How big is the hole in the UK’s finances?

It has been a chaotic few weeks but we are starting to get some clarity. Rishi Sunak is now Prime Minister, Jeremy Hunt is still Chancellor of the Exchequer, and it has been announced that he will deliver an Autumn Statement – including the medium term fiscal plan – on Thursday 17 November.

The backdrop to that statement is the government’s debts and the interest rate on them. Liz Truss and Kwasi Kwarteng had a plan to borrow big and it scared the bond market. Potential lenders wanted a premium interest rate for lending to the UK government – which suddenly looked riskier. So, after the Mini-Budget on 23 September, interest rates spiked and that in turn made the structural fiscal deficit bigger.

Consequently, the government had to change tack and plug the hole in the finances. After numerous U-turns and the resignations of Kwasi Kwarteng and Liz Truss, it is down to Jeremy Hunt and Rishi Sunak to deal with the issue. It has been suggested that a Hunt/Sunak partnership might reduce the annual government interest payable by £7 billion – so there is a big prize for getting it right. But that prize depends on action being taken to address this structural hole in the finances.

Despite the impression given only a month or so ago, your taxes are headed up, not down.

By the time of the Mini-Budget, interest rates and inflation were already much higher than the Office for Budget Responsibility (OBR) had forecast in March, when Rishi Sunak delivered his last Budget as Chancellor. Back then, the base rate had just increased to 0.75% and the OBR expected CPI inflation to hit 8.7% in late 2022.

Even then, Rishi Sunak said the UK government was forecast to spend £83 billion on debt interest in 2022/23. Already a fourfold increase on the previous year and that was long before the energy price guarantee and central bank tightening across the world (especially the US Federal Reserve). In late 2021, he had previously warned that a 1% increase in inflation and interest rates would add around £23 billion to the government’s annual borrowing costs. At that time, inflation was forecast to peak at just 4.4% and the base rate was 0.1%.

Back in March, the economic outlook was considerably better, with GDP forecast to grow by 3.8% over the coming 12 months and then hold steady at 2% a year for a few years. I thought at the time that looked a bit too rosy but things have turned down even more than a pessimistic accountant might worry about. We are probably now in recession, it’s just not clear how much of one.

Jeremy Hunt now needs to tighten the purse strings more than would otherwise have been the case in order to regain credibility.

So, borrowing costs for the UK are up, economic growth is down and the outlook looks much tougher.

During the summer, I suggested interest on government debt would be running at £5 billion more a month than the £83 billion forecast (so an extra £60 billion a year), which might have been toppy at the time, but with higher inflation and increasing interest rate expectations in the USA and elsewhere, that now looks optimistic.

Any attempt to borrow more against this background looked foolish, and Rishi Sunak warned of this during the Conservative Party leadership campaign. Liz Truss and Kwasi Kwarteng ignored those warnings – and here we are. Jeremy Hunt now needs to tighten the purse strings more than would otherwise have been the case in order to regain credibility and to try and influence the Bank of England Monetary Policy Committee that they don’t need to tighten monetary policy as much because fiscal policy is being tightened. That would mean a lower base rate, which not just helps businesses and individuals, but also reduces the interest cost for the government.

Politically, higher taxes on wealth might be seen as expedient. The most obvious possibility is increasing the capital gains tax rate.

Regaining that credibility depends on addressing the structural hole in the finances. We will have to wait until 17 November to get Hunt’s assessment of the size of the hole and the OBR figures. However, it seems that the structural hole is probably between £25 billion and £35 billion (ignoring the short term energy price guarantee). This has been increased by maybe £10 billion by the cancellation of the National Insurance/Health & Social Care Levy, net of the reduction in the basic rate of income tax of 1p not happening as Rishi Sunak had promised in April 2024. So, if the Mini-Budget hadn’t happened at all, there was still a large funding need, and ignoring it really spooked the markets.

If the markets take a favourable view of the Sunak/Hunt partnership and reduce interest rate expectations on gilts, there is still probably a hole of £25 billion a year or so to fill. To achieve this, it seems likely that there will be spending reductions and tax rises in, perhaps, equal measure – maybe £10-15 billion of each. These are sizeable numbers.

A windfall tax/excess profits tax on energy companies has been mooted, but that is likely to be short term and is more about keeping the overall debt down rather than filling the structural hole. Another possibility is a tax on bank deposits at the Bank of England, or increasing the bank levy and/or corporation tax surcharge, but, one way or another, there is going to have to be more tax coming from one of the big mainstream taxes. The most suggested idea is that income tax allowances and thresholds will be frozen for longer – so letting fiscal drag increase future tax revenue.

There will be concerns that the Conservative Party is favouring the rich and the political mismanagement of the Mini-Budget has cemented that impression amongst the public. Sunak’s wealth might exacerbate that impression and so, politically, higher taxes on wealth might be seen as expedient. The most obvious possibility is increasing the capital gains tax rate.

We will have a better idea soon enough, but despite the impression given only a month or so ago on 23 September, your taxes are headed up, not down.

Read more analysis in our Budget hub: Mini-Budget 2022 – the ongoing saga