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Sunak faces ‘messy’ economic outlook as inflation eats into his Budget, Resolution foundation says

The chancellor, Rishi Sunak, should plan for more tax hikes as his Budget faces a storm of “messy and unpredictable” economic challenges.

UK growth may have defied bleak forecasts made early in the Covid-19 pandemic, but recent challenges, including vast disruption to global trade, could scupper the recovery, according to a report by the Resolution Foundation thinktank.

Beyond supply chain disruptions, which have caused a host of shortages and stalled growth in some sectors of the economy, the Treasury will also have to address the problem of climbing inflation and a fuel crunch. This means that while Mr Sunak may hope GDP climbs by enough to lower taxes, “he should also plan for the eventuality that the economy turns out to be smaller than expected and that more tax rises are needed,” the thinktank said.

The Budget and Spending review comes after 18 months of an emergency footing during which the chancellor had to prop up the UK economy as it seesawed in and out of lockdowns.

The furlough scheme, aimed at minimising the damage of lockdown on the labour market, ended last month. It is still unclear what impact this will have on unemployment going forward. Some economists anticipate a modest rise in unemployment but others warn that many workers may have dropped out of the workforce altogether.

Few of the choices the chancellor faces will be easy, said James Smith, research director at the Resolution Foundation. The cost-of-living squeeze is only one of a host of challenges for the chancellor.

The government has lauded efforts to tackle regional inequality through public investment under its flagship levelling up policy. Mr Sunak will also have to juggle the competing interests of departments starved of cash due to the long-term effects of austerity. Another huge challenge facing Mr Sunak and the government is exactly who will foot the bill for slashing the UK’s carbon emissions, with growing resistance toward green-levies from tory backbenchers.

Forecasts for economic growth are set to be upgraded by the biggest amount on record, with GDP expected to increase by 7.5 per cent in 2021, the largest amount for nearly 100 years, aside from wartime distortions, according to the thinktank. But the sharp turnaround comes after the economy suffered its biggest contraction in a century last year.

Meanwhile, the steep rise in inflation may prevent the chancellor from cashing in on improvements to the financial outlook due to recent GDP growth eating into the “windfall” from higher GDP.

Early estimates of headroom before next week’s Budget have been eroded by climbing price growth. Higher inflation will feed into borrowing costs, leaving Mr Sunak with only £30bn more than hoped for this year, and around £10bn a year by 2025.

“Temporary or not, higher inflation is a problem because it will reduce real incomes by as much as 2 per cent,” the report warned, equivalent to £1,000 for the average household income.

Yet, if the Bank of England raises interest rates while the government increases taxes it could cause “major headwinds” for consumers’ spending power, the Resolution Foundation said.

The situation is a challenge for the Bank of England, as it seeks to follow its mandate to keep prices low and stable, while also not triggering a slowdown in the UK’s weakened economy by raising interest rates, which increase the cost of borrowing for households and businesses.

“The backdrop to the Budget will be a strong recovery from the pandemic that risks being derailed by rising inflation and economic disruption that will squeeze both the chancellor’s borrowing windfall and family budgets.

“The decisions the Rishi Sunak will take next Wednesday will help to define the rest of the parliament, and the type of chancellor he’ll be remembered as. But amid such long-term and legacy-defining announcements, he must not forget the cost of living crunch facing families up and down the country right now,” Mr Smith said.