March Budget 2007

By John Clarke 21- Mar -2007

In his first Budget in 1997, Gordon Brown surprised financial markets by granting operational independence – essentially responsibility for setting interest rates - to the Bank of England.

In this year’s Budget, his eleventh and in all probability his last, he was desperate to do something similarly eye-catching.

The problem, of course, was that the fiscal arithmetic didn’t appear to leave him with much room for manoeuvre, at least as regards possible Budget measures. Despite, as the Chancellor was bound to point out in his speech, an unprecedented period of continuous economic growth (extending back to the second quarter of 1992) and with growth last year stronger than most commentators had been expecting, public sector net borrowing remains extremely high. True, with public sector net borrowing in the first 11 months of the financial year amounting to £26.9bn, his full year forecast made at the time of the Pre-Budget Report of £37bn was never really under threat. Nevertheless, the conventional view in “the City” was that this was unsustainable, requiring tax increases of some £10bn in order to plug the hole in the public accounts. It was also felt that that Mr Brown was hamstrung by his own fiscal rules. Although the Chancellor was expected to announce that he had satisfied the “Golden Rule” – of borrowing only to finance capital expenditure over the cycle as a whole – this had only been possible because of a series of changes in the last few years to the timing and the duration of the economic cycle. In addition, the Treasury has also seen fit to re-classify certain types of current spending as capital expenditure. Against this backdrop, the Chancellor’s scope for an opinion poll-boosting giveaway Budget was likely to be severely constrained. And in any case, with the Monetary Policy Committee already concerned about the upside risks to the economy and inflation, the last thing he wanted to do was to increase the probability of higher interest rates. For these reasons, financial markets expected Mr Brown to deliver a broadly neutral Budget. In the event, whilst this is precisely what he delivered (a small net fiscal tightening of £280 million in 2008/09), he enhanced his reputation for surprising the markets by announcing a number of substantial changes to both personal and corporate taxation.

Main Budget Measures

Personal tax reform
• Basic rate of Income Tax cut from 22% to 20% from April 2008.
• This was broadly offset (in terms of the cost to the Exchequer) by the removal of the 10% starting rate of Income Tax on non-savings income.
• Personal allowances up in line with inflation.
• Phased alignment of higher thresholds for National Insurance

Contributions and Income Tax – upper earnings limit rises by £75 in April 2008, but in April 2009 it will be aligned with the point at which the higher rate of Income Tax becomes payable. At the same time, the higher rate threshold will be increased by £800 more than inflation. The effect is to increase the proportion of earned income upon which 11% NICs is payable.

• Increase Age Allowances by £1,180 and raise those for 75 year olds and above to £10,000.
• Increase Child Tax Credit by £150 above indexation.
• Raise the threshold for Working Tax Credit by £1,200.
• Inheritance Tax threshold to rise to £350,000 by 2010.
• Capital Gains Tax allowance increased from £8,800 to £9,200.

Corporate tax reform
• Main rate of Corporation Tax reduced to 28%.
• General plant and machinery capital allowances at 20%.
• Long-life plant and machinery capital allowances at 10%.
• Industrial Buildings Allowance to be phased out.
• Small Companies Rate of Corporation Tax phased to 22% in 2008.
• One year extension of 50% First Year Allowances for small enterprises.

Supporting families and communities
• Raising the Cash ISA limit from £3,000 to £3,600.
• Reduced VAT rates on products for the elderly.

Modernising the tax system
• Extension of the dividend tax credit.
• Reduced VAT rate for smoking cessation products.

Duty changes
• Alcohol duties are up in line with inflation on beer and wine. No change in spirits.
• Tobacco duties are up in line with inflation.
• Gaming duty bands and rates are increased, raising £35 million in 2007-08.

Property
• Rationalisation of empty property relief which raises £950 million for the Exchequer in 2008/09.

Protecting the environment and supporting a clean and efficient transport system
• VED rate increased to £300 for four by four vehicles.
• Road fuel duty increased by 2p a litre on unleaded petrol from October 2007.
• Aggregates levy increased to encourage sustainable use of resources.

Economic Implications

Gordon Brown’s eleventh Budget was considerably more interesting than most of his previous ten. Although the Budget measures were broadly neutral in macro terms, within this the Chancellor made a number of substantial changes to personal and corporate taxation. The changes in personal taxation deserve particular mention. Throughout his tenure at No.11, Gordon Brown has always insisted that he would not put up the basic rate of income tax – a common concern ahead of the 1997 general election. Consequently, by announcing he was cutting the basic rate to 20%, the lowest it has been for 75 years, not only was he able to demonstrate he had kept his word, but he was also able to put one over on the Conservatives. At a cost to the Exchequer of £8.1bn in 2008/09, at face value this looks like an extremely expansionary move. However, Mr Brown effectively financed the cut by removing the 10% lower band, which he introduced 10 years ago, a move that will net some £7.3bn. In addition whilst he raised, from 2009 anyway, the higher Income Tax threshold by £800 more than indexation, by simultaneously bringing the upper earnings limit for National Insurance Contributions into line with it, the Chancellor managed to net a further £1.1bn. This happens because the move effectively increases the amount of earned income upon which the full 11% NI rate is paid.

As regards the Treasury’s economic projections, Gordon Brown gave us very little new information. After an expected 3% this year, growth was forecast to be 2½-3% in both 2008 and 2009, with consumer spending growing by 2.25-2.75% a year and with exports and fixed investment remaining firm. We think that this is too optimistic, with consumer spending likely to be constrained by softening conditions in the labour market and by high debt servicing costs. However, we concur with the Treasury’s expectation that inflation will fall to 2% this year and remain there over the next two years. Indeed, if anything, we believe that the risks are to the downside, reflecting both our weaker growth profile and our judgement that the UK economy is still operating beneath its productive potential. We don’t really have any major problems with the Chancellor’s revised projections for the public finances, with net borrowing forecast to fall only modestly from £35bn this year to £24bn by 2011. If anything, given that these incorporate projected asset sales of £36bn over the next three years (including £6bn for the sale of the student loan book) compared with £18bn in December, we would have thought the improvement ought to be faster than this.

Implications for Financial Markets

Financial markets generally responded positively to the Budget, with the reduction in the main rate of Corporation Tax to 28% particularly well received. However, by far the most important factor today was that by delivering a neutral Budget Gordon Brown did nothing to increase the pressure on the Monetary Policy Committee to raise interest rates over the coming months. Indeed, by postponing the fuel duty hike until October he has increased the chances that inflation will fall below the Government’s 2% target over the coming months. In due course, the Income Tax and National Insurance changes may be seen as a negative for equities as middle to higher income earners will be worse off as result of this Budget. The main medium term concern for investors remains the prospect that at some stage taxes will have to be raised sharply in order to plug the “black hole” in the public finances. However, for now we remain relaxed about the outlook for equities in the year ahead. Our end-year projection for the FTSE All-Share Index remains 3500.