Chancellor Rishi Sunak said on Wednesday that the UK had fallen into a “significant recession” after official figures showed the British economy contracted by 5.8 per cent in March.
With the Bank of England having warned last week that the UK is heading for its worst recession in 300 years, Mr Sunak has begun thinking about how to address the cost of the coronavirus crisis, which could result in a budget deficit exceeding £350bn.
Most economists think ministers should continue borrowing to help companies and households through the crisis, but they recognise that at some point the public finances will need to be stabilised, albeit at much higher levels of government debt.
Mr Sunak’s problem as he eyes the deteriorating state of the exchequer is that he is boxed in by significant political and economic constraints.
Boris Johnson has ruled out deep public spending cuts of the sort launched after the 2008 financial crisis. “It’s certainly not going to be part of our approach,” the prime minister said last month.
Government figures have admitted the idea of freezing public sector workers’ pay in the wake of the Covid-19 outbreak — when the contribution of NHS and other staff has been applauded — was not attractive.
Mr Sunak on Tuesday stressed his commitment to the government’s “levelling-up” agenda for underperforming regions, which involves significant additional spending over the coming years.
And tax rises never appeal to Conservative governments. Although Mr Sunak has been careful to leave himself room for manoeuvre to put up taxes, his party will be reluctant.
“It’s too early to speculate about any future decisions,” said Downing Street. “We’re facing a time of unprecedented economic uncertainty.”
If tax rises and spending cuts are difficult to contemplate, one important question is whether the government can simply borrow more to finance its response to the virus crisis.
Following Mr Sunak’s decision to extend the flagship job-retention scheme, the Financial Times estimates the additional borrowing needed to pay for the government’s crisis measures and offset lost taxes could be in excess of £350bn.
But with the Bank of England standing behind the gilts market with a £200bn quantitative easing programme and interest rates on public debt close to zero, bond investors appear willing to extend credit to the government.
Nick Wall, a bond portfolio manager at Merian Global Investors, said: “The government can spend all this money and hardly get charged anything for it at all. The idea that bond vigilantes have them over a barrel completely ignores the environment we are living in. It would be a policy mistake if they went down the road of reducing the deficit too fast.”
Most economists agree. This suggests that if the scenarios outlined by the BoE and the Office for Budget Responsibility prove correct — a deep recession followed by a rapid recovery as lockdown is lifted — there is no need to reduce the deficit as the gap between public spending and tax revenues will close of its own accord.
“If the BoE and OBR are right, you don’t need to do anything,” said Paul Johnson, director of the Institute for Fiscal Studies, a think-tank.
But the forecasts by the BoE and UK fiscal watchdog are considered highly optimistic by many economists. The Treasury is not nearly as optimistic about a V-shaped recovery and this was reflected in an internal briefing paper which raised the possibility of tax rises and spending cuts.
The Treasury said the document — obtained by the Daily Telegraph — had never formed part of ministerial discussions, although officials accepted it had been circulated widely.
The potential problem feared by officials is not the depth of the recession induced by coronavirus, but the degree to which there is permanent damage to the economy that will leave the deficit persistently higher alongside a rising debt burden.
Economists call this effect “scarring” because the damage wrought remains long after the crisis is past. This serves to lower productivity levels, perhaps reducing economic growth rates and ensuring that tax revenues fall sufficiently short of public spending that debt as a share of gross domestic product continues to increase.
Even those who have been vocal opponents of austerity worry about scarring and were not surprised that the leaked Treasury paper raised the possibility of tax increases and spending cuts.
Jonathan Portes, professor of economics at King’s College London, said “the degree of fiscal adjustment required does depend on scarring”, adding that “certain sectors are going to have a productivity shock”.
But few economists think an imminent Budget is required to address the questions over the sustainability of the public finances.
Treasury officials insisted it was “too early” to talk about a summer Budget, while Nick Macpherson, the department’s former top official, said: “You don’t want to have a Budget while the crisis is in full throttle.”
Mr Johnson of the IFS said the government could wait even longer. “I would be very surprised to see tax rises in the 2020 November Budget,” he added. “That would be something more for late 2021 once we have a better idea how well the economy has recovered.”
The crunch decisions for the government are therefore likely to come later and will depend on the outlook for productivity and growth once the virus subsides.
Mr Sunak’s colleagues see him as a “modern supply-sider”, who is expected to stress that investing to improve productivity and growth is the only sustainable route out of the crisis, keeping the country’s debt-to-GDP ratio under control.
The more successful he is in that mission, the less the need for Mr Sunak to consider tax rises to cut government borrowing.
Robert Halfon, Conservative MP for Harlow and a champion of blue-collar workers, on Wednesday made it clear this would be a difficult path for the chancellor.
“We won’t get out of this by hammering pensioners or workers or businesses by raising income tax and business rates,” he said. “If anything we should be looking to cut taxes for the lower-paid or small businesses.”