Lucky Labour

In my last blog, I returned to one of my favourite subjects: the poor forecasting record of the institutions charged with overseeing (and in the case of the MPC setting) the UK’s fiscal and monetary policy. My fundamental point is that if these vital institutions cannot properly forecast what will happen to the economy, we will all be disadvantaged by inappropriate policy settings. As a result, the UK economy won’t perform as well as it should.

Having said that, one “advantage” of the OBR’s persistent underestimate of the economy’s performance is that when growth (both nominal and real) turns out to be much better than forecast, the economy generates significantly more tax revenue than expected, which of course means that the incumbent administration then has a windfall which it can either use to reduce borrowing or, more likely, spend whilst sticking to the current trajectory of deficit reduction.

I will use a few numbers here to illustrate the point. First, the OBR’s forecasts. These are for calendar years 24 and 25 and cover inflation, as measured by the CPI and real GDP growth. They were last updated in March.

Next, the size of the UK economy. By the end of 2024, the ONS estimates that the UK economy's nominal GDP (by expenditure) will be just about £2.8trn.

Regular blog readers will know that the OBR’s forecasts for growth in 2024 are significantly too low, with the economy having delivered growth in Q1 alone of 0.7% and with growth accelerating to 0.9% in the three months to May. My best guess is that growth in 2024 will end up being above 1.5%, with the economy exiting the year at a growth rate of somewhere close to 2.5%. My forecast for 2025 is that the UK will deliver growth above 2.5% for the year, which might reach 3% with a following wind. (The key to this outcome will be a function of UK households’ savings decisions. If the savings ratio declines from its current elevated level, growth will come in at the higher end of this range).

I also think that the OBR’s inflation forecasts are wrong. In this case, they are too low. Based on what we know from the first six months of the year and what is likely to happen for the next six, factoring in the all-important base effects, inflation will average just under 2.5% this year and stay at about this level in 2025. So, when I compare my numbers to the OBR, they look like this:

In terms of nominal GDP (which drives tax revenues), if I am right, the economy will be 0.9% bigger at the end of 2024 than the OBR has forecast, and at the end of 2025, it will be just under 2.4% bigger. The only other number to factor in here is the tax share of GDP, which will change over time but is currently just over 40%.

For additional tax revenue (over and above what the OBR has forecast and assuming no change in tax rates), the numbers look like this:

2024	£2.8 Trn × 0.9% × 40% =	£10 Bn
2025	£2.9 Trn × 2.4% × 40% =	£28 Bn

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So, over the two years (2024 and 2025), the additional tax revenue the economy delivers over and above the OBR forecast is, therefore, £38bn, assuming no change in tax rates. As I said in a previous blog, based on these numbers, the black hole is not in the nation’s finances but in the OBR’s forecasts.

£38bn will, barring some sort of unforecastable event, present the incoming Labour administration with a significant windfall and enable it to fund a substantial number of its pre-election promises without the need to raise additional taxes. For the incoming Chancellor, who has described the UK as confronting the worst set of economic circumstances since World War Two, this might come as quite a pleasant surprise!

Instead of the “dire inheritance” that Rachael Reeves has described, it looks to me as if she will turn out to be the “lucky” Chancellor who inherits a significantly healthier economy than the consensus and the OBR have forecast and one that will deliver a very positive fiscal surprise. This should, in turn, allow this administration to fund many of its election promises without resorting to tax increases, which, given the current burden on UK taxpayers, would come as a very welcome development.

Napoleon is reported to have said that he preferred lucky generals rather than good ones. In today’s political world maybe we would all settle for lucky politicians, even if we can’t get really good ones.