Back in the red: why the UK faces a fiscal “black hole”

If you have a sense of déjà vu reading the title for this article, you aren’t mistaken – we’ve been here before. It was just over a year ago when the Chancellor, Rachel Reeves, revealed the contents of her red box to fill a touted £22bn fiscal “black hole” in public finances. 

In this article, we’ll explore some of the events over the last year that have led the UK’s public finances to a precarious position once more.

What is the fiscal “black hole”?

In its most basic form, the fiscal “black hole” is the difference between how much the government has coming in the front door through tax receipts, compared to how much it’s losing out the back door through spending. The bigger the deficit, the bigger the hole, and the darker the prospect gets; hence the name – the “black hole”.

The exact figure that measures the size of the hole is a moving picture. The latest estimates from economists sit at around £30bn, but this could rise further in the run up to the Budget over the next couple of weeks. The calculations are based on a number of assumptions and forecasts – which are imperfect at the best of times – especially over longer time frames of say, three to five years. 

Economic shifts and new data released can also change the outlook. For example, if the economy grows faster or slower than expected, this can dramatically shrink or grow the size of the hole – even to a greater extent than spending cuts or tax rises set to be announced at the end of November.

Why is Rachel Reeves facing another fiscal hole?

Come Budget day on 26th November, there’s likely to be a lot of finger pointing on who’s to blame for another fiscal gap in public finances – and the manifesto-breaking tax rises that might come as a potential consequence. The Labour government will be quick to pin the blame on the previous government and its policy decision-making – particularly around Brexit and austerity.

If truth be told, it’s probably a combination of policy decisions from the previous and current government, economic headwinds from Covid and Trump’s tariffs and potential changes to productivity forecasts; that arguably should’ve been downgraded sooner.

Productivity forecasts

The Office for Budget Responsibility (OBR) – the independent fiscal watchdog – will publish its official economic forecasts for the UK in tandem with the Autumn Budget announcement. Whilst the exact details of the report are still unknown, all eyes will be on the UK’s productivity growth projections.

Why does productivity matter? Productivity is a measure of how efficiently resources like the workforce and capital are used to produce goods and services. In layman’s terms, this means how much output each worker produce per day, or per hour worked. Higher levels of productivity can spur the economy to grow at a quicker rate, and/or require less workers to achieve the same level of output. The latter can improve the profitability of businesses and therefore boost tax revenues through corporation taxes.

On the other hand, low levels of productivity can lead to slower economic growth, lower tax receipts and higher borrowing requirements. Productivity has long been the Achillies heel for the UK. 

If the rumours on the grapevine turn out to be true, the OBR is expected to downgrade its long-term productivity growth forecasts by 0.3%. A figure that may seem insignificant, but it could equate to around £20bn in additional borrowing. Yet another fiscal headache for the Chancellor.

That being said, some other changes across the economic landscape could put a few coffers back in the Chancellor’s pocket. The OBR will soon outline its near-term outlook for wages, which have grown faster than expected over the last six months. Increased wages are good news for income tax receipts – a key piece of the pie that makes up around 25% of overall tax revenues.

Read more: when is the Autumn Budget?

Policy measures 

Unfortunately, economic factors aren’t the sole reason for the deterioration of the public finances since the last Budget. Policy choices made by the current, and previous, governments are undoubtedly a contributing factor too.

Toing and froing on welfare reforms, as well as the decision to reverse the plan to cut winter fuel payments, will add an additional £6bn to borrowing since the OBR’s last forecast in March. 

This week, Rachel Reeves hinted at removing the two-child benefit cap, which could cost an estimated £3.5bn. The two-child limit restricts certain benefits to two children in a family. This is different from the child benefit – which is paid to families where the highest-earning parent earns less than £80,000. These changes, if announced, will count for around a third of the touted £30bn “black hole”.

Rachel Reeves has also made it clear she wants more breathing space when it comes to her self-imposed fiscal rules. One of those rules is to cover day-to-day spending with revenues by the end of the decade. Sounds simple enough – but the reality is far from it.

Back in March this year, Reeves had around £10bn of fiscal “wiggle room”. That might sound like a lot, but by historical terms, it’s not much to shout about, and it’s left her exposed to the ups and downs of the OBR’s budget forecasts. If she can increase fiscal headroom by £5bn-£10bn that could calm jittery bond markets, bring down borrowing costs (currently running at over £100bn a year), and reduce the chances of her having to return to the table with additional measures at a later date. Sound familiar?

That said, creating extra space now might not be a priority as it means bigger tax rises in the Budget at a time when the government has made economic growth its number one priority. More taxes could put the brakes on that growth. All in all, it’s a delicate balancing act.

Read more: Reeves refuses to rule out rax rises in the Budget

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