The Backdrop
One has to put Chancellor Jeremy Hunt’s first Budget, delivered on 15 March, calmly if hoarsely, to a rowdy House of Commons, in the context of the national mood.
Inflation is still running at over 10 percent – though there was already some realistic prospect that it will be less than half that by the end of the year. We have an increasing population but a contracting labour force, a growing welfare class and a shrinking tax base.
Public services – from schools to hospitals to the police to courts – are said by union leaders to be “on their knees”, hence the sporadic strikes by teachers and junior doctors, alongside railway workers and the rest. Living standards have been falling across the income spectrum, as prices rise faster than wages. Interest rates are heading up, squeezing mortgage payers harder. Moreover, this was the week when significantly higher council-tax bills landed on doormats across the UK.
All the spending departments desperately want more money. I argued the special case for the British Army here two weeks ago – and the MoD was fobbed off earlier in the week with an extra £5bn − though Minister of Defence Ben Wallace had demanded £11bn. Much of that new money will go to the construction of a new generation of submarines in line with our commitments to the AUKUS pact. (Rishi Sunak was in San Diego on Monday, meeting Joe Biden and Australian prime minister Anthony Albanese). The Army will remain short of artillery. But then all the big spenders think their cases are special.
I heard the outgoing chief executive of Legal & General Group (L&G), Sir Nigel Wilson, who ultimately manages £1.3trn of investments – say on the BBC Radio 4 Today programme last week, that the UK was a “low-growth, low-wage, low-productivity economy fraught by political infighting.”
He has a point about political infighting: the UK has had five chancellors in less than five years. Sir Nigel would love to invest more in the UK, he said, but commented: “We have starved our economy of growth equity.” There is certainly a correlation between investment, productivity growth and therefore GDP growth. L&G used to have about 55 percent of its defined-benefit-pension portfolios invested in UK equities – now that is down to just five percent.
Companies such as Ireland’s building-supplies champion, CRH are deserting the London stock market in favour of New York – as fellow Irish business Ryanair did some time ago. Other tech companies are rumoured to be about to do the same. The prestigious, Cambridge-based chip designer ARM (now being spun off by SoftBank) has chosen to list on NASDAQ. The perception is that public companies can command higher valuations on the other side of the ‘pond’. No doubt Brexit and the weak pound (languishing at $1.2163 and €1.1403 this morning) are factors – as is the plodding regulation of the Financial Conduct Authority. The City – the UK’s ‘golden-egg-laying goose’ – seems to be in retreat. The ‘money men’ are out of love with UK PLC.
And the mood on the Tory backbenches is, if anything, grimmer than the national mood at large. Most Tory MPs believe that the hike in corporation tax from 19 percent to 25 percent (a headline rate well above the OECD average) will grievously deter investment. As evidence of that, AstraZeneca is to build its new pharmacology facility, not in Merseyside, but in a Dublin suburb.
We are not in a 1930s-style slump; indeed, unemployment is at a near-record low. But we are in a stagflation spiral in which growth is barely positive and inflation continues to erode living standards − and where the national finances, sapped by the pandemic and then the need to subsidise energy bills, are unlikely to improve in the short term. The ‘Trussites’ still believe that the only solution is to cut taxes and initiate supply-side reforms to bolster enterprise; the Tory realists think this is no time to take risks.
Hunt knew he could not afford to lose the confidence of the financial markets, as his predecessor Kwasi Kwarteng did. Thus far, the mantra of the Sunak-Hunt partnership (former head boys of, respectively, Winchester and Charterhouse, whose ties are always perfectly knotted) has been “steady as she goes.” But, on the Ides of March (the day, readers will recall, when Julius Caesar met his untimely end), the whiff of conspiracy on the backbenches was palpable.
On Wednesday, Hunt needed to mollify his Tory detractors while reassuring the markets and demonstrating that he has plotted a navigable course for the nation’s economy. Most of all, he needed to restore hope. His confident performance succeeded in all four aims – up to a point.
Good News, Bad News
“The plan is working”, Hunt told the Commons in his opening remarks. The OECD reckons that the UK will escape recession this year – something that seemed very likely at the end of last year. This was “a budget for growth.” He wants us to become a “science and technology superpower.”
The first priority was to get inflation down – though it will not fall to its two percent official target until 2028. The chancellor said the outlook was brightening, with the forecast that inflation will fall to 2.9 percent by the end of the year thanks to falling gas and electricity prices – although food-price inflation will remain stubbornly high. Hunt said the economy was now “on the right track” after the Office for Budget Responsibility (OBR) said any downturn would be “shorter and shallower” than predicted just four months ago.
Overall, the UK economy will shrink by 0.2 percent this year but will grow by 1.8 percent next year and by 2.5 percent in 2025, according to the OBR, which is more optimistic than the Bank of England. Borrowing will be £24.7bn lower this year compared to the forecast in last November’s Autumn Statement, due to buoyant tax receipts and the lower costs of energy. The debt-to-GDP ratio will fall from 94.8 percent today to 94.6 percent in 2027-28. The annual fiscal deficit (tax revenues minus spending) will remain below the target of three percent of GDP.
Hunt extended the £2,500-equivalent Energy Price Guarantee for households for another three months. Happily, this is not as expensive a measure as previously envisaged, as European gas prices hit an 18-month low last month.
There were a few concessions such as the freeze in fuel duty for this year − but also some surreptitious tax raids in respect of alcohol, air passenger and vehicle-excise duties all rising in line with inflation. Just what will replace fuel duty after the internal-combustion engine is euthanised in 2030 is still a mystery.
Corporation Tax
As I have argued here before, the headline rate of business profit tax is psychologically important but only part of the story. The issue is whether various forms of capital investment can be written off against tax and over what period. In this respect, tax regimes vary considerably, even within the supposedly fiscally homogenous EU. When he was chancellor, Sunak delivered a Mais Lecture in which he observed that “Despite the UK’s highly competitive headline corporation tax rate [then 19 percent] the overall tax treatment for capital investment is much less generous than the OECD average.” Hunt said something very similar on Wednesday.
The rabbit out of the top hat in this Budget was the announcement that all permissible capital expenditure – capital allowances − could be deducted from profit in the year they were incurred, just as loan interest payments are. This is what accountants call “full expensing” – even if the headline rate will remain above the OECD average of 24 percent. This incentivises businesses to invest in new capacity sooner rather than later – but full expensing is only guaranteed for three years, after which it will be reviewed. Moreover, it applies only to plant, IT and machinery. UK companies can still only write off 39 percent of the cost of buying new buildings and 83 percent of the cost of intellectual property. The entire edifice of business taxation is still stuck in the pre-digital age.
Making capital expenditure tax-deductible, however, is sounder than messing around with “windfall taxes” on perceived ‘bad guys’ such as the oil and gas majors. Windfall taxes distort the net present values of very long-term strategic investments on which, ultimately, we rely. Unfortunately, the energy sector windfall taxes will remain.
But “full expensing” was not enough to satisfy the Trussites. Jacob Rees-Mogg told the Commons that the rise in corporation tax would make the UK “less competitive.” He said: “The best approach to tax policy is low tax rates with few exclusions.” Actually, he is right. When foreign companies evaluate where to invest plant overseas, they tend to look at the headline tax rate rather than the freebies. Moreover, companies that pay more tax have less cash available to pay higher wages.
The Back-To-Work Budget?
The UK needs to get more “economically inactive” people back in to work – as discussed previously in this column. Hunt approached this issue in two ways.
First, he boldly abolished the lifetime allowance (LTA) on personal pension pots. George Osborne cut the maximum tax-free pension pot from £1.8m to £1m (though that figure was subject to an inflation uplift and stood at £1.0731m for this tax year). Contributions to pension pots out of income are topped up by the amount of income tax deducted from that income. That makes pensions a highly tax-efficient way of saving. The annual maximum pension contribution will be raised from £40,000 to £60,000.
Under the pre-existing rules, any pension assets in excess of the LTA were taxed at 55 percent if taken out as a lump sum, and at income tax plus 25 percent if taken out as income. That is now history.
These changes will benefit a relatively small number of high earners who have already exceeded the LTA. One target group consists of NHS consultants and high-level clinicians who have been taking early retirement or refusing overtime because of sky-high marginal tax rates. Now, with no upper limit, tax experts foresee that pensions will become an efficient route for avoiding inheritance tax (IHT), since pensions are entirely exempt from IHT. I’ll unpack that soon.
Labour has already pledged to reverse this move. Given that it is likely to be in power in about 21 months, that will give high earners pause. Indeed, the inconsistency of pension taxation over many years entails that many pensioners will feel that their financial security in retirement is still at risk.
Second, Hunt tackled the cost of childcare. The UK’s childcare costs are among the highest in Europe. The average cost of sending a child under two to a nursery in London for 25 hours per week has risen to £7,729 per year, compared to £7,212 in 2022, according to Daynurseries.co.uk. Childcare costs are paid out of taxed income.
But from the end of next year, children aged between nine months and two years will be entitled to 30 hours a week for 38 weeks a year of “free” childcare − that is to say paid for by the government. This will cost about £6,500 per child. It is unlikely that any parent’s additional tax bill would cover that, so this represents a further extension of the welfare state. The cost of welfare and pensions, according to the OBR, will balloon from £261.5bn this year to £294.5bn. It will be £330.5bn in the 2027-28 tax year.
The staff-to-child ratio will be relaxed, thus reducing costs for day nurseries.
Market And Think-Tank Reaction
Reaction to the chancellor’s economic package was overshadowed in the equity markets by increasing concern about the health of the international banking system further to the collapse last weekend of Silicon Valley Bank (SVB) and Signature Bank – plus, a new crisis at Credit Suisse.
The FTSE-100 fell by 3.9 percent on Wednesday. Prudential lost 12 percent of its market cap and Barclays nine percent. Some of those losses were recovered on Thursday. The pound was more or less flat on the day by close of business. This morning, 50 percent of IG’s clients are short sterling against the dollar, and 69 percent of IG’s clients are long sterling against the euro.
The Adam Smith Institute was cock-a-hoop about “full expensing”, while the Tax Payers’ Alliance opined that the Budget was “full of problems for taxpayers”. The left-leaning Resolution Foundation thought that there was little good news for the least well off. The Institute for Fiscal Studies said that the measures to encourage people to return to work would have limited impact.
The Bigger Picture
Even if the most optimistic forecasts prove correct, the next parliament to be elected at the end of 2024, or possibly January 2025, will preside over a poorer country than the previous one inherited. The tax-take as a proportion of GDP, nearing 38 percent, will be at a 70-year high. The economic weather could yet become more inclement with geopolitical risk at its most acute in my lifetime.
Personal asset values, which drive consumer confidence, are also likely to decline as property prices fall. We are now paying the price for years of cheap money and monetary alchemy in the form of quantitative easing, which pushed up asset values while disguising stagnation in the real economy. Taxes as a proportion of incomes will inevitably rise, given the freezing of the personal allowance and tax thresholds until 2028, making everybody poorer through “fiscal drag.” An additional 2.1 million people will be paying income tax at 40 pence in the pound by 2028, making the total 6.7 million.
The UK now faces stiff competition in the automotive industry from the US and the EU which are subsiding the transition to electrification. Where are the British EV-battery gigafactories? The UK automotive industry still accounts for 800,000 jobs in the UK: if it falls, we shall become poorer still.
No one expects Sunak and Hunt to become born-again tax cutters before the next election, though I suspect there might be enough headroom for a one-pence reduction in the basic rate of income next year – but that won’t be enough. The British people will most likely take out their resentment about falling living standards on the Tories. Labour’s chances of forming the next government are further bolstered by the prospect of winning back some of their historic fiefdoms in Scotland from the SNP. At least, in opposition, the Tories will have the luxury of working out what they really believe in.
Apart from opposing everything that the Tories do, we don’t really know what a Labour government’s economic policy would be – though it would be one that is more acceptable to the progressively-inclined (that is, left wing) civil service. It’s all very well aspiring to achieve the fastest growth in the G-7 – but the ‘how to do it’ is still missing.
A Labour government would be unlikely to grasp the real fiscal ‘nettle’. Welfare spending and the cost of the NHS have been rising faster than GDP – and that is likely to continue for the foreseeable future given an ageing population. To date, governments have managed that trend through increased borrowing and squeezing other spending departments – particularly the Ministry of Defence. This cannot continue indefinitely.
The economic outlook for UK PLC is not as bleak as the Bank of England and the OBR thought at the end of last year. But consistent growth remains elusive, and the economy lacks resilience to further macroeconomic shocks. Advances in technology – AI, quantum computing and life sciences − will boost the economy at the margin but will not resolve its structural weaknesses.
Steady as she goes, indeed. But where to?
Afterword: Market Jitters Are Driven By Fears Of Another Banking Crisis
The failures of SVB and Signature Bank have spooked investors. Shares in Credit Suisse suffered a 30 percent loss on Wednesday. Credit Suisse is effectively now being propped up by a CHF50bn loan from the Swiss National Bank. The other major Swiss bank, UBS, has also experienced setbacks in recent years. It seems the perceived solidity of the Swiss banking system was a mirage.
Bank stocks right across Europe have been falling fast this week. The oil market has responded, with oil prices plummeting nearly six percent on Wednesday − the biggest one-day drop in more than eight months. Brent crude fell to below $74 a barrel. The collapse in the oil price suggests that the markets anticipate a general economic slowdown further to another possible systemic banking crisis.
What is happening in the European banking system and in North America could have been foreseen. As interest rates rise, so the mark-to-market values of their bond portfolios fall. This impacts their capital ratios adversely (asset values decline but liabilities remain unaffected). Whether there is indeed a systemic banking crisis in the making is still unclear. Suffice to say that on Thursday (16 March) the ECB felt sufficiently confident to raise rates by 50 basis points, as anticipated. The Fed is now thought unlikely to go through with its anticipated rate hike later this month.
It seems that SVB, Silvergate Capital and Signature were all exposed to the cryptocurrency markets. Their demise follows that of the crypto exchange FTX in November last year. However, the proximate cause of SVB’s collapse was an old-fashioned bank run after word got round that it was insolvent. Depositors were insured by the Federal Deposit Insurance Corporation and SVB’s UK subsidiary was immediately purchased for £1 by HSBC.
Shares in Credit Suisse collapsed when its largest shareholder, the Saudi National Bank, refused to advance additional funding. That suggested the Saudis might know something the markets don’t. Fear is always self-reinforcing.
On Budget day, Larry Fink, chief executive of BlackRock said that the collapse of SVB, Silvergate and Signature Bank could be the start of a “slow, rolling” systemic crisis. Fink thinks that it was inevitable that some banks would have to rein in their lending to strengthen their balance sheets. He added for good measure that the world is sleepwalking into a silent retirement crisis as people live longer. On the same day, the founder of the hedge fund Citadel Capital, Ken Griffin, told the Financial Times that American capitalism is “breaking down before our eyes.”
Last night, a consortium of 30 US banks secured a line of credit for San Francisco-based First Republic Bank. First Republic is best known for wealth management and was thought to have a low risk profile. The word contagion is back on our lips.
The influential economist and commentator Charles Gave thinks that eurozone bank shares today could be as fragile as Japanese bank shares in 2007, when they saw a peak-to-trough decline of 75 percent. On the other hand, European banks are much better capitalised and have better liquidity buffers than in 2008. But they have loaded up with huge quantities of government debt which is rapidly declining in value.
The doom loop is back. How worried should we be?
To which question the reply is always: Don’t panic!