The Emergency Budget: The UK’s turn to sample Euro zone style austerity

Today sees the Chancellor of the Exchequer present the emergency Budget which was promised as part of the Conservative Party manifesto. It is something that survived the Coalition Agreement with the Liberal Democrats, indeed if you listen to the pronouncements of the Deputy Prime Minister Nick Clegg he seems positively enthusiastic about the idea. The essence of the problem facing the UK is the size of the fiscal deficit she expects to have going forwards. According to the new Office for Budget for Responsibility we expect to borrow in the next five fiscal years (from this one) £155 billion, £127 billion, £106 billion, £85 billion and £71 billion respectively. It is simply too much and needs to be reduced.

A Fortunate Windfall

One area where we have been very fortunate as Spring has moved into Summer in the UK is the way that our gilt (government bond ) yields have moved. They have fallen back after rising based on fears about the size of our deficit. As of last nights close our ten-year government bond yield was 3.48%. To put this into an international perspective our yield is now 1.1% below Spain’s equivalent government bond when only 2 months ago their yield was below ours.So in financial if plainly not in football terms we have had a windfall relative to Spain. In essence we have benefitted from “safe-haven” status as problems have hit the euro zone and Dubai making us look more attractive to foreign investors. This has bought us some time and I feel that we should take advantage of it.

To put the cost of our borrowing into perspective consider the next two years where if the OBR are correct we will have to borrow some 155 + 127 billion respectively. So in two years time we will be paying interest on an extra debt in the region of £282 billion or so. We know that our ten-year gilt yield is 3.48%. So in 2 years time we would be paying an extra £9.81 billion every year just on interest payments on two years of debt. In effect it is like an interest-only mortgage as there is no allowance here for ever repaying the money. In fact in the following years we currently plan to borrow more….

Should events turn against us then the costs will rise quickly for example an increase of 1% in gilt yields would cost us £2.82 billion a year just in interest on this and next years expected borrowing. I think that Greece is something of a special case at the moment but if out yields went to those of Ireland’s we would have to pay some £16.1 billion in interest each year as opposed to £9.81 billion.

What would I do today?

Taxes

Firstly there do need to be tax rises and I have written on here before that I would raise VAT to 20% which would raise some £12/13 billion a year. It does not have to come in immediately and could be delayed to help the economy in its recovery but it has to be announced now in my view so that our deficit going forwards is credibly reduced.

I have seen a lot of talk about a rise in Capital Gains Tax. It was a curious act by the previous Labour government to cut it to 18% a rate which bears no real relation to any other tax rate in the UK.  It seems much more logical for it to be raised to 20% to be the same as the basic rate of income tax. However for all the talk about it and the apparent importance of raising it to the Liberal Democrats it does not raise much money at £2.7 billion a year. As increasing it is likely to see more and more effort put into avoiding it and we will not actually gain a lot of revenue from it then my view is that too much time is being spent on discussing it. I have seen articles suggesting that it is a very inefficient tax ( it costs a lot to collect per pound) and others which suggest that raising it will lead to less revenue being collected.

I  accept that in the short-term my proposal to raise VAT would raise inflation. Therefore it is not ideal but of the other choices in front of us I still feel that it is the best one and combining it with a fiscal deficit reduction plan  will help to control the inflationary implications. In a way it is of course both inflationary and deflationary as it will take money out of the economy. It is also regressive but using some of the money as I have discussed in the past to help alleviate this could have quite a few economic benefits.

The Laffer Curve

I discussed this back on the 4th December 2009.

I wish to remind people about the Laffer Curve a concept which was created by Arthur Laffer who was an adviser to US President Ronald Reagan in the 1980s. He postulated that there is a link between tax rates and tax revenue received by a government and that it could be represented as a curve. Furthermore this curve suggests that, as taxes increase from low levels, the total tax revenue collected by the government also increases. It also shows that tax rates increasing after a certain point would cause people not to work as hard or not to work at all, leading to a reduction in total tax revenue. Eventually, if tax rates reached 100% , then all people would choose not to work because everything they earned would go to the government. Just to be clear it is usually applied to income tax rates and revenue.

 

This was applied by both the UK and US governments in the 1980s. Both reduced higher rates of income tax and both received higher levels of tax revenue,in fact income tax revenue increased considerably (of course not all of this was due to the Laffer Curve!). In essence at the levels of income tax then being levied it worked. This does not mean that it works at every level of income tax but does mean that moving back to those sort of levels is likely to reduce rather than increase the level of income tax revenue received.

How is this relevant now?

As of the 6th April 2010 there have been new higher rates of tax in the UK. For incomes above £150,000 the income tax rate rises to 50%. Also for incomes above £100,000 the Personal Allowance (which would otherwise be £6475) is taken away in two stages. This rather complicated measure creates two zones where the marginal tax rate is in fact 60%. Now under the logic of the Laffer Curve these were bad moves. Initially they seem to have helped the tax take but I feel that over time they will act to reduce it. There is however a much worse example of this in our tax system.

The Poverty Trap

Our poorest citizens often have what are the highest tax rates in our system. This is because not only might they be paying income tax but “means-testing” can take benefits away at the same time. the rates at which this can happen can leave what are quite poor people with effective tax rates of up to 90%. I wish also to add that not only is it bad economics but it is to my mind a national disgrace that the interaction of the benefit and taxation systems can leave people who are often quite poor with marginal tax rates in the region of 90%. Our political leaders and previous governments should be ashamed of this. Back in December 2009 I suggested the following “My suggestion for the Pre Budget Report is to set about making sure that “implicit” tax rates for the poor are never above those for the rich”.

As we have had something of a windfall in that our deficit forecasts have fallen and our gilt yields have remained (surprisingly) low I feel that the timetable for this can be accelerated. For this budget I would reduce  the rates at which benefits are taken away such that no-one has an effective tax rate of more than 50%. I would hope in future years to do more. If indeed there is the money available to give all basic rate taxpayers an increase in the personal allowance of £1000 as has been heavily trailed then perhaps after a good look at the books I would be able to do more, I certainly hope so. I consider a rise in the personal allowance to be an inferior  and less efficient move because many on much lower marginal tax rates will get it as well as the most deserving. It might be good politics but to my mind it is less good economics.

Banks and Bank levies

The taxpayers of the UK have in effect acted as insurers for the UK banking sector. What we have failed to do is charge them an insurance premium for it. My suggestion is that we start to do so. We have made a mistake in not doing this in the past but that is no reason not to do so now. I would also make the levy risk based as for example payments to the Financial Services Compensation Fund has hit the (generally safer and more conservative) building society sector quite hard. Levying such a risk based premium would also help to dissuade banks from indulging in the sort of behaviour that helped create the “credit crunch”. It is hard to be exact as to how much this would raise but rather than the current idea of balance sheet size I would set it to achieve a revenue of say £3/4 billion a year.

Spending Cuts

This is more the governments problem and I expect it to prove very difficult for them. There is a public facility that I use which I feel is over-manned and yet recently it has taken on more staff! So I would suspect Local Authorities will be difficult to deal with. I still remember the battles that Mrs Thatcher had with them in the 1980s and the scale of cuts then was smaller.

Some subjects  are simple for example the Royal Navy has more admirals than warships these days and I understand the army could field a whole battalion of under-used colonels (although to do quite what….), but these have persisted for years so I do not expect this process to be easy or painless. But it is a once in a generation chance to clear out some relatively dead wood and I hope that we grasp it.

However I expect spending cuts to be much harder to achieve than to suggest or to plan. it is mainly for that reason I would start with raising the headline number for VAT so that a clear schedule for the funds raised coming in gives us some time to make progress with spending cuts. We have a new inexperienced government which is going to try to make cuts of a size not attempted for a generation so I think caution should be the watchword and we should give ourselves some room for failure. After attempting to find a net £5 billion of spending cuts for this fiscal year I suspect that our new government is facing this challenge rather soberly.

Updates 14.20pm

As the day progresses I will update on anything which is economically significant. As a point of timing UK  and European equity markets have been falling this morning and we are down 1.5% on the FTSE 100 before the Chancellor speaks. This is mostly due to a downgrade of the French bank BNP.Regular readers will no doubt have a rueful smile on this subject as they may well remember the discussion on here when the French Central Bank Governor suggested that French banks did not have significant investments in Greece…

We now have some of the meat of the Chancellors plans.

1. VAT will rise to 20% in January 2011. I would have done this as I wrote earlier although politicians keep putting changes in VAT at the turn of the year which must be awkward for retailers as it is the period for annual sales.

2. The rise in Capital Gains Tax was lower than many had thought will an upper rate of 28% and an indirect reference to the Laffer curve as a reason for not raising it more. This seems to be something of a political compromise with the rates now being 18% and 28%.

3. Perhaps the thing that most stands out is the way that benefits are now to be uprated in line with Consumer Price Index inflation rather than Retail Price Inflation. I will write more on this shameful move later.

4. The overall tightening of our fiscal position will be £40 billion in the year 2014/15.

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12 thoughts on “The Emergency Budget: The UK’s turn to sample Euro zone style austerity

  1. Hi Shaun. The date given for this blog post today is the same as that given yesterday; today is the 22nd June.

    Doesn’t the Laffer curve theory apply to all taxation? So surely it would apply to VAT also?

  2. I seem to remember Shaun suggesting even a 20% VAT rate would, in his opinion, still be centre left on a Laffer curve. I think it only brings us more into line with our immediate competitors and as such should be achievable, however undesirable!
    There would seem a ‘Catch 22’ in all this public sector bashing because to slim down that sector, and I believe it has to be as a lot of it only services the private sector, the resulting loss of purchasing power will be felt immediately. If the only ‘real’ growth in jobs many regions had at the top of the economic cycle has been in public sector jobs what chance do these regions have now in terms of private sector job creation during recession and austerity?

    • Hi Drf and Mac
      As Mac points out my argument has been that we have not travelled as far on the Laffer curve with VAT as we have with income tax or indeed corporate taxation. I notice there was an indirect reference to it by the Chancellor when he talked about the new upper rate for Capital Gains Tax, and this is the reason why it only went up to 28%

      As to regional policy and cuts there were some references to this and the FT published a helpful chart which I will put on one of my updates.

    • Hi Mac

      I never got round to a full answer to your question but I haven’t forgotten! Here is a link to a chart which the FT had which showed the impact of public spending cuts on the regions so it tells us where problems are likely to arise and gives an idea of the potential scale of the problem.

  3. You might be aware that most existing commercial banking facilities contain clauses reserving the right for the bank to increase its margin on the interest rate charged or impose additional charges to cover such matters as new government-inspired levies. So, I am not so enthusiastic about the idea which will become an additional business expense, and passed on to us.

    What worries me is this new committee called the Financial Policy Committee of the Bank of England. It will supposedly have powers to direct bank lending / deterr bank lending to sectors / countries. So, a key driver of growth ( credit) will now be in the strategic hands of an unaccountable set of central bankers. Who will answer for their decisions?

    Having read your posts on the fragility of gilt yields, I wouldnt borrow more money now on the strength of today’s volatile flight to so-called quality.

    What I really want to know is how banks are going to recapitalise themselves and refund their wholesale liabilities over the next five years when the sovereign guarantee will be withdrawn. Persistent credit starvation could derail SMEs.

    • Shireblogger – you are raising the real tough questions surrounding the present situation.

      If the rate of increase of government borrowing reduces and then government borrowing reduces then the private sector will not be competing with lower risk lending at an attractive interest rate: i.e. large scale new gilt issuance. Therefore more money will be available for the private sector.

      May be that could happen within five years. May be by that mechanism.

    • Hi Shireblogger
      The problem of the banks is like a many-headed hydra! I agree that as banking reform seems to be under the aspices of a Commission then we cannot really expect much particularly if you are a fan of Sir Humphrey Appleby of Yes Minister who saw them as a way of delaying any result until everybody had forgotten the reason for the Commission in the first place. So I agree that there are isses as we stand but would point out that I would reform the banks if I got a chance in line with my articles on official and unofficial interest rates.

      As to recapitalisation I think that in many ways we have only repeated Japans mistakes and I hope that we do not get the same result.

      • Thank you for your response. I do find your posts topical, informative and that they do what they say on the tin!

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