OBR warns of breakdown in fiscal discipline, recession risk

The Office for Budget Responsibility (OBR) has warned that a no-deal Brexit could see public borrowing doubling to some £60m next year, with the risk of recession increasing sharply

The independent scrutiniser of government finances says in its latest fiscal risks report that continuing Brexit uncertainty means policy risks to the public finances in the medium term are significant and look greater than they were two years ago.

For the first time, the OBR has used a stress test to illustrate the potential fiscal impact of a no-deal, no-transition Brexit scenario set out by the International Monetary Fund (IMF) in its April 2019 World Economic Outlook.

It says this scenario is not necessarily the most likely outcome and is relatively benign compared to some (for example, assuming limited short-term border disruptions). However, it still adds around £30bn a year to borrowing from 2020-21 onwards and around 12% of GDP to net debt by 2023-24, compared with the OBR’s March forecast baseline.

The OBR says a more disruptive or disorderly scenario could hit the public finances much harder.

It points out that heightened uncertainty around Brexit and declining confidence deter investment, while higher trade barriers with the EU weigh on exports. Together, these push the economy into recession, with asset prices and the pound falling sharply. In its model, real GDP falls by 2% by the end of 2020 and is 4% below its March forecast by that point.

Overall, the report states that short-term cyclical risks appear to have risen this year. The latest data and surveys suggest the economy flatlined at best in the second quarter. Some of this is likely to be a ‘pay-back’ after Brexit-related stock building in the first quarter. But surveys were particularly weak in June, suggesting that the pace of growth is likely to remain weak. This raises the risk that the economy may be entering a full-blown recession.

Higher trade barriers also slow growth in potential productivity, while lower net inward migration reduces labour force growth, so potential output is lower than the baseline throughout the scenario (and beyond). Lower receipts – in particular income tax and NICs (due to the recession) and capital taxes (due to weaker asset prices) – explain most of the deterioration.

These are partly offset by lower debt interest spending (thanks to lower interest rates and RPI inflation) and the revenue raised customs duties (which are treated as EU rather than UK taxes in the baseline). Higher borrowing and the assumed rollover of Term Funding Scheme loans leave public sector net debt around 12% of GDP higher than the March forecast by 2023-24.

Aside from its Brexit forecasts, the OBR also sounds caution about apparent changes in the government’s fiscal policy.

The OBR’s report states: ‘In his recent statements the current Chancellor has all but abandoned the government’s legislated objective to balance the budget by the mid-2020s.

‘And the £27bn a year NHS settlement announced in June 2018 – unfunded, unaccompanied by detailed plans for reform and outside the normal timetable for spending decisions – has cast doubts over the Treasury’s usually firm grip on departmental spending.’

It goes on to warn that additional tax cuts or spending increases would push government borrowing and debt up from the levels expected in its forecasts, and cautions ‘there is no war-chest or pot of money set aside that would make a free lunch’.

The report points out: ‘The remaining Conservative leadership contenders have made a series of uncosted proposals for tax cuts and spending increases that would be likely to increase government borrowing by tens of billions of pounds if implemented.

‘So all the signs point to a fiscal loosening and less ambitious objectives for the management of the public finances.’

Fiscal Risks Report July 2019

Pat Sweet | 19-07-2019

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