Was there ever a black hole?

Truss and Kwarteng may have been judged too soon

Artillery Row

Prime Minister Liz Truss resigned this week — a result which had become inevitable the moment when, six short days before, she relieved Chancellor Kwasi Kwarteng of his duties and reversed the plan not to increase corporation tax as part of her strategy to increase medium and long term GDP growth.

His sacking was followed by the appointment of Jeremy Hunt who in the space of three days completely reversed the Kwarteng budget, binning entirely any attempt to increase the UK’s long-term growth rate. Not only did Hunt announce higher tax rates, he also announced there would need to be spending cuts as well to balance the books.

What caused the abrupt about turn? And where does it leave the UK now?

Whilst there had been market volatility following the Kwarteng budget and the disconnect between the fiscal changes announced and the Bank of England’s moves on interest rates just days before, the catalyst for this abrupt U-turn was a report by the Institute of Fiscal Studies (IFS) which claimed a £60b black hole in the nation’s finances as a result of the budget changes. 

The £60b “black hole” has been heavily covered in the media and spooked the markets which, in the absence of independent forecasts, feared the Government would be unable to balance the books in the medium term and as a result increased the yields on UK Government debt (Gilts).

What exactly is this “black hole” the IFS has identified?

Effectively, it is the gap between its forecast for tax revenues raised and taxes spent in the period between now and 2026–27 — a forecast for a £62b rise in net debt.

But how realistic is the forecast?

I have studied the IFS report, which can be found here, and there are a few points to note. Firstly, the report makes clear that the IFS does not itself produce macro-economic forecasts. Rather it relies on economic modelling produced by the US investment bank Citi. Second, despite being several hundreds of pages long, the report does not seem to provide a clear breakdown of Citi’s GDP forecasts for the UK in the period the IFS finds this “black hole”. 

The apparent absence of clear and specific GDP forecasts seems rather strange because it is well known that the single biggest determinant of tax revenues is GDP growth. The larger the growth, the larger the tax revenues.

The Citi forecast of UK GDP falling is an outlier

What we do know from the report is that Citi is forecasting UK GDP to fall by 0.7 per cent in 2023.

To put this forecast into perspective, the IMF this week published its latest forecasts for global economic growth. Its forecast for UK GDP growth in 2023 is now +0.3 per cent. This is lower than its previous expectation of +0.5 per cent, although it made clear that this estimate did not include the tax changes made in the budget which it expected to enhance GDP growth.

The NIESR, meanwhile, also updated its UK GDP forecasts following the budget. It stated: “We now forecast the energy support guarantee, together with the tax cuts announced today, will lead to positive GDP growth in Q4 of this year, shortening the recession and raising annual GDP growth to around 2 per cent over 2023-24.”

The French banking giant BNP has also published-post budget forecasts, which also predict UK growth in Q4 2022 (avoiding a UK recession by its estimation) and about 2 per cent GDP growth in each of 2023 and 2024.

The Citi forecast of UK GDP falling in 2023 by 0.7 per cent is a bit of an outlier — a full one per cent below the IMF forecast (which it admits is probably too low) and at least 2.5 per cent below the forecasts of the NIESR and BNP.

To be fair, in its Green budget report, in the section looking at the £60b forecast black hole, the IFS does state that this forecast is very heavily dependent on GDP growth (which it reminds readers is not its forecast but Citi’s). Indeed the IFS makes the point that the OBR might take a more optimistic view of the outlook for growth than Citi has.

In fact the IFS goes further. It calculates exactly how much higher GDP growth would be required in order to wipe out the “black hole” completely. Just 0.75 per cent:

We know that based on Citi’s economic forecasts there is likely to be a £60b “black hole” in the UK finances by 2026–27. We know that if growth is 0.75 per cent higher than Citi’s forecasts there will be no black hole at all. All we need to do is add 0.75 per cent to Citi’s GDP forecasts and work out if they seem achievable or not.

I spoke with the IFS and asked for the GDP forecasts on which its analysis was based. It provided me with the following figures for forecast growth in real-terms national income. Not exactly the same as GDP, but these are the figures on which it has based its forecasts and good enough for our purposes. 

IFS/Citi October Forecast Annual Growth 
2021/2 100.0
2022/3 102.0 2.0 per cent
2023/4 101.4 -0.6 per cent
2024/5 101.5 0.1 per cent
2025/6 102.5 1.0 per cent
2026/7 104.1 1.5 per cent

This equates to an average growth in the period 2021/22–2026/7 of +0.8 per cent and in the period 2022/23–2026/27 of +0.5 per cent. If the IFS model had GDP growth averaging 1.55 per cent over the whole period and just 1.25 per cent between 2022/23–2026/27, there would be no “black-hole”.

How realistic is that?

We know that the NIESR and BNP upgraded forecasts after the Kwarteng budget were for about 2 per cent growth in each of 2023 and 2024 (compared to -0.6 per cent and +0.1 per cent by IFS/Citi). That would require GDP growth of only 0.75 per cent per annum in each of 2025 and 2026 to remove the “black hole” entirely. 

The Truss/Kwarteng plan maybe would have worked after all

That does not appear to be particularly aggressive, but how does it compare to the long term growth of the UK economy historically?

Average GDP growth post the Great Financial crash in 2008/9? 1.5 per cent. The average in the last ten years? 1.5 per cent. The average in the last twenty years? 1.5 per cent. 

It seems, then, that if the IFS/Citi forecasts for UK GDP had been anywhere close to the forecasts of other economic bodies including the IMF, NIESR and BNP, or in line with the historic long term growth rate of the UK economy, the IFS would have reported no “black hole” at all.

The Truss/Kwarteng plan — already in the dustbin of history (a week is a long time in politics) — maybe would have worked after all. Even if it failed to boost the long term growth rate (and we were still waiting for details of the supply side reforms which would have driven that) it would appear, on reasonable GDP estimates, that the tax cuts would have been self-financing and left the UK in a better economic position.

What about the Hunt plan which replaced it?

Over to Goldman Sachs who reported updated estimates for the UK economy in the wake of the Hunt changes. “We now forecast the UK economy will shrink 1 per cent in 2023” in part due to the “decision to increase corporation tax to 25 per cent in April”. The ratings agency Fitch concurred, also updating its forecasts to a “1 per cent decline in GDP in 2023” following the Hunt budget changes.

At least Goldman’s had some good news: 

The good news is Goldman analysts believe UK interest rates will now peak at 4.75 per cent, slightly lower than the 5 per cent previously factored in.

Under the Hunt plan we will now have not just lower growth but also higher taxes and lower public spending. But at least UK interest rates will peak 0.25 per cent lower. 

The Truss/Kwarteng plan offered a possible route to higher long term growth. The Hunt plan is a guarantee of lower growth, higher taxes and lower public spending. It is a route to nowhere other than a dead end.

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