The Economic and Market Impacts of the UK Budget

Ethan Ilzetzki and Marta Grzana

Monday, December 16, 2024

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Summary

The November 2024 CfM survey asked the members of its panel about the impact of the UK Autumn Budget and the market reaction to the budget. The panel unanimously attributed the rise in medium-term interest rates in the runup to and the aftermath of the budget. Yet it was evenly split on what fraction of the rise in interest rates was due to the budget. Moreover, the vast majority of the panel believes that the rise in employer national insurance contributions will have small or no impact on UK economic growth in the upcoming five years.

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Background

The November 2024 CfM survey asked the members of its panel for their reaction to two aspects of the UK Autumn Budget. The panellists were asked about their whether the increase in gilt yields in the second half of 2024 was due to the budget. They were also asked about the impact of the increase in employer national insurance contributions on UK economic growth.

UK Autumn Budget Reactions
The Labour government announced its Autumn Budget on October 30th. The Office of Budget Responsibility (OBR) predicts that it will spur growth in the short term (next two years) and in the much longer term (ten to fifteen years) through infrastructure investment, with a slight dip in growth over the three to five year horizon. The National Insurance changes for employers will likely weigh down disposable income and hit private investment (Islam, 2024). On the other hand, the increase in public investment is likely to raise public capital stock and incentivise some private investment (OBR, 2024). Moreover, the forecasted growth is relatively small: perhaps disappointing relative to its costs of £70bn a year. The Budget also slows the pace of deficit reduction with borrowing projected to rise from £122bn last year to £127bn this year before falling back to £71bn in 2029-30 and net debt failing as a share of GDP from 98.4% to 97% by 2029-30 (OBR, 2024).

Overall, the budget announcement was followed by a moderately negative reaction in financial markets causing a rise in government bond yields and weakening the pound by around 0.8% against the dollar intraday (Hoggan & Islam, 2024). Bond yields increased by 0.25 percentage points in the week following the budget. Some have argued that the rising yields could be a result of the higher borrowing needed to fund the budget’s commitments as only £25bn of the additional tax revenue will materialise in the next fiscal year relative to the extra £60bn in spending over the same period (Smith, 2024). Moreover, some analysts attributed the rise in yields to the risk that the Bank of England will cut interest rates less than estimated in response to the budget (Schomberg & Milliken, 2024). Some fund managers also seem to think that the market reaction has more to do with the potential slower and fewer interest rate cuts coming from BoE due to higher inflation coming from the higher growth in the short-term, sparked by the budget (Johnson, 2024).

The market movements were about a tenth of those seen by the mini budget of Liz Truss. Moreover, the rise has occurred in the context of a wider global increase in borrowing costs, led by the US (Hoggan & Islam, 2024). Yield movements on budget day were part of a trend with 10-year gilt yields rising from 3.9% this summer to roughly 4.4% today: almost precisely the increase in 10-year US Treasury yields over the same 3 months. Regardless of the cause, higher borrowing rates also decrease the projected headroom for public investment. In the budget documentation, the OBR has said that the Reeves could afford to see these yields rise by about 1.3 percentage points. Crossing that threshold would eliminate the headroom against the fiscal rules (Conway, 2024).

According to the Monetary Policy Committee’s (MPC) forecasts, the budget measures will increase GDP by 0.75 percentage points and CPI by 0.5 pp in a one-year horizon. The budget has reinforced caution when it comes to the scope of further interest rate cuts. The MPC also predicts inflation running at 2.7% in Q4 of 2025 relative to the previously forecasted 2.2%. The MPC analysis reflects the budget measures which will take effect next year, such as the rise in a cap on bus fares, VAT on private schools, and the increase in vehicle excise duty. However, it is much more uncertain about the effects of the large business tax hike through changes to employers’ national insurance (Strauss & Fleming, 2024).

The change in National Insurance Contributions (NIC) for employers is one of the biggest single tax-raising measures in a historical perspective, predicted to raise around £25bn annually. Employers’ national insurance contributions were increased by 0.2 percentage points (to 15%) and the threshold at which employers start paying national insurance was lowered from to £5,000 from £9,100. This measure is expected to raise around £25bn per year - most of which will come from the lower threshold. But this may therefore cause a significant increase in the cost of employing lower paid workers (Thomas, 2024).

Yet, those changes may risk unequal side-effects: they will mostly affect low-income jobs in medium-sized corporations, mainly in the hospitality industry. In the first two weeks following the budget, more than 200 leaders from the hospitality industry signed a letter disapproving of the decision (Thomas, 2024). Morgan Stanley estimated that these changes would result in an overall 3% increase in staff costs for UK retailers. They predict that those costs, combined with increases in living wages would lead to an acceleration of food inflation (Speed et al., 2024). These tax rises are also partly reflected in the OBR’s downgraded projections for real household income growth over the next few years (Johnson, 2024). Therefore, some are calling the NIC changes a big gamble on whether the economy is in robust enough health to handle it (Islam, 2024). The overall effect will depend on the strength of customer demand and employees’ bargaining power (Strauss & Fleming, 2024).

Question 1: How much of the 20 basis point increase in 2-year gilt yields and the 30 basis point increase in 10-year gilt yields since the election can be attributed to the increase in borrowing in the Autumn Budget and the anticipation thereof?