What the new PM could, should and should not do

• The new Prime Minster should acknowledge the size of the economic crisis, announce measures to shelter households and businesses from it, leave the Bank of England’s mandate largely unchanged, create a more constructive relationship with the EU and develop a long-term plan to boost productivity growth.
• On Monday 5^th September we will find out whether Liz Truss or Rishi Sunak will become Prime Minister the following day. We are hosting a “Drop In” webinar for clients at 4pm BST on the Monday to discuss the implications for the economy. (Register here.) The main issues fall into one of four categories.
• 1. The economy and fiscal policy. We don’t think the new Prime Minister and their Chancellor will be able (or willing to spend the funds necessary) to prevent the recent surge in inflation to a 44-year high from triggering a recession. We think the economy is already in recession and that GDP will fall by around 1% from its peak to its trough. (See here.) But there are three things they can do.
• First, acknowledge that this crisis is potentially as significant as the Global Financial Crisis and the COVID-19 crisis and that, as a result, a big package of support is necessary to prop up households and businesses. That’s the best way to ensure that once the crisis is over, the economy doesn’t grow at a slower rate forever more. The government has already provided support worth £37bn. But to put things in context, we estimate that without any extra support, real household disposable incomes will be around £100bn lower in 2023 than they were in 2021. That’s equivalent to around 4% of GDP.
• Second, quickly implement measures that support households and businesses. Table 1 shows the main policies that Truss and Sunak have pledged on the campaign trail, their cost and their potential influence on GDP based on the Office for Budget Responsibility’s (OBR) fiscal multipliers.
• Truss has focused on reversing April’s 1.5% rise in National Insurance contributions and cancelling the rise in the main rate of corporation tax scheduled for next April. Those two measures would cost an average of £12.6bn and £13.1bn respectively per full year and each add something like 0.2% to GDP. She’s also said there would be immediate support for households to cope with higher utility bills, but has not specified what form this would take. There are rumours she’s considering cutting VAT for one year, perhaps from 20% to 15%, and raising the threshold above which workers start paying income tax. Those measures would cost an average of £7.4bn and £38.0bn respectively per full year, and perhaps add around 0.1% and 0.6% to GDP. If we also include her pledge to raise defence spending, in total these measures would cost around £49bn per full year and add about 1.3% to GDP, albeit not all in one year.
• Sunak has pledged to further lower the rate of income tax. It’s already scheduled to be cut by 1p cut to 19p in 2024/25 and he’s said he would cut it to 16p by 2029. Every 1p cut costs £6bn per full year and could add about 0.1% to GDP. He’s also pledged extra cost-of-living support worth just under £10bn, made up of a 12-month decline in the VAT rate on utility bills from 5% to 0% and £5.0bn of handouts, which together may add around 0.2% to GDP. In total, these pledges may cost £5.7bn per full year and add around 0.3% to GDP.
• Even if Truss and Sunak implemented all the measures they have pledged (we’re assuming that extra support of around £30bn will be announced) that’s only going to offset a small part of the drag on the economy from high inflation. What’s more, most of the measures they are contemplating won’t get the money to those who need it most. So we wouldn’t be surprised if the new Prime Minister is also considering increasing payments to households receiving universal credit and providing cheap loans to some businesses.
• Some of the potential policies have the added benefit of lowering the measured rate of inflation. That would mean the government’s debt servicing costs are lower than otherwise (which would cover some of the cost of the policy) and it may also mean there are fewer second-round effects on inflation expectations and wage growth, which all else equal may mean the Bank of England doesn’t need to raise interest rates as far.
• A cut in the VAT rate from 20% to 15% would mean that CPI inflation is about 2 percentage points (ppts) lower than otherwise for 12 months, although it would mean inflation is 2 ppts higher than otherwise in the 12 months after the VAT reverts to 20%. A reduction in the VAT rate on utility prices from 5% to 0% for one year would reduce CPI inflation by just 0.2 ppts for the first 12 months and raise it by 0.2 ppts for the second 12 months. The proposals of Labour and some of the energy companies to freeze the Ofgem utility price cap at £1,971 rather than increase it to £3,549 on 1^st October would reduce inflation by around 4 ppts in the first 12 months.
• Third, the new Prime Minister needs to acknowledge that they can’t have it all and that this economic crisis is reducing the ability to cut taxes further ahead (without corresponding cuts to spending). Indeed, if the OBR were to update its economic forecasts, we think it would conclude that a lot of the “fiscal headroom” has already been wiped out before any new policies are announced.
• At the time of the Budget last March, the OBR said that the government would meet the main fiscal mandate (for the underlying debt to GDP ratio to be falling in three years’ time, i.e. in 2024/25) with £27.8bn (1.0% of GDP) room to spare (“fiscal headroom”) and meet the supplementary fiscal rule (for the current budget to be in balance in three years’ time, again in 2024/25) with a margin of £31.6bn (1.2% of GDP). If the OBR were to update its economic forecasts, we think it may conclude that the fiscal headroom has been reduced to around £9bn (0.4% of GDP) and that the breathing room against the supplementary fiscal rule has been trimmed to about £25bn (0.9% of GDP).
• This means that most of Truss’ individual policies would be enough to wipe out the remaining fiscal headroom. Indeed, the second column from the right in Table 1 shows that reversing the National Insurance rise and cancelling the scheduled rise in corporation tax would cut the fiscal headroom by £11.6bn and £15.5bn respectively. In total, the main policies of Truss could worsen the fiscal headroom by £42.3bn (1.5% of GDP). Since Sunak’s policies are much smaller, they would hardly turn the dial.
• Of course, the Prime Minister and their Chancellor could just suspend the fiscal rules for the duration of the crisis or rewrite them. Indeed, the law permits the Chancellor to suspend the fiscal mandate and supplementary targets “in the event of a significant negative shock to the UK economy”. And previous fiscal rules have been broken and changed all the time. (See here.)
• But the key point is that the new Prime Minister should acknowledge that the situation has changed, that there is less room to cut taxes than before and that at some point either spending may need to be cut or taxes may need to rise. This may mean that once in office, both Truss and Sunak back away from some of the pledges they have made on the campaign trial. And it is possible that the comment by Truss that if she were Prime Minister there would be “no new taxes” will come back to haunt her.
• 2. The Bank of England’s mandate. Because this economic crisis is being caused by high inflation and the Bank of England’s job is to keep inflation at 2.0%, it’s easy to understand why Truss has said she would review the Bank’s mandate. (Sunak has said he would leave it alone.) Truss has not specified her intention, but it’s been suggested she’s considering replacing the inflation target with a target for the growth rate of nominal GDP or the money supply.

• While it is clear in hindsight that the Bank kept monetary policy too loose for too long during the recovery from the pandemic, it’s not clear that inflation would have been lower if there were a nominal GDP or money supply target. In fact, nominal GDP targeting would have required a larger policy stimulus during the pandemic since the rate of nominal GDP growth fell by more than inflation. And while money supply growth surged during the initial phase of the pandemic (reflecting the restarting of quantitative easing), it has slowed in recent quarters. There are other problems too, including that the nominal GDP data are released later than the inflation figures, the nominal GDP data are regularly revised (the CPI inflation data are not) and that there is not a reliable relationship between the growth of the money supply and inflation.
• And at a time when inflation is five times the 2% target, it would make more sense for the government to emphasise the importance of the inflation target. If the new Prime Minister cast doubt over the longevity of the inflation target, that may only boost inflation expectations and keep inflation higher for longer. There are some small tweaks to the Bank’s mandate that may prove useful, but the new Prime Minister should double-down on the inflation target. (See here.)
• 3. Relations with the EU. By lowering the pound, contributing to the reduction in the supply of labour that has supported wage growth and holding back UK exports, Brexit has played a part in the rise in inflation and the weakness of the economy. Both Truss and Sunak support the bill to overwrite parts of the Northern Ireland Protocol. But the rumours that Truss is considering triggering Article 16 of the Brexit agreement suggests that she would adopt a more combative stance in negotiations than Sunak. That would increase the risk that a bigger falling out between the UK and the EU leads to higher tariffs and perhaps even the suspension of parts of the Brexit deal. (See here.) By putting more downward pressure on the pound, that would only add to inflationary pressures and would presumably further hold back UK exports.
• Instead, the new Prime Minister should take the opportunity to reset relations with the EU and take a more constructive approach to negotiations. A more cordial working UK-EU relationship would surely help the UK attract suitable labour from the EU and aid UK exporters in the medium term. That said, we’re not holding our breath as this is one of those areas where the politics clash with the economics.
• 4. Boost long-term productivity growth. The holy grail would be a Prime Minister that has an actual plan, rather than just the buzzword of “levelling up”, to boost the growth rate of productivity in the long term. A good start would be to address two areas. First, the Prime Minister should aim to directly boost the UK’s worryingly low investment rate by committing to long-term public investment plans that have broad cross-party support. That should include investment in green technologies and in energy and food security. This in itself could spill over into more private investment. Over and above that, there may also be a role for public-private partnerships in stimulating private investment and more tax credits for tangible and non-tangible private investment.
• Second, the Prime Minster must find a way of providing reassurance to companies over the future and creating an environment conducive to more private investment. This is where all the key issues highlighted in this note come together and work in the same direction.

• Overall, the new Prime Minister will take over at a critical time for the economy. Their polices and plans will determine the depth and length of the recession and the rate at which the economy can grow after the crisis. The leadership campaign has highlighted an abundance of policies the new Prime Minister could implement. We think they should quickly announce a large package of support to help those households and businesses that need it most and they should acknowledge that the crisis limits the scope for tax cuts further ahead. They shouldn’t cast doubt over the longevity of the Bank of England’s inflation target, worsen relations with the EU or neglect the long-term aim of boosting productivity growth.

Paul Dales, Chief UK Economist, +44 (0)7939 609 818, paul.dales@capitaleconomics.com
Ruth Gregory, Senior UK Economist, +44 (0)20 7811 3913, ruth.gregory@capitaleconomics.com
Nicholas Farr, Assistant Economist, +44 (0)20 7808 4080, nicholas.farr@capitaleconomics.com