Why it’s hard to be optimistic about ‘the age of optimism’

Why it’s hard to be optimistic about ‘the age of optimism’

The latest Budget is memorable for a number of reasons. The first is that it was Rishi Sunak’s first true opportunity to start pontificating about a life after COVID, which, as the title suggests, he heralded as ‘the age of optimism’.

It was also the first time he has really extolled the virtues of being free from the manacles of Europe, giving him more freedom to make sweeping changes, an opportunity he seized when he reformed alcohol duties. More on this below. And finally it is hard to recall a budget in living memory that was so widely leaked, with speaker, Sir Lindsay Hoyle suggesting ministers should ‘walk’ for such misdemeanours. Mr Sunak did manage the odd surprise though.

The budget came against a backdrop of unprecedented government borrowing, supply chain disruption, rising energy prices, and surging inflation. Yet with economic growth forecasts more optimistic than six months ago, he moved away from the March budget’s focus on protecting people’s jobs and livelihoods to one of investing in public services, communities and infrastructure.

The high frequency data has for some time been pointing to a levelling off in the pace of recovery post-COVID. So whilst the Office for Budget Responsibility (OBR) said the UK economy was less impacted by shut-downs than previously feared, and it would recapture pre-pandemic levels by the year end, in our view this represents quite a low bar. Several major developed economies have already comfortably achieved this.

This is not to denigrate the life-support that has been provided by packages like the furlough scheme. The OBR expects unemployment to peak at 5.2% now rather than the previously pessimistic 12%, courtesy of 2m jobs being preserved. Overall the economy is expected to grow at 6.5% this year and 6.1% in 2022 (revised up from 4%) but below economists’ estimates of 7%. This before losing steam in 2023 to 2.1% and 1.3% in 2024. Recognising this, the Chancellor felt he could unleash £75 billion of giveaways which defied predictions for fiscal restraint. Mr Sunak slashed taxes for pubs and restaurants and earmarked billions more for infrastructure, education and worker skills. Whilst not reckless, it is speculative as such a spending spree could tilt the economy back to ‘overheat’ territory.

One issue that has hardly featured to any degree in budgets over the past decade is inflation, but here the news looks much bleaker. There was an admission that the current rate of inflation in the UK of 3.1% will accelerate and will average 4% over 2022. There are a number of factors at play here.

Prices are undoubtedly higher now than in 2020 but things were very different then so we are comparing current prices to a low base. We have long argued that this would be a temporary phenomenon but the damage to the supply chain caused by shutting down the economy will be longer-lasting. The economy is not like a light switch which can be turned off and on. Shutdowns have led to many firms in the global supply chain disappearing, leading to component shortages, logistics problems, higher input costs and this all points to higher inflation.

Having outlined the economic backdrop, the Chancellor announced a new charter for budget responsibility comprising of two rules designed to keep government on the path of ‘discipline and responsibility’. First is to ensure public sector net debt continues to fall as a percentage of GDP and secondly, borrowing should only be to invest for ‘future growth and prosperity’ with day to day spending having to be covered by taxes. Flopping open the government chequebook during COVID has undoubtedly saved jobs but it has also led to much higher borrowing and Mr Sunak pointed out what we all know, that the inevitable consequence of more debt is higher taxes further down the line.

There were no changes to personal tax allowances, thresholds or rates but he had already said in the March budget that these would be frozen until 2026. This is known as fiscal drag and is actually a nifty way for him to collect more revenues because as salaries rise in line with inflation, more of that revenue ends up in the tax coffers. That said, the budget is probably more eye-catching for the tax concessions to shipping, airlines, corporations and reliefs for retail hospitality and leisure – all sectors still very much in the recovery suite following the pandemic.

He reiterated the Tory maxim of being a party that wants to cut taxes and he expected this downward path to be evident by the end of this parliamentary term. For now though, his first step was to reduce the taper on Universal Credit, with the aim of financially rewarding claimants to work. The reduction in the taper was widely expected but the size of the reduction (from 63% to 55%) was higher than most were expecting, to be implemented no later than 1st December this year.

The most radical reform was reserved, unexpectedly, for the drinks industry and here again the Chancellor was keen to reiterate the additional autonomy afforded him in a post-Brexit world. The OBR regarded the system for alcohol duties ‘a mess’ so Mr Sunak took the cue to make changes to some of the rules which had their origins dating back to the 17th century. This should be welcomed by the drinks industry which is still trying to build back some momentum.

Below is a summary of some of the other changes outlined:

Support schemes
• A £5.9bn boost for the NHS to help clear the backlog of testing and scanning
• £5.7bn to transform transport networks outside of London
• Freezing the business rates multiplier for a further year, which he said would be equivalent to a tax cut worth £4.6bn over the next five years, with bills 3% lower than without the freeze. He also announced plans to temporarily halve business rates for the retail, hospitality and leisure sectors (to £110,000 max)
• Extra £2.2bn for courts, prisons and probation services, including funding to clear the courts backlog
• Government backing projects in Aberdeen, Bury, Burnley, Lewes, Clwyd South, Stoke-on-Trent, Ashton under Lyme, Doncaster, South Leicester, Sunderland and West Leeds
• Flights between airports in the UK nations will be subject to a new lower rate of Air Passenger Duty from April 2023. From April 2023, a new ultra-long haul band in Air Passenger Duty for flights of over 5,500 miles will be introduced
• Financial support for English airports to be extended for a further six months

Helping families and communities
• Public sector pay freeze to end
• National living wage, widely expected, to increase to £9.50, This is a 6.6% increase, more than twice the rate of inflation
• Tax relief for museums and galleries will be extended for two years, to March 2024
• Schools to get an extra £4.7bn by 2024-25. There will be nearly £2bn of new funding to help schools and colleges to recover from the pandemic
• £300m will be spent on a ‘Start for Life’ parenting programmes, with an additional £170m by 2024-25 promised for childcare
• A UK-wide numeracy programme will be set-up to help improve basic maths skills among adults

Personal taxation
• Already announced in March that the personal tax allowance and higher-rate tax threshold would be frozen for five years from April 2021
• The personal allowance, which is the amount people can earn each year before they start paying income tax remains at £12,570
• The higher-rate tax threshold remains at £50,270. By freezing these thresholds, more people could drift into higher and additional-rate income tax bands
• The national insurance (NI) threshold was also frozen at £9,568. However, as announced in September, the rate of NI for employees and the self-employed will increase by 1.25% from April 2022 to help fund health and social care costs. Working pensioners will pay 1.25% on their earned income for the first time from April 2023
• Also announced in September, the rate of dividend tax will rise by 1.25% from April 2022 to 8.75% for basic-rate taxpayers, 33.75% for higher-rate taxpayers, and 39.35% for additional-rate taxpayers. The annual dividend allowance – the amount of dividend income before tax kicks in remains at £2,000
• There was some speculation that the chancellor would scrap existing rates of capital gains tax (CGT) and align them more closely with income tax rates. This was recommended by the Office of Tax Simplification in November 2020 and if implemented, would have resulted in higher-rate taxpayers paying CGT at 40% on profits or gains exceeding the annual CGT exemption. The Chancellor resisted this and CGT rates remain at 10% and 20% (18% and 28% on properties that are not a main home). The annual CGT exemption remains at £12,300 after being frozen in the March budget until 2026
• The inheritance tax (IHT) thresholds remain the same and will be frozen until April 2026. Everyone is entitled to pass on assets of up to £325,000 on their death, free from IHT. This may be boosted by the residence nil-rate band, for passing on a property to a direct descendant – which remains at £175,000 per person. This means a married couple with children could be able to pass on a maximum of £1m in total without having to pay IHT – two lots of £325,000 (£650,000) and two lots of £175,000 (£350,000)

• It was rumoured that the chancellor would look at overhauling pension tax relief by moving to a flat rate of 25%. He left this alone, meaning higher-rate and additional-rate taxpayers can continue to benefit from tax relief of up to 40% and 45%, respectively. The pension annual allowance also remains at up to 100% of taxable earnings or £40,000, whichever is lower (this may be tapered for those with high incomes). As more people drift into higher tax bands due to the personal allowance and higher-rate tax threshold being frozen, these tax reliefs could make pensions an even more valuable financial planning tool
• The chancellor had already flagged in March that the pension lifetime allowance, which is the total amount an individual can save into their pension before incurring tax charges, would be frozen until 2026. The allowance will therefore remain at £1,073,100 in the 2022/23 tax year
• ISA allowances were frozen meaning savers can commit £20,000 to an ISA. The Junior ISA limit stays at £9,000

VAT and indirect tax
• The stamp duty land tax holiday on property up to £500,000 will be extended by three months to 30 June 2021, then tapered off until 30 September
• The temporary 5% reduced rate of VAT for hospitality and tourism businesses will be extended by six months, followed by a 12.5% rate for six months
• The VAT registration threshold will remain fixed at £85,000 until 31 March 2024
Company taxation and duties
• The main rate of corporation tax will increase to 25% in April 2023. A new small profits corporation tax rate of 19% will be introduced in April 2023 and a 130% ‘super deduction’ will be introduced for capital investments in qualifying new plant and machinery. Trading losses can temporarily be carried back for three years
• Levy on bank profits reduced from 8% to 3% from 2023. This (partly) offsets the general corporation tax rise meaning banks will move from 27% to 28%. The threshold for the additional levy was increased four-fold, which aims to create a level playing field for the competitiveness of British banks
• Reform to alcohol duties – see below
• Planned fuel duty increase is scrapped

Alcohol duty reform
• A simplification of the duty categories from 15 to 6
• To try and encourage a more healthy and measured approach to alcohol consumption, the higher duties will be applied to the strongest drinks
• Relief for small craft producers whereby smaller brewers relief will extend to other providers as long as the alcohol ABV rating is less than 8%
• Cancelling the duty premium for sparkling wines to create an even playing field with still wines. Also fruit ciders paid more duty (2-3 times as much) as those on apple ciders. This surcharge has been scrapped
• To assist the hospitality sector, pubs will enjoy ‘draft relief’ which sees lower duty on draught beer and cider from containers over 40 litres
• All planned duty increases have been scrapped

The stock market barely moved on the day and at the time of writing, reaction is very subdued. Sterling was also practically unchanged. The most notable move was in bonds. The yield on the 10 year benchmark gilt fell sharply (the price rose). This represents quite an ‘about-turn’ as yields have been ramping up over the past few weeks on concerns about the inflation picture. Traders regard a budget which increases the tax-take as a percentage of GDP to 36%, the highest since the 1950s, as generally positive for bonds as it helps to tamp down consumer activity and reduces the dependency on borrowing (gilt issuance).

It is easy to see the argument but we think they might be overlooking the elephant in the room. Whilst an increased tax-burden is necessary, not to mention an inevitability, and might take some heat out of the economy, the burgeoning inflation number is not transitory in our view. The growth in money-supply and the damage to the supply chain will take a long time to unwind and this will lead to more persistent inflation than we have been used to.

We are not suggesting a return to the rampant inflation of the 1970s or anything like it, but certainly enough to warrant higher interest rates, probably starting before the year is out. Yesterday’s reaction makes no sense to us. Persistently higher inflation and interest rate rises have not been adequately priced in to bonds and yields will have to rise (prices fall). Within our strategy, we are positioned accordingly, even taking money out of bonds recently and holding liquidity in all profiles. This may find its way back into bonds if prices correct, but for now, we are very happy to be patient.

We hope you find this update useful but if you have any questions or need more information, please feel free to contact your adviser, who will be happy to help.

Dr Andrew Mann
Investment Director