It is going to be bad, very bad. But it could be worse, a lot worse.
In tomorrow’s Spring Statement, Rachel Reeves will be forced to plug a £15billion gap in the public finances with a swathe of state spending cuts to balance the books.
It wasn’t meant to be like this.
At the time of last Autumn’s Budget the Chancellor had hoped to be in ‘credit’ by this stage to the tune of £10billion – her so-called ‘fiscal headroom’.
Instead, her bombshell £25billion hike in employers’ National Insurance contributions slammed business confidence and stunted growth.
This caused government borrowing costs to soar and plunged the Government’s accounts into the red to the tune of around £5billion, as revealed in The Mail on Sunday.
She has ruled out further tax hikes – at least for now – and is claiming the ‘world is changing’, due to the confusion created by President Donald Trump on tariffs and other issues, as justification for slashing Whitehall budgets.
That, however, does not explain why the economy was already grinding to a halt before Trump took office in January.
Reeves, pictured before the Budget last autumn, has been warned that overly optimistic forecasts by tax and spending watchdog the Office for Budget Responsibility could be hiding a huge £45billion shortfall in the public finances
The black hole she is now scrambling to fill – as opposed to the fictional one the Chancellor accused her Conservative predecessor Jeremy Hunt of leaving her – is largely of her own making.
And, alarmingly, it may be even worse than it appears.
Reeves has been warned that overly optimistic forecasts by tax and spending watchdog the Office for Budget Responsibility (OBR) could be hiding a huge £45billion shortfall in the public finances. That figure comes from an analysis by experts at financial data provider Bloomberg.
Scarily, it is three times the size of the deficit OBR is expected to declare tomorrow.
So, can Reeves dodge this bullet and avoid further tax rises and spending cuts?
Or is the OBR merely putting off the evil day when even more punishing tax rises become inevitable unless elusive growth miraculously returns?
The £45billion black hole will emerge, experts fear, because the official estimates of how much productivity will grow in the next five years are so cheery they are, in the words of one economist, ‘starting to look insane’.
If this proves correct, then Britons will be hit with even more punishing tax rises on top of the biggest burden since the Second World War.
To understand what is going on, you need to consider the Chancellor’s supposedly ‘ironclad’ fiscal rules. These stipulate day-to-day public spending must be paid for by tax receipts, not borrowing.
Debt must also fall as a share of national income by the end of this Parliament.
The OBR checks the Chancellor’s tax-and-spend plans to see if her sums add up over the next five years.
To do this, it factors in things such as economic growth forecasts – the OBR is likely to halve its prediction to just 1pc for this year – along with the outlook for inflation, jobs and wages.
The influence of the OBR has grown since Labour came to power and it increasingly calls the shots on the Chancellor’s economic policies.
A crucial part of the OBR’s calculations is how much it thinks productivity is likely to grow – in other words, how much more efficiently we will, as a country, use our assets including labour and technology to produce more goods and services.
Strong productivity growth matters because it is needed to raise tax revenues sustainably. These in turn pay for public services like schools, hospitals and the military, where there are demands for higher spending.
Productivity – as measured by output per hour worked – has flatlined in recent years.
This is down to a lack of investment both in key public services such as infrastructure and transport and by the wealth-creating private sector, which has scrimped on training and new technology that would make workers more efficient. Productivity growth is now running at a dire rate less than a third of the 2.25pc annual rate recorded in the decade before the financial crisis.
But the OBR stands accused of painting an overly rosy picture of future productivity gains.
It is expected to stick to its view that output per person will rise from just 0.2pc in 2023 to 1.25pc in 2029 – which would be a huge increase.
The projected productivity leap will massively help Reeves meet her fiscal rules – though it will still leave her with just a tiny cash buffer if things don’t go her way.
But a different, darker picture emerges if the OBR’s heroic assumptions on productivity growth are set aside and we take a more realistic view – based on what actually happened over the last 15 years.
Assuming annual productivity growth continues at its current rate, which has been 0.5pc since 2010, the size of the economy would 3pc lower than the OBR and the Chancellor expect by 2029.
This would create a huge £45billion ‘fiscal hole’, according to the recent analysis by Bloomberg.
The OBR has been ‘consistently too optimistic about the scope for productivity growth to accelerate’ which presented a ‘big risk to the public finances in the medium term’, the report added.
It means Reeves and the OBR face intensifying scrutiny among City experts and on the financial markets about the underlying health of the economy.
Last month, Berenberg economist Andrew Wishart said official productivity estimates were ‘starting to look insane’.
Bank of England governor Andrew Bailey also has his doubts.
‘The story of growth is, I’m afraid, quite clear,’ he said this week. ‘It has slowed markedly in the last 15 years or so, and this has affected the advance of living standards.’
An ageing population and the rise of women in employment coming to a ‘natural end’ meant growth would not arise from more people working, he added.
Instead ‘some quite large technological advance’ such as artificial intelligence (AI) was needed restore growth to rates seen before the financial crisis.
Bailey had previously noted that the UK population and workforce had grown faster than previously thought, but economic growth had stalled.
‘We can only conclude mathematically that productivity has got much worse,’ he said last month. ‘It’s actually negative.’
The Bank’s view is considerably more downbeat than the OBR on productivity, seeing potential output per head rising by just 0.7pc in 2027.
The OBR’s own estimates are highly sensitive to even the slightest of changes.
Even a 0.5pc cut in annual productivity growth would raise borrowing by £40billion in 2028-29 – blowing Reeves’ fiscal rules out of the water.
‘Productivity growth is one of our most important and uncertain judgements,’ the OBR noted drily in a recent report.
In other words, this is finger-in-the-air stuff.
Its optimism on the UK’s output potential is based on the economy becoming more efficient over time from business and Government investment.
But its forecasts are also based on dodgy data, especially around employment activity.
‘Assessing the medium-term outlook for the economy (is) by no means simple,’ economists at investment bank Investec said.
With the threat of steep Trump’s tariffs hanging over the economy, experts say the economic outlook is grim – and it is only a matter of time before Reeves returns with more tax rises
‘Even the recent picture is in doubt, partly owing to the unreliability of data from the (official) Labour Force Survey,’ they added.
If employment growth was much weaker than what the latest official figures show then productivity growth is ‘less grim than it looks’, Investec said.
‘On the other hand, if the OBR was to build in a longer-lasting negative impact from current uncertainty on investment, this could limit the scope for future productivity gains,’ the economists added.
Prime Minister Keir Starmer has talked about a £45billion savings windfall as a result of automation and the introduction of AI.
‘The tricky thing, however, will be getting the OBR to score any such savings – without any firm plans,’ said Sanjay Raja, chief UK economist at Deutsche Bank.
‘Similar to (economic) growth, this is where the Treasury will need to do a lot more work over the summer to convince the OBR that further… savings can be found ahead of the next fiscal update,’ he added.
‘The onus is on Government to convince the OBR, especially with further downgrades to the economic outlook and public finances likely ahead of the autumn budget,’ Raja said.
With the threat of steep Trump’s tariffs hanging over the economy, experts say the economic outlook is grim – and it is only a matter of time before Reeves returns with more tax rises.
‘Britain’s public finances are operating under increasingly fine margins,’ said James Smith, economist at ING investment bank.
‘Cost-cutting can only go so far,’ he added.
‘Barring a surprise boost to UK growth this summer, we think further tax rises look inevitable in the autumn,’ Smith added.
So, if you think the Spring Statement is going to be bad, think again.
Unless growth surges back out of nowhere, you ain’t seen nothing yet.