Six key fiscal challenges for Philip Hammond

Nadya Mihaylova - 01 December 2016

The first Autumn Statement delivered since the June referendum has attempted to support the economy through the challenging and uncertain times that lie ahead. The Chancellor of the Exchequer, Philip Hammond, has introduced several key measures to address the public discontent which partly contributed to the Brexit vote, but failed to tackle other serious concerns. Here are the six key fiscal challenges facing the Chancellor:

  1. As expected, Brexit is the biggest and most obvious impediment to economic growth. The Office of Budget Responsibility (OBR) has projected that over the period between 2016 and 2021 public sector borrowing will increase by £122bn (fig 1). Of that, £56bn is attributed to Brexit-related impacts, such as reduced business investment, lower tax revenue and higher inflation. This is clearly shows that the expected worsening of the fiscal position is attributed to weaker anticipated outcomes rather than an expansionary government policy. While the OBR has projected that economic growth will begin to normalise by 2019, the estimates seem too optimistic, particularly for business investment.
 
  1. Britain’s poor productivity record compared to other advanced economies has long been a reason for concern. As such, Hammond’s focus on boosting productivity by increasing investment in infrastructure, innovation and housing is a move in the right direction. However, given the small size of the stimulus package and the long timeframe needed for the benefits to fully materialise, it is unlikely that his plan will deliver a material change.
 
  1. To soften the hit on low-income households left behind by structural changes in the global economy, the Chancellor also increased the tax-free income allowance and softened the impact of some of the benefit cuts previously announced. However, with inflation rising (and likely to persist), the prospect for improved living standards and higher consumer confidence in the future has weakened. Nevertheless, the post-referendum rebound in activity and the strong labour market provide some reassurance that real wages will prove resilient. 
 
  1. The Autumn Statement failed to address several other burning issues. While additional resources have been found to alleviate the funding crisis in the NHS and in social care for this year, these services are likely to fall deeper into deficit over the next few years. Realistically, Hammond will need to build in an extra £2bn to £4bn per annum of expenditure to prevent an unacceptable and politically damaging deterioration of service.   
 
  1. Donald Trump’s scepticism about NATO during the US presidential campaign has encouraged many European countries to increase their defence spending, especially as Russia undertakes military manoeuvres along its western border. Perceptions of the cybersecurity threat are escalating as are related budget requirements. While the UK currently meets its commitment to spend 2 per cent of GDP on national defence, the likelihood is for spending commitment to rise as new threats emerge.
 
  1. Despite the higher level of borrowing and inflation, the OBR has projected that the debt servicing costs will be reduced from 2017-18 onwards on the back of a lower interest rate. However, adverse assumptions associated with Brexit are likely to be factored in by investors and consequently increase the cost of borrowing. Therefore, the assumption on lower bond yields now looks less credible.

 
While the Chancellor showed a clear commitment to address the first three challenges on the list, the remaining three demand a bold response as well. Despite the pressures on the public finances, political and economic expediencies dictate that the government set aside its near-term ambitions for a budget surplus and respond to the expensive structural challenges enumerated above.

 
 
Figure 1: Sources of changes to public sector net borrowing since March


Table 1: Sources of change to public sector net borrowing since March

Source: OBR



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