Austerity is not coming to an end
At best, austerity won’t get any worse.
Better-than-expected revenues over the last 18 months has left the Treasury with more money. In the 2018 Budget, the Chancellor, uncharacteristically, reallocated this windfall to future spending, along with additional future revenues now forecast by the Office for Budget Responsibility (OBR) in its attempt to address its recent admission that it had been consistently too pessimistic in the past. So how much more is Chancellor Philip Hammond forking out? By the end of the current Parliament, the government will spend an additional £17.9 billion while raising just an additional £280 million in taxes.
But remember, this is relative to the spending plans already set out. That’s crucial to assessing the validity of Mr Hammond’s proclamation that “austerity is coming to end”. It’s no more than rhetoric and the politically-neutral OBR’s report tells a different story.
At best, fiscal policy won’t be getting any more austere in 2019-20, but the independently verified numbers clearly show that ‘the cyclically adjusted budget current budget deficit’ – day to day net spending adjusted for the ebb and flow of the business cycle and arguably the standard international gauge of fiscal thrust or drag – will tighten again from 2020-21. And that’s after eight long years of extraordinary fiscal tightening. As a result, we are not changing our outlook for the UK economy. Low growth and tight fiscal policy is here to stay.
The Chancellor put together the Autumn Budget knowing that he borrowed over £5 billion less in the 2017-18 fiscal year than he thought he had at the time of the Spring Statement, and that borrowing between April and September in the current fiscal year was 35% lower than during the same period last year – twice as a big a reduction as forecast.
Sure, this year’s numbers appear flattered – though not fully explained – by temporary factors, calendar quirks such as a sharp drop in interest payments and infrastructure investment. The extra £5 billion from last year was largely the result of lower-than-expected spending by local authorities, which seems unlikely to continue given the intense squeeze on council services. Nevertheless, public sector net borrowing is likely to be 1.9% of national income this year, back in line with the 70-year average, albeit still above the 1.3% average seen through the Blair years.
Ordinarily, a Chancellor lording over such numbers would fill his red briefcase with a firm sense of empowerment. Yet Mr Hammond approached the Commons decidedly hamstrung: the Prime Minister had already promised to freeze fuel duties once again, costing £0.8bn in 2019-20, and pledged more money to the NHS, £7bn next year increasing to £20.5bn in 2023-24. And there’s the Brexit cumulonimbus hovering over No. 1 Horse Guards, in response to which Mr Hammond had previously committed to maintaining some “fiscal” headroom (more on this later). Nevertheless, the Chancellor still put through some additional expenditure items, including an extra £1 billion on cyber and nuclear defence, £560 million to local governments and £420 million to fill in potholes! There’s extra money for house-building, and the personal allowance and higher rate thresholds for income tax will be increased to £12,500 and £50,000 a year earlier than planned.
It’s still going to get more austere
But a net giveaway Budget does not reverse eight years of austerity. Sure, total real spending has fallen by just 1.5% from a peak of £800bn in 2010-11, but this must be seen in the context of an increasing – and increasingly aged – population that requires more government services, not fewer. In this context, eight years of cuts were deep and unprecedented. The average department’s budget was cut by 20%. Local authorities and the Ministry of Justice have had their budgets slashed by more than 40%. There have been swingeing cuts to benefits too: the child benefit is worth less today than it was 17 years ago, for example. All told, total public spending as a share of GDP has fallen from 45% in 2009-10 to 38%, close to the US’s 36% which has always been viewed as disconcertingly low and an international outlier.
Mr Hammond previewed the forthcoming spending review by announcing that day-to-day spending limits will rise by an average of 1.2% a year. However, the OBR clearly illustrates that most of this will go to the Department of Health: real expenditure limits per capita will not rise at all once we exclude the NHS. Moreover, the government has discretely slashed the money set aside for long-term capital spending in the coming years. According to the OBR, the capital spending budget has been cut by £7bn per year in 2020-21.
The fiscal rules
The Chancellor delivered his net giveaway budget while lowering the national debt to GDP ratio by 2020-21 and keeping the structural deficit below 2% of national income. But he had to jettison one of his fiscal rules and a manifesto pledge – to run a fiscal surplus from the mid-2020s. Reneging on the rule shouldn’t concern investors, we have had 12 fiscal rules since 1997, and 10 of those have been broken or abandoned. Breached or dumped, markets rarely bat an eyelid. The UK is not known for consistent budget surpluses. It’s been seven decades since there were four consecutive years without a deficit: they weren’t needed, strong growth kept the debt to GDP ratio on a downward path until 2008 (although wayward inflation in the 70s and 80s also helped – not something we would want to repeat!).
Gilt yields were unmoved. Unsurprising given that the UK has the second lowest public debt to GDP ratio among the G7 economies.
Raising the minimum wage
The 4.9% rise in the national living wage to £8.21 per hour will help lower-income households. This is not a new policy: the 2017 manifesto promised to raise it to £8.75 by the end of the current Parliament. Someone, somewhere along the chain must pay for higher minimum wages. Either domestic firms make less profit, cut jobs or other benefits, or pass the costs on to households in the form of higher prices. In practice, there’s precious little evidence that firms cut jobs as a result of higher minimum wages. But that may be because the historic examples almost invariably start from a relatively low base. Theoretically, there must be a point beyond which higher minimum wages lower employment – more technically, when they rise above the market clearing wage – but that point is unknown.
We do not expect the higher living wage to exert significant pressure on inflation. We must remember that the relationship between wages and prices is historically very weak – close to zero between 2001 and 2016.
Tax on big tech
The Chancellor unveiled a new digital services tax aimed at technology platform providers (think Facebook, Alphabet’s YouTube, Apple’s App Store) with large revenues. A new tax on business is not something one would typically expect from a Conservative Chancellor, especially a tax designed with explicit interventionist intentions. However, it could be seen as correcting for a de facto market distortion created by the tax loopholes online companies use so deftly.
After a year with a net outflow of foreign direct investment, one might be concerned about disincentivising investment from growing, globally dominant companies. But it is, moreover, a sign of the times for tech companies. The next ten years are likely to see a tightening of regulation in all jurisdictions and we are keeping a close eye on long-term earnings projections accordingly.
These companies could move more staff to Continental Europe, but EU regulators have shown themselves to be particularly precocious, especially their competition commission, and a similar digital services tax has been scheduled to start in the next 18 months. Furthermore, big tech appears committed to maintaining UK HQs. Over the last 18 months, despite Brexit uncertainty, Amazon moved into a large new UK HQ in Shoreditch, Google broke ground on a £1bn London HQ – a so called “landscraper” – and Facebook has leased 600,000 square feet of space, doubling its current footprint.
Do we need Brexit ‘headroom’?
The Chancellor maintained headroom of around £15bn against his fiscal rule to reduce the structural budget deficit to 2% of GDP by 2020-21.
We sometimes hear the argument that forecasts of economic deterioration were wide of the mark after the referendum, so pessimistic forecasts may be similarly wide of the mark after a “no deal” Brexit. Certainly, the lesson for forecasters is that not all political events cause an uncertainty shock that affects the economy as quickly or as severely as the Eurozone debt crisis, for example. And economic forecasts should always be viewed in the context of a rather wider margin of error.
That said, those post-referendum forecasts may not have been as wrong as you might think. For example, after the referendum the Bank of England estimated that GDP would increase by just 0.5% over the 12 months to June 2017, after which the economy would gather a little more steam and increase by 3% to September 2018. As it turned out, GDP increased by about 2% over the first 12 months, before decelerating to grow by 1.5% to September 2018 (we’ve estimated the final quarter based on the monthly data available so far). In other words, while the popular narrative has it that the initial forecasts were way off, the 27 month forecast was actually spot on, the economy just took a different route!
At the time, we thought other forecasters’ initial estimates were too pessimistic but the first 12 months even beat our expectations, largely because households unexpectedly decreased their rate of saving. In fact the saving rate plunged from 8-9% of disposable income before the referendum to just 4%, where it has remained more or less since. We do not believe that household balance sheets will allow them to repeat that in the event of a “no deal”.
Business investment has been very weak indeed, barely growing at all since June 2016, while it has grown strongly in other major economies, such as the US and Germany, which the UK had been keeping pace with in the few years before. In 2017 there was a net outflow of foreign direct investment (investment which involves some degree of controlling stake) – net FDI outflows are unusual in the UK.
The size of the UK’s trade in services relative to the size of its economy is bigger than any other large advanced economy’s. Its manufacturing is one of the most specialised, involving above average use of overseas supply chains. Even if Brexit eventually turns out to be a great change of direction, the disruption to regulatory regimes and supply chains that a hard Brexit would entail over the short to medium term means that the likelihood of investment surprising to the upside in such a scenario is very low indeed.
So, in short, the Chancellor is wise to keep some fiscal headroom.
In our recent report, Shedding light on Brexit’s unknowns, we set out why we believe the most likely outcome next year is deal de minimis with the salient details still to be hammered out during an extended negotiating period. Indeed, in the last fortnight the EU and UK have reportedly considered a year’s extension to the two-year transition period, taking us to December 2021. However, that would overlap with the start of the EU’s next seven-year budget cycle, and could leave the UK liable for a bigger ‘divorce bill’.
Economically, by preserving ‘business as usual’ for three years and giving more time to arrive at a trade agreement, a transition extension would likely be positive for the economy. That said, it sustains the cloud of uncertainty and could hold back investment decisions for longer too.
It may be a very long-running show – and it may have become boring to some – but we don’t think this bull market will be cancelled in the coming months
Financial planning implications
The Chancellor delivered on the Conservative Party’s manifesto a year earlier than promised by increasing the personal allowance to £12,500 and the higher rate band to £50,000 from 6 April 2019. Scotland sets its own rates of income tax, as will Wales from 6 April; the respective governments will announce their Budgets later this year.
The individual savings allowance (ISA) remains unchanged at £20,000 per annum. The junior ISA and the child trust fund (CTF) subscription will increase with CPI to £4,368. A consultation next year should ensure CTF accounts retain their tax-free status after maturity.
The capital gains tax (CGT) allowance will increase by £300 to £12,000 from 6 April.
The private residence relief will be more restrictive from April 2020, subject to consultation. Currently, people can claim the relief if they let out a property that is, or has been, their main residence. Under new rules, relief only applies when the owner of the property shares the home with a tenant. In addition, the exemption also means individuals do not have to pay CGT on gains made in the last 18 months of ownership, this will drop to nine months.
The off-payroll working rules (IR35) for the private sector will be reformed from April 2020, bringing them in line with the changes made to public sector rules implemented in 2017.
Despite the usual pre-Budget scuttlebutt, there were no changes to the annual pension allowance. It remains at £40,000, the money purchase allowance stays at £4,000 also and there were no changes to the high income allowance taper rules.
The Chancellor continues to limit total pension savings with the lifetime allowance, which is rising in line with CPI to £1,055,000.
Entrepreneurs’ relief is safe; however, the qualifying criteria will be tightened. As of 6 April 2019, the claimant must have a 5% interest in both the distributable profits and the net assets of the company. In addition, the minimum period throughout which the conditions must be met will increase from one to two years.
The Chancellor announced that first time buyers will be exempt from stamp duty land tax (SDLT) on purchases of qualifying shared ownership property. The first £300,000 of an initial share purchased will not be liable to SDLT. The remainder of the initial share will be chargeable at a rate of 5%. The relief will not apply to purchases of properties valued over £500,000. First time buyers who have already paid SDLT on a qualifying property on or after the 22 November 2017 have until 29 October 2019 to make a backdated claim.
As expected, the inheritance tax (IHT) nil rate band remains frozen at £325,000 until April 2021. The residence nil rate band will increase from £125,000 to £150,000, allowing couples to leave up to £950,000 to future generations free from IHT.
There will be a consultation to consider the simplification and fairness of taxation on trusts.
In the meantime, additions of assets to existing trusts by UK domiciled, or deemed domiciled, people to trusts created when they were non-domiciled won’t be classed as excluded property. This change will be applied retrospectively once the 2019-2020 Finance Bill receives royal assent.