You are going to hear a lot about the “fiscal headroom” over the next week as the Chancellor will probably use it to justify cutting taxes in the Spring Budget on Wednesday 6 th March, with two eyes firmly on the next election.
But this headroom is nothing more than an illusion that makes the Chancellor look careful when in fact he’s being economical with the truth.
The fiscal headroom has nothing to do with height and the door frames at the Treasury. If it did, then Rishi Sunak (5’ 6”) would always have had more when he was Chancellor than Jeremy Hunt (6’ 2”) does now. Instead, this magic number comes from the government’s self-imposed main fiscal rule, namely for public debt as a share of GDP to be falling in five years’ time.
The headroom is the money the Chancellor can use to cut taxes and/or raise public spending without breaking that rule.
The rule is designed to show that the Chancellor’s decisions make sense financially, are not burdening future generations with more debt and are not about the politics of winning elections.
And as it is the independent Office for Budget Responsibility (OBR) that calculates the headroom, the appearance is that the Chancellor is spending only what he’s allowed to.
My colleagues at Capital Economics estimate that at the Budget the OBR will present the Chancellor with fiscal headroom of about £15bn. The Chancellor may hold back about £5bn of that for a rainy day and use about £10bn, mainly by cutting taxes to garner favour ahead of a general election later this year. The rumours are that he’ll cut national insurance contributions for employees by 1 percentage point (costing about £4.5bn by 2028/29) and freeze fuel duty at 53p per litre instead of increasing it in April as scheduled (costing about £6bn by 2028/29).
On the face of it, it all looks and sounds sensible. But there are two reasons why it’s an illusion.
First, the fiscal rule isn’t as restraining as it appears and can easily be gamed. The rule says nothing about the actual level of debt as a share of GDP aside from that it needs to fall in five years’ time.
The £15bn of headroom stems from our estimate that the OBR will forecast debt as a share of GDP falling from 93.4% in 2027/28 to 92.9% in 2028/29 (that 0.5% fall in the ratio is worth £15bn). But the same rule would spit out the same headroom if the debt to GDP ratio were falling from 150.0% to 149.5%. Similarly, the Chancellor could still meet his fiscal rule if he dramatically increased debt in the next four years as long as it fell a tiny bit in the fifth year.
Second, the OBR has no choice but to base the headroom on projections for future tax revenues that include hikes that will never happen, such as rises in fuel duty every April (fuel duty has been frozen since 2011), and projections for public spending that include cuts that are implausible when public services appear to be creaking. In other words, the headroom is based on unrealistic forecasts.
Of course, Labour is meant to hold the government to account. But they know that if they win the next election, they will benefit from the same leniency in the rules. The financial markets will ultimately restrain the government, as was the case when the surge in government bond yields after the mini-budget brought a swift end to the loose tax and spending policies of Liz Truss. But the markets know it is the policies of whoever wins the next election that count and not what’s announced in the Budget. And unless the winner of the election wants the Liz Truss treatment, they are going to have to admit that public spending will be higher than projected and that taxes will need to rise to pay for it.
Overall, the Chancellor will say that it’s only because of his sound management of the country’s finances that he is able to cut taxes and put money back in people’s pockets. The reality is that he’s withholding the truth and that some tough decisions will need to be made after the election. That, of course, may not be his problem.
Paul Dales is Chief UK Economist of the independent global research consultancy Capital Economics.
