So far, the focus has been on the short-term implications for government borrowing. Rather than borrowing £ 55 billion in 2020/21, as predicted by the Office of Budget Responsibility before Covid, we are probably headed for an annual deficit of £ 350 billion. For the first time since the early 1960s, the size of public debt will exceed the size of the British economy.
The government should be relatively relaxed about the immediate increase in borrowing. It is able to repay its debt quite easily (largely thanks to the actions of the Bank of England) and the costs of servicing the debt remain low. But once we have gone through the immediate crisis, the persistence of high borrowing levels risks losing market confidence. If this happens, the pound will fall, the costs of servicing the debt will rise, and the country will face even more painful choices.
How much will we have to do to stabilize public finances? It’s hard to say with confidence at this point, as it will depend on how quickly we recover from the current crisis and the level of scars in the economy. But, as Carl Emmerson of the Institute for Fiscal Studies said, an estimate of a gap of £ 35 billion to £ 40 billion seems reasonable, even before taking into account the demands for increased public spending that he will be very difficult to resist.
Once we get through the economic shock caused by Covid-19, the government will have to fill this gap with tax increases or spending cuts. Unlike the situation in 2010, it is difficult to see that there are substantial savings to be made in public spending. The only obvious exception is the triple locking of pensions – if wages stagnate (or even fall) and inflation is negligible, it would be an act of intergenerational injustice to increase the state pension by 2.5% .
But it is clear that the tax increases will have to do most of the heavy lifting. To give an idea of the magnitude of the commitment, an increase of £ 40 billion would be equivalent to an increase of 7%. 100 of the basic rate of income tax or an increase of 6% in the standard rate of VAT.
The political challenge of raising taxes by the amount required will be immense. Any plan should be seen as fair – those with the broadest shoulders will bear the heaviest burden – but should not undermine our attractiveness as a place of investment and wealth creation. It is also not yet clear that the Conservative Party as a whole is reconciled with the reality that sound public finances will require higher taxes.
The time to implement these higher taxes can sometimes come to an end. However, to reassure the markets on its fiscal credibility and provide companies with certain certainty about the fiscal environment, Mr. Sunak will have to outline his strategy of raising taxes in the fall budget. It will be an even more difficult test than anything he has faced so far.