UK budget
June 23rd, 2010
The surprises in the budget were the big increase in VAT for next year, and the decision to continue with large cash increases in total public spending over the five year period. The Chancellor, who had said that 80/20 was the right balance for spending cuts and tax increases, settled instead for a 57/43 balance in 2011-12 and for 64/36 the following year. His spending totals are:
2009-10 (Last Labour year) £669bn
2010-11 £697bn
2011-12 £700bn
2012-13 £711bn
2013-14 £722bn
2014-15 £737bn (£68bn or 10% above Labour level)
It is true that the substantial cash increases in total public spending still require cuts in some areas. Debt interest, overseas aid and EU contributions, especially the first of these, make up a substantial increase in spending on their own. The previous government decided to cut capital investment by around 40% which remains the plan in this budget. If welfare bills do not come down, and if public sector inflation remains a problem then the cuts in other programmes will have to be bigger. If the wage and pensions bill can be held down and the welfare bill brought under control the pressures on the rest of public spending will be reduced. We should place greater reliance on the next two year’s forecasts and less on the subsequent years, as plans will be subject to revision depending on economic recovery, inflation and other variables.
The country is currently running a public sector deficit in excess of 10% of National Income. The budget measures will cut most people’s living standards by 1% through tax increases, to start to narrow the gap between public spending and revenue, and by 2% for those on £50,000 a year and higher. The bulk of the reduction comes from the VAT hike, with some contribution from the removal of tax credits to the better off and from the failure to increase certain benefits in line with price rises. In subsequent years more of the deficit is reduced by rising tax receipts from economic growth, and from reductions in previous planned increases in public spending.
Our overall view is that the Chancellor has done enough to reassure markets concerning his wish to eliminate the structural deficit over the lifetime of the current Parliament. We are therefore changing our negative stance on UK government bonds. For three years we have argued that investors should avoid all UK government fixed-income bonds other than very short-dated ones held in lieu of cash for a specified time period. We do not regard gilts at current yield levels as exciting investments, but do think this budget has cut the risk of holding them. We think this can be helpful to sterling corporate bonds which give a considerably higher income than gilts and than comparable bonds in the US and the Eurozone. One of the things holding back sterling corporate bonds has been fear of a major rise in UK government bond rates.
The budget will also have an impact on the private sector and the general economic recovery. The Chancellor’s decision to do more by way of tax increases and less by way of spending cuts in the next year is mildly damaging to recovery, according to the Office of Budget Responsibility forecast. The OBR believes that the budget will lower UK growth by 0.1% in the first year and 0.3% in the second year. The increase in VAT comes into effect in January 2011, so there will be a stimulus to spending over the second half of the current year as people bring forward spending plans for larger items. As many basic items are exempt from VAT we may also see some continued pressure to import discretionary purchase items in the next few months to meet the demand.
The Chancellor has decided to make a substantial reduction in the Corporation Tax rate to 24% from 28%, taking it down by 1% a year. Small businesses benefit from a reduction in their profit tax rate to 20% and special relief in the north and west of the UK from National Insurance for new jobs created. Overall business will pay a bit more tax as a result of the bank levy and the removal of investment incentives from Corporation Tax, but there will be many individual winners from the changes.
The budget does not change our view of the UK private sector economy. The government needs to fix the banks and get more credit flowing to accelerate the recovery. We agree with most forecasters that trend growth has been reduced by the wild years 2005-2010. Inflation remains too high and the VAT increase will prolong that problem.
