OBR still says there is just £13 billion of headroom then there is not the money for either the hoped-for income tax cut nor the smaller chop to NI, because the Treasury thinks around £6 billion also has to be kept back in reserve to keep the markets happy.

That has had two knock-on consequences. The first is that a long list of “nice to haves” – stamp duty cuts, child benefit reforms to fix quirks in the system – look less likely.

The second is spending: if the OBR’s numbers do not give Hunt the room for tax cuts, he will be forced to look for it through belt-tightening elsewhere.

It is now said to be more likely than not that he will lower public spending assumptions for after the election from a real term annual rise of one per cent to 0.75 per cent.

That would mean, according to the Resolution Foundation think tank, cuts of 20 per cent to the budgets of the Home Office, Ministry of Justice and Communities Department by the end of the decade.

That path would inevitably lead to Hunt being grilled by broadcast journalists about “austerity 2.0”.

But it would also end with a pot of gold for Budget day. Around £5 billion could be saved, according to government estimates – a boost for those hoping the “2p or not 2p” debate ends on the former.

Labour plans to match Tory tax cuts

The big squeeze is not just coming from the numbers, however. The Tories are being frustrated by a Labour Party that is going all out to scrub away any tax dividing lines.

Rachel Reeves, the Labour shadow chancellor, has been having regular huddles on economic strategy with two stalwarts of the New Labour years.

Pat McFadden, Tony Blair’s political secretary and now Labour’s national campaign coordinator, is one. Lord Livermore, who was by Gordon Brown’s side throughout his time in office and is now shadow economic secretary, is another.

And a third has recently been consulted directly: Ed Balls, the former shadow chancellor.

What has emerged is a strategy straight out of the New Labour playbook. Labour is preparing to match Tory tax cuts announced this year. Likewise, the party leadership is planning not to promise higher across-the-board spending than their election rival.

There are caveats. Three limited tax changes to fund specific extra spending hinve been carved out: putting VAT on private school fees, scrapping non-dom rules and raising stamp duty for property buyers based overseas.

Others are being looked at for the months ahead. Labour may also not pledge to keep any Tory reductions in inheritance tax, should they come. (Sunak inner circle figures have ruled out an inheritance tax move this spring, fearing Labour would weaponise the move.)

On the major working taxes, though, Labour will be lock-step with the Tories. “There is no way we’ll go into the election promising higher income tax and National Insurance,” says a Labour economic source.

The strategy is a straight lift from Blair and Brown’s 1997 approach, when they promised to keep tight Tory spending plans for two years to neutralise the Tory “tax bombshell” attacks that had proved so impactful in the 1992 campaign.

If the Conservatives cannot go all in on tax cuts because of tight numbers, and Labour will promise to keep any moves anyway, will the Budget really be an election game-changer?

The big squeeze has limited Hunt and Sunak at just the wrong time. So the package will be framed as gradual improvements, the proof that a credible economic plan can in the end have financial benefits.

The political danger? Slow and steady does not always win the race.