Bad times ahead

Published on 1 March 2017

The UK economy has already had an extremely tough decade. If it proves right, the weak economic forecast spells more bad news for living standards – while also limiting the scope for the chancellor to do anything about it.

The UK economy has already had an extremely tough decade. If it proves right, the weak economic forecast spells more bad news for living standards – while also limiting the scope for the chancellor to do anything about it.

FOR EACH OF his final seven fiscal events, George Osborne stated within the first five minutes of his speech that the UK had grown faster than any other major advanced economy. Phillip Hammond, at his first fiscal event, stuck to the same script. But the story of this Autumn Statement was not historical economic growth, but expectations for future growth. While the Chancellor unveiled some policy changes and new fiscal rules, it is the changes in the macroeconomic outlook forecast by the Office for Budget Responsibility (OBR) that – if they prove correct, or at least in the right ballpark – will have the biggest implications for living standards in the UK.

Of course these forecasts come with a huge degree of uncertainty: even at the best of times the macroeconomy is very difficult to forecast, and all the more so when neither the policy environment following Brexit nor its economic effects are known with any precision. Uncertainty over both the economy and government policy implies that the path for real incomes and the public finances could be considerably better or worse than the OBR currently expects. One of the biggest challenges the Chancellor faces is how to navigate the economy and the public finances given that degree of uncertainty.

Before delving into the forecasts, remember that the UK economy has already had an extremely tough decade. Due to the deep recession and very sluggish recovery, our national income (real GDP) per capita has grown by just 1.5 per cent over the nearly nine years following its peak at the end of 2007. In large part this is due to a dismal record on productivity, which barely changed at all over the same period. Back in March the OBR had expected that this difficult season would be followed by modest growth in GDP and productivity. The OBR now forecasts real GDP to be £30 billion lower in 2020-21 than they had expected in March, corresponding to an average of £1,000 per household. Productivity growth forecasts are down by 0.3 percentage points a year thanks to lower investment. And the OBR raised their forecast for inflation, following the sharp depreciation of sterling and resulting higher import prices.

These changes to national income and prices feed through to living standards. The OBR forecast for real average earnings for those in work by the beginning of 2021 is down by 3.7 per cent relative to their March 2016 forecast. Higher inflation has some role to play in this, but weaker expected productivity growth – the key driver of earnings growth in the long run – accounts for most of the change. If the OBR is right then even by 2021-22, real average earnings will be below their 2007-08 peak – meaning well over a decade without real earnings growth. Even allowing for a substantial margin of error it is safe to say that we have not had a period of earnings growth this weak for at least the last 70 years. And looking at the external forecasts that the Treasury collects, of which 11 include real earnings growth forecasts between 2015 and 2020, they range from a fall of 1.7 per cent to growth of 5.7 per cent: in comparison the OBR actually looks relatively optimistic at 4.9 per cent.

While weaker earnings will affect working households, higher inflation will affect everyone by raising the prices they pay. We estimate that the two per cent average price increase expected as a direct result of the 13 per cent sterling devaluation since March will affect households across the income distribution about evenly, with higher vehicle, holiday and furniture costs hitting richer households more, while poorer households are more affected by rises in food, telephone, and utility costs.

The inflationary impact on people’s incomes is more complex, and interacts with government policy. The basic state pension is ‘triple locked’, to go up with the highest of inflation, average earnings, or 2.5 per cent – so under this policy it can never fall in real terms. But with average earnings growth lower than previously forecast and inflation higher, the real increases that pensioners will see is now expected to be smaller than thought previously.

For working-age benefit recipients the picture is somewhat different. Normally they are protected from inflation because their benefits are priceindexed, but the government has frozen most working-age benefits in nominal terms through to March 2020. Under previous OBR forecasts this implied a four per cent cut in the value of benefits, but higher inflation means that it now represents a six per cent cut. This is expected to affect around 11 million households by an average of £390 per year in today’s terms.

But for many low-income working-age households a bigger change is yet to come, in the form of the transition to universal credit (UC). This represents a substantial cut to inwork benefits as UC is less generous than the existing benefit and tax credit system. In his first Autumn Statement Phillip Hammond made a tweak to UC which will put about £0.7 billion per year more in the pockets of working recipients; but this only very partially reverses a more than £3 billion takeaway from essentially the same group announced at last summer’s budget. Taken together with the other tax and benefit changes the Chancellor announced – an increase to the personal allowance, another freezing of fuel duty, and an increase in insurance premium tax – the Autumn Statement’s personal tax and benefit policies represent a very small net giveaway, slightly tilted in favour of those towards the bottom of the income distribution. But they pale into insignificance relative to policies already in the pipeline for this parliament, which on average will hit low-income households hardest.

While not making extensive further changes to the tax and benefit system, the Chancellor did opt to significantly increase capital investment. His plans will take public sector net investment to around 2.3 per cent of national income – pretty much exactly Labour’s pre-crisis planned level, and well above the average over the last 30 years. Well-targeted investment should raise national income in the long run, and so the Chancellor has essentially chosen to target higher incomes in the future via stronger earnings growth, rather than higher incomes now via tax and benefit giveaways.

The combined effects of these policies and changes in economic forecasts is that the Chancellor would have had about a two-thirds chance of missing his predecessor’s fiscal targets, with the previously hoped for budget surplus of £10 billion in 2019-20 now expected to be a £20 billion deficit according to the OBR’s central forecast. But, unsurprisingly given the change in economic outlook, Mr Hammond chose to change the targets. Overall tax and departmental spending plans are broadly unchanged, but the main fiscal target is now to reduce the structural budget deficit (the bit not explained by the economic cycle) to under two per cent of GDP by 2020-21, rather than to reduce the total deficit to zero by 2019-20. The OBR gives the Chancellor a two-thirds probability of meeting this new goal.

In summary, Mr Hammond’s first fiscal event was relatively light on policy, and dominated by forecast changes. If it proves right, the weak economic forecast spells a very bad decade for living standards – while also limiting the scope the Chancellor has to do much about it in a hurry.

This article appeared first in Society Now