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 grew by 0.1% between July and September, according to the Office for National Statistics (ONS).
However, despite the small positive GDP growth recorded in the third quarter, the economy shrank by 0.1% in September, dragging down overall growth for the quarter.
The growth was also slower than what had been expected by experts and a drop from the 0.5% growth between April and June, the ONS said.
Economists polled by Reuters and the Bank of England had forecast an expansion of 0.2%, slowing from the rapid growth seen over the first half of 2024 when the economy was rebounding from last year’s shallow recession.
And the metric that Labour has said it is most focused on – the GDP per capita, or the economic output divided by the number of people in the country – also fell by 0.1%.
Reacting to the figures, Chancellor of the Exchequer Rachel Reeves said: “Improving economic growth is at the heart of everything I am seeking to achieve, which is why I am not satisfied with these numbers,” she said in response to the figures.
“At my budget, I took the difficult choices to fix the foundations and stabilise our public finances.
“Now we are going to deliver growth through investment and reform to create more jobs and more money in people’s pockets, get the NHS back on its feet, rebuild Britain and secure our borders in a decade of national renewal,” Ms Reeves added.
The sluggish services sector – which makes up the bulk of the British economy – was a particular drag on growth over the past three months. It expanded by 0.1%, cancelling out the 0.8% growth in the construction sector
The UK’s GDP for the the most recent quarter is lower than the 0.7% growth in the US and 0.4% in the Eurozone.
The figures have pushed the UK towards the bottom of the G7 growth table for the third quarter of the year.
It was expected to meet the same 0.2% growth figures reported in Germany and Japan – but fell below that after a slow September.
The pound remained stable following the news, hovering around $1.267. The FTSE 100, meanwhile, opened the day down by 0.4%.
The Bank of England last week predicted that Ms Reeves’s first budget as chancellor will increase inflation by up to half a percentage point over the next two years, contributing to a slower decline in interest rates than previously thought.
Announcing a widely anticipated 0.25 percentage point cut in the base rate to 4.75%, the Bank’s Monetary Policy Committee (MPC) forecast that inflation will return “sustainably” to its target of 2% in the first half of 2027, a year later than at its last meeting.
The Bank’s quarterly report found Ms Reeves’s £70bn package of tax and borrowing measures will place upward pressure on prices, as well as delivering a three-quarter point increase to GDP next year.
Business
Chancellor’s Mansion House speech vows to rip up red tape – saying post-financial crash rules went ‘too far’
Chancellor Rachel Reeves has criticised post-financial crash regulation, saying it has “gone too far” – setting a course for cutting red tape in her first speech to Britain’s most important gathering of financiers and business leaders.
Increased rules on lenders that followed the 2008 crisis have had “unintended consequences”, Ms Reeves will say in her Mansion House address to industry and the City of London’s lord mayor.
“The UK has been regulating for risk, but not regulating for growth,” she will say.
It cannot be taken for granted that the UK will remain a global financial centre, she is expected to add.
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It’s anticipated Ms Reeves will on Thursday announce “growth-focused remits” for financial regulators and next year publish the first strategy for financial services growth and competitiveness.
Rachel Reeves
Bank governor to point out ‘consequences’ of Brexit
Also at the Mansion House dinner the governor of the Bank of England Andrew Bailey will say the UK economy is bigger than we think because we’re not measuring it properly.
A new measure to be used by the Office for National Statistics (ONS) – which will include the value of data – will probably be “worth a per cent or two on GDP”. GDP is a key way of tracking economic growth and counts the value of everything produced.
Brexit has reduced the level of goods coming into the UK, Mr Bailey will also say, and the government must be alert to and welcome opportunities to rebuild relations.
Mr Bailey will caveat he takes no position on “Brexit per se” but does have to point out its consequences.
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Bailey: Inflation expected to rise
In what appears to be a reference to the debate around UK immigration policy, Mr Bailey will also say the UK’s ageing population means there are fewer workers, which should be included in the discussion.
The greying labour force “makes the productivity and investment issue all the more important”.
“I will also say this: when we think about broad policy on labour supply, the economic arguments must feature in the debate,” he’s due to add.
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The exact numbers of people at work are unknown in part due to fewer people answering the phone when the ONS call.
Mr Bailey described this as “a substantial problem”.
He will say: “I do struggle to explain when my fellow [central bank] governors ask me why the British are particularly bad at this. The Bank, alongside other users, including the Treasury, continue to engage with the ONS on efforts to tackle these problems and improve the quality of UK labour market data.”
Business
Reeves has welcome support from Bank’s governor as she goes for growth and seeks to woo City
When Gordon Brown delivered his first Mansion House speech as chancellor he caused a stir by doing so in a lounge suit, rather than the white tie and tails demanded by convention.
Some 27 years later Rachel Reeves is the first chancellor who would have not drawn a second glance had they addressed the City establishment in a dress.
As the first woman in the 800-year history of her office, Ms Reeves’s tenure will be littered with reminders of her significance, but few will be as symbolic as a dinner that is a fixture of the financial calendar.
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Her host at Mansion House, asset manager Alastair King, is the 694th man out of 696 Lord Mayors of London. The other guest speaker, Bank of England governor Andrew Bailey, leads an institution that is yet to be entrusted to a woman.
Ms Reeves’s speech indicates she wants to lean away from convention in policy as well as in person.
By committing to tilting financial regulation in favour of growth rather than risk aversion, she is going against the grain of the post-financial crash environment.
“This sector is the crown jewel in our economy,” she will tell her audience – many of whom will have been central players in the 2007-08 collapse.
Sending a message that they will be less tightly bound in future is not natural territory for a Labour chancellor.
Her motivation may be more practical than political. A tax-and-spend budget that hit business harder than forewarned has put her economic program on notice and she badly needs the growth elements to deliver.
Rachel Reeves on budget day. Pic: PA
Her plans to consolidate local authority pension schemes so they might match the investing power of their Canadian and Australian counterparts is part of the same theme.
Infrastructure investment is central to Reeves’s plan and these steps, universally welcomed, could unlock the private sector funding required to make it happen.
Bank governor frank on Brexit and growth
If the jury is out in a business financial community absorbing £25bn in tax rises, she has welcome support from Mr Bailey.
He is expected to deliver some home truths about the economic inheritance in plainer language than central bankers sometimes manage.
Britain’s growth potential, he says, “is not a good story”. He describes the labour market as “running against us” in the face of an ageing population.
With investment levels “particularly weak by G7 standards”, he will thank the chancellor for the pension reforms intended to unlock capital investment.
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Governor warns inflation expected to rise
He is frank about Brexit too, more so than the chancellor has dared.
While studiously offering no view on the central issue, Mr Bailey says leaving the EU had slowed the UK’s potential for growth, and that the government should “welcome opportunities to rebuild relations”.
There is a more coded warning too about the risks of protectionism, which is perhaps more likely with Donald Trump in the White House.
“Amid threats to economic security, let’s please remember the importance of openness,” the Bank governor will say.
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All that is welcome for Ms Reeves.
Already a groundbreaking chancellor, she is aiming for a political and economic legacy that extends beyond her gender and the dress code.
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