In every downturn, the government’s finances will deteriorate, sometimes sharply. Tax receipts fall as job losses, bankruptcies and subdued spending impact the three big sources of revenue for the Treasury – income tax, National Insurance and VAT. On the debit side, government spending rises through unemployment benefits and welfare payments.
There is always a moment at the depths of a downturn when the budget deficit looks awful and the prospect of a return to more balanced books impossible. Wednesday’s budget statement was the epitome of this.
Not surprisingly this pandemic has had an even more profound impact than we usually see during downturn. Government measures to support the economy from complete collapse during extended lockdowns, has pushed their spending to levels unprecedented during peacetime. Roughly 75% of the increase in the budget deficit has arisen due to these support measures – about £200bn in all. This week’s commitment to extend support until September will only increase the scale of this spending. And it’s all funded through borrowing.
Whilst tax receipts have fallen during COVID, the reduction is less than might be expected, testimony to the success of the support package in stunting the rise in unemployment and bankruptcies so far. Tax receipts as a percentage of GDP have remained roughly in line with their long run average of 37% of GDP. Contrast this with Government spending, which has risen from its more usual level of 40% of GDP to 55% and rising.
Whilst interest rates are virtually zero, stretching the balance sheet might be perfectly legitimate, but if interest rates were to rise (more on this later), the interest burden on the borrowing becomes problematic. This explains the Chancellor’s desire to ‘level with the British people’ on the unsustainability of current levels of spending and borrowing and the need to rebuild public finances in the future.
Budgets are, by their very nature, a balancing act and this week’s was no exception. Few have been so keenly anticipated, and with very good reason. Rishi Sunak was faced with the dilemma of starting the process of raising revenues to repair the UK’s battered balance sheet but equally he had to tread carefully to avoid choking off economic recovery before we had even rejoiced at seeing any green shoots. His tone was one of recognition that some tough decisions would need to be made, but that the economy is simply too fragile to withstand this at present, meaning most of the pain would be felt further along the recovery path.
As expected, and with very little alternative, he extended emergency tax cuts to help the British economy recover from the coronavirus but warned he would ask profitable businesses to help pick up some of the tab for the U.K.’s pandemic support. With the country still in the (hopefully) final throes of lockdown, the Chancellor made it clear that safeguarding jobs remains his priority in the short term, adding another £65 billion of financial support to help the country recover this year and next.
Integral to maintaining life-support for the economy he extended the stamp duty concession on property purchases for a further 3 months, a move widely expected, before this tapers down to the pre-crisis level at the end of September. The residential property market has been especially buoyant during the COVID crisis and the Chancellor, rightly in our opinion, does not want to whip away the punchbowl until there are more signs of life in the wider economy.
But in recognising the enormity of the deficit which has been racked up, he sketched out a plan to start plugging the gap, with an increase in corporation tax to 25% from the current 19% though this does not apply to the vast majority of businesses and even where it does, it kicks in from 2023. He said ‘The government is providing businesses with over £100 billion of support to get through this pandemic, so it is fair and necessary to ask them to contribute to our recovery’. He added ‘Even after this change, the U.K. will still have the lowest corporation tax rate in the G-7’. Whilst this may be true, there is no doubting the steepness of this rise and we would have expected to see more of a taper.
But it is not just businesses that will foot the bill. The decision to maintain income tax, National Insurance and VAT at their current levels should come as a welcome relief to consumer confidence and household budgets in the short term, but there was an inevitable sting in the tale. With tax allowances including the lifetime allowance, being frozen from next year until 2026, known as fiscal drag, this effectively increases the amount of tax consumers and savers pay over time. We see this as the only credible solution to not jeopardising the near term recovery for an immediate tax-grab, but stealthily tackling the conundrum of driving up tax revenues in the future.
Below is a summary of the key changes outlined:
Taxation and duties
Financial markets had generally priced in the announcement, since several of the measures had been leaked. The pound barely changed but the equity market reaction was generally positive with the FTSE100 ending the day up 1%. It was no real surprise to see rising share prices among those businesses that should be beneficiaries of further support to the domestic economy, such as banks and leisure stocks, alongside housebuilders, with the latter getting a boost from the extension of the stamp duty holiday and mortgage guarantee programme.
Rising too was the yield on government bonds. Whilst this might sound positive, it isn’t because when the yield rises, bond prices fall. This move continued the trend seen for much of this year. Bond markets are anticipating economic recovery, which brings with it the threat of inflation and ultimately higher interest rates and Mr Sunak’s comments on Wednesday did little to convince investors otherwise. This remains one of the key reasons we have been underweight bonds across all CDC portfolios and tactically we still favour stocks over bonds.
As always, if you have any questions about this, or need more information, please feel free to contact your adviser, who will be happy to help.
Dr Andrew Mann