With a new government tackling the nation’s finances, political flash points will appear, warns Ian Fraser
With the unprecedented political horse-trading of 7-11 May now behind it, and the coalition government of prime minister David Cameron and deputy Nick Clegg settled into Downing Street and Whitehall, it remains far from certain that it has what it takes to rescue the UK economy from a severe fiscal bind.
The economic legacy of the last Prime Minister, Gordon Brown, is a truly terrible one. The situation had become so precarious towards the end of Labour’s 13 year rein, that some commentators believed a Greek-style meltdown awaited Britain.
In February Bill Gross, chairman of California-based fixed interest investors Pimco, warned that the scale of UK debt – a £890 billion structural deficit and a £156bn PSBR (public sector borrowing requirement) – coupled with Brown’s lackadaisical approach to the crisis, meant that “gilts were resting on a bed of nitroglycerin.”
Against this backdrop, the markets (if markets can) breathed a tremendous sigh of relief when the Con-Dem coalition came to power and made a firm commitment to getting the UK’s fiscal house back into order after decade of Labour profligacy. It helped that bond investors were distracted by the even bigger fiscal crisis in certain eurozone countries.
In their coalition agreement, Cameron and Clegg committed to a “significantly accelerated” reduction of the structural deficit by 2015, claiming this would be mainly achieved through spending cuts than through tax increases.
The government said it would slash spending, but not “front line roles”, by £6bn in the year to April 2011. The coalition also confirmed it would establish an Office of Budget Responsibility, another Tory manifesto pledge, chaired by veteran economist Alan Budd as part of a bid to ensure the country retains its triple-A credit rating.
Strong and powerful
The credibility of these early moves was enhanced when Bank of England governor Mervyn Kind – who has warned that we are currently only “half way through” the financial crisis that commenced three years ago – endorsed them as “strong and powerful”, and implied he was much happier with them than he was with former chancellor Alistair Darling’s more half-hearted plans for addressing the deficit, within 24 hours of the announcement.
Even so, some economists remained underwhelmed. Many characterised the initial £6bn of spending cuts as far too timid. They want more detail and greater depth, and claim to await with interest the moves chancellor Osborne will announce in June’s emergency budget, as well as the comprehensive spending review and pre-budget report later in the year.
“The cuts announced to date don’t even scratch at the surface of what’s required,” said Danny Gabay, director of Fathom Financial Consulting and a former Bank of England economist. He said that retaining fiscal credibility whilst avoiding tipping the economy back into recession remains a very difficult balancing act.
The seven-page coalition agreement unveiled on May 12 down-played the prospect of tax hikes. However many economists believe that the chancellor of the Exchequer George Osborne – whose senior Treasury team includes the Lib Dems Vince Cable and David Laws – will also have to impose some pretty significant ones if the markets are to believe he means business about deficit reduction.
A rise in VAT would be easier to imppose, and many economists, including Roger Bootle, economic adviser at Deloitte, believe this will be raised from the current level of 17.5% to the European level of 20% almost immediately.
If this happened, it would clearly choke consumer demand and spell pain for retailers and consumer facing business. Justin King, chief executive of Sainsbury’s, said: “We think spending cuts rather than further tax rises is the right approach.”
If the government does increase VAT, King wants the government to give adequate notice and to commit to leaving the higher rate in place for some time. “We don’t want to see VAT swinging around.”
An inevitable rise?
There is also a certain degree of inevitability to a rise in capital gains tax. This is currently only 18%, but is likely to have been increased to 40% or even 50% before they year is out, which would enable the government to raise an additional £2bn-£2.5bn a year. The prospect of such a move, initially opposed by the Lib Dems who feared it would demotivate entrepreneurs, has already sparked a spate of asset sales by wealthier individuals.
Kevin Hindley, managing director at tax advisers Alvarez & Marsal Taxand, said: “We believe that VAT will be raised to 20%, equating to an annual net revenue increase of £13bn. Capital Gains Tax will increase to at least 25% bringing it nearer the higher rate of income tax and discouraging avoidance activity.”
Two of the biggest policy changes the Clegg’s Lib Dems wrung out of the Tories was the axing of plans to raise the inheritance tax threshold to £1m, a move that would have been popular in the shires, and the widening of the tax-free allowance, which was a key part of the Lib Dem manifesto. Personally allowances are due to be stretched by £1000 from April 2011, with a “long-term policy objective” of increasing them to £10,000 – something that would cost the Treasury £17bn per year.
Concessions from the Lib Dems included the scrapping of plans for a so-called “mansion tax”. The two sides also managed to hammer out a compromise on Tory plans for a £550m a year tax break for married couples, a policy that Clegg rubbished as “patronising drivel” during the campaign. The Tories will seek to push the proposal through, allowing the Lib Dems to abstain in a Commons vote.
The new administration also said it would scrap Labour’s planned rise in National Insurance contributions – although only for employers. Employees will still have to pay the higher rate. New taxes for higher earners brought in by Labour in the wake of the financial crisis, including the 50p higher rate of income tax, look set to remain.
Even if Cameron’s coalition holds together (which is far from certain), and manages to push through the austerity measures economists (with the exception of the likes of Prof David Blanchflower) agree are required, Britons are going to have to make a major psychological shift.
Far too many Brits, still regard early retirement, free public healthcare and generous unemployment benefits as their rights. Years ago, as Gideon Rachman explained in his Financial Times blog, they stopped asking how such things were paid for.
Tougher times
One of the biggest stress points will come with the trade unions, particularly in the public sector. Owen James, an economist at CEBR, said: “Unless the public sector can demonstrate the flexibility that the private sector did during the recession, large-scale job public sector cuts would seem inevitable, with private firms dependent on government contracts also likely to face tougher times.”
Flare-ups can also be expected in banking. Vince Cable, the new business secretary, has described bankers’ “pin-striped Scargills”.
The new government has already unveiled plans for a crackdown on City bonuses and a levy on bank earnings. However structural reforms including separating the “casino” of investment banking from the “utility” of deposit taking have been kicked into the long grass, with an “independent commission” to investigate the matter and report back in a year.
Jonathon Crook, financial services partner at lawyers Eversheds sees this as a cop out. “By the time the Commission reports back, the economic position will be very different, and the banks will be able to show that they have got their houses in order.”
An edited version of this article was published in the June 2010 issue of Accountancy Magazine.