Rishi Sunak, Britain’s third prime minister in seven weeks, took office on Tuesday with a pledge to fix the “mistakes” of predecessor Liz Truss and tackle a “profound economic crisis.”
The task won’t be an easy one, he acknowledged.
“This will mean difficult decisions to come,” Sunak said in his first speech from No. 10 Downing Street.
The United Kingdom was already sliding towards a recession when Truss took office in September, as soaring energy bills ate into spending. Now, Sunak has another headache: He must restore the government’s credibility with investors after Truss’ unfunded tax cuts sparked a bond market revolt, forcing the Bank of England to intervene to prevent a financial meltdown. Borrowing costs, including mortgage rates, shot higher.
Accomplishing this goal will require delivering a detailed plan to put public finances on a more sustainable path. (A government watchdog warned in July that without major action, debt could reach 320% of the UK’s gross domestic product in 50 years.)
The problem? There’s little appetite for government spending cuts after years of austerity in the wake of the 2008 global financial crisis. Plus, failing to help households deal with surging living costs could prove politically devastating and further weigh on the economy.
“It’s not a particularly pleasant economic hand to be dealt [as] a new prime minister,” said Ben Zaranko, a senior research economist at the Institute for Fiscal Studies.
Where does £40 billion come from?
Finance minister Jeremy Hunt got the ball rolling last week when he reversed £32 billion ($37 billion) in tax cuts that formed the bedrock of Truss’ plan to boost growth.
Yet Sunak and Hunt — who will stay in his job — still need to find between £30 billion and £40 billion in savings to bring down public debt as a share of the economy in the next five years, according to calculations by IFS, an influential think tank.
“It is going to be tough,” Hunt said in a tweet. “But protecting the vulnerable — and people’s jobs, mortgages and bills — will be at the front of our minds as we work to restore stability, confidence and long-term growth.”
Sunak and Hunt won’t have the option of going light on the details. If investors don’t buy into their plan and borrowing costs shoot up again, getting the situation under control would only become trickier, as interest payments on government debt rise.
“If markets don’t [see] the plans as credible, then filling the fiscal hole could become even harder,” said Ruth Gregory, senior UK economist at Capital Economics.
One area Sunak may be tempted to tap is the social welfare budget. Questions have swirled about whether the Conservative government may try to avoid boosting state benefits in line with inflation, as is customary. (American recipients of Social Security will receive the biggest cost-of-living adjustment in more than four decades next year.)
Most UK working-age benefits would typically go up by 10.1% next April based on inflation data. But there’s speculation the increase could be linked instead to average earnings, which are growing at a much slower rate than inflation. That could save £7 billion ($8 billion) in 2023-24, according to IFS.
Such a move would prove controversial, however — especially since benefits have not kept up with rampant inflation in 2022.
“I would like to see if we could find a way to increase benefits by inflation, but what I will say is that trade-offs are involved,” former Conservative cabinet minister Sajid Javid told ITV this week.
The windfall tax debate
A more palatable option, at least for households, would be extracting more taxes from corporations.
Hunt has already said that corporate taxes will rise from 19% to 25% next spring. The Financial Times has reported that Hunt could also target earnings from oil and gas companies by extending a windfall tax on profits.
In an interview with the BBC earlier this month, Hunt said he was “not against the principle” of windfall taxes and that “nothing is off the table.” Higher taxes on the financial sector are also under consideration, according to the Financial Times.
Industry groups are already circling the wagons. Banking trade association UK Finance said its members already pay “a higher rate of taxation overall than any other sector,” and urged the government not to “risk the competitiveness of the UK’s banking and finance industry.”
Sunak could also walk back Truss’ commitment to boosting defense spending to 3% of the economy by 2030, though that carries its own political risks given Russia’s war in Ukraine. Other countries in the region, such as Germany, have said they will ramp up military investments, and the United Kingdom may be loath to fall behind, Zaranko said.
Risk of a ‘doom loop’
Investors and economists expect that the government will announce a mixture of tax increases and spending cuts shortly. Hunt is due to reveal his plans in greater depth on October 31.g
“Despite the fiscal U-turns, the government will still need to show a fiscally credible path next week in the budget to balance the books,” Sonali Punhani, an economist at Credit Suisse, said in a note to clients this week.
That could exacerbate the country’s downturn. The Bank of England has projected that the United Kingdom is already in a recession, and a gauge of business activity in October slumped to its lowest level in 21 months.
“We are seeing quite a dramatic shift in the fiscal outlook from being much looser than we expected just a few weeks ago to being much tighter than we expected,” Gregory of Capital Economics said. “I think the risk is that the recession is deeper or longer than we expect.”
A weaker economy would present its own complications.
No one wants to repeat the errors of the brief Truss era, when her gamble that unfunded tax cuts would jumpstart growth backfired spectacularly.
But business groups are warning that completely abandoning the objective of boosting Britain’s anemic economic growth would create problems, too.
The austerity of the 2010s produced “very low growth, zero productivity and low investment,” Tony Danker, head of the Confederation of British Industry, told the BBC on Tuesday.
“The country could end up in a similar doom loop where all you have to do is keep coming back every year to find more tax rises and more spending cuts, because you’ve got no growth.”
