A new era for UK fiscal policy, but will the gamble pay off?

A new prime minister, new chancellor, and a new era for UK fiscal policy. Following the change in leadership of the ruling Conservative party, the new Chancellor of the Exchequer, Kwasi Kwarteng, has truly delivered a landmark fiscal statement, ushering in a new era of lower taxes for the UK economy.

Kwarteng delivered a skilful and concise statement that left audiences with little doubt that the priority for the new administration is to boost growth through lowering taxes. He declared that the government is “…getting out of the way to get Britain building”.

The relatively short speech delivered few but significant measures. He began by confirming that the prime minister’s announcement of support for households and businesses with energy bills will go ahead, before unveiling a plethora of tax cuts – many of them were simply reversals or cancellations of previously announced tax rises.

Some of the measures announced included:

  • Energy price guarantee of £2,500 confirmed for two years
  • Energy Bill Relief Scheme to lower the cost of energy for firms, charities and public institutions for six months
  • Planned increase in corporation tax from 19% to 25% has been cancelled (although an 8% surcharge on banks is to remain in place)
  • Reversal of the increase in National Insurance contributions (1.25 ppts) and the Health and Social Care Levy from November 2022.
  • Planned reduction in the Annual Investment Allowance from £1 million to £200,000 will be scrapped
  • Off-payroll reforms (IR35) reversed
  • Basic rate of income tax reduced from 20% to 19% from April 2023
  • Additional rate of income tax of 45% will be removed from April 2023.
  • Cap on Bankers’ bonuses to be scrapped
  • Stamp duty thresholds for property purchases have been increased substantially
  • Duties on alcohol to be frozen for this year (would have increased by RPI).

Either by the chancellor’s choice or due to a lack of time, the Office for Budgetary Responsibility (OBR) did not provide the usual independent scrutiny and economic forecasts to accompany the policy decisions. The OBR will provide an updated forecast before the end of the year, but until then, we are reliant HM Treasuries’ costings.

The total cost of the various measures announced is expected to reach £161.5 billion over this financial year and the next four years (6.6% of current nominal GDP). However, this figure excludes the near-term support for households and firms with regards to energy bills, which is estimated to total £60 billion over the next six months. We estimate that this figure could rise to £150 billion over the next two years, without assuming an extension of help for firms – which would raise the total estimated cost of new measures to £311 billion (12.8% of current nominal GDP). Even based on the Treasury’s own estimates, the Institute for Fiscal Studies has announced that this is the biggest set of tax cuts since 1972.

Boosting productivity, attracting investment

Many of the measures announced that are designed to encourage businesses to invest and grow should be welcomed by investors. The UK’s productivity growth has been deteriorating for some time, along with its ability to attract foreign direct investment.

The other tax cuts, especially for households, are designed to reverse the trend of rising tax revenues as a share of national income. Under previous plans, tax receipts as a share of GDP were forecast to rise to 35% by 2025/26 – the highest since World War II. This is seen as unacceptable for the majority of centre-right Conservative Party members.

However, the timing of these tax cuts could not have been worse. With inflation near double digits, the Bank of England (BoE) is raising interest rates in an attempt to slow demand in the economy and bring inflation back to its target of 2%. While the chancellor stated that the independence of the BoE was “sacrosanct”, his tax cuts conflict with the central bank’s objectives.

Interest rates likely to rise by more than previously expected

The scale of the fiscal stimulus announced will likely force the BoE to raise interest rates by more than previously planned. Although the Energy Price Guarantee measure helps lower headline inflation next year by some three percentage points by our estimates, the giveaways, particularly for households, are likely to raise inflation at the end of 2023 and beyond.

The BoE disappointed markets with its half a percentage point rise this week (22 September), causing the pound to fall against its peers. The mini-budget has only poured fuel on the fire today, with the pound down 0.9% against the euro and 2% against the US dollar. Sterling has fallen by 2.7% against the euro and 4.2% against the US dollar since the new administration took over on 6 September.

The government’s big gamble is that tax cuts and reductions in regulations will fuel stronger growth, and in turn generate greater tax revenues. At the margin, this is likely to occur, but whether growth can return to 2.5% per annum sustainably without generating significant inflation is unlikely at this stage.

The main restraint for the UK economy today is a lack of growth in the supply of labour. There are more unfilled job vacancies in the economy than unemployed people available to fill them. The pandemic has probably reduced the participation of the older cohorts of the population, and perhaps even sped up some retirement plans. However, Brexit is the other key issue which has contributed to a lack of available staff, especially migrant workers.

Dramatic reaction in gilt markets

And so, the additional huge fiscal stimulus is likely to drive up inflation more than growth, which will be less useful for the exchequer, leading to more borrowing and debt. This explains the dramatic reaction in gilt markets where the benchmark 10-year gilt yield (interest rate) has risen by 25 basis points (bps) in response to the announcement but is up around 84 bps since rumours began to circulate over the governments’ response to the energy crisis. This is equal to a 4.5% fall in the price/value of those bonds.

Some investors are also concerned that sovereign rating agencies may now consider downgrading the UK’s rating, which could lead to some holders of government bonds to be forced to sell some or even all of their holdings. This may follow in time, and it will be up to the government to defend its new approach to taxation in the coming months. Importantly, if growth and increased tax revenues do not follow, the chancellor has to be ready to pivot, and prepare some austerity measures.

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