From 1981 to 2005 I lived in Guernsey. It was small, a bit limited in terms of entertainment and very windy. I found it quite tough to live there. It had its perks though: commuting to work took less than 10 minutes and I had my own office with a sea view and balcony. More importantly, income tax was 20% and there was no Capital Gains Tax (CGT), VAT or Inheritance Tax (IHT). OK, no NHS or army either, but we managed to get along so long we didn’t antagonise the Crapaud (Guernsey slang for the Jersey-born named after their national dish – toad).
I decided to swap all that for a chance to work in London and pay more tax, lots more tax. Now it looks like I will get the chance to pay even more. The new Labour administration in its first few weeks is softening us up for tax rises. Apparently, the country’s finances are even worse than they thought. Blow me down, I didn’t see that coming!
While we knew about VAT on private school fees, we could only guess at what other new and higher taxes were to come. There’s a good outline of some of the possibilities here, but in summary: CGT rates linked back to marginal income tax rates, taxes on pension incomes, second home taxes, other forms of wealth taxes, carbon-related taxes (road/air), corporations and inheritance must all be on the table.
Will greater tax and spend be inflationary or not?
What is important is the scale. Will the level of fiscal tightening embolden the Bank of England (BoE) to reduce rates more quickly? If we’re to avoid a recession in 2025, then this feels critical. Despite the politicians’ favourite claim that ‘we will borrow or tax more to invest in public services’ the reality is that they are just spending more. The first back-bench rebellion was in removing the child welfare cap – and word is that only seven Labour MPs resisted the whip because a removal of the cap is in the works anyhow. Then, this week the government agreed inflation-busting pay rises for junior doctors, teachers and other public service workers. Junior doctors got a headline-catching 22% average pay bump, while the rest got between 4.75% and 6%.
In addition, passenger rail will be nationalised as contracts come up for renewal (albeit about 40% of journeys are already provided by the state after franchise failures in recent years). The government assumes that it will save money this way, but that seems a bit too win-win for a real policy trade-off. We will have to see. Then there’s a new state-owned energy company that needs to be funded.
None of this suggests government borrowing is coming down soon, and the coupon payments on government debt remain high, so lower rates would really help the Treasury. The problem is all this spending might be inflationary, which leaves BoE Governor Andrew Bailey and chums with a dilemma. To cut, or not to cut?
A dilemma shared is a dilemma still
All of this gives us our own dilemma – one shared by all UK investors.
We own a relatively large amount of UK government bonds in our portfolios and have felt quite confident for some time that rates will be lower by the end of the year. That would send bond yields lower and therefore deliver gains to bondholders. The latest government moves have given us pause for thought, however. We didn’t expect the old Labour tax and spend narrative to come to the fore so soon.
Now, we’re trying to calculate whether the increased taxation will reduce consumer spending and dampen growth, encouraging the central bank to cut? Or will the recent inflation-plus pay rises offset the effects of tax rises elsewhere, increasing consumer spending and making inflation reaccelerate?
So, the next couple of weeks are critical. So far, the UK bond market hasn’t reacted to the latest comments from the new government. We are not so sanguine. We haven’t reacted yet, but we have a nervous finger hovering over the sell button.
One set of people who will be happier with the current trend are the Treasurers in Guernsey and Jersey, as they may see an influx of the ultra-high net worth cohort to the islands, attracted by the nice beaches!
Tune in to The Sharpe End - a multi-asset investing podcast from Rathbones. You can listen here or whenever you get your podcasts. New episodes monthly.
