A dose of realism

Weak growth and fragile confidence, but cautious optimism ahead as tax hikes seem unlikely.

Growth is anaemic, confidence is fragile and business frustration is mounting. Speaking at CIL’s Annual Economic Update, Sunday Times Economics Editor, David Smith admitted that conditions have been tough. But better times may lie ahead. Smith does not expect any major tax hikes for business in next month’s Budget. And many companies remain optimistic about their prospects.

It was all supposed to be different. This time last year, optimism was riding high. The UK was on the cusp of change, with a new government, a fresh agenda and a stated intention to kickstart growth.

Then came ‘that Budget’ followed by a string of ill-judged decisions, which have depressed growth, sent confidence tumbling and fuelled frustration with policymakers.

The Investment 360 Index provides graphic evidence of plunging sentiment across the UK business community. More than 70% of respondents believe the government is not doing a good job, the worst reading since the survey began nine years ago. Short-term confidence has plummeted too, with almost 60% of respondents feeling negative about economic prospects over the next two years, compared to 15% just 12 months ago.

Government dithering lies at the heart of businesses’ frustration, with 30% of respondents claiming UK domestic policymaking has the greatest impact on boardroom decisions, far ahead of Trump’s maverick trade policies, at 9% or even technological change, at 20%.

It is not a pretty picture. Fortunately, it is not entirely grim either. While business leaders are damning of overall economic prospects, they are decidedly more optimistic about their own – and more upbeat about long-term growth too, with almost 75% feeling neutral or confident about the 5-10 year outlook.

Such sentiments seem about right. As Smith points out, even though there are many obstacles in businesses’ way, GDP growth has exceeded expectations so far this year, making the UK the fastest growing economy in the G7 during the first half of 2025.

In other words, reality on the ground may not be quite as bad as it seems. Not that people’s fears and frustrations are unwarranted. The UK has faced a series of shocks since the early 2000s, including the financial crisis, Brexit and Trump’s first term in government, the pandemic and Russia’s invasion of Ukraine. Although Brexit was the only homegrown problem, all seemed to have had an outsize impact on the UK and there have been more challenges in recent years, not least Liz Truss’s brief period in Downing Street, which sent shudders through bond markets and have left gilt yields permanently higher than those of other developed economies.

What next?

Against this backdrop, Smith poses four key questions, which could determine UK prospects.

• Will America drag the world into recession and will the UK be able to return to strong and sustainable growth?
• What will be in the Budget?
• Will Rachel Reeves last as Chancellor?
• How far and fast will interest rates fall?

Looking to the first, Smith highlights the sharp slowdown in US employment growth this year. In January, there were 300,000 additions to non-farm payrolls. By August, that had tumbled to just 22,000. Partly a reflection of Trump’s determination to deport immigrant workers and partly the result of Elon Musk’s Department of Government Efficiency, the slump has largely been blamed on Trump’s tariffs. Some economists believe a recession is now inevitable in the world’s biggest economy. Smith is more sanguine. Unlike our own central bank, the US Federal Reserve has a dual mandate – to keep inflation under control and to promote employment. True to that directive, the Fed has already started cutting rates and is expected to continue doing so, a policy that Smith believes will help the US economy to keep on growing and stave off a global recession.

That would spell good news for the UK, especially now. According to the UK’s oldest economic think-tank, the National Institute of Economic and Social Research, GDP growth is most likely to hover between 1% and 1.5% over the next five years. Uninspiring in itself, the forecast is particularly sombre when compared to our track record. Between 1945 and 2008, GDP growth averaged a healthy 2.8% per annum. Since then, figures have consistently disappointed.

The principal reason for this soggy performance is persistently poor productivity growth. Having risen by an average of 2% annually for decades, UK productivity plummeted after the financial crisis and is now running at less than 0.5%.

Various attempts have been made to address this. Successive Tory Chancellors tried to stimulate business investment through fiscal incentives and other schemes. Nothing really moved the dial. AI has been hailed as a magic productivity bullet. It may yet prove to be but the impact has been limited so far, with only 5% of respondents to our survey describing it as business critical.

The Government said on election that it wanted to make the UK the fastest growing economy on a sustainable basis. But actions to date have seemed at odds with that pro-growth rhetoric, particularly Reeves’ decision at last year’s Budget to reduce National Insurance thresholds from £9,100 to £5000. Smith describes this measure as ‘a guided missile aimed at sectors which employ lots of low-paid people.’ And the missile hit hard. Official data indicates that bars, pubs, restaurants and hotels have laid off almost 90,000 staff since last year, prompting trade body UKHospitality to accuse Reeves of slowing down investment and hiring, the very opposite of her stated growth ambition.

The growth conundrum

Smith acknowledges that Reeves was dealt a difficult hand by the outgoing Tory administration and she has since put day-to-day spending on a more realistic footing. Nonetheless, the 2024 Budget left the Government with marginal headspace and, after policy U-turns, rising debts, increased borrowing costs and reduced growth forecasts, Reeves now faces a multi-billion-pound black hole in the public finances.

That makes the forthcoming Budget ‘a real challenge.’ So, how will the Chancellor respond? Rumours have been flying for months but even the Treasury has stated that most are ill-founded, including such ideas as capital gains tax on high-value homes or cuts in pension tax relief. Crucially too, Smith believes Reeves will shy away from any further tax hikes on business, a move that would be welcomed across the business community.

Instead, the Chancellor will probably try and solve her problems by creative accounting and delayed tax hikes, such as freezing income tax allowances, ‘the biggest stealth tax increase in history,’ according to Smith but one that brings in revenues without explicitly losing votes.

Reeves will not just be thinking about voters but also about bond markets. UK borrowing costs are elevated across the board and the 30-year gilt yield is now at its highest rate since 1998. That indicates the markets lack confidence in this Government’s ability to bring borrowing down. For Smith, the pension triple-lock is an obvious area to consider. This pledge to raise pensions by the highest of three measures, inflation, wage growth or 2.5% annually, is enormously costly and criticised by many, even some of those who benefit from it. Yet Governments dare not tinker with it for fear of upsetting millions of senior voters. Smith understands this reluctance but suggests that even a review could be well received by bond investors. He also proposes cutting the freeze on fuel duty, a measure that may elicit unwelcome headlines but would bring in some much-needed revenues.

Reeves has had more than her share of unwelcome headlines in recent months, prompting questions about whether she will remain in post for much longer. Smith thinks she will, provided that this year’s Budget is more successful than the last one.

More cuts

She – and Starmer – will also be keeping a close eye on interest rates. The Bank of England has cut rates five times since last year, from 5.25% to 4% but recent reductions have been controversial. UK inflation remains above target, prices are rising faster than in other G7 countries and the cost of food is particularly problematic, with prices up 5% and trending higher. These stubborn price gains make it hard for the Bank to cut rates further in the near term, but Smith believes rates will come down to 3.5% next year and should remain at that kind of level in the long run.

Lower interest rates would bolster business confidence and may even kickstart investment. The corporate sector would also welcome some genuine signs of stability from the Government, an indication that they have a vision and will stick to it.

Even without such clarity, however, there are pockets of hope. The Investment 360 Index shows that more than half of all respondents are positive about the investment environment, they are broadly happy with current credit markets and increasingly confident in Bank of England policymaking. Businesses may not be keeping calm, but they are keeping motivated and they are certainly carrying on.