Why the inflationary surge in UK public finances is unlikely to last

Inflation was a boon for Rishi Sunak, increasing Britain’s tax revenue and reducing the country’s budget deficit, giving the Chancellor a windfall which he used to promise future tax cuts.

But politicians, officials and economists don’t believe the good times will last.

They predict that a combination of higher interest payments on the debt, real wage cuts and pressure on public services should make the Chancellor’s life more difficult, leaving him with the choice between deteriorating public services or deterioration of public finances.

Sunak expressed similar concerns, saying last week that “rising inflation and rising debt interest costs pose a challenge for public finances, as they do for family budgets.”

In what the Chancellor might consider unnecessary comments, David Miles, one of three heads of the Office for Budget Responsibility, the government’s spending watchdog, told a public conference last month that how public finances were likely to improve in the coming years “has much more to do with raising taxes than the ability to inflate debt or expect higher GDP growth beyond above the average levels we have seen over the past 10 or 15 years.

The effect of inflation so far

Despite the Chancellor’s warnings, inflation has so far improved public finances by reducing the deficit, as tax revenues are more sensitive to rising prices than government spending.

Over the last financial year, tax revenues paid to central government have been much higher than expected by the OBR, with particularly strong revenues coming from income tax.

The latest official estimate of total tax revenue shows £837.5bn was collected in 2021-22, better than the £823.5bn forecast by the OBR at the time of the March Spring Statement, and over 6% better than the £789.5. billion in the watchdog’s October forecast.

At the time of the spring statement, the OBR predicted that over the medium term higher inflation and faster wage growth would bring in £37bn a year in additional tax revenue, but added that this would be offset by £23bn a year. billion pounds of higher social security spending. and debt interest.

He added that in the short term, when inflation was likely to peak in 2022-23, there would be a one-off sharp increase in the amount of money the government had to set aside to pay for its £500billion hike. inflation. – related obligations. The OBR said in March it would be £42.2bn more than it had forecast six months earlier.

How inflation could help public finances

Inflation tends to reduce government borrowing because it increases tax revenue more than government spending. Tax revenue is closely related to nominal gross domestic product – the amount of spending or income in an economy – so if nominal GDP increases because prices or wages increase, tax revenue also increases.

Parts of government spending are also linked to rising prices. Pensions and social benefits are indexed to inflation, with a lag of several months, as is the cost of servicing indexed government bonds. These represent about half of public expenditure, the other half being determined by fixed budgets.

If these fixed budgets do not increase, inflation reduces borrowing at the cost of an unplanned decline in the real level of government spending.

This positive effect is currently reinforced as all income tax allowances and thresholds have been frozen for four years. When Sunak implemented the policy, he expected the measure to raise £8.2bn a year by 2025-26. The OBR now expects it to raise £18bn, as higher inflation ensures the freeze will reduce the actual level of these thresholds more than expected.

How Inflation Could Harm Public Finances

Higher social benefits and the increased cost of servicing indexed bonds due to rising inflation automatically increase government spending. But the difficulty for the chancellor is that he will come under heavy pressure to increase total public spending in the fixed budgets he directly controls.

Bar chart of rising forecast for interest on debt (in billions of pounds sterling) showing that inflation has increased the cost of servicing UK public debt, particularly in the year it peaks

To address the cost of living crisis, Sunak has already offered municipal tax rebates, fuel tax rebates, energy bill rebates, and a one-time supplement for all who benefit from means-tested benefits – a package worth £15 billion.

Economists believe it will have to go further and increase public speaking more generally. Carl Emmerson, deputy director of the Institute for Fiscal Studies think tank, said government spending plans are now much tighter than Sunak had expected when he set them in 2021. “He may have to be reopening spending agreements,” Emmerson said.

A flashpoint will be public sector compensation. Torsten Bell, chief executive of the Resolution Foundation think tank, said: ‘It is unrealistic to bank better tax revenue forecasts when public sector wages are expected to be lower than those in the private sector.

And with gas and electricity prices soaring and the UK a net importer of energy, the country will be worse off due to rising inflation. Emmerson said: “This kind of inflation makes us poorer, so improving public finances is fundamentally unlikely.”

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