Global Insight Perspective | |
Significance | Darling delivered his speech at a time when growth prospects have been deteriorating significantly and leeway for public-sector investment and tax reductions has narrowed sharply. |
Implications | A range of eye-catching tax reforms were announced (which inspired some déjà vu following similar pledges from the opposition Conservatives) including a cut to inheritance tax, a single capital gains tax rate, and a crackdown on non-domiciled foreign workers. With heavy public services investment set to continue, albeit growing more slowly, a balanced budget is not foreseen until 2009/10. |
Outlook | Although growth projections have been scaled back and borrowing projections raised somewhat, the former still exceed Global Insight's forecast of 1.9% in 2008, and we thus expect the fiscal situation to deteriorate further. |
Thankless Task
Chancellor Alistair Darling hardly faced the most auspicious of circumstances when delivering his first Pre-Budget Report (PBR) and Comprehensive Spending Review (CSR) yesterday. The U.K. growth outlook has recently deteriorated significantly, public finances were worse than targeted in the first five months (April-August) of fiscal year (FY) 2007/08, and a substantial squeeze on future public spending growth was already imposed on the CSR by the need to cope with the largesse of recent years. Darling consequently did not have the leeway that his predecessor (and now prime minister) Gordon Brown enjoyed, and he needed to produce some impressive conjuring tricks. His task was made all the more difficult by the farcical saga over a potential snap general election. Only a week or so ago the government seemed set on sending voters to the polls in November, and were gearing up for this with stage-managed announcements. The PBR/CSR was apparently intended to fire the campaign's starting gun. In the event, the opposition, centre-right Conservatives staged a comeback in the polls after their annual conference, Brown's advisers suddenly got cold feet and he was persuaded to abandon election plans. Darling faced a barrage of derision in parliament yesterday, particularly as some of his announcements were uncannily similar to Conservative pledges (see below).
Tax Moves
The chancellor was under pressure to come up with some popular measures following the Conservatives’ well-received plans to raise the inheritance tax threshold to £1 million (US$2 million) and to levy a flat £25,000 charge on non-domiciled foreign workers. He responded by doubling the inheritance tax threshold for couples from £300,000 to £600,000 with immediate effect, and announced that this will rise to £700,000 by 2010. Although Darling rejected the Conservatives’ plans for a flat £25,000 charge on non-domiciled foreign workers, he announced that he would be launching a consultation process on a potential levy on "non-doms" after seven years, raised again after 10 years. Another closely watched move is the introduction of a set rate of 18% for all capital gains tax. This is aimed at closing a tax break for private equity bosses, who have often ended up paying just 10% on the bulk of their profits. However, today there has been a backlash from businesses, which claim that this will also hit thousands of small companies, employees, and shareholders who have also benefited from 10% tax rates. This could hold back entrepreneurship and ultimately damage economic growth prospects, they argue. Ironically, private equity firms have expressed relief that Darling did not go further and treat their profits in the same way as regular income (with the attendant 40% rate). Those who stand to benefit most from the capital gains tax change will be buy-to-let homeowners, investors in publicly limited companies, and second home-owners, all of whom pay a minimum of 24% at present. Finally, on the tax front the chancellor announced a rise in duty for passengers on business-class-only airlines, which doubles to £80 from November 2008. From November 2009 levies will instead be imposed on aircraft rather than passengers, in line with journey length and emissions. These changes are expected to raise an additional £520 million by 2010.
Spending Plans Toned Down
The Comprehensive Spending Review confirmed that spending growth will be limited to a real 2.0% over the three-year period 2008/09-2010/11. The big winner is the National Health Service (NHS), which receives a bigger-than-expected increase of 4.0% a year. Nevertheless, this is well below the 7% increase seen in recent years. A further £250 million over previously announced plans has been allocated for education, with the result that its expenditure rises by 2.7% a year in real terms through to 2010/11. Again though, this is substantially below the growth rate seen since 1999. These bigger-than-expected increases for health and education will be largely paid for by efficiency savings of £30 billion rather than £20 billion by government departments and town halls. Whether or not these efficiency gains can be made remains to be seen. Some £440 million is expected to be saved by bringing forward changes to the state second pension to 2009.
Fiscal Risks
Although the tax changes are unlikely to hit the public purse and spending growth is contained, Darling nonetheless accepted yesterday that the Public Sector Net Borrowing Requirement (PSNBR) must rise up until 2011/12. The 2007/08 PSNBR projection has been raised from £33.7 billion to £38 billion, from £30 billion to £36 billion for 2008/09, from £28 billion to £31 billion for 2009/10, from £26 billion to £28 billion for 2010/11, and finally from £24 billion to £25 billion for 2011/12. The planned return to surplus of the current budget has been put back to 2009/10 from 2008/09. The current budget deficit for 2007/08 now stands at £8.3 billion, almost double the £4.3-billion shortfall envisaged as recently as the March budget. The 2009/10 surplus forecast has now fallen from £6.0 billion to £3.0 billion. The public finance data for August was particularly poor, with the result that both the current budget deficit (at £11.7 billion, versus £8.6 billion) and the PSNBR (at £19.2 billion, versus £16.0 billion) were higher in the first five months of FY 2007/08 than in the corresponding period a year ago. This had already put the government's fiscal targets under pressure for 2007/08.
The chancellor forecast GDP growth at 3.0% for 2007, which is justifiable given the performance of the economy over the first three quarters. However, although he has downgraded the 2008 GDP growth projection from 2.5-3.0% to 2.0-2.5%, this still looks too optimistic to us. We expect growth to be limited to 1.9% in 2008; and, if anything, the risks to this forecast may well be to the downside. We also think that the growth forecast for 2009 at 2.5-3.0% is modestly on the optimistic side. We currently project growth at 2.5% in 2009.
Outlook and Implications
Consequently, we believe that the public finance forecasts for 2007/08, 2008/09, and 2009/10 are based on shaky foundations. The slower growth is over the coming months, the more likely that tax revenues will come in markedly below the government's forecasts. A slowing housing market (which reduces stamp duty receipts) and likely markedly lower City bonuses also seem certain to hit tax receipts. The government now expects current receipts to rise by 6.2% in 2007/08 to £551.2 billion, and by 5.4% in 2008/09 to £581.0 billion. Previously, receipts had been projected to increase by 6.9% in 2007/08 and by 6.0% in 2008/09. Meanwhile, current expenditure is now projected to climb by 6.8% in 2007/08 to £541.2 billion and by 4.6% in 2008/09 to £566.0 billion. Previously, expenditure had been projected to increase by 5.9% in 2007/08. The 2008/09 projection was unchanged.
Although the chancellor can justifiably blame some of the sharper-than-expected slowdown in growth on the global credit crunch, it was always likely that U.K. expansion would slow significantly in 2008. In particular, even before the credit crunch, consumer spending was coming under increasing pressure from higher interest rates, muted real disposable income growth, and increased debt levels. A slowing housing market and increased concerns about the economic outlook are also likely to weigh down on consumers going forward. Meanwhile, we expect U.K. exports to be limited by a persistently strong pound and slowing global growth.