Philip Hammond is facing what officials describe as “a bloodbath” in the public finances in his Budget next month as weak economic forecasts derail the government’s plans.
As much as two-thirds of the £26bn of headroom in the public finances that the chancellor created last year as a buffer for the economy through the Brexit period is likely to be wiped out after the government’s fiscal watchdog concludes its forecasts for growth have been too optimistic.
The Office for Budget Responsibility will publish on Tuesday a new analysis suggesting it has persistently over-estimated Britain’s productivity over the past seven years and will give a broad hint that it will rectify the situation with a more pessimistic Budget forecast.
Slower growth in the forecast will limit deficit reduction and cut the size of the war chest that Mr Hammond put aside to smooth the Brexit transition. This leaves him in an awkward position politically, because he is under increasing pressure to end the austerity cap on public pay, lower the burden of debt on students and build houses.
The situation will dismay the Treasury and surprise economists, who have been encouraged by a steady improvement in Britain’s monthly public finances figures, even as economic growth has slowed this year. In August, the UK posted its lowest budget deficit since before the financial crisis, borrowing a net £5.7bn, well below the consensus estimate of £7.1bn.
But Britain’s terrible productivity performance over the past decade has deepened this year.
Output per hour worked declined 0.2 per cent in the year to the second quarter of 2017, compared with an OBR forecast for 1.5 per cent growth as recently as the March Budget.
If productivity growth stalls, the economy can only grow if the employment rate rises further above its current record levels or higher immigration boosts the number of employees.
The fiscal watchdog warned in July that the “renewed weakness of actual productivity growth in the latest data” suggested it would have to rethink its forecasts for economic growth, living standards and deficit reduction.
A recent internal Treasury analysis suggests that the OBR’s revisions will be sufficient to wipe out two-thirds of the £26bn headroom Mr Hammond put in place last year to deal with Brexit risks.
Mr Hammond’s budgetary rules seek to reduce the deficit to less than 2 per cent of national income by 2020-21 and such a cut would leave him with a margin of error of only “single digits of billions” left, Treasury officials said.
But they are resigned to the OBR downgrading the growth outlook for the UK economy as it is currently significantly more optimistic than the Bank of England, the Organisation for Economic Co-operation and Development and most private sector forecasters.
Another senior government official did not dispute the likelihood that the OBR will scale back its assumption of the potential for the UK economy to grow in the official Budget forecasts, which will hurt Mr Hammond’s deficit reduction plans.
But the exact degree of difficulty for the chancellor is still unknown, the official added, because the OBR has not yet officially given the Treasury its first Budget economic forecast and that there are still many moving parts.
A less rosy outlook for productivity growth and higher estimates for interest on government debt are offset by assuming Britain’s unemployment rate can remain lower for longer and that some of the £6bn improvement in the 2016-17 deficit will persist.
In the Budget, both the OBR and Mr Hammond are likely to stress that the downgraded forecasts do not reflect a new assessment of the damage to the UK economy from Brexit, but a reassessment of likely productivity growth after so many recent disappointments.
The OBR has already estimated that Brexit will hit the public finances to the tune of £15bn a year by 2020-21. Theresa May’s government, including the Eurosceptic ministers Boris Johnson, David Davis and Liam Fox, has not disputed these estimates.
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