Labour’s budget hopes rest on overly optimistic UK forecasts, say economists

Labour’s claims that higher growth will boost government revenues and bolster the public finances have been called into question by economists who warn that the budgetary outlook is already founded on overly optimistic forecasts. 

The UK would need GDP growth rates of about 2 per cent a year for much of the next parliament to generate enough extra tax revenue to avoid steep real-terms cuts to the budgets of unprotected government departments, according to estimates by Capital Economics. 

That would exceed the Office for Budget Responsibility’s projections at a time when many analysts say the watchdog is already too optimistic about the UK’s potential growth outlook. 

“The OBR would clearly need to make a big upward revision to its view on labour market participation or productivity growth in the medium term to deliver this kind of potential growth, and the related uplift to the public finances,” said Ruth Gregory, deputy chief UK economist at Capital Economics. 

Cara Pacitti, senior economist at the Resolution Foundation, said a downgrade to the OBR’s outlook for productivity growth — a critical driver of the economy — appeared more likely. 

The Institute for Fiscal Studies has accused all the main political parties of engaging in a “conspiracy of silence” on the harsh budgetary choices the next government will face. Absent higher tax revenues or borrowing, the Treasury will have to push through tough real-terms spending cuts that many analysts see as unrealistically steep given the existing pressures on public services. 

The IFS has estimated that the government would need to top up the budget by £10bn-£20bn to avoid steep real-terms cuts to unprotected areas of government including justice and local government. The Resolution Foundation has predicted reductions towards the top end of that range. 

Rachel Reeves, shadow chancellor, has brushed aside suggestions that Labour would need big tax increases if it wins power, claiming the country’s budgetary prospects will be boosted by stronger growth. 

“I’m going to put my energy and political capital into growing the economy,” she told the Financial Times this month. 

While it is possible growth will surprise on the upside, making the fiscal arithmetic easier, that would imply a sharp break from the recent sluggish trend. The UK’s GDP in the first quarter was only 0.2 per cent higher than the same time a year earlier. 

The OBR in March predicted that the economy would grow 1.2 per cent in real terms in the fiscal year 2024-25, followed by growth of 1.9 per cent the following year and 2 per cent in 2026-27, before growth fell back to 1.8 per cent and then 1.7 per cent. 

Capital Economics said that if the OBR upgraded its 2024-25 GDP forecast to 1.4 per cent, and then predicted growth rates of 2 per cent until the end of the forecast period, it would generate more than £12bn of extra capacity in the budget. 

Added to the existing budgetary headroom of about £9bn, that would be enough firepower to avoid the need for the spending cuts to unprotected departments, said Gregory. 

But those growth rates would be more optimistic than those of the IMF, which sees growth peaking at 1.7 per cent over the same period. The outlook would entail an increase to the OBR’s estimate of potential growth — the rate at which the economy can expand on a sustainable basis — at a time when the watchdog is already more optimistic than the Bank of England and IMF. 

“If you compare the OBR’s productivity forecast to the average growth achieved since the financial crisis, it looks much more optimistic,” said Pacitti. “We think a downgrade to OBR productivity growth estimates looks more likely . . . That would be damaging for the public finances and make it even harder to avoid steep real-terms cuts to unprotected departmental spending.” 

The National Institute for Economic and Social Research is among the other forecasters that are more downbeat about the UK’s sustainable growth rate. It thinks trend growth in the UK is just 1 per cent a year. 

In an assessment of the party manifestos, Niesr found that neither Labour nor the Conservatives would manage to get the ratio of public debt to GDP falling until 2030-31, later than would be implied by either party’s fiscal rules. 

Attempting to prevent declines in spending by unprotected departments may not go far enough. The IMF has warned the UK faces a budgetary hole of £30bn because it should be attempting to raise overall spending by 2 per cent a year in real terms. 

The outlook for growth is only one driver of the public finances, and other influences will affect the next government’s fiscal inheritance. A drop in interest rates, for example, would reduce the government’s debt interest bill, easing some of the strain. 

“But this is not something they should count on happening,” said Pacitti.