Introduction
The Chancellor claims the Coalition’s second offering as a “Budget for Growth”. In truth, it is an economically unexciting affair that is mainly of interest to the tax planning industry.
An increment to the levy on banks finances a cut in corporation tax. The Fair Fuel Stabiliser taxes North Sea Oil to finance the reduction in the total duty on fuel.
That is not to say nothing changes on 6 April. Many measures will take effect then which will cost almost all UK taxpayers considerably more money than they are expecting, but most of these were announced last June.
Also in June, Mr Osborne set the fiscal course that he expects to follow for the whole of this Parliament, reining back public spending so as to eliminate the bulk of forecast deficit of £149bn for the year to 31 March 2011 by the end of the Parliament.
Progress since the Emergency Budget has been mixed.
It seems likely that the forecast deficit will be met and not exceeded this year. Record tax receipts in January have been offset by record borrowing in February, itself resulting from a relative collapse in self-assessment income tax collections;
Inflation is accelerating in the UK faster than in the US or Eurozone. In those territories, inflation is still under 2% but UK RPI rose to 5.5% in February and the CPI (excluding mortgage interest) rose to 3.6%, its highest level since October 2008
These pressures lead to a downward revision in projected economic growth. The unexpected contraction in Gross Domestic Product in the last quarter of 2010 suggests 2010/11 growth will be no more than 1.7% (compared to the 2.1% forecast) whilst the 2.6% growth forecast for 2011/12 is reduced to 2.5%.
The Bank of England is also under pressure to raise interest rates to offset the inflationary pressure though it is questionable whether such a move would be effective at the moment. For the most part, UK inflation seems to derive from external pressures – leapfrogging commodity and energy prices, exacerbated by the 25% depreciation of sterling in 2007/8. Thus far, this argument seems to have prevailed with the Monetary Policy Committee but a rise – and the consensus expectation is for three quarter-point rises starting in the summer – cannot be deferred indefinitely.
This Budget is fiscally neutral in broad terms. The austerity measures announced last June have reassured the bond markets and have enabled the government to borrow the money to finance the deficit – not just the 10% of GDP forecast for 2010/11, but also the £122bn forecast for 2011/12, £101bn in 2012/13 and £70bn in 2013/14, each of these being about £10bn more than last forecast in June..
In the crudest of terms, lenders believe the UK will be able to repay. This Budget seems unlikely to alter that perception.
One might also suspect that relatively high inflation is not that unwelcome. Although some government debt is index-linked so its servicing costs are rising faster than expected, most government debt is not. Inflation erodes the value of that debt so that those fortunate enough to be able to borrow at 1% or 2% above base rate are presently experiencing negative real interest rates.
This is a tricky balancing act as any suspicion that UK is seeking to monetise its deficit will lead to a rapid deterioration in the exchange rate, something which has so far been avoided by the 0.3% excess of 3-month LIBOR over base rate and the expectation of a rise in the base rate itself.
The bond market thus expects at least one quarter percent rise.
Tightening monetary policy at a time of fiscal austerity risks increasing domestic unemployment and perhaps even stagflation. Keeping rates artificially low props up asset prices, but it also risks borrowers becoming more indebted than they would otherwise be, making the adjustment to more ‘normal’ levels of rates all the more painful. Investors may also be tempted to assume that the support will last forever because the Bank fears the consequences of withdrawal.
Even a modest rise in rates will be surprisingly painful. A rise of just ¼% is an increase of one sixth for a borrower paying 1% over base; an increase of ½% would add one third to such a borrower’s finance cost.
The prudent will bear in mind the effect a rate rise might have both on their own affairs and on the affairs of those that owe them money.
