How big a fiscal hole is the British government in? With Paul Johnson

Episode Summary

Executive Summary: The episode examines Rachel Reeves’s mounting fiscal squeeze amid weak UK growth, higher debt-servicing costs, and new defence pressures. Paul Johnson of the IFS argues the government is already near its fiscal limits and will likely face a choice between more taxes, slower spending growth, or both—warning that muddling through with small fixes could damage credibility and the economy.

Main Topics: UK fiscal strain under Rachel Reeves (Priority: 5/5): Johnson rates the government’s fiscal trouble as severe but not yet crisis-level, saying borrowing, debt and weak growth are pushing the UK close to the edge of its rules. Stalled growth and weak forecasts (Priority: 5/5): The discussion centers on the UK’s prolonged low growth, the OBR’s likely downgrade, and how disappointing economic performance undermines tax receipts and public finances. Rising debt costs and market pressure (Priority: 4/5): Higher inflation and interest rates have raised gilt yields and debt interest burdens, making the UK’s already-high debt more expensive to finance. Defence spending as a new fiscal claim (Priority: 5/5): Trump-era uncertainty and pressure for higher European defence spending mean the UK may need to permanently reallocate resources toward defence. Tax rises vs spending cuts (Priority: 5/5): Johnson argues that permanent spending commitments, especially defence, cannot be funded by borrowing alone and will require either higher taxes or lower spending elsewhere. Political credibility and budget uncertainty (Priority: 4/5): He criticizes both Labour and Conservatives for unrealistic pre-election fiscal promises, warning that vague future plans create damaging uncertainty for business and households.

Key Arguments: The UK is in serious fiscal trouble, but not in an immediate default-type crisis; Johnson places it around 7–8 out of 10. Borrowing is moving in the wrong direction: instead of falling as projected, it is rising sharply, reflecting both higher spending and weaker revenue. Long-term low growth is a central problem because it reduces tax receipts and leaves average earnings far below where they might have been with pre-crisis growth rates. The OBR is likely to downgrade GDP forecasts, partly because its prior forecasts were optimistic and because global conditions, including US policy uncertainty, have worsened. The government’s pro-growth rhetoric has not been matched by enough concrete supply-side reforms to persuade the OBR that future growth will materially improve. Higher defence spending is now likely a permanent structural commitment, so it must be matched by permanent tax increases or spending cuts rather than borrowing. There is limited room to cut major spending items: aid has already been heavily reduced, health and pensions are politically protected, and local government/social care are already squeezed. If Reeves only barely meets her fiscal target, she risks months of speculation over tax rises in the autumn, which Johnson sees as economically and politically harmful. Johnson believes governments should be more upfront about hard choices rather than relying on implausible growth or efficiency assumptions. He worries future governments will continue to choose economically poor tax measures and incremental service cuts instead of making honest, politically difficult decisions.

Data Points: Current fiscal trouble rating: 7 or 8 out of 10 - Johnson’s assessment of the UK government’s fiscal position relative to crisis. Last March OBR borrowing projection: Borrowing expected to fall from about £120bn to less than £90bn - The forecast used by the Treasury last year. Actual borrowing trend: Borrowing expected to rise by around £30bn instead of falling - Johnson’s description of the turnaround from the OBR’s prior expectation. Monthly borrowing figure: £10.7bn - Borrowing reported for one recent month, about £4bn above expectations. Difference from expected monthly borrowing: About £4bn higher than expected - Illustrates the recent borrowing overshoot. Debt level: Close to 100% of GDP - The UK’s public debt burden discussed as a key constraint. Current UK tax burden: Highest level ever by UK standards - Johnson notes taxes are historically high domestically but still below some peers. Projected tax revenue rise: 4% to 5% of national income over the decade - He says this is an unusually large post-war increase in tax take. European defence target discussed: 3% of national income - Potential future UK defence spending level referenced as a likely policy goal. Potential extra funding for 3% defence target: About £15bn a year - Johnson’s estimate of what would be needed to move from current plans to 3%. Official current defence increase: Around 2.5% of GDP - Recent announcement described as an initial step rather than the final endpoint. Overseas aid level: 0.3% of national income - Johnson says aid has been cut to a historically low level. Debt interest across OECD: Higher in around two-thirds of OECD countries in 2024 - Used to show the issue is broad but especially acute in the UK. Long-run earnings gap: Average earnings could be about £10,000 a year higher - Estimate of what UK earnings might look like if pre-financial-crisis growth had continued. Departmental spending growth: Average 1.3% a year originally promised - The spending path likely to be revised downward to create savings.

Pivotal Quotes: "We’re sailing very close to the wind." — Paul Johnson: His summary of the UK government’s fiscal position. "The economy would be dramatically different if we’d grown at our pre-financial crisis rate for the last 17 years." — Paul Johnson: He explains how weak growth has harmed public finances and living standards. "If you’re meeting your fiscal target by a minuscule margin, you’re much better making the decision now about how you’re going to deal with that rather than leaving everyone wondering for months and years." — Paul Johnson: His advice to Rachel Reeves on how to handle the looming fiscal gap.

Implications: The UK likely faces a harder fiscal choice set: higher taxes, slower spending growth, or both. Businesses and households may face prolonged uncertainty unless Reeves makes clearer, earlier decisions on taxes and spending.