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As the economy plunges, tax revenues take a huge hit

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The government is facing a double hit to tax revenues. Providing tax holidays and other help in response to the coronavirus crisis is expensive. A bigger effect is the impact of a fast-shrinking economy on tax revenues, with the government’s fiscal watchdog warning of a drop in revenues of well more than £100bn. The question is how quickly the public finances will recover.

Everybody has got used to normality being turned on its head by the coronavirus crisis, but you still have to pinch yourself to get used to some of the changes being seen now. It is only a matter of weeks since individuals and accountants were burning the midnight oil to submit their tax returns and pay their tax bills before the 31 January deadline. Now it is the officials of HMRC who have been burning the midnight oil to hand out huge sums of money to businesses under the job retention scheme and other special coronavirus initiatives.

Meanwhile, out of an almost clear blue sky, when the main thing to worry about was a messy Brexit, we are looking at the biggest recession in a century – possibly three centuries – and some devastatingly awful numbers for the public finances.

All this has happened at breakneck speed. In my last piece for Tax Journal (6 March 2020), written just before Rishi Sunak’s first Budget on 11 March, coronavirus loomed, but mainly as an outbreak that had serious implications for the Chinese economy and had panicked global stock markets. Now, that March Budget, with all the chancellor’s confident talk about levelling-up the regions, partly via a huge commitment to extra infrastructure spending, looks like a relic from a different age.

That coronavirus has transformed the outlook is not in doubt, though I suspect nobody knew quite how much until the Office for Budget Responsibility (OBR) went public with its coronavirus scenario just over a month after the projections it had presented alongside the Budget had been rendered obsolete.

Ahead of the OBR’s release, independent economists had been tiptoeing towards what they thought would be reasonable estimates of the hit to the economy from the virus and lockdown. Would Britain’s economy shrink by 10% in the second quarter, or could it be as much as 15%? One investment bank set itself up as something of an outlier by predicting a drop of nearly 25%. That was until the OBR knocked them all out of the park by saying, on the assumption of a three-month lockdown, gross domestic product would shrink by 35% in the second quarter.

Official bodies do not usually put independent forecasters to shame with the boldness of their projections. The OBR did with its coronavirus scenario, which was quickly endorsed by Andrew Bailey, the Bank of England governor. There are mutterings that the Treasury’s private view is even gloomier.

The OBR’s grim view of what could happen in the current quarter, based on its assumption of a three-month lockdown, translates into a plunge in gross domestic product for the year of nearly 13%, twice the contraction that occurred during the global financial crisis and, in fact, the biggest annual fall since the early 1700s, when a mainly agricultural economy was particularly affected by harvests.

It also translated into some enormous numbers for the budget deficit. The OBR’s scenario suggested public borrowing of £273bn this year, easily the biggest ever. At 14% of GDP it would also be the biggest peacetime deficit. And, just in case anybody is inclined to think that the OBR’s economists have got carried away, on 23 April the Treasury and Debt Management Office issued new guidance to the markets. This was that, taking account of redemptions, there would be £382bn of gilt issuance in 2020/21, with £225bn of it to take place over the April–July period.

These are quite extraordinary numbers. Normally they would provoke severe indigestion in the markets, but the presence of the Bank of England as a willing buyer of gilts, with its £200bn expansion of quantitative easing, is clearly helping. The lurch into record deficit reflects the government’s crisis measures, including the job retention scheme. It also reflects the fact that the government is offering tax holidays to ease the pain. With economic numbers of the kind we are seeing, the other key component is a plunge in tax revenues.

There was a flavour of this in the official public finance figures for March, which showed a drop in tax revenues compared with a year earlier, driven by weakness in most receipts, but particularly income tax. This is just a taste, however, of what is to come. The OBR’s coronavirus scenario projects tax receipts of £743bn for 2020/21, compared with its Budget forecast of £873bn, a drop of £130bn or just under 15%.

All the main revenue streams are projected to fall significantly, including a £57bn shortfall for income tax and NICs, £30bn for VAT, and £10bn each for corporation tax and excise duties. These figures, I should stress, are based on a ‘clean’ lockdown, which ends after three months. The government’s scientific and medical advisers warn that social distancing measures will have to remain in place for considerably longer than that.

This is a very difficult and unprecedented position for the Treasury to find itself in. How quickly will tax revenues recover from a shock like this? The OBR assumes that the fiscal carnage will be confined to a single tax year, 2020/21. The budget deficit, it suggests, could drop to a modest 3.2% of GDP in 2021/22, without the need for the tax hikes and new round of austerity that some say will be inevitable. The coronavirus crisis, in the OBR’s view, would mean a permanent increase in government debt of 10% of GDP, or over £200bn in today’s prices.

That, in these unusual circumstances, would be a good outcome. It rests, as noted, on the crisis not dragging on. It rests too on tax revenues not suffering a sustained post-recession hangover, of the kind we have seen on many occasions in the past. We have to hope it is not looking at the situation through rose-coloured glasses.