Rachel Reeves is braced for revised forecasts by the Office for Budget Responsibility (OBR) to blow a £20bn hole in her tax and spending plans before the autumn budget.
Even without changing the totals the chancellor set out in her spending review on Wednesday, a weaker forecast from the the Treasury’s independent watchdog could force her to find significantly more money at the budget to meet her “non-negotiable” fiscal rules.
Reeves has said repeatedly that flexing her fiscal rules – designed to provide certainty over UK public finances – is not an option even if the economic outlook deteriorates.
At her spring statement, she left herself on course to meet those rules with less than £10bn of headroom to spare, on a total budget for day-to-day spending of more than £1.3tn.
Amid trepidation at the Treasury, the OBR has kicked off its annual summer review of the “supply side” of the economy – including productivity, which it has consistently overestimated.
Sources with knowledge of the OBR’s thinking told the Guardian that the watchdog was “uncomfortable”, with the fact its current forecast for productivity growth was more positive than the consensus from other economic forecasters, and wanted to “rein it in”.
Productivity is one of the key determinants of economic growth, and revising it down would have a significant knock on effect on the OBR’s forecasts for gross domestic product.
The consultancy Oxford Economics estimates that moving the productivity forecast back in line with the average independent projection, would knock 1.4% off forecast GDP at the end of the OBR’s five-year forecast period.
That would force Reeves to increase taxes or cut spending by an eye-watering £20bn, to meet her fiscal rules and maintain her slim £10bn of headroom. That would be roughly equivalent to raising both the main and higher rates of income tax by 2p.
A more cautious approach, taking the middle path between two alternative “scenarios” the OBR set out in its March economic and financial outlook, could still force the chancellor to make a £12bn correction.
The OBR could send an early signal of its intention to revisit its productivity outlook as soon as 1 July, in its regular forecast evaluation report.
Andy King, a former member of the OBR’s budget responsibility committee, now at the consultancy Flint Global, said: “The reason why anyone in the Treasury who cares about this will be worried, is that the OBR is currently more optimistic than everyone else.
“What can happen next? Either everyone else thinks, ‘We’re too pessimistic’; or the OBR thinks, ‘We are too far away from the pack, there’s been more bad news than good since March, we should revise down.’ I think that’s the expectation for many.”
The Treasury is likely to point the OBR to policies it hopes will be positive for productivity growth in the long term, including infrastructure investment, though the scale of this was already known before the OBR’s last forecast in March.
Alongside weaker productivity, slower net migration as a result of the government’s recent white paper could also prompt the OBR to be more pessimistic.
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James Smith an economist at ING, said: “Further downgrades to trend productivity growth projections, as well as net migration, mean the chancellor is likely in the red, before even considering the mounting pressures on the public purse.
“The overall shortfall may amount to at least £20bn, and that means tax rises are highly likely.”
Adrian Pabst, the deputy director of the National Institute of Economic and Social Research, said the prospect of another significant forecast revision underlined the current instability of tax and spend policy.
“We’re in this vicious circle where we’ve got these fiscal rules, then the OBR have to take a view, because that’s their remit, that’s their mandate; and then we’re constantly speculating about what is going to happen at the next fiscal event,” he said, adding: “It’s not a good place for fiscal policy to be.”
In a recent speech, Reeves said: “Strong and transparent fiscal rules are an indispensable safeguard for working people – and that is why my rules are non-negotiable.”
The Treasury declined to comment on the prospect of an OBR growth downgrade but underlined Reeves’s determination to stick to her fiscal rules.
The OBR declined to comment.