Hammond eases, but still squeezes
A small giveaway budget offset by a grave deterioration in the outlook for UK growth and the government’s tax receipts shouldn’t move the dial for investors.
The first Autumn Budget was a giveaway budget. Policy decisions sum to a net £22 billion over the next four fiscal years, the bulk attributable to new spending rather than lower taxation. Yet £22 billion equates to approximately a quarter of a percent of GDP over the period. Chancellor Phillip Hammond has eased the squeeze he brought to Parliament in his red briefcase eight months ago, but he is still squeezing nevertheless. The austerity programme will not end before 2022-23. In other words, while the November Budget marks a fiscal loosening relative to the March plan, it is still a programme of fiscal tightening in absolute terms.
Moreover, the modest giveaway is framed by a grave deterioration of the outlook for UK growth, driven by the downgrades to business investment and productivity as assessed by the Office for Budgetary Responsibility (OBR). The OBR also forecast real wages to continue to fall and unemployment to start to increase again from 2019. Growth is now expected to average just 1.4% over the next five years, and this is the first time since the OBR was established in 2010 that growth is expected to be lower than 2% in every year forecast.
We discuss the growth downgrade in more detail below, but the OBR’s estimates are now towards the lower end of the range of estimates from other independent forecasters. However, we do not believe the OBR’s medium term projection is particularly pessimistic. They estimate growth will stabilise at 1.6% in 2023; coincidentally, our own projection of the UK’s potential GDP growth over the next 10 years is 1.6% per annum. And our forecast does not include any adjustment for Brexit.
All told the November Budget has not caused us to reassess our assumptions for domestic investments or sterling.
We prefer to analyse the future impact of fiscal policy on an economy – the degree of fiscal drag or thrust, if you will – using something called the cyclically adjusted current budget balance. Without the jargon, this refers to the government’s spending on day to day activity adjusted for the ebb and flow of the business cycle. The November Budget presents a fiscal drag of £32 billion over the next four years (down from £57 billion in March), equating to 0.3% of economic output next year, 0.5% the year after and 0.6% in the year after that.
Policy measures are forecast to reduce the deficit in 2021-22 relative to 2017-18 by £31.5 billion, the vast majority being spending reductions. In the March Budget, the economy’s tax burden was already forecast to increase to – and remain at – a level not sustained deliberately since the 1950s. And there are over £10 billion of extra taxes still in the pipeline, according to the Institute for Fiscal Studies.
Spending was forecast to fall to its lowest share of national income since the early 2000s. There are still £12 billion of cuts to working age benefits in the pipeline, on top of the £29 billion of cuts since 2010. Departmental expenditures are set to fall further.
The Treasury, HMRC and the Department of Work & Pensions, the Department of Justice and the Department for Environment Food and Rural Affairs face another 20% cut to inflation-adjusted departmental budgets on top of the 40% cuts that have already been made since 2010.
While the UK’s austerity programme becomes more acute again, fiscal policy is scheduled to be a relatively slight drag on economic activity across the rest of the developed world. Based on the November Budget, we estimate that fiscal drag will be between two and four times more severe in the UK than across the G7 economies as a whole.
In March, the Chancellor spoke of an estimated £26 billion ‘headroom’ in the public finances. In other words, he believed that the structural borrowing requirement would be 0.9% of the UK’s potential economic output in the 2020-2021 tax year – 1.1% below the 2% target this Parliament set itself. At the time, Mr Hammond said he wanted to preserve that headroom to protect against any Brexit-related upset to the economy. After the November giveaways and the gloomier economic outlook, the headroom has been cut to just £14 billion. And this figure was flattered by the removal of housing associations from the public sector balance sheet, which reduces public sector net borrowing by a cumulative £24 billion over the next five years.
The headroom is lower for a number of reasons. After a revolt from the backbenches of the Conservative Party, the government failed to enact some of March’s revenue-raising measures, most notably changes to the national insurance contributions of the self-employed. Expectations for interest rates have also risen, and that means the government will likely have to pay a little more to service its existing debt. The public finances are more sensitive to base rates than usual due to the way in which quantitative easing is accounted for in the government Budget.
That said, these debits were largely offset by the much stronger starting point for the forecasts than previously anticipated. Revised data showed the government borrowed £6 billion less last year than the OBR had estimated in March. Receipts of VAT, income tax and national insurance contributions were higher, while spending on public services was lower. Although some of this was due to one-off factors such as the timing of tax changes, the OBR assume that the rest is structural – here to stay – given that the business cycle has been weaker than forecast.
The reduced headroom is due largely to the significantly weaker outlook for the country’s productivity – how much output the UK can produce for a given amount of labour and capital – that the OBR has applied to its forecasts. This was widely expected. It brings their forecast more or less in line with the Bank of England’s, and the OBR signalled the revision plainly in its October Forecast Evaluation Report.
And although this a particularly large adjustment, the OBR has revised down its productivity forecasts repeatedly. With output-per-hour worked estimated to have fallen in the first half of 2017 just as it did in 2015 – a particularly dire result for an economy outside of a recession – the nation’s productivity is at the same level recorded at the end of 2014. Although 2016 saw some improvement, the UK appears to have returned to a pattern of higher than expected employment and disappointing productivity now all too familiar since the financial crisis. In other words, firms keep resorting to hiring more staff and increasing working hours in the absence of productivity gains.
Productivity growth is now expected to recover on a shallower trajectory to 1.3% a year by 2022-23. Previously the OBR assumed it would return to the 2% trend. This lowers potential output growth to 1.6% by the end of the forecast, and that means lower tax receipts on future output.
But the recent absence of productivity growth may mean that even this will still prove too optimistic, especially when one considers that lower-than-expected productivity growth is a global phenomenon. Comparing the forecasts made by the OECD in 2014 for productivity growth across the G7 economies to the actual output makes plain that the UK is not unique.
We do not adjust our estimate of the long-term equilibrium value of the pound, which is in part driven by the UK’s productivity relative to that of other economies. Our own estimates were already rather sanguine. Moreover, today’s exchange rate is still almost as far below the equilibrium rate implied by the economic fundamentals as it has been at any time in the last 35 years. We expect the actual exchange rate to move towards the equilibrium rate over the next three to five years, but unfortunately this does not preclude the possibility of further sterling weakness in the interim.
Why so low?
It’s possible that low productivity growth may be a result of mismeasurement. The 2016 Independent Review of UK Economic Statistics, led by Professor Charles Bean, hypothesised that the failure to fully capture the digital economy might mean UK productivity is underestimated by around 0.5 percentage points per year. For example, business investment in intangible intellectual property such as computer code is often not captured in business investment. Furthermore, the gap between what is measured and what is valued often grows every time access is gained to a completely new good or service, or when existing goods or services are offered free after digitalisation. Yet most studies have found that mismeasurement alone is unlikely to account for the majority of the productivity puzzle. Moreover, the slowdown in productivity appears to be largely unrelated to the penetration of IT across business sectors and countries.
There are a number of other possible explanations. These are fiercely contested by economists and consensus has not formed around any salient arguments.
There’s plenty of evidence to suggest that financial crises can have a persistent downward effect on growth. After 2008, the availability of bank financing was constricted as banks rebuilt balance sheets, constraining firms’ investment plans. It may have hit young companies hardest, where productivity growth is often fastest. However, the UK and US financial systems have been back to much better health for some time and this explanation looks less plausible today.
It’s also possible that highly accommodative monetary policy has kept borrowing costs for weaker firms – with low or even negative productivity growth – low enough for them to survive, constraining the amount of capital that could be reallocated to firms with higher productivity growth. At the same time, business investment has been depressed for a long time, despite these highly accommodative interest rates. The slow growth of new investments has also likely slowed productivity gains.
Some economists argue that today’s innovations do not have the same productive potential as those of yesteryear, although others contend that many emerging technologies could revolutionise the economy, such as robotics, artificial intelligence, the blockchain and personalised medicine (which we have discussed in our recent report on disruptive technologies, How soon is now?).
Certainly, there is evidence to suggest that productivity can lag innovation. For example, considerable organisational investment is required from companies before new technology can become transformative. The internet didn’t disrupt retail until billions were invested in new shipping logistics and supply chain management. It could also be that the vast sums invested in social media have changed our consumption habits but not our productive potential (in fact, think about how it presents many more distractions from our work!).
Although the idea that innovation has slowed is contentious, the idea that the diffusion of innovation has slowed is becoming more accepted. The fierce defence of patents and the greater need for scale and scope in today’s globalised marketplace could be inhibiting the transmission of new ideas across firms and industries.
Initiatives to boost productivity
The Chancellor introduced a number of measures aimed squarely at raising productivity. But despite the simultaneous publication of the Budget and the long-awaited Patient Capital Review, which considered how innovative firms can get the funding they need, the measures were rather piecemeal and in part restated measures previously announced.
Pleasingly the R&D tax credit has been increased to 12%. A new £400 million pot will be allocated to charging infrastructure for electric vehicles.
Stamp duty for first-time buyers
If only the under-40s had been allowed to vote in the general election, the Conservative Party would have lost resoundingly, and so rumours circled that the Chancellor would propose a number of policies designed to woo the younger vote. There were few of any substance. A new railcard for 26-30 year olds is not the sexiest of giveaways.
The most trumpeted measure was the abrogation of stamp duty for first time buyers on homes under £300,000 and stamp duty relief on the first £300,000 of homes valued between £300,000 to £500,000. But pleasing optics belie poor economic logic: lower stamp duty is likely to be ‘capitalised’ in higher property prices, potentially precluding even more first-time buyers from gathering together a large enough deposit in the first place. A review by HMRC after the introduction of a similar policy following the financial crisis concluded that it fed through to higher house prices, did not improve affordability and that most buyers would have bought a home regardless. The OBR estimate that the new measure will raise property prices by 0.3%.
Housebuilding stocks fell initially, after the Chancellor threatened developers sitting idly on land for speculative gain with compulsory purchase orders. We do not expect this to be much more than rhetoric, though shares of any firm with a disproportionately large land bank may continue to suffer.
Financial planning implications
In terms of financial planning implications, the key new points were as follows:
No alterations were announced to the capital gains tax exemption, inheritance tax exempt amounts, the starting rate for savings or the level of corporation taxes. The ISA annual subscription limit for 2018/19 will remain unchanged at £20,000 with the allowance for JISAs and Child Trust Funds rising in line with CPI to £4,260.
A significant announcement was the removal of the corporate indexation allowance, which is used to value chargeable gains made by companies. This had allowed chargeable gains to be offset in part by the impact of inflation, but no relief will be available for inflation accruing from January 2018.
Personal service companies received a similar warning shot across the bows. Having completed their work to reform the off-payroll working rules (known as IR35) for engagements in the public sector, the chancellor signalled his intention to switch his focus to the private sector to ensure compliance with tax legislation. Those who work on a contract basis may need to take advice on whether they remain compliant.
Despite much media speculation, there were no changes to either the annual allowance, pension’s tax relief or the lifetime allowance. The lifetime allowance (LTA) will rise in line with CPI to £1,030,000 from 6 April 2018, bringing a small measure of relief to those with significant pension savings.
However, even with the modest rise in the LTA, the impact of this limit will continue to trickle down to more middle earners. Furthermore, with the money purchase annual allowance having been reduced from £10,000 to £4,000 those considering accessing their pensions under the new ‘pension freedoms’ may need to carefully consider their ability to replenish funds.
The headline grabber was the abolition of stamp duty for many first time buyers, mentioned above.
The government also used the Budget as an opportunity to remove an advantage that non-residents had over UK residents. Broadly all gains accrued on or after April 2019 on disposals of immovable property, such as land, housing and commercial property, by non-residents will be brought within the scope of UK tax. Those individuals affected by the new provisions should carefully consider whether to dispose of property ahead of their introduction.
Not announced in the Budget, but found in the supporting documents, was an announcement that the government will publish a consultation in 2018 on how to make the taxation of trusts ‘simpler, fairer and more transparent.’ Traditionally consultations are forerunners for more significant changes and it is clear the government are concerned about the use of trusts as tax shelters. Those who are either considering using a trust structure, who are trustees or a beneficiary of the trust should keep a watching brief.
Finally, keeping to its promise in the spring Budget, the Treasury published its review of the taxation and structure of Venture Capital Trusts (VCTs) and Enterprise Investment Schemes. Although a new principles based test will be introduced to ensure that such schemes are focused on their intended purpose of encouraging investment for long-term growth, there was a great sigh of relief that no changes were made to either the level of tax relief or investment properly focused VCTs or EICs could enjoy.
Indeed, the Chancellor announced that the annual investment will be doubled from £1 million to £2 million, provided that any amount above £1 million is invested in knowledge-intensive companies.
These provisions will mean that Enterprise Investment Schemes and VCTs will continue to provide valuable diversification opportunities for those investors who are comfortable and able to accept a higher degree of risk. Advice in this area, however, remains essential.