In Labour’s previous eleven Budgets, his predecessor Gordon Brown had presided over a vast array of fiscal policy changes, culminating in last year’s eye-catching 2p cut in the basic rate of income tax, even if this was almost completely offset by the abolition of the 10% starting band. However, whilst doing all this Mr Brown always emphasised the importance of adhering to his two fiscal rules; the Golden Rule of borrowing only for investment (over the cycle as a whole) and the Sustainable Investment Rule of keeping public sector net debt to less than 40% of GDP. In addition to numerous definitional changes, the main reason for Mr Brown’s success in this area was the persistent strength of the economy, which had been growing continuously since 1992. This has boosted tax revenues and reduced spending on unemployment, whilst low inflation has helped cut debt servicing costs. Unfortunately for Mr Darling, the times they are a changing. Although an outright recession still looks unlikely at this stage, growth in 2008 will be significantly weaker than the 2.0-2.5% he predicted in last year’s Pre-Budget Report. Sharply weaker growth will mean slower growth in tax revenues, whilst the spike up in inflation will put upward pressure on benefits. Against this backdrop, and following the ridicule he received in October after pinching the Conservatives’ plans for Inheritance Tax, financial markets were not expecting much from Mr Darling’s first Budget. They weren’t disappointed. With so many of the Budget measures “pre-announced” either in the Pre-Budget Report or by Mr Brown last year, the Budget was reduced to a slew of comparatively minor changes. Overall the Budget was fractionally expansionary in 2008-09, injecting a net £140 million, but becoming contractionary over the next two financial years, withdrawing £790 million in 2009-10 and £1,865 million in 2010-11.
Main Budget Measures
Fairness and opportunity for all
- Increase in child element of Child Tax Credit by £50 a year above indexation from April 2009.
- Increase first child rate of Child benefit to £20 a week from April 2009.
- Pilots of new approaches to tackling child poverty.
- A Child Benefit disregard will be introduced for Housing Benefit and Council Tax Benefit from October 2009.
- In 2008-09 a one-off payment of £100 will be made to households containing someone aged over 80 and £50 to households containing someone aged over 60. Brings Winter Fuel Payments to £400 (over 80) and £250 (over 60).
- The savings and basic rate limits of income tax up in line with inflation.
- The ability to work of incapacity benefits claimants to be re-assessed.
Duties changes
- Tobacco duties up in line with inflation. Adds 11p to a packet of 20 cigarettes.
- Excise duties on alcohol increased by 6% over indexation from 17 March and by 2% above inflation in each subsequent year up to 2013. Adds 14p to a bottle of wine, 4p to a pint of beer and 55p to a bottle of spirits.
Protecting the environment
- The increase in main road fuel duty rates of 2p per litre, due to take place on 1 April 2008, is to be deferred until 1 October 2008.
- Fuel duty to rise by 0.5p per litre above indexation on 1 April 2010.
- From 1 April 2009, Vehicle Excise Duty for cars registered on or after 1 March 2001 will be reformed to include six new bands.
- From 1 April 2010, a new first year VED rate will be introduced.
- Government considering raising carbon emissions target from 60% to 80% cut by 2050.
- Also considering introducing legislation in 2009 on plastic bag charging, with all money raised going to environmental charities.
Modernising and simplifying the tax system
- Capital gains Tax: As announced on 24 January, a new entrepreneur’s relief will be available in respect of certain disposals on or after 6 April 2008. This will reduce the effective tax rate to 10% for up to the first £1 million of qualifying gains made over a lifetime.
- From 6 April 2008, charities will be able to claim Gift Aid at a transitional rate, consistent with a basic rate of income tax of 22%, for three years.
Economic Implications
Alistair Darling’s first Budget was a tedious affair. Given the deteriorating outlook for the real economy, and the already parlous state of the fiscal arithmetic, there was never any prospect of the Chancellor surprising us all with a US-style fiscal stimulus package. However, even we were surprised by lack of anything of real substance in the “Red Book”. Given the net size of the various measures, the macroeconomic implications of this year’s Budget are negligible. The announcement that the “work capability” of all people currently in receipt of incapacity benefit will be reassessed is potentially quite interesting, as the effect should be to boost labour supply and therefore the economy’s long run sustainable growth rate. But against this, the Chancellor’s decision not to increase the higher rate income tax threshold at all (not even in line with inflation) will have the precise opposite effect, by reducing incentives to work.
The real interest in this year’s Budget was the Treasury’s revised economic projections. As expected, Mr Darling cut his growth forecasts for both 2008 and 2009, which now stand at 1.75%-2.25% and 2.25-2.75% respectively. However, whilst we wouldn’t argue with the view that growth will be driven more by companies and exports (and less by the consumer) than has been the case in recent years, we still believe the Chancellor is being far too optimistic. Our view is that the economy will struggle to expand by 1.5% both this year and next, with the risks in both years being to the downside. However, we concur with the forecast (more an assumption made by the Treasury) that inflation will fall back to the 2% target next year where it will remain. Indeed, if anything, we think inflation may be even lower than this by the end of next year. The fiscal projections also deserve some comment. Mr Darling took great pleasure in announcing that both the deficit on the current budget and overall net borrowing in 2007/08 would be less than the projections made at the time of the Pre-Budget Report (£8.0bn and £36.0bn), not mentioning of course that both were significantly higher than Mr Brown forecast a year ago. However, he was much quieter about the deterioration he now expects in future years, with the current deficit in 2008/09 projected to be £6bn higher than anticipated in October, with surplus not being attained until 2010/11. Nevertheless, Chancellor Darling continued to emphasise that he was still satisfying the Golden Rule. But we think this rather misses the point, which is that after such an extended period of economic expansion, the current budget should already be in healthy surplus. What’s more, if we are right and growth turns out to be weaker than the Treasury expects, the current budget will move further and further into deficit.
Implications for Financial Markets
Financial markets’ initial reaction to the Budget was muted – hardly surprising given the size of the measures and the absence of any discernible economic effects. The gilt market was slightly disappointed by the hikes in alcohol duties as these are likely to push measured inflation even higher in the near-term, although a partial offset came from the decision to postpone the planned 2p a litre increase in fuel duty until October. However, the Debt Management Office’s subsequent announcement that gross gilt issuance in 2008/09 would be £80.0bn compared with £58.5bn in 2007/08 sparked an altogether larger response. Although £14bn of the increase was attributable to the costs of funding Northern Rock, gilt yields surged, climbing from 4.34% to 4.46%. Meanwhile, equities moved higher, but this was more in response to yesterday’s co-ordinated central bank intervention aimed at boosting liquidity in financial markets than anything emanating from the Budget. That said, whilst this year’s Budget was largely a non-event, the sheer scale of public borrowing presents a major medium to longer term threat to financial markets. Regardless of what Mr Darling says about his fiscal rules, at some stage he (or his successor) will have little option other than to raise taxes in order to plug the hole in the public finances.
John Clarke
GHC Capital Markets Limited