Could the OBR bring good news for the UK?

With the UK’s Office for Budget Responsibility (OBR) set to publish its updated economic and fiscal outlook on March 26, we are starting to see headlines concerning potential changes the Labour government could make to its budgeting plans in response to shifting forecasts.

The OBR’s October 2024 outlook included growth projections of 2% for the UK in 2025, which at the time we said looked optimistic. The current Bloomberg consensus is at 1% for 2025, which gives some idea of the size of the adjustment that might be needed. Since lower growth means lower tax revenues, as the saying goes there are only so many ways to skin a cat; the government must either reduce spending, increase taxes, or abandon its fiscal rules and deficit targets (or find a suitable combination of the three).

In recent days, we have seen comments from the employment minister, Alison McGovern, and Prime Minister Keir Starmer himself on the government’s plans for reform of the welfare system, as markets and taxpayers eagerly await the release of its “green paper” on getting more people back into work. According to McGovern, “The whole point of the green paper is to reshape the system, so we increase the possibility, the chance, the likelihood of people moving into work,” and “(the current system) is setting us in a bad direction in terms of the fiscal position.”

As investors, we will believe it when we see it. Given the current fiscal situation in the UK and the lack of room the Chancellor, Rachel Reeves, has to stick to her targets, markets will not be giving much credit to right directions or well-intentioned plans to change things in the future. However, at the very least we can assume that the welfare system, and chiefly how benefits are assigned, will be part of the discussion, and there are two parts of the benefits system that are regarded as strong candidates for a shakeup. One is the work capability assessment, or WCA, and the other is the personal independence payment, or PIP. Given these terms might appear in both the OBR’s revised outlook and the Chancellor’s Spring Statement, we thought it would be useful at this stage to summarise where they sit in the government’s budget and give readers some idea of the numbers involved.

The OBR splits welfare system benefits into two categories, both of which can be claimed at the same time and are aimed at supporting people affected by sickness or disability.

The first category is incapacity benefits, which are meant to provide income replacement for people of working age who have difficulty performing day-to-day activities due to ill health. One of the most important steps in the process is that the claimant must complete a WCA, which includes a questionnaire and a medical assessment. This WCA can yield three outcomes: the person is fit for work, has limited capacity for work (LCW or “less severe incapacity”) or has limited capability for work and work-related activity (LCWRA or “more severe incapacity”).

Exhibit 1 below shows WCA decisions made by the UK’s Department for Work and Pensions split by outcome on the left-hand side, while the right-hand side shows the percentage of claimants that are awarded incapacity benefits (the chart shows the number of decisions in each period, rather than cumulative). The trend is clearly towards higher approval ratios, which according to the OBR’s Welfare trends report from October 2024 is partly down to changes over time that have influenced behaviour. Some of these include the scope of coverage, changes to the WCA and reductions in awards for the “less severe incapacity” group, which seems to have led to higher claims in the “more severe incapacity” group. After 2017, claiming LCW benefits became more cumbersome, and some restrictions were introduced. For context, the monthly amount of £156.11 for LCW benefit pales in comparison to the £416.19 claimants receive if they are deemed to have LCWRA. The percentage of WCA decisions resulting in “more severe incapacity” benefits being paid increased significantly more than other categories following the 2017 changes.

To be clear, we are making no comment on the desirability or otherwise of this trend towards more severe incapacity benefit – this is simply to demonstrate that when the government does make changes to some of the criteria, the impact can be meaningful.

Another way of looking at the problem is by tracking the number of people that are not currently in the workforce due to long-term illness. Even after a mild decline in recent months, there are over 2.7m people aged 16-64 that are not in the UK labour force (either in employment or looking for employment) due to long-term illness (see Exhibit 2). As a comparison, there are 32.3m in that age group currently in employment.

The second category is disability benefits, which are aimed at covering the extra costs of daily life and mobility brought about by disability and long-term health conditions. The process for disability benefit does not include a WCA since the decision does not have to do with the claimant’s ability to work, it is not means-tested and is available to those who work as well. According to the OBR, around two-thirds of those who receive disability benefits also receive incapacity benefits, and close to one-sixth of claimants have a job. The PIP is the UK’s main disability benefit today, with the previous disability living allowance (DLA) scheme mostly closed to new claimants. As opposed to incapacity benefits, the disability benefits process allows for more granular analysis. Numbers show that 40% of people on PIP/DLA benefits are claiming due to mental health reasons. An article in the FT on Tuesday noted that “ministers believe that the PIP system was never intended to pay for so many people with mental health conditions,” so this might be an area where changes are introduced.

According to the OBR’s October 2024 economic and fiscal outlook, in the 2023/24 tax year the government spent £64.7bn on incapacity and disability benefits combined, equivalent to 2.4% of UK GDP and representing 6% of public sector current expenditure. The OBR’s expectation at the time was that this number would rise to £100.7bn (3.0% of UK GDP) in 2029/30. As a comparison, the amount the central government spent in debt interest was £82.8bn in the same period. The trends are worrisome for the UK’s fiscal position, which is why we have seen government officials discussing ways to address the issue now that the OBR’s new forecasts are due to be published on March 26.

Stakes are high, both politically and economically, when it comes to potential changes aimed at reducing these benefits. Let’s not forget that there is a planned increase in defence spending that Reeves must work into her budget, with limited room for manoeuvre. The positive spin on this situation would be that if the government’s welfare reforms were to result in more people entering the workforce, this could have a positive impact on productivity and wage inflation. Along with the increase in defence spending, an investment that should provide a future boost to GDP and an expansion in installed capacity in the economy, these developments might see markets reward the UK government with lower Gilt yields. The combined effect of the above might also be a lower debt-to-GDP ratio in the future.

At this stage, and with a mind on the generally negative reaction to Reeves’ October Budget, we would prefer to remain on the sidelines when it comes to Gilts and instead look for UK opportunities in solid corporate and financial names rather than government bonds. However, for the first time in a long time, we might find some mildly positive news in the OBR’s update later this month.