UK's Fiscal Stability Under Threat: How US Tariffs Could Impact Economic Growth
UK Prime Minister's Stance on Fiscal Rules
In a recent statement, UK Prime Minister Keir Starmer emphasized that the country's fiscal regulations are 'ironclad' and 'nonnegotiable.' Despite growing calls for the government to ease these rules for financial flexibility, Starmer insists that these self-imposed limits are crucial for ensuring economic stability in the UK.
The 'stability' rule mandates that the UK must align its daily public expenditures with tax revenues, avoiding borrowing throughout the parliamentary term.
However, the economic turbulence triggered by US President Donald Trump's tariff policies poses a significant challenge to this rule. The potential repercussions of US tariffs could reverberate through both the UK and global economies.
The International Monetary Fund (IMF) has projected that a 10% increase in tariffs could lead to a 0.5% reduction in global economic growth by 2026, particularly if retaliatory measures are taken by China and the EU.
Similarly, the UK's Office for Budget Responsibility (OBR) forecasts that a 20% tariff rate could diminish the nation's economic growth by up to 1%, potentially reducing the anticipated budget surplus for 2029-30 to nearly zero.
This situation complicates the UK's fiscal framework. A decline in GDP growth would likely lead to decreased tax revenues, necessitating either tax hikes or cuts in public spending, as borrowing is not an option under the stability rule.
Concerns are mounting that the government's nearly £10 billion spending cushion could vanish by the end of the parliamentary term, prompting questions about how it plans to adhere to its fiscal guidelines. Any resulting tax increases or spending reductions could stifle economic growth and adversely affect citizens' lives, especially if based on forecasts that may not materialize.
This uncertainty was evident during the spring statement in March, when Chancellor of the Exchequer Rachel Reeves announced spending cuts after the GDP growth forecast was halved from 2% to 1% for the year.
The extensive tariffs introduced by President Trump could similarly impact the UK's growth trajectory.
Relaxing or eliminating fiscal rules might alleviate the pressure to respond to potential growth downgrades, which remain uncertain given the fluctuating nature of US tariffs.
The Debt Dilemma
Despite these pressures, both the Prime Minister and Chancellor have resisted altering the fiscal rules, fearing it could undermine the UK's credibility with creditors who assess government debt in the bond markets.
Like many advanced economies, the UK relies on borrowing from bond markets to cover budget deficits. With a debt-to-GDP ratio exceeding 95%, there are concerns that creditors may demand higher interest rates to lend to the UK.
Increased interest rates on national debt would inevitably reduce funds available for public services.
Currently, the UK allocates over £100 billion annually to debt interest payments, surpassing expenditures on education and investment.
This figure has surged in recent years due to the global financial crisis and the COVID-19 pandemic. Comparatively, the UK spends a larger portion of its GDP on interest payments than other G7 nations, with 3.3% in 2022 compared to the G7 average of 1.7%.
A significant factor is the UK's higher proportion of inflation-linked debt, with about 25% tied to inflation, which is double that of Italy, the next highest in the G7 at 12%. Given the recent inflation trends, this makes the UK particularly vulnerable to fluctuations in bond markets.
For instance, a one-percentage-point decrease in borrowing costs could save £21 billion over five years, which is double the current fiscal buffer at risk from US tariffs.
Without clarity on how bond markets might respond, the government faces challenges in modifying its fiscal rules. However, applying the stability rule during such volatile times is equally difficult. Given the unpredictable nature of US tariffs, this debate is likely to persist.