The daunting economic challenges facing the UK’s next chancellor

Nadhim Zahawi’s successor will have to provide support as the country grapples with falling into recession

The chancellor picked by Britain’s new prime minister will face a daunting array of issues from the moment he or she takes office.

Whoever takes the hot seat in the Treasury will find themselves in a similar position to Rishi Sunak in March 2020 when the pandemic hit and the economy faced being shutdown for several months.

Nadhim Zahawi, the current chancellor, is widely expected to be replaced under a Truss or Sunak government. In his final weeks, the Treasury has been drawing up a menu of options for the incoming prime minister to tackle the cost of living crisis.

Here we outline the top agenda items:

Support for households

Both Truss and Sunak have pledged help for families bracing for the typical energy bill rising to £3,549 from October, at a time when inflation is already above 10% and some economists say it could hit 22% – close to a postwar high – if high oil and gas prices are sustained.

Any package would probably build on or replace the £15bn of support announced by Sunak in May, reflecting continued sky-high prices in wholesale energy markets seen over recent months amid Russia’s war in Ukraine.

The Resolution Foundation has warned families will see their spending power cut by £3,000 on average by the end of next year, unless the new government acts to counter the biggest hit to living standards in a century. Forecasts from Cornwall Insight show the Ofgem price cap could come close to £7,000 for a typical bill by autumn next year, more than six times the level a year ago.

Truss committed in the Tory leadership campaign around £30bn to reversing Sunak’s rise in employee national insurance payments earlier this year, cuts to income tax and a pledge to block a rise in corporation tax.

Sunak has pledged to increase a £650 payment due this October for households on means-tested benefits.

Support for business

The British Chambers of Commerce has called on the government to agree a temporary 5% reduction in VAT on energy bills and a Covid-style emergency energy grant for small and medium-sized businesses.

“The government must grapple with high energy prices and the cost of doing business crisis as a matter of urgency in order to boost productivity and deliver economic growth for the UK,” it said.

Zahawi has confirmed that targeted reductions in VAT and business rates are being prepared by Treasury officials to help the retail and hospitality sectors, but without saying how much they would cost.

He expects the next prime minister to also offer energy-intensive industries tax breaks to get through the winter.

So far there is little else on offer to businesses to cushion the blow of rising energy costs. Businesses have complained the additional burden of higher wages that follow acute skills shortages in many industries and flagging sales as the UK enters recession also need to be considered when a rescue package is agreed.

The public finances

Investors have become wary since Russia’s invasion of Ukraine revealed the UK’s vulnerability to an energy and food shock.

While ministers have successfully cut imports of Russian gas to zero, the UK continues to pay the global market price for its own gas and for imports from the Middle East.

Fertiliser and transport costs have rocketed, pushing up the price of domestic and imported foodstuffs. Imports account for about 40% of UK food sales.

Investors are also concerned that Brexit has limited access to workers and meant the UK has an acute skills shortage, pushing up wages.

These fears have pushed down sterling and increased the interest rate on Britain’s debts, which soared in August at the fastest monthly rate in almost 40 years.

Ten-year UK government bond yields, which are a proxy for the effective interest rate on public borrowing, hit 2.78% to register the biggest monthly rise since September 1986.

The pound has dropped from $1.36 in March to just above $1.15 last week as confidence in the UK’s ability to recover strongly from the crisis has ebbed away.

An expected borrowing cost of £83bn is likely to be nearer £110bn, according to the consultancy Capital Economics from a spending budget of almost £1tn.

It is a chunky increase and takes the annual interest bill to more than 10% of spending but when the world is borrowing more to cope with the current crisis, investors will be willing to lend to the UK government.

Economic growth

The new chancellor will enter the Treasury with alarm bells ringing for economic growth. Some analysts warn the economy has already fallen into a recession this summer, while the Bank of England expects a lengthy downturn triggered by the cost of living crisis to begin this winter.

Consumer spending is expected to plunge into reverse as households tighten their belts to cope with soaring energy bills, with a knock-on impact for hospitality, leisure and retail firms still only just recovering from the Covid pandemic.

Recession is expected to drive up unemployment as companies come under pressure, reversing the post-lockdown trend for chronic staff shortages, amid a period of strained labour relations between trade unions, some employers, and the government.

Rebooting the country’s faltering growth engine will be a key priority, although experts warn this is easier said than done. Truss has set a 2.5% annual growth target, promising tax cuts, “supply-side reforms” and scrapping EU-derived laws to achieve her aim.

According to analysts at the consultancy Capital Economics, Truss’ tax-cutting plans and immediate support for families struggling with their energy bills could add about 1.3% to GDP, albeit not all in one year, but would cost almost £50bn to achieve.