Finance Minister Rishi Sunak had hoped that the end of the pandemic would produce a more predictable and stable economy. In reality, it meant supply shortages, rising inflation and exceptionally heavy pressure on households’ real disposable income. On top of that comes the shock of the war in Ukraine.

This week’s spring statement has therefore become an important test for Sunak. How should he comply? It is clear that neither he nor the Bureau of Budgetary Responsibility knows what will happen. But they do know the direction of travel. As a net energy importer, the UK could become as much as 1 percent poorer as a result of price changes. More broadly, inflation will be higher (possibly well above 8 percent) and output and real income lower than previously expected. This is a stagflationary shock.

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Not everything is bad news for Sunak. High inflation leads to higher nominal incomes and higher tax revenues. Meanwhile, cash spending constraints, including delays in benefit upgrades, mean sharp cuts in real spending. As a result, tax results will improve dramatically. Lending this fiscal year is expected to be about £23 billion (about 1 percent of gross domestic product) less than forecast by the OBR in October. The £25bn surplus in the current budget forecast for 2024-25 could now be between £45bn and £75bn. In addition, as Chris Giles argues, there is also an overwhelming case for a windfall tax on energy producers.

In short, barring an economic collapse caused by even bigger shocks, such as an outright energy embargo, the chancellor has room for fiscal manoeuvre. To decide what to do with it, he must distinguish between adaptations to permanent changes and temporary shocks. It is still likely that the jumps in energy and food prices and the downturn in activity will be temporary. Temporary damping is therefore the right approach.

Column chart of annual real growth in median non-retired household equivalised disposable income, net of housing costs (%) Pressure on UK living standards will be exceptionally severe

A first priority is to protect real government spending. There is no apparent reason for an unplanned return to austerity. A temporary rise in inflation should be offset by increases in department cash limits. Increasing benefits is particularly important. According to the Resolution Foundation, the value of most benefits will fall in real terms by 4.2 percent in 2022-2023, equivalent to a total cut of £10 billion. This is largely an unplanned consequence of delays in the inflation adjustment. But it will cause real hardship. It is not only wrong, but also foolish to let many millions fall into poverty.

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A second priority is to absorb increases in energy prices, especially for heating. Since the share of the poorest households’ expenditure on energy is about three times that of the richest households, aid should be concentrated there, most clearly by increasing universal credit. Sunak reportedly hates these perks. Maybe he thinks the recipients are bums, Labor voters, or both. That may be why his current plans to dampen the rise in energy prices take the form of a £150 council tax cut for a large number of households, plus a temporary £200 cut on electricity bills for all customers. This is grossly misdirected. It will also not be nearly enough, given the impact of the war in Ukraine.

A third priority could be to reduce the fuel tax for motorists. This may be a political necessity. But it’s hard to see that it has a high priority on the use of fiscal resources.

Finally, a number of permanent increases in expenditure must be taken into account. Aside from the well-known priorities of health and social care, defense is the obvious choice. UK spending is now certain to rise substantially and permanently.

Line chart of UK tax receipts (% of GDP) showing that the tax burden is now expected to rise to exceptional levels

Meanwhile, there is strong backbench pressure on the chancellor to abandon the planned increase in national insurance contributions. It would have been much better to increase the income tax more broadly. But there are two strong arguments for continuing. The first is that this tax increase is at least moderately progressive. The second is that it recognizes the reality that taxes must rise permanently in response to demographic and social pressures. The Tories hate being a tax raiser. But that was inevitable at some point. Given this, it might as well be done now.

But while the chancellor has to deal with the enormous pressures of today, he also has to look at the long term. The biggest problem for the UK remains bleak underlying productivity growth. The answers must include higher investment and more dynamic capital markets. One hundred percent investment tax credits, along with higher nominal corporate tax rates, should contribute to this, along with a shift to defined-contribution collective retirement plans.

Crises dominate today’s agenda. But chancellors should never ignore opportunities for longer-term reform.

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This post Rishi Sunak has short term challenges, but he also needs to look further ahead

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