What is the UK fiscal hole and what has contributed to it?

UK government officials normally avoid the phrase “fiscal hole” like the plague because it suggests ministers have lost control of the public finances and that nasty tax rises and public spending cuts are imminent.

Not this autumn: allies of chancellor Jeremy Hunt have said he is considering tax rises and spending cuts worth about £55bn a year, with one Treasury official warning that “after borrowing hundreds of billions of pounds through Covid-19 and implementing massive energy bills support, we won’t be able to fill the fiscal black hole through spending cuts alone”.

Government insiders have floated multiple ways of filling the hole in recent media stories. Some but not all of these will be implemented in the chancellor’s Autumn Statement on November 17.

What is a fiscal hole?

Paul Johnson, director of the Institute for Fiscal Studies, a leading think-tank, said almost everyone “rather skates over” the definition of a fiscal or budgetary hole.

It is not this year’s budget deficit, nor the level of public debt. Gemma Tetlow, chief economist at the Institute for Government, another think-tank, said that at its most basic, the fiscal hole represented “the gap [in the public finances] between where we are projected to be and where we want to be”.

That means the hole depends on the chancellor’s own definition of sustainable public finances.

Hunt has said that he wants public debt to be falling as a share of gross domestic product, and he is expected to give himself five years to meet that target.

To hit the goal, Hunt’s allies have said he is examining tax rises and spending cuts worth about £55bn a year by 2027-28, which would serve to reduce public borrowing and in turn cut the debt burden.

As part of filling the fiscal hole, Tetlow said the chancellor was likely to want to “build in some room for error because forecasts for public finances are uncertain”.

What factors have contributed to the UK budgetary gap?

Since the Treasury’s Spring Statement in March, almost everything that could go wrong has done so.

New forecasts by the UK fiscal watchdog due to be published alongside the Autumn Statement are expected to cut economic growth because high energy prices make a country like the UK, which imports fossil fuels, poorer.

On top of this, high inflation and interest rate rises increase the cost of government borrowing and welfare benefit payments compared with the March forecasts by the Office for Budget Responsibility.

The third issue is the government’s decision to spend tens of billions of pounds more on support for households’ energy bills, putting further pressure on the public finances.

Tetlow said the biggest contributors to the fiscal hole were “higher interest rates on government borrowing and a slowdown in the expected growth of the economy”, which would depress future tax revenues.

Much of this was common to the UK and other European countries, but Bank of England governor Andrew Bailey last week flagged “UK factors” raising British borrowing costs by more than other advanced economies.

This was a reference to how Liz Truss’s ill-fated “mini” Budget, involving £45bn of unfunded tax cuts, unleashed turmoil in financial markets and temporarily increased yields on government bonds compared with peer nations.

Johnson said: “An ironic consequence of the “mini” Budget . . . is that the Treasury will need to do more quicker to fill the hole than had the “mini” Budget never occurred because of the scale of the worry in financial markets.”

What influence do the government’s fiscal rules have?

The government’s existing fiscal rules state that debt as a share of GDP should be falling by the third year of the latest OBR forecast, and that the current budget should be in balance on the same timeframe. Hunt is expected to overhaul these by saying the targets should be hit after five years rather than three.

The OBR’s job is to “examine and report on the sustainability of the public finances”, and it does so primarily by issuing forecasts and comparing these with the fiscal rules.

Johnson said this role can be effective for three reasons. First, it sets out the government’s targets for future borrowing and debt. Second it ties the chancellor’s hands to independent forecasts so it is harder for the Treasury to fiddle the figures.

He added the third and “most important” reason was the power it conferred on the chancellor to negotiate internally in government and tell cabinet colleagues that their pet projects cannot be financed because they will breach the fiscal rules.

Not everyone is a fan of the rules, however. Jagjit Chadha, director of the National Institute of Economic and Social Research, another think-tank, said that “in a world when we’ve been hit by such large shocks such as Covid, energy and Brexit”, it made little sense to be trying to hit strict rules in five years.

“I’m not arguing for moving away [from fiscal rules], but for not trying to do [budgetary consolidation] too quickly,” Chadha added.

How will Hunt fix the public finances?

Hunt will shortly receive forecasts from the OBR revealing how big the hole is due to be when he wants to meet his main fiscal rule — most likely in 2027-28.

This figure is thought to be somewhere between £30bn and £40bn. On top of this figure, Hunt is expected to add so-called fiscal headroom of between £10bn and £15bn.

Hunt needs to put in place tax rises and spending cuts worth about £55bn a year, or a bit more, because as he seeks to lower borrowing and cut the debt burden, economic growth will be hit and therefore by extension tax revenues. This highlights how some of the budgetary measures may not ultimately help fill the fiscal hole.

Chadha said the last point was crucial in the design of fiscal consolidation. “It’s important in order to bring debt down that [the measures] don’t lead to policies that frustrate the economy doing its thing and growing.”