Stewart Robertson, Aviva Investors' economist, comments - Chancellor offsets short-term hardships with long-term debt burden.
Stewart Robertson, Aviva Investors' economist, comments:
Chancellor offsets short-term hardships with long-term debt burden
- In yesterday's pre-budget report, the Chancellor of the Exchequer, Alistair Darling, announced a £20 billion fiscal expansion program between now and April 2010. The program was designed specifically to help Britain spend its way out of recession. At the heart of the stimulus program was a temporary cut in VAT from its present level of 17.5% to 15%, the lowest level allowed in the EU. This tax change is to take effect on 1 December 2008 and is to remain in place for 13 months. The hope is that by effectively putting "£12.5 billion in consumers' pockets," this package would boost spending over the holiday season, while also encouraging consumers to bring forward their purchases. Alcohol, tobacco and petrol are, however, exempt from this reduction in sales taxes.
- The Chancellor pledged to part-fund these cuts with a new 45% income tax rate on earnings over £150,000. The new tax band is not expected to come into effect until April 2011. From the same year, the National Insurance (NI) rate would increase by 0.5%, however, no-one on less than £20,000 will see their NI contributions increase.
- In the statement, the Treasury revised-down its 2008 GDP forecast to 0.75%, encapsulating consensus views. It also published a GDP forecast range of -0.75% to -1.25% for 2009, considerably lower than the 2.75% growth forecast published in March; and stated that inflation would reach 0.5% by the end of next year. In 2010 the Treasury also expects growth of between 1.5% and 2%.
- Government borrowing would also more than double to £78 billion this year and £118 billion next year (8% of GDP), before starting to come down, with books not to be balanced again until 2015/16. The statement also provided some relief for the corporate sector in the form of exemptions on foreign dividends for large and medium sized firms, a new flexible tax payment regime for struggling businesses and a temporary increase in threshold for empty property relief for small companies.
- Published each autumn, the pre-budget report is the Treasury's chance to explain in advance the measures likely to be presented in the full budget the following spring, and to update its economic and budget forecasts.
Aviva Investors view:
- We believe that given the dire situation that the UK economy is in, some sort of fiscal stimulus was probably justified. However, while we feel the VAT cut may have a direct, positive and immediate impact on the UK economy, the legacy of Monday's fiscal package is likely to be significantly higher levels of public debt as a percentage of GDP; and possibly five to six years of painful public sector retrenchment, as the government works to reverse current borrowing.
- In our opinion, cutting VAT by 2.5% could knock 1% to 1.25% off inflation (both CPI and RPI) with immediate effect; possibly resulting in negative inflation by mid 2009. Sustained deflation is, however, unlikely.
- In reviewing the pre-budget report, we believe that the excessiveness of the measures announced on Monday, probably have as much to do with politics as they do with economics; for the measures have simply offset short-term hardships with a long-term debt burden which will take several painful years to erase.
- Furthermore, we believe that the deferred 45% income tax bracket is unlikely to be effective, as the amounts raised will be negligible and therefore not have any material impact on the hole in public finances.
The opinions expressed are based on Aviva Investors internal forecasts and should not be relied upon as indicating any guarantee of return from an investment managed by Aviva Investors.
The source for all information is Aviva Investors as at 25 November 2008, unless stated otherwise
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