Tax after coronavirus Contents

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2The scale of the public finances challenge

The fiscal legacy of coronavirus

11.The economic downturn caused by the outbreak of coronavirus, social distancing and lockdowns, together with the Government’s series of discretionary fiscal interventions, are having a huge and rapid impact on public borrowing and debt. It is estimated that central Government receipts were down by 14 per cent on a year earlier in the first nine months of the 2020–21 fiscal year, while central Government spending was up 31 per cent.7

Figure 1: Annual changes in public sector net debt since 1800 (% of GDP, OBR forecast after 2019–20)

Source: OBR, Economic & Fiscal Outlook November 2020, 25 November 2020, Chart 4.

12.The Office for Budget Responsibility (OBR) has revised its forecast of public sector net borrowing (PSNB) in 2020–21 up by £339 billion since its March 2020 forecast (in its central scenario). The OBR states clearly that a failure to provide support to firms and households would have caused “immense economic damage” and that “[fiscal] sustainability would have been damaged.” Nonetheless, the pandemic is having a major impact on the public finances.8

13.The OBR analyses the medium-term impact on the public finances against three scenarios in its November 2020 forecast. In its upside scenario, in which the economy rebounds by the end of 2021 without any scarring, there is a one-off rise in the level of public sector net debt (PSND), while ongoing borrowing (PSNB) returns to the pre-crisis forecast of 1.7 per cent in 2025–26. PSND stands at 91 per cent of GDP in 2025–26, up from 75 per cent in the March 2020 forecast. In the OBR’s central and downside scenarios, in which the economy does not return to peak until the end of 2022 and 2024 respectively and there is long-term scarring of 3 per cent and 6 per cent of the level of GDP respectively, there are larger initial rises in the debt and rises in ongoing borrowing. PSNB rises to 3.9 per cent and 6.1 per cent respectively in 2025–26, while PSND stands at 105 and 123 per cent of GDP respectively. These are the highest levels of public debt since the 1960s, albeit still well below the World War II peak of over 200 per cent.9

Figure 2: Medium-term public sector net borrowing and public sector net debt, receipts and expenditure (OBR scenarios, % of GDP)

Source: OBR, Economic & Fiscal Outlook November 2020, 25 November 2020, Chart 3.15

14.However, countervailing against the impact of coronavirus support and falling revenues, the interest rates being paid on Government borrowing have fallen further from already historically low levels. The yield on 10-year gilts is under 0.5 per cent at the time of writing, from around 5 per cent at the start of 2007, prior to the Financial Crisis.10 Paul Johnson, Director of the Institute for Fiscal Studies (IFS), explained to us that on this measure, the public debt was more affordable than it had ever been:

It is astonishing that we have so much debt and that we are spending the lowest fraction of our revenue on debt interest as we have ever done, or at least since 1700 or thereabouts. In the short run, in the arithmetic sense, it is extraordinarily affordable. [ … ] That feels like a very good time for Government to be borrowing, partly reflecting, of course, international circumstances.11

15.Richard Hughes, the Chair of the OBR, explained that as a consequence of this, the OBR projects the public debt to be broadly stable as the economy recovers from the pandemic, despite its elevated level:

One of the paradoxes of the consequences of the pandemic for our public finances has been the fact that our debt burden has gone up from around 80% of GDP to already over 100% of GDP, and that it stays there for the five-year forecast period. It has not been at that level since 1960, but [ … ] the burden of servicing that debt has gone down relative to even what we were forecasting back in March, and has gone down considerably compared to how much having a 100% debt-to-GDP ratio cost us back in 1960.12

16.Faced with an extraordinary economic downturn and exceptionally low debt servicing costs, witnesses to this inquiry were unanimous that significant tax rises should not be attempted in the short term. On the timing of any tax rises, Mr Johnson said:

The answer is “not yet”. [We] are not very clear about where the economy is going to go, but we are pretty clear that it is going to be weak for some period. [ … ] Remember that through the financial crisis we had at least two years—maybe three—of spending increases and tax cuts to support the economy, and at least in the short run, the impact of this crisis has been more substantial than we saw back then. [ … ] If we do need higher taxes then, we are probably looking at bringing them in from two to three years hence, rather than six months to 18 months hence, when we hope the economy will be firing on all cylinders, or close to it.13

17.Professor Sir Charlie Bean, a member of the OBR’s Budget Responsibility Committee leading on economic issues, said that fiscal consolidation should be a long-term matter:

[One] should not think that there is a great urgency in closing the deficit. It is entirely appropriate, given the large and very unusual shock the economy has been subject to, for the Government to run a large deficit so long as the virus emergency persists. That is something pretty much all economists would agree with.

As one goes beyond the emergency, it will be appropriate to stabilise the public finances and potentially start building in fiscal space to recognise that there will be future bad shocks further down the road.14

18.On the other hand, Richard Hughes warned that the elevated public debt stock does leave the public finances more exposed to rises in interest rates:

We show that [a 1 per cent rise in interest rates] ends up costing you about a third of a percent of GDP within the forecast period, so that is going to be somewhere in the ballpark of £10 billion by the end of the five-year period.15

[ … ]

[ … ] We are in exceptional times at the moment with very low interest rates for a number of reasons, partly reflecting flight to safety concerns and people wanting to hold on to safe assets and liquid assets. How long that will last is a big question.16

19.Witnesses also warned that low interest rates reflect low growth expectations, which if fulfilled will have a negative impact on the public finances. Karen Ward, Chief Market Strategist for Europe at JP Morgan Asset Management, told us:

We have to be very careful with this narrative that low interest rates are good news, because we have to think about what is driving low interest rates on both sides of the Chancellor’s ledger. [ … ] Interest rates are this low because expectations of nominal growth are so very low. [Both] our outlook for our spending via interest rates as well as the outlook for our tax receipts via the nominal economy are looking fairly bleak at the moment.17

20.As well as fiscal consolidation, public debt as a proportion of GDP can be reduced by other alternatives such as growth, inflation or repressed interest rates. Witnesses questioned whether growth could have the same impact now as in earlier periods of high public debt, and warned of the risks of high inflation and repressed interest rates. On growth and inflation, Paul Johnson, Director of the Institute of Fiscal Studies (IFS), told us:

After the second world war we got the overall level of debt down very substantially and really quite fast, because both real growth and inflation were running at much higher levels than we have been used to [ … ] over the last several decades. [ … ] Whether we have the magic solution to getting growth at those levels, and whether we would want inflation at those levels, is very much open to question.18

On inflation, Philip Booth, Professor of Finance, Public Policy and Ethics and St Marys University and Senior Academic Fellow, Institute of Economic Affairs, said:

[We] should not forget the pain of the 1970s, with the industrial strife and so on, and the early 1980s, with the unemployment that arose from trying to squeeze inflation out of the system. [ … ] We took a long-term, very big hit from allowing inflation to rise. It is not a pain-free way to deal with a debt problem.19

On repressing interest rates, Karen Ward told us:

[The Bank of England’s quantitative easing has] perhaps given us a little bit of a premium between where interest rates should be on the economy and where they actually are [ … ]

If it is the case that central banks globally can hold down bond yields well into the recovery, it could be very helpful in allowing us to grow into our debt. We saw, for example, in the US, after the Second World War, very high debt levels came down very easily because of that combination of the central bank holding down the interest rate as the economy gathered steam. That could be a very effective strategy but, at the same time, we are not the US; we are the UK, and we are vulnerable to global interest-rate movements.20

21.When the Committee asked the Financial Secretary to the Treasury whether he foresaw a need for tax rises in future, he cited the OBR’s upside scenario and Paul Johnson in saying that there may be no need for future consolidation:

[The OBR’s] optimistic scenario has us returning to the growth path that they had anticipated in March. It is not absolutely obvious, therefore, that there may be any future need for consolidation [ … ] I was struck, in looking at some of the testimony you have been given, by the remarks of some of the experts. Paul Johnson said that he was not absolutely sure that taxes need to rise, and that was quite an interesting external expert view.21

22.However, while as quoted earlier, Mr Johnson did tell the Committee that tax rises were not recommended in the near term, he also told us that the fallout from the pandemic may require tax rises in the longer term:

I think that is probably true [that taxes will have to rise]. It is worth saying that that is not because of the scale of the deficit this year. I think it is likely to be for two reasons. The first is that the economy, certainly according to most forecasts, will be smaller in four or five years’ time than we were expecting, and therefore tax revenue will be less than expected. Secondly [ … ] the pressure on public services will be greater [ … ]22

23.Gemma Tetlow, Chief Economist at the Institute for Government, suggested that the Chancellor could set out some strategies for a medium-term fiscal consolidation at the next Budget:

This year and in the next Budget, the Government need to set out broad fiscal objectives based on the best forecast that the OBR is able to provide to them at that time, showing the “no policy change” forecast for borrowing. The Chancellor could then say, “But actually our objective is over the medium to longer term to reduce borrowing down to some level, or to stabilise debt or reduce debt over some period of time.”23

24.In our September 2020 report on Economic Impact of Coronavirus: The Challenges of Recovery, we concluded that:

The Chancellor should, at the next fiscal event, set out an initial roadmap of how he intends to place Government finances on a sustainable footing. The milestones on that roadmap will need to be flexible—tax increases imposed too early are likely to stifle economic recovery. A reassurance that the Government intends to take steps to ensure fiscal sustainability in future will underpin market confidence and reduce uncertainty for households and businesses that may fear immediate tax rises.24

25.In its response, the Treasury only committed to a revised fiscal framework “in due course.”25 The Financial Secretary told the Committee that “now is not the moment to be bringing in new fiscal rules.”26

26.The pandemic will leave behind a large increase in the public debt and, possibly, a rise in ongoing borrowing into the medium to longer term. However, low interest rates have helped to open up fiscal space, and our expert witnesses said that now is not the time for tax rises or fiscal consolidation, which could undermine the economic recovery. However, the public finances are left more exposed to rises in interest rates; and witnesses told us that economic growth, inflation and measures to lower interest rates probably could not on their own be relied upon to stabilise or reduce the public debt. Indeed, interest rates increasing from current low levels would put further pressure on the public finances. Significant fiscal measures, including revenue raising, will probably be needed in future.

27.The Financial Secretary to the Treasury is right to point to the uncertainties in the economic and fiscal forecasts. However, the Government would be prudent not to focus on the OBR’s upside scenario at the expense of failing to prepare for its central and downside scenarios. We re-iterate our earlier conclusion that “the Chancellor should, at the next fiscal event, set out an initial roadmap of how he intends to place Government finances on a sustainable footing.”

The long-term fiscal gap

28.Witnesses to the inquiry stressed that projected long-term trends in the demography of the UK, associated public spending commitments and shifts in the tax base likely represent an ultimately greater challenge to the public finances than the pandemic. These trends all pre-date the pandemic. Philip Booth told us:

I would not get too wound up about the increase in debt caused by the Covid crisis; that is not my big concern. One of the reasons why you accumulate Government debt is to deal with one-off emergencies. My big concern is the next 30 or 40 years when, as a result of demographic pressures, the relationship between the tax base and Government spending changes dramatically.27

29.Since 2011, the OBR has published a regular Fiscal Sustainability Report (FSR) that makes fifty-year projections of the public finances, based upon currently-stated Government policy and assumptions about how these apply to the demographics and economics of future decades.28 It has been a feature of every FSR that the OBR has concluded that the public finances are on an unsustainable long-term path, in the sense that “the public sector is on course to absorb an ever-growing share of national income simply to pay the interest on its accumulated debt.”29

30.In the July 2020 FSR, the long-term unsustainability of the public finances is exacerbated by higher starting points for debt and—depending on the scenario—borrowing, due to the coronavirus pandemic. In all scenarios, public debt and borrowing stabilise following the recovery from the pandemic but expand without limit from 2025–26. In 2069–70, public borrowing (PSNB) is projected to reach between 24 and 37 per cent of GDP, while the public debt (PSND) is projected to reach between 320 and 522 per cent of GDP. In the July 2018 FSR, PSNB and PSND were projected to reach 19 and 247 per cent of GDP respectively over the same period.30

Table 2: OBR long-term projections for 2069–70 by scenario (% of GDP unless stated otherwise)

	2019–20	Central	Upside	Downside
Primary receipts	36	36	37	36
Primary spending	37	49	47	51
Health spending	7	15	14	15
Adult social care spending	1	2	2	2
State pensions	4	7	7	7
Primary deficit	1	13	10	15
Gilt rates (%)	0.7	4.1	4.1	4.1
Net interest spending	1	18	14	22
Public spending net borrowing	3	31	24	37
Public sector net debt	88	418	320	522

Source: OBR, July 2020 Fiscal sustainability report–supplementary tables, 14 July 2021

Figure 3: Long-term public sector net borrowing and public sector net debt (OBR scenarios, % of GDP)

Source: Office for Budget Responsibility, Fiscal Sustainability Report July 2020, 14 July 2020, Chart 4.5

31.We took evidence from members of the Budget Responsibility Committee on the OBR’s 2020 FSR. While in previous Parliaments the Treasury Committee has routinely taken evidence from the OBR on the five-year forecasts in its biannual Economic & Fiscal Outlook, it has not before taken evidence on the long-term FSR.

32.Richard Hughes explained to us the main drivers of the OBR’s projection of a rising primary deficit:31

There is a very modest decline in the tax to GDP ratio over our 50-year forecast horizon driven by an ageing population and the fact that pension incomes are less taxed than those of people of working age, but the vast bulk of that increase [in the projected primary deficit] is driven by age-related spending. It goes up by about 9 per cent of GDP from 15 per cent of GDP in 2024–25 to around 25 per cent of GDP by 2070 [in the central scenario]. About half of that increase is due to increases in the unit cost of healthcare and social care. The cost of providing health services and social care per person is going up for a number of reasons.

Then the other half is driven predominantly by demographic pressures. The population of people who need healthcare and social care is also going up. Of that 9 per cent of GDP increase in primary spending over the next 50 years, the increase in unit cost of healthcare accounts for about 5 per cent of GDP and then demographic pressures and an ageing society add another 4 per cent of GDP to that.32

Andy King, a member of the OBR’s Budget Responsibility Committee leading on fiscal issues, explained further the reasoning behind these judgements:

Innovation in health tends to push up costs, whereas in most businesses it pushes down costs, either because more things can be treated or because they can be treated better but the cost of each treatment is higher. [The remaining spending increase] is demographics: in health, because of the cost of care at the end of lives, and in the pensions system, for obvious reasons.33

33.The OBR also assumes that interest rates rise from today’s historic lows and converge towards the rate of nominal GDP growth, which increases debt servicing costs. Sir Charlie Bean acknowledged that “there is a lot of uncertainty about that [since] there has been downward pressure on long-term interest rates in recent years [that we] do not fully understand.”34 However, Mr Hughes stated that low interest rates “is not something that you would want to base Government policy on in the longer term, if you look back at the broad sweep of history.”35

34.Long-term shifts in the tax base, related to trends including globalisation, digitisation, ageing demography and a rising wealth-to-income ratio (which in itself puts pressure on inequalities of income), also present a long-term challenge to the public finances. These are explored in the following chapters of this Report.

35.The OBR were not able to tell us at what level the public debt ought to be stabilised, nor at what level, if any, public debt undermines economic growth or Government’s ability to borrow. Mr Hughes told us:

On the question of the danger level of debt, many people much smarter than I am have got themselves into trouble by naming particular figures, including Reinhart and Rogoff saying 90% of GDP was the threshold beyond which Governments face debt spirals because of rising debt stocks and rising interest rates.36 We clearly have not seen that with the projections in the aftermath of the coronavirus shock. That comes back to the fact that interest rates have been very accommodative, and markets have enabled Governments to finance their debts at historically low interest rates.37

36.Despite these uncertainties, independent witnesses agreed that the public finances were on an unstable trajectory in the long term, and that future Governments faced a dilemma between raising additional revenue, limiting rises in age-related public spending and provision, raising private age-related spending, and/or limiting rises in other public spending. Mike Brewer, Deputy Chief Executive and Chief Economist at the Resolution Foundation, told us:

The OBR report is not a forecast; it is really illustrating that there are long-run pressures in providing the sort of health, social care and pensions that we are used to now to our population over the next few decades. Something’s got to give somewhere. We either need substantial tax rises or we need to provide less good health and social care and pensions, or the population have to pay more themselves. That is really what the OBR is telling us.38

Philip Booth described an unavoidable trade-off:

There are no really easy ethical options here, because promises have been made to future generations for which nothing was set aside in order to finance the promises of income, healthcare and all the rest of it [ … ] So you are in the position of either reneging on those promises, reducing spending in other areas, or taxing the next generation at very high rates [ … ] taxing the next generation in order to pay for the promises that were made in the past generation.39

37.Dr Gemma Tetlow, Chief Economist at the Institute for Government, warned that limiting rises in non-healthcare public spending had been done in the past but would be more difficult in future:

[The] way we have paid for extra spending on healthcare has typically been to squeeze other areas of public spending. We squeezed defence spending through the 1980s. We have squeezed education spending at some points, police spending at other points. So far, we have just found it elsewhere rather than cutting back the offer on healthcare, but I think it is a political choice for future Governments what we offer.40

38.When asked whether he agreed that the Government’s current long-term fiscal commitments were unsustainable, the Financial Secretary to the Treasury said:

We look to the OBR to tell us what the debt position is going to be and, of course, it is reflective of a set of policy assumptions, and those assumptions themselves may change. There is no doubt that the levels of debt and borrowing are sources of continuing concern and importance to Treasury officials, and certainly to Ministers.41

39.The Financial Secretary also acknowledged the opportunity and challenge in using the FSR as a tool to hold Governments to account:

The joy of having the OBR’s forecasts now is that we have a 50-year planning basis on which to make an assessment of these policies and, ultimately, to hold Governments to account.

[ … ]

You run up against the fundamental problem in our constitution, which is that no Parliament can bind its successors, so the key is to evolve a culture between parties and within our public administration [ … ] that is frugal in regard to the long-term fiscal effects of policy.

40.The Chancellor’s official response to the 2020 Financial Sustainability Report was a 300-word statement to the House that promised “further details on its plans to put the public finances back on a sustainable footing over the medium-term at the next Budget.”42

41.The public finances are on an unsustainable long-term trajectory. This is due primarily to projections of rising age-related spending based on existing Government commitments. This situation is being exacerbated by the fiscal impact of the coronavirus pandemic. Even in the most optimistic scenario, the current and future UK Governments face a dilemma: if public spending and revenues are not to diverge without limit, either the former must be restrained or the latter must be raised.

42.The Office for Budget Responsibility has been stating that the public finances are on an unsustainable long-term trajectory since 2011, but the Government has not done enough to engage with the issue. The Government should routinely produce a more extensive and considered response to the Fiscal Sustainability Report than the 300-word statement it provided in 2020. Such a response should set out a strategy for how and at what level the public debt could and should be stabilised. To support this process, the Committee intends to carry out full scrutiny of the biennial Fiscal Sustainability Report in future, as it did for the first time in 2020.

Scope for raising additional tax revenue

43.Tax revenues as a share of GDP in the UK stood at a little below 34 per cent of GDP prior to the outbreak of coronavirus. This was the highest level since the early 1980s, although not greatly above the average since 2000 of 33 per cent of GDP and the post-war average of 32 per cent. Prior to the outbreak of coronavirus, the OBR forecast that the taxation-to-GDP ratio would edge up a little further over the forecast period. The near-term future for public revenues is now far more uncertain, but the OBR projects that taxation will be around 34 per cent of GDP in 2025–26.43

Figure 4: UK aggregate tax revenues (% of GDP, OBR forecast from 2020–21)

Source: OBR, Public Finances Databank—January 2021, 28 January 2021

44.Some evidence submitted to us said that the overall levels of taxation had reached or surpassed the point at which higher rates would reduce economic growth and/or reduce levels of taxation by reducing taxable economic activity—the latter would mean that overall tax rates were past the peak of the theoretical “Laffer curve”.44 Philip Booth told us that he thought that the UK was past the point where rises in overall tax rates would reduce growth but not yet past the point where they would reduce tax revenues:

[You] damage the economy with a tax system a long time before you get to the point at which you cannot raise any more taxes. [Some politicians believe that] “If we tax any more, we’ll end up raising less revenue because of the impact on economic growth.” That may not yet be the case where we are currently in terms of tax revenue, but you are doing an awful lot of damage before you get to that point by raising taxes in any case. [ … ] You could go higher, but only with a much better-designed tax system.45

45.Other witnesses were more optimistic about the UK’s ability to raise additional taxation without significantly hampering growth, should the Government want to do so.46 Paul Johnson observed that tax levels in the UK were currently below the levels of certain other advanced economies:

[Our] tax take is significantly below that of many other countries [ … ] in the old European Union [ … ] So that does indicate that it is possible to run a pretty effective and efficient economy with a higher tax burden than the UK currently has. [ … ] I wouldn’t necessarily agree with the statement that we are at the limit of taxable capacity.

Dr Gemma Tetlow said that it is unclear that a single growth-maximising level of taxation exists:

My reading of the economic literature is that the relationship as between overall tax levels and growth is very murky. There is no clear evidence that there is a growth-maximising level of tax, not least for the reasons we have talked about: it matters how you tax, not just the total level you are taxing at.47

46.Beth Russell, Director General of Tax and Welfare at HM Treasury, confirmed to us that the Treasury works on the assumption that the UK is not at or past the point at which tax rate rises (cuts) would lower (raise) revenue:

[It] is for the OBR to certify and agree the costings for any tax cuts or tax rises, but [ … ] we would not expect that any tax cuts would, in effect, pay for themselves. The OBR would be expecting tax cuts to cost money.48

47.Notwithstanding their views on the overall taxable capacity of the UK, witnesses agreed that reform of the tax system was desirable, that the case for it would be greater if taxes were to rise, and that tax rises could be focused on taxes that are less distortionary and less damaging to growth. Mike Brewer, Deputy Chief Executive and Chief Economist at the Resolution Foundation, told us:

[The] large deficit means that you should look really carefully at those parts of the tax system where you are taxing apparently similar things differently, because that is what causes distortions and a reduction in overall economic activity. [ … ] Ultimately, we have to raise taxes somehow, so it is really a question of finding the ones that do the least damage to the economy, rather than hoping for ones that would actually be good for growth.49

Ms Tetlow said that broadening the tax base could be a less distortionary way of raising revenue:

There are current problems with the tax system which create distortions to economic behaviour and therefore may discourage economic growth. Simply increasing the rates of existing taxes runs the risk that you increase those distortions. For that reason, I would [think] about broadening the base of some of these taxes rather than just increasing the rates, which has tended to be what Governments have liked to do in the past.50

48.Witnesses also emphasised that any programme of tax rises and/or tax reform in the aftermath of the pandemic would be best announced and planned as part of a long-term strategy. Professor Booth told us:

If you are going to make significant policy changes that put our tax system on a better footing, it is best to at least announce that, if not implement it, sooner rather than later, because there is going to be a very large adjustment in economic activity. [ … ] You do not necessarily have to implement it immediately, but the thinking and the planning should be done very quickly.51

Ms Tetlow warned against resorting quickly to the most politically palatable tax measures:

The OBR central scenario for July suggests that Covid may well have knocked a hole of about £60 billion in the finances in the medium term. That is a huge number and trying to announce a package of tax measures to fill it would be significant, and the public has not really been talked through the necessary tax rises. Trying to announce specific measures quickly runs the risk of ending up being backed into a corner of introducing the most politically feasible tax changes, which [ … ] are often not the most sensible economically in terms of tax changes.52

49.The evidence submitted to this inquiry generally supports the proposition that the UK is able to raise taxation as a share of GDP and raise additional tax revenues. However, there is also a need for reform of the tax system.

50.The public finances are on an unsustainable long-term trajectory that has been exacerbated by the coronavirus pandemic. Additional tax revenue could make a contribution to addressing this. But the tax measures that are most politically palatable in the short term are often not those that minimise distortions to economic activity in the longer term. This is a large-scale and long-term challenge that requires taking a view of the whole tax system, how it can be reformed, and how it can raise revenue in a way that minimises economic damage as well as effectively supporting public services, which can in turn promote growth. As part of its recovery from the coronavirus pandemic, the UK has an opportunity for a comprehensive review and reform of the tax system.