UK Budget: Preview and Perspective

The challenges

In preparing the Budget Sunak has a number of considerations to balance:
 

• The very large and unsustainable budget deficit of the past 12 months resulting from the extraordinary measures put in place to counter the impact of the coronavirus and associated constraints on activity. For the year to end December 2020 the deficit was 12.3% of GDP.
• The need to provide ongoing support to individuals and businesses through the continued period of heightened uncertainty.
• A desire to create conditions supportive of future growth for when the coronavirus crisis has passed.
• The need to increase revenues and reduce spending as the economy recovers and uncertainty diminishes.
• The additional complications of Brexit which imply the Chancellor needs to ensure the UK remains an attractive place to do business.

Withdraw stimulus too early and the Chancellor risks plunging the economy back into recession, causing enormous social distress. Apply too much stimulus and he risks both losing market confidence as a result of being fiscally profligate and also the possibility of a surge in inflation, particularly given reduced supply side flexibility in the wake of Brexit. Furthermore, fiscal retrenchment is something that could damage both his personal reputation and the Conservative Party’s political prospects if handled badly. It is an unenviable task indeed.

Cyclicality

Much government expenditure is non-discretionary in the sense that it takes place automatically. For example, when unemployment rises, the amount the government spends on benefits increases. The government does have some discretion in changing the level of benefits but it has little direct control over the number of people receiving those benefits.

Chart 1. The UK government budget balance and the cycle

Source: ONS, EFG calculations

Chart 1 illustrates this point. It shows the actual cash balance of the UK government (receipts less expenditures as % of GDP) and the forecast cash balance based on a regression for which the sole explanatory variable is the deviation of GDP from its trend.¹ The UK budget balance deteriorates during periods of weaker growth and it improves during periods of stronger growth regardless of the ruling party. It is interesting to note that this simple model anticipated well the cash balance as a % of GDP during last year’s crisis.

This chart also highlights the point that it is in the Chancellor’s interests to put policies in place that seek to maximise future growth since this is the best way of reducing the budget deficit. It suggests that given the choice between fiscal restraint now at the possible expense of future growth, there is a strong incentive to defer tightening until there is greater confidence in recovery.

Rumours²

The main expenditure elements of the Budget are thought to be:
 

• Extending to the end of June (by which time the majority of constraints on activity are expected to be lifted): the furlough scheme, relief on Value Added Tax (VAT) and business rates and the stamp duty holiday on home purchases worth up to £500,000.
• £5bn in grants to help High Street shops recover from the crisis.
• A new business loan scheme to replace the three existing ones.
• The launching of a UK Infrastructure Bank, supported by £12bn of equity and debt capital plus an additional £10bn in UK government guarantees.
• A £375mn tech investment fund (Future Fund: Breakthrough).
• A mortgage guarantee scheme for homes worth up to £600,000 to allow people to purchase residential property with only a 5% deposit.
• A six month extension to the £20 per week increase in Universal Credit.

Boris Johnson has previously said his government will not raise income taxes, VAT or national insurance rates. The Chancellor will therefore have to be creative in finding ways to help pay for this largesse. It is thought the following measures will be adopted:
 

• A freezing of income tax thresholds, expected to drag another 1.6 million people into the top 40% tax rate.
• A freeze in the lifetime limit on pension savings, currently £1,073,100.
• An increase in corporate tax over the lifetime of the government from the current 19% possibly as high as 25% (in line with or lower than the largest European Union countries).
• A possible rise in Capital Gains Tax (CGT) to reduce the arbitrage with income tax.

Freezing income tax thresholds and pensions savings limits are stealth tax hikes. They are passive and, as a result, individuals notice them much less than explicit increases in tax rates. Whilst no government likes to raise taxes, corporation tax and CGT are thought to be two of the less politically sensitive taxes since they impact a smaller proportion of the electorate than income taxes and VAT. Nonetheless, the Chancellor needs to ensure the UK continues to be an attractive place to invest both in financial markets and in the real economy, as mentioned above. And, of course, he also needs to ensure that he does not alienate a large number of MPs from his own party.

One option for the Chancellor that is perhaps slightly more palatable is to commit to raise taxes and reduce spending contingent on future dates or events. He could, for example, say that he intends to raise tax rates only once the level of GDP has surpassed its previous peak, to withdraw certain benefits and grants only once the unemployment rate has fallen below a certain level or to reduce emergency measures at a specific point of time in the future such as three months after the lockdown restrictions have been lifted in full. By implementing fiscal tightening in a contingent way the Chancellor might just be able to balance the needs of supplying ongoing stimulus and support through these continued difficult times whilst also ensuring a reputation for fiscal prudence.

¹ The dependent variable is the cash balance as % of GDP. The explanatory variable is the deviation of GDP from its 10 year rolling trend level. Using quarterly data, rolling 10 year regressions were used in the analysis.

² The information in this section has been collated across multiple sources including: the FT, the Guardian, Bloomberg and Which?.