Daniela Glocker
OECD
Nicolas Gonne
OECD
OECD Economic Surveys: United Kingdom 2024
OECD Economic Surveys: United Kingdom
Abstract
The growth outlook is improving. Economic activity is gaining momentum, supported by household consumption. Albeit increasing, sluggish investment and trade continue to weigh on growth. Monetary policy has tightened appropriately, but inflation remains slightly above the target. Fiscal policy is restrictive, supporting monetary policy. Low growth and high interest rates aggravate the already tight fiscal position following substantial fiscal support during the pandemic and the energy price crisis. The cost of servicing public debt has increased substantially, while a historically high tax burden and already reduced public spending leave limited room for fiscal manoeuvre. Growing spending needs due to ageing and investment necessary to support the green transition call for tax reforms to strengthen revenues.
1.1.1. The energy crisis disrupted a robust recovery from the pandemic
Economic activity slowed after recovering to pre-pandemic levels in late 2021, and came to a standstill in 2023. Like in other OECD countries, private consumption, a key driver of growth in the post-pandemic recovery, stalled on the back of rapidly rising inflation (Figure 1.1, Panel A). High energy prices, aggravated by Russia’s war of aggression against Ukraine, were passed through to consumers, contributing to a cost‑of-living crisis and deteriorated consumer confidence (Figure 1.1, Panel B). Government support helped households with high energy cost, but real disposable household income per capita declined and remained about 0.4% lower at the end of the first quarter of 2024 than before the pandemic. Easing price pressures since the end of 2022 and the ensuing recovery in real household incomes started to improve consumer confidence, but only gradually translated into improved private consumption. In the first half of 2024, private consumption picked up supporting GDP growth, which gained momentum and increased by 0.7% in the first and 0.6% in the second quarter.
Source: OECD Main Economic Indicators (database).
The labour market is easing from very tight conditions. The number of job openings has fallen since the summer 2022 (Figure 1.2, Panel A), aided by high net migration. Unemployment picked up slightly in 2023 but stayed close to historical lows before reaching 4.2% in the second quarter of 2024 (Figure 1.2, Panel A). Particularly strong nominal pay growth fully caught up with falling inflation in the second half of 2023, delivering real wage increases (ONS, 2024[1]). Real hourly wages increased by 3.1% between the pre-pandemic and the first quarter of 2024, more than the OECD average (Figure 1.2, Panel B). However, structural factors weigh on labour supply (Chapter 4). The employment rate, while high by international standards, has settled at about 74%, one percentage point below its pre-pandemic level (Figure 1.2, Panel C). The inactivity rate increased to about 22% in the first quarter of 2024, largely driven by a 5 percentage points increase in the youth inactivity rate compared to its pre-pandemic level (Figure 1.2, Panel D).
Note: Panels B and C: G7* refers to the G7 average excluding the United Kingdom. Panel B: Labour demand includes all occupied and vacant jobs.
Source: OECD Labour Force Statistics; OECD Main Economic Indicators (database); ONS.
Sluggish investment, albeit improving, continues to weigh on growth. While together private non‑residential and government fixed investment reached their highest level in a decade at 19% of GDP in 2023, total investment remains low compared to OECD peers (Figure 1.3, Panel A). The private sector, which contributes about three quarters of total investment, accounts for the improvement in 2023, as businesses likely brought forward investment to benefit from the temporary “Super-deduction”, whereby companies were able to claim capital allowances worth 130% of investment expenditure on qualifying plant and machinery until the end of March 2023 (HM Treasury, 2021[2]). The Super-deduction was replaced with the less generous “Full expensing” scheme, which offers 100% capital allowances on qualifying new plant and machinery investments (HM Treasury, 2023[3]). The scheme was made permanent in Autumn 2023 (HM Treasury, 2023[4]), a welcome but insufficient development to restore business confidence, which remains subdued on the back of persistent price pressures and uncertainty (see Figure 1.3, Panel B; Chapter 3).
Note: Panel A: G7* refers to the G7 average excluding the United Kingdom. Panel B: Business confidence refers to the manufacturing sector.
Source: OECD Main Economic Indicators (database).
1.1.2. Competitiveness and trade performance weakened due to higher non-tariff barriers
The current account deficit stabilised at 3.3% of GDP in 2023, following a widening in 2022 driven by a negative terms of trade shock (Figure 1.4). Import values increased rapidly due to rising energy prices and export volumes slowed on the back of low external demand. Growth in goods exports and imports since 2019 as a share of GDP has been the weakest among G7 countries (Figure 1.5, Panel A). By the second quarter of 2024, UK trade intensity remained 0.6 percentage points below its pre-pandemic level. By contrast, it was 2.6 percentage points above pre-pandemic levels on average in the rest of the G7 countries by the first quarter of 2024. However, goods and services have shown strong and growing differences in performance since the pandemic (Figure 1.5, Panel B and C). While growth in UK goods trade has fallen well behind the rest of the G7, services trade has been resilient, reflecting a mixture of strong global demand growth in areas of UK strengths, including intellectual property, business services and education services, and less dependence on the European Union for services exports. Moreover, obstacles to services trade are particularly low in the United Kingdom (OECD, 2024[5]), whereas leaving the EU single market and Customs Union on 1st January 2021 created more trade frictions for goods (OECD, 2022[6]; Office for Budget Responsibility, 2024[7]).
Note: Panel B: G7* refers to the G7 average excluding the United Kingdom. The terms of trade refer to the ratio between the index of export prices and the index of import prices. If the export prices increase more than the import prices, a country has a positive terms of trade, as for the same amount of exports, it can purchase more imports.
Source: OECD Main Economic Indicators (database).
Index 2019 Q4=100
Note: Trade intensity measured as Imports+Exports as share of GDP. G7* refers to the G7 average excluding the United Kingdom. In 2019, UK firms started stockpiling goods in anticipation of the exit from the EU single market and customs union, therefore goods trade was overinflated that year leading to a more negative picture compared to that basis.
Source: OECD Main Economic Indicators (database).
The European Union remains a key trading partner. About 43% of UK’s goods and 36% of services were exported to (Figure 1.6, Panel A and B), and about 48% of all UK’s imports were coming from the European Union. While the contribution of EU trade to the UK’s total trade intensity has remained broadly stable at around 47% over the past years, declining goods exports were counterbalanced by a rising share of services trade with the European Union. The Trade and Co-operation Agreement (TCA) governs trade between the United Kingdom and the European Union since 2021, allowing zero-tariff, zero-quota trade. However, leaving the EU Single Market and the Custom Union made it costlier for UK firms to access EU markets due to new non-tariff barriers, including customs procedures, logistics and conformity standards. Importers of products with a high content in EU imports passed on higher trade costs due to non-tariff barriers to consumers leading to a pick up in consumer prices (Bakker et al., 2022[8]). Higher costs for importers also pushed up producer prices, thus reducing the competitiveness of UK exports. Research suggests that smaller firms in particular have reduced trade with the European Union as cross‑border activity was no longer profitable, whereas larger firms that drive aggregate exports have been less affected (Freeman et al., 2022[9]). These developments are broadly in line with ex-ante estimates discussed in previous Economic Surveys, which suggested a reduction in output by 3.5% resulting from leaving the EU Free Trade Agreement (OECD, 2020[10]; OECD, 2017[11]). Moreover, the United Kingdom has lost importance as an export market for the European Union (Kren and Lawless, 2024[12]). While goods exports within the European Union and from the European Union to the rest of the world grew more than a quarter between 2019 and 2023, goods exports from the European Union to the United Kingdom grew only by about 5% over the same period (European Commission, 2024[13]). Similarly, the share of goods imports into the European Union from the United Kingdom has trended downwards (Figure 1.6, Panel C).
Source: UN Comtrade; OECD International trade statistics; IMF.
The departure from the EU Single Market and Customs Union is an ongoing process, rather than a single event, as the TCA is gradually phased in. Over the course of 2024, further sanitary and phytosanitary checks will be implemented for imports from the European Union. As UK exporters to the European Union already must comply with these checks, this will level the playing field and help safeguard biosecurity and food safety. However, the effectiveness and efficiency of the newly introduced Border Target Operating Model should be closely monitored (HM Government, 2023[14]). Higher costs for imports falling under the new rules are likely to impact food prices. Analysing price developments between January 2022 and March 2023, Bakker et al. (2023[15]) find that the price of food products with a higher reliance on imports from the EU increased by about 3.5 percentage points due to the introduction of non-tariff barriers. The government estimates that the introduction of the Border Target Operating Model will cost around GBP 300 million per year and add about 0.2% to food price inflation over the next three years (HM Government, 2023[14]). The government should therefore ensure an efficient running of the Border Target Operating Model with short waiting times to reduce costs for importers and, ultimately, for consumers.
The UK government is pursuing a new trade strategy. Having left the European Union and its trade framework, the United Kingdom has replaced the EU external tariff with a new “UK global tariff” under which the number of goods with zero tariffs increased. While the United Kingdom is still in early stages of pursuing new trade relations, progress in negotiating new trade agreements has been made. The United Kingdom has concluded continuity agreements with almost all countries that had trade agreements with the European Union at the time of exit, as well as new agreements with Japan, the EFTA countries (Iceland, Liechtenstein, Norway and Switzerland), Australia and New Zealand (OECD, 2022[6]). Most recently, in July 2023, the United Kingdom became a member of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which comprises 11 other countries, however the overall impact on GDP is expected to be limited (Department for International Trade, 2022[16]; Department for Business and Trade, 2023[17]). A closer trade relationship with the European Union, geographically the closest trading block, would be advisable in the context of heightened geopolitical uncertainty and increased logistical costs. Building on previous progresses, the United Kingdom should continue to work with the European Union to further reduce trade barriers. In 2023, the United Kingdom and the European Union have made important advances by agreeing to the Windsor Framework agreement, which restores the free flow of goods between Great Britain and Northern Ireland and reduces the number of checks on goods travelling from the rest of the United Kingdom to Northern Ireland (Box 1.1). This is a welcome development, and the expansion of the free movement to all goods between Great Britain and Northern Ireland should be advanced according to the agreed timeline. To support exports to the EU market, the United Kingdom and the European Union should continue to evaluate potential reductions in non-tariff barriers for EU-UK goods trade and improve market access for services, including the recognition of professional qualifications. This will also depend on the United Kingdom’s future trade strategy and whether it aims for greater divergence from EU regulations, especially in food and manufacturing.
On 27 February 2023, the United Kingdom and the European Union agreed the Windsor Framework, providing a fundamentally new set of arrangements to restore the free flow of trade within the UK internal market and safeguard Northern Ireland’s place in the United Kingdom.
To smooth the flow of trade of goods crossing the Irish Sea from Great Britain to Northern Ireland, green (for goods remaining in Northern Ireland) and red lanes (for goods which may be sent on to the European Union) are introduced to reduce checks and paperwork. It also includes several agreements on medicine control, VAT and alcohol duty.
These arrangements were adopted at the Withdrawal Agreement Joint Committee on 24 March 2023. The implementation of the Framework will happen in stages through 2024 into 2025, to provide businesses with time to adapt to new arrangements.
Timeline
On 1 May 2023 a temporary VAT zero-rate was introduced in Northern Ireland for the domestic installation of solar panels, insulation, heat pumps and other energy saving materials (further details can be found here). This relief has been available in the rest of the United Kingdom since 2022 but was previously blocked in Northern Ireland by the Protocol.
On 30 June 2023, the Government launched a new reimbursement scheme for EU duty paid on “at risk” goods which have been sold or used outside of the European Union.
From 30 September 2023, a new UK Internal Market Scheme expanded the range of businesses able to benefit from the new arrangements provided to protect internal UK movements, including the removal of EU tariffs. In tandem, the new sanitary and phytosanitary “green lane” arrangements have taken effect, including a new Retail Movement Scheme for agrifood retail products; new rules to allow plants to move smoothly into Northern Ireland; and new arrangements to enable seed potatoes to move once again from Great Britain to Northern Ireland.
From September 2024, the full “green lane” will take effect for the movement of all goods between Great Britain and Northern Ireland, restoring the benefits of the UK Internal Market Scheme and ending unnecessary bureaucracy. New arrangements will also come into effect for the movement of parcels between Great Britain and Northern Ireland, with a new set of data-sharing requirements put in place to ensure that customs declarations are not needed for deliveries to consumers.
In 2025, new arrangements for the supply of medicines into Northern Ireland will take effect, ensuring that medicines available in Northern Ireland are those approved by UK authorities, enabling a single licence and a single pack for medicines right across the United Kingdom.
Source: HM Government (2023[18]).
1.1.3. The growth outlook is improving
GDP is expected to grow by 1.1% in 2024 and 1.2% in 2025 (Table 1.1). Strong real wage growth and monetary easing will sustain private expenditure, including a modest increase in household investment as mortgage volumes start recovering. However, sticky services price inflation and fiscal drag (i.e., the increase in households’ tax liability due to the freeze of personal tax thresholds) will continue to weigh on consumers’ purchasing power, soft external demand will constrain trade growth, and uncertainty will continue to impede on investment. Unemployment is expected to increase, reaching 4.5% as the labour market cools.
In the absence of severe shocks (Table 1.2), the risks to the outlook are balanced. Uncertainty about the degree of slack in the labour market is a key risk as data based on the labour force survey are of poor quality (Chapter 4). Overestimating the availability of labour resources could lead to a faster reduction in the Bank Rate, which would boost GDP but possibly entrench wage inflation and risk inflation not returning to target. Underestimating actual availability would entail high rates for longer, slowing the economy. Limited fiscal space to confront possible shocks is a continued downside risk, given the country’s exposure to further potential surges in wholesale energy prices due to tensions in the Middle East and Russia’s war of aggression against Ukraine. A rundown of excess household savings would boost growth, but could limit the pace of disinflation.
Annual percentage change, volume (2019 prices)
Note: 1. Contribution to changes in real GDP; 2. As a percentage of potential GDP; 3. As a percentage of the labour force; 4. As a percentage of household disposable income; 5. As a percentage of GDP.
Source: OECD Economic Outlook database.
Consumer price inflation fell continuously during 2023, helped by restrictive monetary policy, lower contributions from energy and food price inflation, and continued easing of supply chain pressures. Annual consumer price inflation has been trending downwards since its peak of 11.1% in October 2022 slowing to the 2% inflation target in May and June, before slightly picking up again to 2.2% in July Figure 1.7, Panel A). Goods price inflation has fallen to -0.6% in July, but services price inflation at 5.2% has been stickier, as wage-driven underlying price pressures persist. Annual nominal wage growth remains robust despite a marked slowdown since the summer of 2023, with an increase of 5.4% in the second quarter of 2024.
Monetary policy should remain restrictive to ensure that inflation decreases durably to the 2% inflation target. In August 2023, the Bank of England (BoE) ended a rate hiking cycle that began in December 2021, bringing interest rates from 0.1% to 5.25% (Figure 1.7, Panel B). Only in August 2024, the BoE has lowered rates to 5%, maintaining a restrictive monetary policy and allowing monetary tightening to continue to work its way through the economy. Closely monitoring domestic inflationary pressures is warranted, especially given concerns regarding the quality of labour market data (Chapter 4). Current trends indicate a decrease in inflation expectations. The Bank of England’s Decision Maker Panel reports a drop in one-year ahead consumer price inflation expectations from 3.1% in the three months to April to 2.7% in the three months to July. Similarly, three-year ahead inflation expectations between May to July have fallen to 2.6%, a decrease of 0.1 percentage points from the three months to April. But inflation expectations are surrounded by risks, including imbalances in the labour market, high growth in wages and labour costs, and persistent price pressures in services sectors. The BoE should continue to pursue a restrictive policy, and only start to ease as incoming data points to substantively slowing wage growth and service price inflation. To better manage inflation expectations in the longer term, implementing the recommendations from the independent review into the Bank’s forecasting process (Box 1.2) would be a positive step.
The Bank of England’s Monetary Policy Committee (MPC) is pursuing its quantitative tightening strategy as set out at the end of 2022 (Bank of England, 2022[19]) (Figure 1.7, Panel C). By the end of 2023, the Bank of England’s Asset Purchase Facility (APF) was holding GBP 744 billion assets for monetary policy purposes. The MPC decided to increase the pace of tightening by reducing the stock of UK government bond purchases held for monetary policy purposes by GBP 100 billion over the 12‑month period from October 2023 to September 2024, bringing the balance sheet to a total of GBP 658 billion (Bank of England, 2023[20]). While quantitative tightening has so far proceeded smoothly, uncertainty remains about its potential impact once policy rates begin to decline. The likely coexistence of quantitative tightening and policy rate reductions, with potentially opposite impacts on long-term yields and financial conditions more generally, calls for the BoE to continue to clearly communicate its strategy to guide markets.
Source: OECD Main Economic Indicators (database); ONS; BoE.
The Bernanke Review refers to an independent assessment led by Dr. Ben Bernanke, focusing on the forecasting and communication processes of the Bank of England during times of significant uncertainty. The review was announced in July 2023 and published on 12 April 2024. It provides a thorough evaluation of the Bank’s current forecasting approach and its relationship with monetary policy decisions and their communication. The review outlines 12 recommendations across three major themes:
Forecasting Infrastructure: To improve and maintain the Bank’s forecasting infrastructure, including data management, software, and economic models:
Prioritise updating and modernisation of data management software;
Prioritise model maintenance and development;
Consider replacing or revamping the COMPASS forecasting model in the long term;
The new forecasting framework should, at the very least, include a realistic representation of the monetary transmission mechanism, short and long-run inflation expectations, a wage-price system with gradual adjustment to shocks and wages affecting prices and vice versa, detailed models of the housing, energy and financial sectors, and greater attention to the supply side.
Forecast Process: To provide a forecast process that better supports the Monetary Policy Committee’s (MPC) decision-making, including learning from past forecast errors and dealing with uncertainty and structural change in the economy:
Pay more attention to forecast errors for flexible policy adjustment;
Consider staff deployment to improve forecast infrastructure and quality;
Regularly augment central forecast with early-stage alternative scenarios.
Communication: To help the MPC communicate its view of the economy, the risks and uncertainties surrounding its outlook, and its policy rationale, to the public:
Publish selected alternative scenarios in the Monetary Policy Report;
o De-emphasize central forecast and clarify forecast assumptions inconsistent with the MPC’s view of the outlook;
Replace or cut back the detailed quantitative discussion of economic in favour of a shorter and more qualitative description;
Eliminate the fan charts;
Implement proposed changes in phases, starting with improving the forecasting infrastructure, while moving cautiously in adopting changes to policymaking and communications.
The Bank of England has welcomed the recommendations and is committed to implementing them, with an update on proposed changes expected by the end of the 2024.
Source: Bank of England (2024[21]).
The UK banking system has remained stable and resilient during successive economic shocks, maintaining capitalisation and liquidity positions well above prudential requirements (Figure 1.8, Panels A and B). The Financial Policy Committee has gradually increased the counter cyclical buffer (CCyB) to a neutral 2% in July 2023. This development is welcome as the current environment of high interest rates and slow economic growth raises vulnerabilities in the financial sector. High interest rates support banks’ profitability (Figure 1.8, Panel C) through higher interest income, but may lead to losses from their fixed income trading portfolio due to declining bond prices. In addition, credit defaults may rise, although so far, they remain low (Figure 1.8, Panel D). The 2022-23 stress test by the Bank of England (2023[22]) finds that major banks have capacity to absorb future shocks without restricting lending. The Bank of England should continue to monitor developments closely and adjust the counter cyclical buffer in line with credit conditions and financial stability risks.
2023Q4 or latest quarter
Note: Bank capitalisation refers to the capital adequacy, regulatory tier 1 capital to risk-weighted assets.
Source: IMF Financial Soundness Indicators database.
1.3.1. A large non-banking financial institution sector creates vulnerabilities
High interest rates can create vulnerabilities in parts of the system of market-based finance. In the United Kingdom, the non-bank financial sector has grown in importance, now accounting for around half of total financial sector assets (Bank of England, 2023[23]). The non-bank financial institutions sector comprises a heterogeneous group of institutions including insurers, pension funds, investment funds, finance companies, broker dealers and central counterparties, each with different risks related to their respective investment strategies, making close monitoring particularly important as highlighted by the stress episode following the Autumn 2022 “Mini Budget”. The subsequent rapid rise in gilt yields highlighted the risks with liability-driven investment (LDI) funds, which many defined benefit (DB) pension schemes use in their investment strategies. DB pension funds with leveraged LDI strategies had to quickly raise a large amount of cash to meet margin and collateral calls, contributing to fire-sales of longer-dated gilts. The Bank of England had to step in with a temporary and targeted intervention to restore financial stability (see Box 1.3). Following the episode, the ability of LDI funds to absorb shocks has been reinforced with new standards. In March 2023 the Bank’s Financial Policy Committee judged that LDI funds should be resilient to a shock to the gilt yield curve of 250 basis points at a minimum and in addition to maintaining sufficient resilience to manage other risks and day-to-day movements in yields (Bank of England, 2023[24]), which is a welcomed development. Further, liquidity backstops should be expanded to adequately supervised systemically important NBFIs such as large DB pension funds. It will also be important to better understand the interconnectedness across the financial sector that could amplify and spread financial stress. The Bank has therefore launched a “system-wide exploratory scenario” (SWES) exercise, which aims to improve understanding of the behaviours of banks and non-bank financial institutions in stressed financial market conditions and how these behaviours might interact to amplify shocks in financial markets that are core to UK financial stability (Bank of England, 2023[23]). Advancing this toolkit by continuing to close data gaps will be an important contribution to understanding and addressing vulnerabilities in market-based finance.
Direct risks from corporate indebtedness to the financial sector are low, but indirect risks through the non-banking sector warrant attention. Corporate debt levels are generally low with limited immediate refinancing needs as most UK corporate debt on fixed rates is due to mature only after 2025 (Bank of England, 2023[23]). Despite a rise in corporate insolvency rates, primarily among small firms with minimal debts, they remain below the long-term average. However, the non-bank financial sector holds more than half of UK corporates’ debt (Bank of England, 2023[23]), and requires close monitoring and consideration of adequate action in line with the Financial Stability Board’s guidelines to prevent potential transmission of credit defaults from the corporate sector to the financial sector.
In Autumn 2022, the UK government bond market exhibited extreme volatility following the fiscal statement of 23 September. UK financial assets were severely repriced, particularly affecting long-dated UK government debt. That period saw two daily increases in 30-year gilt yields of more than 35 basis points. Measured over a four-day period, the increase in 30-year gilt yields was more than twice as large as the largest move since 2000, which occurred during the ‘dash for cash’ in 2020.
The unexpected and unprecedentedly sharp fall in the prices of long-dated gilts held by liability-driven investment (LDI) funds (‘LDI funds’ refers to leveraged LDI funds and LDI mandates) pushed up their leverage and forced the funds to post additional collateral on their secured borrowing or pay margin calls on derivatives. To meet collateral and margin calls, as well as reduce leverage, LDI funds had to rebalance their portfolios sharply by selling liquid assets or asking their defined benefit pension scheme investors to provide more collateral.
Where this rebalancing could not be achieved quickly enough, LDI funds were forced to sell gilts into an illiquid market. This was a particular problem for many pooled LDI funds, given operational lags and the large number of smaller investors. Forced deleveraging into an illiquid market risked reinforcing the downward pressure on gilt prices. This downward spiral threatened to cause broader market dysfunction and to lead to an unwarranted tightening of financing conditions for businesses and households. The Bank of England’s Financial Policy Committee noted the risks to UK financial stability from the dysfunction in the gilt market and recommended that action had to be taken.
On 28 September, the Bank announced a gilt market intervention on financial stability grounds, using temporary and targeted asset purchases to restore market functioning. The aim of this intervention was to temporarily ‘support market functioning as a backstop’ to buy time for LDI funds to build resilience, thereby reducing risks of contagion to credit conditions to UK households and businesses. On 11 October, inflation-linked gilts (‘linkers’) were added to these operations. In total, the Bank bought GBP 19.3 billion of gilts between 28 September and 14 October 2022, comprising GBP 12.1 billion of conventional gilts and GBP 7.2 billion of index-linked gilts. These were subsequently sold back to the market in a timely but orderly way, over 12 trading days between 29 November 2022 and 12 January 2023.
Source: Bank of England (2023[25]).
1.3.2. Monitoring housing market developments and mortgage refinancing
Risks arising from the housing market remain contained, but ongoing vigilance is needed. After a slowdown in 2023, house prices increased again to about 24% above pre-pandemic levels by the second quarter of 2024 (Figure 1.9, Panel A). Mortgage approval rates, albeit recovering from their trough in summer 2023, remain slightly below pre-pandemic levels on the back of increased mortgage rates (Figure 1.9, Panel B), lower real incomes due to the higher cost of living, and high house prices, which have all affected affordability. The full impact of higher financing costs has however not yet passed through to all households, as most mortgages rates in the UK are fixed at 5 years (Bank of England, 2024[26]). Since interest rates began rising in late 2021, about 55% of mortgage accounts have repriced, and higher rates are expected to affect around 5 million households by 2026 (Bank of England, 2023[23]). Given robust capital and profitability, UK banks can offer forbearance and limit repayment increases for borrowers, including by allowing loan refinancing. Thus, borrowers can offset the near-term impact of higher mortgage rates by opting to borrow over longer terms to reduce monthly repayments. New mortgage lending at terms longer than 35 years has increased from around 5% in the first quarter of 2022 to 12% in the third quarter of 2023 (Bank of England, 2023[23]). Regulatory conduct standards for lenders with respect to supporting households in payment difficulties have tightened since the Global Financial Crisis. On 23 June 2023, principal mortgage lenders, the Chancellor and the Financial Conduct Authority (FCA) agreed on new support measures for struggling mortgage holders, providing them with targeted solutions for example by extending the term to reduce their payments or offering a switch to interest only payments for six months without a new affordability check or it affecting the borrower’s credit score, but also a range of other options like a temporary payment deferral or part interest-part repayment, which is welcome. The Bank of England should continue to monitor housing market developments and mortgage refinancing closely as high interest rates feed through to households, and buffers to accommodate potential defaults should be maintained.
Developments in the UK housing market
Note: Panel A: Quarterly average of monthly seasonal adjusted house prices. Panel B: Quarterly average of monthly interest rate of UK monetary financial institutions (excl. Central Bank) sterling 5 year (75% LTV) fixed rate mortgage to households (in percent) not seasonally adjusted.
Source: HM Land Registry; Bank of England.
Housing supply continues to lag demand posing affordability challenges. The housing target of 300 000 homes a year by the mid-2020s set by the UK government in 2019 has not been met (Figure 1.10, Panel A). Not only has new housing construction suffered during the pandemic and rising prices in materials following since, but it has also been held back by a complex and inefficient planning system. According to the Competition and Markets Authority (2024[27]) the length, costs and complexity of planning permits have risen over the years and often take a protracted amount of time for builders to navigate before construction can start holding back construction (see Chapter 2). Insufficient housing supply, high house prices and high mortgage rates also reduce affordable housing alternatives for households that rent. The private rental sector covers around 20% of households. Many private landlords finance their investment through mortgage borrowing with around 7% of the total UK housing stock having a buy-to-let mortgage on it comprising around 18% of the overall mortgage market by value (Bank of England, 2023[23]). Many buy-to-let landlords are passing on higher costs to renters, thus given limited supply, renters have continued to face rapidly rising costs whereas the house price to rent ratio has been falling (Figure 1.10, Panel B). This may pose financial stability risks via sharp household spending cuts or credit defaults and while it is unlikely to test UK banks severely, developments should be monitored.
Source: ONS; OECD Analytical house price indicators.
1.3.3. Continuing to adapt financial supervision to cyber-risks and climate change
The United Kingdom remains a front-runner in stress-testing “non-traditional” risks, such as the effects of cybercrime and climate change. Amidst heightened geopolitical tensions, financial institutions are more exposed to cyber-attacks, which can disrupt the economy and the financial system (Table 1.2).The Bank of England conducted the 2022 Cyber Stress Test to better understand firms’ ability to quickly identify the nature of the disruption they faced and to assess potential financial stability impacts. This exercise was an exploratory, voluntary test based on a hypothetical data integrity scenario in retail payments. In March 2024, the Bank’s Financial Policy Committee published a macroprudential approach to operational resilience which considered cyber risks (Bank of England, 2024[28]), and a further exploratory cyber stress test has started in Spring 2024, which is exploring firms’ capabilities and the potential financial stability impact of a hypothetical scenario involving data integrity disruption to wholesale payments and settlement.
As highlighted in the previous Economic Survey (OECD, 2022[6]), the Bank is also leading in assessing climate related risk across the financial system and interactions between banks and insurers. Financial risks from climate change can materialise through physical risks that arise from increasing severity and frequency of climate and weather-related events, such as sea-level rises and floods. These events damage property and other infrastructure, disrupt business supply chains, and impact agricultural output. Early and well managed climate adaptation can lower the potential drag on the profitability of UK banks and insurers due to climate risks (Bank of England, 2021[29]). While the Bank’s current frameworks already capture climate-related risks to some extent, including through capital models and credit ratings, risk capture may be incomplete due to difficulties in estimating climate risks. The Bank’s data collection on non-traditional risks that could become systemic is welcomed. The BoE should adapt its financial sector regulation and supervision as non-traditional risks and vulnerabilities that could become systemic are uncovered by stress-tests and related activities.
1.4.1. Fiscal space is constrained
The fiscal stance is restrictive and adequately supports monetary policy. The government’s efforts to improve fiscal space are visible in both rising tax revenues and reduced spending. The tax burden and tax revenues have been on the rise (Figure 1.11, Panel A), with a tax mix that broadly aligns with the OECD average (Figure 1.11, Panel B). Higher revenues from frozen personal income tax thresholds are partly offset by the cumulated 4 percentage points cut in the rate of National Insurance Contributions since 2023. Moreover, higher revenues from the 2023 increase in the statutory corporate tax rate partly finance the permanent full expensing of investment in place since April 2023. Public spending as share of GDP is around the OECD average but has declined since the global financial crisis (Figure 1.11, Panel C and D). Thus, despite spending increases on health and on enterprises and economic development during the pandemic and the energy crisis, overall real expenditure decreased. Rising spending on general public services, which includes debt servicing costs, also limits available funding for other departments, including areas important for growth such as education and employment policy, which received less funding than before the global financial crisis (Figure 1.11, Panel D).
Note: Panels A and C: G7* refers to the G7 average excluding the United Kingdom. Panel A: The value 2023-24 value for the United Kingdom is a preliminary estimate. Panel B: OECD refers to the year 2021.
Source: OECD Tax database; OECD Statistics on National Accounts; OECD Revenue Statistics; ONS, HM Treasury.
The fiscal stance is appropriate following significant fiscal support during the pandemic and energy price crisis that increased government debt by 15 percentage points between 2019 and 2023. While gross public debt at about 101% of GDP in 2023 is below the OECD average (Figure 1.12), the government finds itself in a difficult position to balance consolidation with public investment and spending needs. With low growth affecting revenues, already low public spending, and increasing debt servicing costs, the government has limited options to restore fiscal space.
Gross government debt, % of GDP
Note: G7* is a simple average of Canada, France, Germany, Italy, Japan and the United States.
Source: OECD Main Economic Indicators (database).
The new government that came into office in July 2024 is committed to pursue fiscal consolidation over the medium term. Between 2023 and 2025, the fiscal balance is projected to improve by almost 2% of GDP (Table 1.4). In Spring 2024, the government announced to increase the threshold at which the child benefit starts to be tapered away and together with previously announced cuts to National Insurance Contributions, these changes are designed to encourage work. The Office for Budget Responsibility (OBR) estimates that these measures could boost GDP by 0.2% and add an average of GBP 0.7 billion (0.03% of GDP) of receipts each year (Office for Budget Responsibility, 2024[7]). Revenues will also be supported by fiscal drag as income thresholds remain frozen until 2028-29 and tax revenues are set to rise to about 37% of GDP by 2028-29. However, the OBR expects public expenditure to be 2.9% of GDP higher by fiscal year 2028-29 than before the pandemic. This increase is mainly due to the pension triple lock, under which state pensions are increased either by price inflation, average earnings growth or a flat 2.5% rise, whichever is higher, as well as rising health and disability benefit claims, leading to a more than 1% of GDP increase in welfare spending. This is despite a consolidation-driven fall in real departmental spending per population, which will be about 8% lower by 2026-27 than anticipated when spending plans were first set in October 2021 (Office for Budget Responsibility, 2024[7]).
High debt interest payments will continue to weigh on public finances. Almost 9% of total government revenues are set to go towards debt interest costs in the next five years, under the OBR’s most recent forecasts, up from an average of 5.5% over the 2000s and 2010s. While recent rapid growth in interest payments on inflation-indexed debt will moderate as inflation eases, high interest rates also entail significant transfers from the UK Treasury to the Bank of England within the Asset Purchase Facility (APF) indemnification arrangement. As of the fourth quarter of 2023, the Treasury had transferred a total of GBP 38.2 billion (about 1.7% of GDP) to cover APF losses, and is expected to further transfer GBP 37.7 billion by the end of 2024 worsening the general government primary deficit (Figure 1.13).
% of GDP
Note: 1. OECD estimates unless otherwise stated; 2. As a percentage of potential GDP.
Source: OECD Economic Outlook database.
General government net lending, % of GDP
Note: APF refers to transfers to and from the Bank of England under the Asset Purchase Facility indemnification arrangement.
Source: OECD Economic Outlook database.
The government’s objective to meet its fiscal targets and restoring fiscal space in the medium term is surrounded by significant risks. The OBR estimates that with policies announced in the Spring Budget 2024, the government will meet both of its self-imposed targets by 2028-29, including falling public sector net debt (excluding the Bank of England) as a share of GDP, and public sector net borrowing not exceeding 3% of GDP. However, the fiscal headroom to meet both targets is small and hinges on the assumption that the “temporary” cut in fuel duty, which has been in place since 2011, will be removed. Moreover, the lack of detailed department-by-department spending plans raises doubt on how stated ambitions to increase defence spending to 2.5% of GDP by 2030 with an extra GBP 75 billion spent over the next six years would be implemented without further cutting back other department’s spending (Office for Budget Responsibility, 2024[7]; HM Government, 2024[30]). Finding additional resources to support the NHS’s efforts to reduce waiting lists for hospital treatment would also come at a cost of other services (Emmerson et al., 2024[31]). In July 2024, the government announced to update the Charter for Budget Responsibility to require spending reviews to be held every two calendar years, and with a minimum horizon of three years (HM Treasury, 2024[32]). This development is welcome as it would ensure that public services delivery is always planned over the medium term.
1.4.2. The current fiscal trajectory is unsustainable in the long term
The United Kingdom faces mounting spending pressures related to population ageing, through higher health, long-term care and pension costs, aggravated by needed investments in the green transition, infrastructure, skills and innovation. Moreover, these needs come on top of the current difficult position of high debt, high interest payments and low growth, which raises borrowing cost over time. Illustrative simulations indicate that public debt will increase substantially to around 200% of GDP by 2060 under current policies (Figure 1.14, blue line). This increase is largely driven by rising costs for health and long‑term care related to ageing and pensions due to the expensive triple lock as well as significant investment needs to advance the green transition (Office for Budget Responsibility, 2024[7]). Still, the baseline scenario is a lower bound estimate, as spending needs due to climate risks are not accounted for in this simulation. More frequent and more severe weather events such as flooding or heatwaves put a strain on the health system, disrupt infrastructure, increase fiscal costs and insurance payments, and can ultimately lower output and productivity. While the UK government has set out a strategic five-year plan, the Third National Adaptation Programme (NAP3, Box 1.4), to boost resilience and protect people, homes, businesses, and cultural heritage against climate change risks , the Climate Change Committee judges the implementation of adaptation to be at an insufficient scale (Climate Change Committee, 2023[33]). As better adaptation will also benefit the resilience of public finances, it remains important that the government strengthens its efforts to prepare for climate risks facing the United Kingdom. This should include improved governance across levels and sectors to accommodate cross-sectoral impacts of severe climate events, sufficient investment to manage the scale of future climate risks and advancing the monitoring and evaluation framework.
Significant action is needed to stabilise public debt over the longer term. To achieve a stable debt trajectory, the primary balance would need to be on average in surplus of 0.8% of GDP throughout the projection period. This is a sizable shift from the pre-pandemic period when the debt stabilising primary balance was -2.5% of GDP (Office for Budget Responsibility, 2023[34]). Hence, immediate actions to increase revenue and manage expenditures are crucial. As outlined above and illustrated in the previous Economic Survey (OECD, 2022[6]), there remains little room for further cuts to public services after a decade of spending cuts in real terms. However, spending related to the triple lock for state pensions could be reduced. Thus, the triple lock is expected to add about 8% of GDP to public debt by 2072-73 (Office for Budget Responsibility, 2023[34]), despite the gradual increase of the retirement age to 67 years by 2028. Replacing the triple lock with the indexation of pensions to an average of CPI and wage inflation and providing direct transfers to poor pensioners to mitigate poverty risks as recommended in the previous Economic Surveys (OECD, 2022[6]; OECD, 2020[10]) would help to contain public debt somewhat (Figure 1.14, green line). On the revenue side, there is scope to mobilise additional revenues in a more efficient and progressive way, as discussed below. In addition to selected tax reforms that would help to improve the primary balance (Figure 1.14, dark red line), structural reforms to boost growth by increasing labour supply and stimulating productivity-enhancing investment could put debt towards a more stable path (Figure 1.14, orange line).
Gross government debt, % of GDP
Note: The Baseline scenario assumes current fiscal policies, average GDP growth of about 1.6% over the simulation horizon, and a deterioration in the primary balance from not offsetting health and long-term and pension-related spending; the Triple Lock Reform scenario assumes an improvement in the primary balance compared to the Baseline scenario due to savings from indexing pensions to an average of CPI and wage inflation; the Selected Tax Reforms scenario assumes a gradual improvement in the primary balance over a 5-year horizon from improved tax compliance and unfreezing the fuel duty; the Selected Tax and Structural Reforms scenario further assumes a gradual 0.5% increase in labour supply over a 5-year horizon and a gradual increase in productivity enhancing investment to G7 average, as described in Table 1.5.
Source: Simulations based on the OECD Economics Department Long-Term Model.
The Third UK National Adaptation Programme (NAP3) outlines the key actions for 2023-2028 that the UK government and other stakeholders will take to adapt to climate, in response to the Third Climate Change Risk Assessment (CCRA3). The programme is part of a statutory cycle under the Climate Change Act 2008, which mandates the government to assess climate risks and plan adaptation measures every five years.
NAP3 focuses on several key areas:
Protecting the Natural Environment: Efforts include enhancing flood defences, promoting nature-based solutions, and supporting biodiversity through schemes like the Nature for Climate Fund and Environmental Land Management schemes.
Supporting Businesses and Infrastructure: This involves adapting critical infrastructure such as electricity networks and railways to withstand climate impacts and promoting resilient construction practices. The NAP3 also includes strategies to help businesses to understand and adapt to the risks and opportunities presented by climate change.
Public Health and Communities: Measures include addressing overheating in schools and hospitals, ensuring resilient water supplies, and protecting vulnerable populations from climate-related health risks.
Mitigating International Impacts: The plan considers the global interconnectedness of supply chains and includes strategies to safeguard food and other imports from climate disruptions.
Local and Regional Efforts: Collaboration with devolved governments (Scotland, Wales, and Northern Ireland) ensures region-specific adaptation plans. Local authorities are also engaged through initiatives like the Local Authority Climate Service pilot scheme, providing localized climate data and support.
Overall, NAP3 emphasizes building a resilient economy and society by investing in adaptation research, enhancing infrastructure, and implementing sustainable land and water management practices.
Source: HM Government (2023[35]); UK Department for Environment, Food & Rural Affaires (2024[36]).
1.4.3. Refining the fiscal framework to better support debt management
The UK fiscal framework is in general stable and features strong institutions, but current fiscal rules within the framework may lead to short-termism and to a trend deterioration of public finances. Since Autumn 2022, the two main targets are falling public sector net debt excluding the Bank of England as a share of GDP, and public sector net borrowing not exceeding 3% of GDP, which are both defined as rolling targets to be achieved in the fifth year of the OBR forecast. The current targets are looser than the ones they replaced, as they are focusing on the fifth year, rather than the third year, of the forecast period (OECD, 2022[6]). Moreover, the actual date for meeting a rolling target never arrives by construction, which at each point in time creates strong incentives to implement looser fiscal policy in the near years and postpone consolidation (Figure 1.15). The government could consider shortening the time horizon of its fiscal rules, while also better defining escape clauses to accommodate economic shocks outside government control, by setting clear conditions for when to suspend the rules and when they should be reactivated. Clear guidelines for the government to invoke escape clauses rather than changing the fiscal rules, as frequently done over the past years (UK House of Commons, 2024[37]), would ultimately strengthen the credibility of the framework.
The timing and horizon of the fiscal rules entail sub-optimal fiscal policy, as they impede large-scale public investment with longer planning horizons. Focusing the assessment of fiscal sustainability solely on rules based on a five-year window does not allow for public investment to feed through into the supply side of the economy and drive-up income. Since investment is treated in the same way as current spending, resources allocated to public investment often end up as the adjustment variable to meet fiscal rules, resulting in inefficiently low levels of productivity-enhancing public investment and significant delays in approved investment projects (Resolution Foundation & Centre for Economic Performance, LSE, 2023[38]). Budgeted public investment as a share of GDP kept being lowered in successive fiscal events (Figure 1.15, Panel C), even as GDP forecasts were revised down. Government spending plans set out in the 2024 Spring Budget imply a significant cut to public investment over the coming decade according to the Institute of Fiscal Studies (Emmerson et al., 2024[31]). As public investment is already low compared to OECD peers (OECD, 2022[6]), this will have important repercussions on the ability to maintain public infrastructure and to create the necessary signal to raise complementary private investment (National Infrastructure Commission, 2023[39]). The OBR has estimated that new public investment of around 0.4% of GDP is needed each year by the end of the decade to meet the investment needs for the green transition alone (Office for Budget Responsibility, 2023[34]), and more is needed to renew or replace existing infrastructure (OECD, 2022[6]).
Note: Fiscal rules for March 2021 and March 2022 aimed for public sector net debt as share of GDP falling after 3 years, and to balance the current budget by the third year of the rolling forecast period.
Source: OBR Fiscal Forecast – March 2024.
Public investment should be prioritised based on rigorous cost-benefit analysis and decisions regarding these investments should be outlined in stable medium-term plans. This would improve planning certainty, which can also provide necessary assurance for private investment. The government should prioritise productivity-enhancing public investment within fiscal rules (see e.g. Box 1.5). The current fiscal rule, based on debt falling as a share of national income over the longer term, has its merits in terms of reduced complexity and easy communication. But only focussing on one side of the government balance sheet by looking at liabilities (debt), and not at assets, might be misleading when assessing debt sustainability. Including a measure such as public sector net worth, that provides a broader measure of public debt sustainability, inclusive of what the government owns and what it owes, as part of a broader range of fiscal metrics could help to better judge the sustainability of debt. It would provide a broader and more comprehensive picture of the public finances and could strengthen the incentive for governments to focus on investing in high-quality projects. However, as government assets often cannot be easily sold, public sector net worth does not provide information about the government’s ability to service its debt. It should therefore just be considered as complementary information.
The United Kingdom has strong fiscal institutions, which could be leveraged more effectively to further raise credibility. The OBR is generally commissioned by the Chancellor to prepare fiscal and economic forecasts twice a year to accompany fiscal events (OECD, 2019[40]). Under current legal requirements, the OBR must condition its forecast on stated policies that reflect budgetary policy decisions at the fiscal event, irrespective of the sometimes-unrealistic budgeting assumptions. For example, the OBR notes that its forecast relies on the seldom-implemented indexation of fuel duty (Office for Budget Responsibility, 2024[7]). Such arrangement insures the fiscal watchdog’s impartiality. However, forecast evaluations regularly conducted by the OBR indicate a general trend to overestimate real GDP growth and a tendency to underestimate the medium-term level of government spending leading to lower government borrowing (Office for Budget Responsibility, 2023[41]). Changing the legal requirement to include a forecast on debt development and fiscal headroom based on a “no policy change” scenario would allow to compare new policy measures to current tax and spending policies, giving a more transparent overview of the benefits and costs of new policy. Rather than focussing solely on compliance with fiscal rules, a requirement to assess the overall fiscal stance could also be introduced, as is for example the case in Ireland, where the fiscal council assesses the government’s overall fiscal stance, its macroeconomic and fiscal forecasts, and its compliance with fiscal rules (OECD, 2022[42]).
Denmark's fiscal framework allows for a structured approach to handling capital expenditures, with several key elements:
Medium-Term Budgetary Framework (MTBF): Denmark’s MTBF sets expenditure ceilings for central government, regions, and municipalities, usually for four years in advance. This framework includes capital expenditures but provides flexibility to prioritize and manage them within the overall limits.
Flexibility within Expenditure Ceilings: The expenditure ceilings are designed to ensure fiscal discipline but are periodically reviewed to allow adjustments based on economic conditions and investment needs. This provides a framework within which capital expenditures can be planned and executed effectively.
Regular Reviews and Adjustments: The government conducts regular reviews and adjustments of the expenditure ceilings to respond to economic changes and investment requirements, ensuring that capital expenditures remain aligned with fiscal policy goals.
The Dutch fiscal framework has provisions that distinguish between current expenditures and capital expenditures, allowing for borrowing specifically for public investment while requiring that current expenditures are to be covered by revenues. This means that the government can borrow to finance investments in infrastructure, education, and other long-term projects without violating fiscal rules.
Medium-Term Budgetary Framework (MTBF): The Dutch government employs a medium-term budgetary framework with multi-year expenditure ceilings. There is flexibility to allocate resources for capital expenditures over several years to ensure effective planning and management of public investments.
Investment Ceiling: Investment expenditure of a one-off nature that takes place over several years is not controlled annually by means of the expenditure ceiling, but falls under the investment ceiling. Expenditure covered by this investment ceiling can be shifted to future years if a project is delayed, as long as it complies with European budget rules.
Investment Prioritisation: Public investment projects are prioritized based on their economic and social impact. The government evaluates the expected returns and benefits of each investment to ensure that resources are allocated efficiently and effectively.
Debt Sustainability: While borrowing for public investment is allowed, the Dutch fiscal rules ensure that overall debt levels remain sustainable. The government aims to keep debt within certain limits to maintain fiscal stability and prevent excessive borrowing.
Transparency and Accountability: The Dutch government publishes regular reports on public finances, including information on borrowing and public investment. This transparency ensures that the public and policymakers are informed about the government's investment decisions and their impact on fiscal sustainability.
Source: OECD (2019[43]; 2024[44]); Danish Ministry of Finance (2024[45]; Danish Ministry of Finance, 2014[46]); Dutch Ministry of Finance (2022[47]; 2012[48]); Vierke and Masselink (2017[49]).
1.4.4. Improving public finances calls for reforms on the revenue side
The government faces a tight fiscal environment as low growth weighs on revenues, substantial spending on debt interest, and limited room to cut public spending. Although the tax burden on households and businesses has increased, it is lower than in G7 and large European economies (see above), and even with the expected rise towards a post-war high of about 37% of GDP by 2028-29 it will remain in line with G7 countries (Office for Budget Responsibility, 2024[7]). While raising taxes will help to finance necessary spending, the government has to shift to solutions that make the tax system fairer and more effective to avoid unnecessary economic distortions, in particular with respect to investment and labour supply.
Raising compliance through a less complex tax system
Compliance with tax payments has improved, but could be further enhanced. The government has made significant advances in increasing compliance and reducing the tax gap, which measures the difference between tax collected and the total amount of tax that should, in theory, be collected if individuals and businesses paid all due tax. The tax gap as share of GDP fell from 2.3% in 2005-06 to 1.5% in 2021‑22 (Figure 1.16, Panel C). About two-thirds of the reduction came from greater compliance in paying VAT, owing to the declining use of cash and several measures introduced by HM Revenue and Customs department (HMRC) to reduce the VAT tax gap. The corporation tax gap has however increased from a low of 0.2% of GDP in 2011-12 to 0.4% in 2021-22 largely driven by small businesses (HM Revenue and Customs, 2023[50]). It is welcome that HMRC has introduced support for small businesses to navigate the tax system. Capacity issues in the HMRC to provide customer service and to collect tax debts are a growing issue as frozen tax thresholds increase the number of taxpayers (Office for Budget Responsibility, 2024[7]). It is therefore a positive step that the government has announced further investments to address non-compliance, including in HMRC’s capacity to collect tax debts, in its Spring Budget 2024 (HM Treasury, 2023[3]).
Tax gap
Note: The tax gap estimates only cover the taxes administered by HMRC, so they exclude any taxes and duties administered elsewhere, such as council tax, business rates (property taxation of businesses) and vehicle excise duty, as well as charges such as the congestion charge.IT, NICs and CGT stand for Income Tax, National Insurance Contributions and Capital Gains Tax, respectively.
Source: OECD Tax database, Office for Budget Responsibility (2024[8]).
Streamlining the tax system could increase compliance and efficiency. Parts of the UK tax system are complex, leading to large compliance costs. For example, the tax system features more than 300 non‑structural reliefs, accounting for about a fourth of all tax revenue in 2022-23, which are reliefs designed to help or encourage specific types of individuals, activities, or products to achieve economic or social objectives (HM Revenue and Customs, 2024[51]). The Treasury and HM Revenue and Customs made important improvements, including publishing the objectives for non-structural reliefs in 2021 and increasing the number of relief with published cost estimates, and started to provide high level commentary on movements in the cost of significant reliefs (National Audit Office, 2024[52]; HM Revenue and Customs, 2024[51]). Non-structural reliefs should be evaluated and phased out if they only have limited impact, run counter to overarching government objectives or constitute an inefficient way to achieve their stated objective. The government should consider reinstating the Office for Tax Simplification, which was closed following the September 2022 Mini-Budget.
Raising revenues through a fairer and more efficient tax system
The government should conduct a comprehensive tax review that goes beyond costing reliefs to identify ways to make the tax system fairer, reduce distortions and close loopholes. Regularly conducting tax expenditure reviews, as for example done in Canada (Government of Canada, 2024[53]), could help identify inefficiencies in taxation. Potential reforms have been highlighted in the chapters of this Survey and previous Economic Surveys, and could include:
Updating council tax and removing stamp duty land tax: The council tax bands in England are based on property values in 1991, in Scotland on property values in 1995 and in Wales on slightly more recent property values in 2003. Thus, every property in England is assigned to one of eight valuation bands ranging from A to H, based on its estimated capital value as of April 1991. Each local authority in England determines the overall council tax level in their jurisdiction by setting a rate for properties in Band D, which is then used to calculate the tax rates for properties in other bands as proportions of the Band D rate (Xu et al., 2020[54]). Updating the property values that determine the amount due for council tax and adjusting thresholds for higher property values should be a first step (OECD, 2020[10]; 2017[11]; 2022[6]). Council tax, along with central government grants, serves as a key funding source for local authorities. As property values evolved differently across England since 1991, updating these values will result in some local authorities receiving increased revenues from council tax, while others will see a decrease in received revenues (Xu et al., 2020[54]). As such, the effects of updating property values on local authority funding should be carefully monitored. Adjustments in complementary central government grants might be necessary if these updates exacerbate inequalities between local authorities. To make the system fairer and less distortive, the government could consider moving towards a more proportional system by introducing more valuation bands or even fully moving towards a proportional system where the tax on a property is determined based on its current value, rather than being assigned to a fixed band. The government could further consider removing stamp duty land tax, which is a tax paid by the buyer of a UK residential property. The amount to be paid depends on the price paid for the property, and whether the buyer is a first-time buyer or owns multiple homes. As such, stamp duty land tax can discourage people to move for better job prospects or to downsize during retirement hampering the reallocation of housing in a tight market.
Broadening the VAT base: Non-structural reliefs in the VAT system created a revenue shortfall in 2022-23 of about GBP 70 billion (HM Revenue and Customs, 2024[51]), in addition to a GBP 20 billion revenue shortfall in structural reliefs (HM Revenue and Customs, 2023[55]). Zero‑ and reduced-rates for goods such as food, children’s clothing and domestic fuel are often justified on distributional grounds but are poorly targeted at helping those on low incomes. Similarly, the VAT reduction on domestic fuel and power meant to reduce costs on individual’s energy bills is poorly targeted and has had a fiscal cost of 0.35% of GDP in 2022-23 (and 0.2% of GDP before the energy price crisis) (HM Revenue and Customs, 2024[51]). While lower income households indeed spend a higher share of their income on energy use, better off households tend to have an overall higher energy consumption in absolute terms (ONS, 2023[56]). Moreover, this VAT reduction disincentivises investment in decarbonised heat solutions (Chapter 3) and runs counter the overall objective to transition to net zero. Broadening the VAT base by reducing or eliminating the zero and reduced-rates on domestic consumption while compensating poorer households through the universal credit system could help to reduce distortions and make the tax system more efficient and effective.
Simplify the income tax system: The current income tax system creates several distortions deterring labour supply. As discussed in Chapter 4, bumps in the marginal income tax rate could deter individuals from increasing working hours. Frozen thresholds disadvantage particularly people at the lower end of the income distribution and should be gradually removed. Moreover, National Insurance Contributions between self-employed and employed could be further aligned.
Reduce interest tax deductibility within the corporate tax system: As discussed in Chapter 2, the corporate tax system allows interest payments to be deducted against corporation tax, up to a limit of GBP 2 million a year. This encourages firms to finance themselves with debt rather than equity and can make unprofitable investments viable by the tax system which is exacerbated when combined with full expensing of new investment.
As discussed in the previous Economic Survey (OECD, 2022[6]), implementing well-designed carbon taxes can help finance necessary green investments, offset negative distributional effects of carbon pricing and help secure public acceptance.
Several proposed reforms could further be designed in a revenue neutral way as illustrated in Box 1.6, such as reforming council tax or extending full expensing to all capital but restrict debt interest deductibility. Some of the proposed reforms should be accompanied by compensation for poorer households as outlined above, but gains are likely to outweigh additional costs. Changes to the tax system should follow an in-depth tax review with a strategic focus on making the tax system fairer and less complex in the medium term.
This box summarises potential long-term impacts of selected recommendations included in this Survey on GDP (Table 1.5) and the fiscal balance (Table 1.6). The quantified impacts are merely illustrative. The estimated fiscal effects include only the direct impact and exclude behavioural responses that may occur due to policy change.
Note: The quantification impacts are merely illustrative. While recommended reforms in this Survey have budget and GDP implications, not all can be quantified due to model limitations.
Source: OECD calculations based on the framework in Égert (2018[57]) and the OECD long-term model.
Note: These estimates are subject to a wide margin of error. They do not represent the actual gain as they do not take account behavioural effects and the impact does not account for the change in GDP. Reforming council tax: Depending on design, could be revenue neutral or enhancing, i.e., doubling the rates for bands F, G, H and E as suggested in OECD 2020. Not all reforms recommended in this survey can be quantified due to model limitations.
Source: OECD calculations based on the OECD Economics Department’s long-term model; UK government (2023), Direct Effects of Illustrative tax changes https://www.gov.uk/government/statistics/direct-effects-of-illustrative-tax-changes/direct-effects-of-illustrative-tax-changes-bulletin-january-2023, IFS.
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