Can we expect tax rises in the Budget?
The Chancellor, Rachel Reeves, has said that she’s going to raise public spending, perhaps by £16 billion or 0.6 per cent of GDP. She’s hinted that she’ll raise taxes to pay for it. I think the Chancellor has a little more wiggle room than most think, because the economy has performed better in the first half of this year than expected. In theory, she could raise public spending without having to raise taxes at all. But in practice, she’s likely to play the political game – raise taxes when it makes sense, and blame it on the previous government. Our view is that taxes and spending will increase, but that it won’t be a negative Budget for the economy overall.
How will the Budget affect the UK economy?
If our forecasts are right and if taxes rise by as much as spending, then it’s a bit of a push and pull. You’ll get more government spending, and higher taxes will reduce households’ disposable incomes, but overall it will more or less net out to leave the economy on a similar path. In fact, near-term increases in government spending tend to boost GDP more than tax increases reduce it. It might be the case that the Budget adds to economic growth in the short term.
Do you agree with the Chancellor that growth is the problem and investment is the solution?
Yes, I think that she’s right on that point. The UK has not invested enough over the past 15 years or so and that has played a part in its disappointing economic performance. Investment is one big lever you can pull to help improve productivity. The UK’s share of public and private investment is 5 percentage points of GDP lower than the average across other G7 economies. We are lagging but there is an opportunity for better investment, for two reasons. First, the Chancellor can tweak self-imposed fiscal rules to give her more scope for a big increase in public investment, perhaps about £15 billion worth. Second, there’s no obvious handbrake on investment as there has been over the past 20 years with the Financial Crisis, Brexit, the pandemic and the energy crisis. There are always unforeseen risks, but there doesn’t seem to be any obvious handbrake on investments just now. This means there’s an opportunity for private businesses to start investing. It won’t solve all the UK’s problems, but it will certainly help chip away at them.
What is your overall assessment of the UK economy over the coming year?
It’s reasonably optimistic. This year we think the UK economy will grow by around 1 per cent and in 2025 and 2026 by about 1.5 per cent each year. This is the normal level of speed that you’d expect from an economy like the UK at the moment. Interest rate cuts are part of the reason why we expect growth will improve but it is also about the drag on growth disappearing. Interest rates rose to 5.25 per cent in 2023 but the full effect on the economy still hasn’t come through. But over time – say the next 6-12 months – the drag on economic growth from higher rates will disappear. It is important that at a time when fiscal policy is being tightened, monetary policy is being loosened because you can put public finances on a more sustainable path. This is good for the long-term health of the economy.
Where are interest rates going to settle?
That is a big question. The key point here is that they’re not going to settle to the level that we were used to before the pandemic, when interest rates were essentially at zero for many years. Changes to the economy suggest the ‘normal’ rate of interest is going to be a little higher. Interest rates are still at 5 per cent, which is high by the standards of the past 20 years. But we didn’t suffer much of a recession, which suggests that the ‘normal’ rate of interest rate is higher than we previously thought. We estimate that interest rates will settle around the 3 per cent mark in a couple of years.
Do you expect further interest rate cuts in the US?
We have forecast the US labour market to continue to soften, rather than collapse or exhibit big cracks. This is consistent with interest rates being able to fall more, but slowly. We believe it’s most likely that the jumbo-sized 50-basis point cut in interest rates announced in September won’t be repeated. Instead, we expect a series of 25 basis point cuts, which might take the interest rate in the US from just below 5 per cent to around 3.5 per cent over the next year or so. The caveat is that if the US economy does start to crack, interest rates will have to fall faster.
How will the US presidential election result affect economic forecasts?
It feels like it could be a big fork in the road for the US economy from an economic point of view. Kamala Harris’s policies seem very similar to the policies of Joe Biden and so it will be more about the status quo continuing. Trump’s policies, however, could push the US down a different path altogether. The two that jump out are his plans to raise import tariffs and his plans to reduce immigration. The former would raise US inflation; the latter would reduce economic growth. If Trump were to win the election, we’d likely revise our inflation forecast and our GDP growth forecasts.
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