How fiscal headroom has come to dominate Westminster and why it could decide the next election
“Fiscal headroom”. It is a desperately boring term, meaningless to many. Yet this bit of economic jargon may well have the power to swing the next election.
It is thanks to fiscal headroom that the chancellor may be able to splurge on billions of pounds of tax cuts in the coming months, hoping to lift the Conservatives’ sagging polls. It is on the basis of “fiscal headroom” that Sir Keir Starmer will decide whether he can go ahead with his much-vaunted plans to invest untold amounts in Britain’s energy sector.
All of which raises a rather important question – what is fiscal headroom anyway?
Happily, the explanation is quite simple. When politicians talk about fiscal headroom they are mostly talking about something quite specific; the room they have to spend money before they break their fiscal rules.
Ever since Gordon Brown, successive chancellors have imposed rules to discipline their borrowing. These rules have changed over time – mostly when the chancellor of the day realised he was about to break them. Today’s chancellor, Jeremy Hunt, has a few such rules but the most important one – the one he and pretty much everyone pays most attention to – is the rule about the national debt.
This rule states that he has to show that he is bringing down Britain’s net debt (in other words, the amount the state owes) as a percentage of gross domestic product (GDP) within five years.
There is plenty of logic in trying to keep the national debt under control. While there’s no hard and fast rule about precisely what level of debt is “safe” or not, there are many episodes throughout history of countries getting into big economic trouble when they allow their national debt to rise too high (since it often means higher debt interest payments, which can spiral out of control).
The fiscal equivalent of St Augustine’s prayer
But it’s also worth pointing out at this point that this rule is actually a lot less strict than it might at first sound. It’s not saying “bring the debt down immediately”. It’s saying “you can absolutely increase the national debt if you want to, provided it looks like it’s on the way down five years from now”. It is the fiscal equivalent of St Augustine’s prayer: “Lord, make me good. But not yet.”
And the current government plans aim to do precisely that. The figures in last November’s autumn statement show that its preferred measure of the national debt (there are many – don’t ask) actually rises in the coming years, from 90.2% of GDP in 2023/24 up to 95% of GDP by 2026/27.
Only in the following years does it start to fall, quite gradually, to 94.9% of GDP in 2027/28 and then to 94.4% of GDP in 2028/29. And, since it’s falling, the debt rule is met. Hurrah!
If at this point you’re still following, you’ve probably noticed a few things.
First, these supposedly strict fiscal rules aren’t actually stopping the national debt from rising. It’ll be considerably higher in five years’ time than it is today.
Second, the rate at which the debt is falling towards the end of this decade is actually quite slow.
Third, we seem to be fixating quite a lot on a couple of years (the difference between 2027/28 and 2028/29) which are a long way away, way beyond the government’s current spending plans.
And you’re right on all three. But no matter, because if all you care about is fiscal headroom, all that matters is the difference between those two figures, 94.9% of GDP and 94.4% of GDP. And that difference works out, in actual money, at about £13bn.
A made-up rule
Now, I could have easily skipped the preceding paragraphs and begun this article with this fact. Headroom equals £13bn. That, after all, is what most of Westminster does.
But every so often context can come in useful, and in this case the context underlines something important. Namely, that headroom is not an immutable law of economics. It is the product of a self-imposed rule. It is, to put it more bluntly, made up.
But this made-up number has an enormous bearing on economic policy right now. Since both the Conservatives and Labour have adopted the same fiscal rule, they also find themselves having to bend their knee to the god of headroom.
Jeremy Hunt says he won’t spend any more than the headroom he has at the next budget. Which, to translate, means he’ll probably spend nearly all the billions of headroom he has. Rachel Reeves says while she would like to invest £28bn on green energy technology projects, she won’t do it if it breaks the fiscal rules.
So the questions of how many tax cuts the chancellor offers this year and how much Labour will invest in the energy transition both hang on this made-up number. Indeed, the two things are related, since if Mr Hunt splurges a lot in the coming months, there’s no headroom left for Ms Reeves if she gets into office.
One of the single most important numbers in politics
Some would say this is all a bit silly. And they might just have a point. But since both main parties have agreed to respect this concept of headroom, it is among the single most important numbers in politics right now.
Yet here’s the other thing. What looks like a monolithic number is actually changing all the time. Since “fiscal headroom” is actually the difference between two other big numbers (the national debt four years hence, minus the national debt five years hence) which change quite a lot when the economy gets bigger or smaller or taxes come in faster than expected, it has a tendency to yo-yo around from one year to the next.
Consider this – last March, the Office for Budget Responsibility (OBR) was saying the amount of headroom was a mere £6bn. Not much, in other words.
But then, at the autumn statement, we learned that the public finances turned out to be in a better state than expected. That, plus the fact that there was an extra year until the deadline, increased the potential headroom by nearly £25bn in one fell swoop. So what looked like £6bn in headroom actually turned out to be £31bn of headroom.
All of which is why the chancellor was able to splurge £18bn in November (on those National Insurance cuts) and to leave us still with a supposed £13bn headroom this time around.
And something similar is likely to happen again when we get to March’s spring budget. The public finances are looking a bit healthier than expected. This morning’s public finance figures showed the deficit and debt interest payments were both lower than anticipated.
The upshot is that most economists think that £13bn of headroom could actually be anywhere up to £23bn. So there’s more money for the chancellor to spend, should he see fit.
It’s possible that at this point your head is spinning. Perhaps you’re wondering why on earth Westminster is tying itself in knots to stay true to a fiscal rule which was only made up a few years ago. Perhaps you’re wondering why the future of this economy hangs not on the question of the smartest long-term policy but on the difference between a few decimal places on a spreadsheet produced by the OBR.
These are all good questions. But mentioning them in Whitehall these days is tantamount to blasphemy. Trust, instead, in the creed of fiscal headroom. Everyone else is.
The UK economy unexpectedly shrank in May, even after the worst of Donald Trump’s tariffs were paused, official figures showed.
A standard measure of economic growth, gross domestic product (GDP), contracted 0.1% in May, according to the Office for National Statistics (ONS).
Rather than a fall being anticipated, growth of 0.1% was forecast by economists polled by Reuters as big falls in production and construction were seen.
It followed a 0.3% contraction in April, when Mr Trump announced his country-specific tariffs and sparked a global trade war.
A 90-day pause on these import taxes, which has been extended, allowed more normality to resume.
This was borne out by other figures released by the ONS on Friday.
Exports to the United States rose £300m but “remained relatively low” following a “substantial decrease” in April, the data said.
Overall, there was a “large rise in goods imports and a fall in goods exports”.
A ‘disappointing’ but mixed picture
It’s “disappointing” news, Chancellor Rachel Reeves said. She and the government as a whole have repeatedly said growing the economy was their number one priority.
“I am determined to kickstart economic growth and deliver on that promise”, she added.
But the picture was not all bad.
Growth recorded in March was revised upwards, further indicating that companies invested to prepare for tariffs. Rather than GDP of 0.2%, the ONS said on Friday the figure was actually 0.4%.
It showed businesses moved forward activity to be ready for the extra taxes. Businesses were hit with higher employer national insurance contributions in April.
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The expansion in March means the economy still grew when the three months are looked at together.
While an interest rate cut in August had already been expected, investors upped their bets of a 0.25 percentage point fall in the Bank of England’s base interest rate.
Such a cut would bring down the rate to 4% and make borrowing cheaper.
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Is Britain going bankrupt?
Analysts from economic research firm Pantheon Macro said the data was not as bad as it looked.
“The size of the manufacturing drop looks erratic to us and should partly unwind… There are signs that GDP growth can rebound in June”, said Pantheon’s chief UK economist, Rob Wood.
Why did the economy shrink?
The drops in manufacturing came mostly due to slowed car-making, less oil and gas extraction and the pharmaceutical industry.
The fall was not larger because the services industry – the largest part of the economy – expanded, with law firms and computer programmers having a good month.
It made up for a “very weak” month for retailers, the ONS said.
Monthly Gross Domestic Product (GDP) figures are volatile and, on their own, don’t tell us much.
However, the picture emerging a year since the election of the Labour government is not hugely comforting.
This is a government that promised to turbocharge economic growth, the key to improving livelihoods and the public finances. Instead, the economy is mainly flatlining.
Output shrank in May by 0.1%. That followed a 0.3% drop in April.
Ministers were celebrating a few months ago as data showed the economy grew by 0.7% in the first quarter.
Hangover from artificial growth
However, the subsequent data has shown us that much of that growth was artificial, with businesses racing to get orders out of the door to beat the possible introduction of tariffs. Property transactions were also brought forward to beat stamp duty changes.
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In April, we experienced the hangover as orders and industrial output dropped. Services also struggled as demand for legal and conveyancing services dropped after the stamp duty changes.
Many of those distortions have now been smoothed out, but the manufacturing sector still struggled in May.
Signs of recovery
Manufacturing output fell by 1% in May, but more up-to-date data suggests the sector is recovering.
“We expect both cars and pharma output to improve as the UK-US trade deal comes into force and the volatility unwinds,” economists at Pantheon Macroeconomics said.
Meanwhile, the services sector eked out growth of 0.1%.
A 2.7% month-to-month fall in retail sales suppressed growth in the sector, but that should improve with hot weather likely to boost demand at restaurants and pubs.
Struggles ahead
It is unlikely, however, to massively shift the dial for the economy, the kind of shift the Labour government has promised and needs in order to give it some breathing room against its fiscal rules.
The economy remains fragile, and there are risks and traps lurking around the corner.
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Is Britain going bankrupt?
Concerns that the chancellor, Rachel Reeves, is considering tax hikes could weigh on consumer confidence, at a time when businesses are already scaling back hiring because of national insurance tax hikes.
Inflation is also expected to climb in the second half of the year, further weighing on consumers and businesses.
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