What Chancellor Philip ‎Hammond should do now

Philip Hammond says the government’s fiscal policy might need a “reset” in the Autumn Statement, in the light of the changing economic outlook, the new government’s priorities and, of course, Brexit. What should such a “reset” consist of? Here’s what I suggest.

First, some key things should stay the same. George Osborne’s main fiscal achievement was in cutting government spending relative to GDP. He was targeting getting that down to around 36% of GDP by the end of this Parliament. We should stick to that target. In addition, Osborne planned for there to be budget surpluses, on average, over the foreseeable future so that government debt got down to a level giving us a buffer before the next time we have a 2008/9-style recession, which added some 40 percentage points to the government debt to GDP ratio. We should definitely stick to that. Adding 40 percentage points to debt to GDP is awkward when you start with 40% debt to GDP. If you do it starting at 80%, you rapidly turn into Italy.

When we turn to things that should change, obviously the deteriorating economic outlook means that George Osborne’s deficit projections for the next few years are unlikely to be met. He rarely met any of them himself, anyway, so that’s no surprise.

But we might as well note for the record that slower GDP growth over the next year or two is likely to mean a slower fall in the deficit. It might even mean a slight rise in the deficit, which there’s no particular need for us to fight with tax rises (at least insofar as it is only a rise in the cyclical deficit). There would be some limits to that, of course. We can be relaxed for now about a temporary deficit of 5% of GDP. We’d have to be much less relaxed if that were to rise to 10% of GDP.

A more interesting set of changes concerns how taxation and spending should be changed in the light of the UK. leaving the EU. That will mean quite significant budget shifts and some extra flexibility. A few examples of the budget shifts are the following.

– When we leave the EU, we will either be making no EU net contribution or a smaller one. We need to make some choices about what to do with that spending reduction. Do we just bank it (e.g. to partially offset any short-term reduction in taxation receipts as the economy slows)? Do we re-allocate it to new spending areas?

– As well as the net contribution, there is spending that the EU undertakes within the UK that the UK government will now have to decide whether to replace with UK government spending or to do without. The most significant part of that is probably the Common Agricultural Policy. That will obviously go when we leave the EU, but equally obviously it is very unlikely we would ask UK farmers to go “cold turkey” [get it?] and suddenly live without subsidies. There will almost certainly be some new British Agricultural Policy involving a system of rural payments that will need to be financed. The EU also provides various forms of regional support grant and research funding. The government will need to decide whether to replace these and, if so, with what.

– Leaving the EU will have implications for certain parts of NHS spending. In particular, about 8% of the UK’s drugs market comes from medicines sold more cheaply elsewhere in the EU that the NHS then buys as imports. (For nerds, this is called “parallel trade”.) For technical reasons, leaving the EU will probably mean either the end of parallel trade or a curtailing of it (nerds may be aware that EU parallel trade is connected with being in the EU’s “patent exhaustion” zone and leaving the EU will probably imply leaving that zone).

That means the NHS will probably face an increase in its drugs budget because of Brexit. The government must decide whether to ask the NHS to find offsetting savings elsewhere (and Brexit itself might potentially imply certain savings, e.g. associated with immigration flow changes) or to raise NHS spending to compensate.

One interesting area of additional flexibility concerns VAT. Governments of various hues have claimed they would have liked either not to charge VAT or to charge it at different rates from now on certain products (of which perhaps the best-known example is domestic fuel), but VAT is subject to certain restrictions by the EU. The government must decide whether it now really does want to change VAT in all those ways it claimed it wanted to but those nasty blighters in Brussels stopped it from doing so.
There are many deeper fiscal implications of Brexit over the medium-term, including in particular to customs and excise duties. But the above should be plenty to keep Philip Hammond busy by the Autumn.