June 2010
Budget First Impressions
With so many well flagged problems facing the country attempts by the new government to strike the right balance in this emergency budget was always going to be interesting.
Our initial thoughts are as follows:
Unsurprisingly the Chancellor emphasised the scale of the budget deficit and the worries of the international capital markets. It did not make easy listening but it was refreshing to see a politician telling the truth, however uncomfortable..
Following the last G20 meeting, where surplus countries were asked to spend more and deficit countries (like us) were asked to save more, the government is aiming to reach a balanced budget by the end of this Parliament. The question was how this would be achieved?
George Osbourne’s goal is that 77% of the deficit reduction will come from reducing public spending, with 23% coming from higher taxes.
Unsurprisingly the Chancellor told us that we will not be joining the Euro during this Parliament. As Prometheus is less than convinced the Euro will be in its current form in five years time this makes more sense than ever!
Pleasingly the Chancellor has recognised the importance of maintaining reasonable capital investment, which is clearly necessary, and will support jobs in both the public and private sectors. This was reflected later in the speech when infrastructure projects round the country, such as extensions to the Manchester Metro, system were discussed
As already disclosed health and overseas aid will be ring fenced but on average other departments will have to reduce expenditure by 25%. Part of this is coming from pay and pension. As the Chancellor points out the public sector has been protected from the hardship of the private sector during the recession. Now the axe falls. There is to 2 year pay freeze across the public sector (apart from the lower paid who will have a small fixed increase), while the public sector pensions will be independently reviewed. The retirement age will also be raised to 66 years of age.
With the welfare system becoming a massive burden on the state the system is to be revised to encourage people back to work (has been tried before, will be interesting to see how it works). Welfare payments will be linked to CPI, not RPI, as this is the Bank of England target inflation rate. This will save a lot of money, although it was a bit cheeky to suggest this is fairer as it will result in smaller increases.
There will be targeted reductions in universal benefits particularly those paid to the higher earners. There will be new assessment for medical disability and housing benefits will be reviewed and reformed.
Reforming National Insurance is seen as key and will actually be reduced for the lower paid to encourage new employment. Combined with schemes to support employment outside the South East, where private sector growth has been poor, this should be a welcome shot in the arm.
Corporation Tax will be reduced by 1% per annum, from 28%, down to 24% at the end of Parliament to try and draw in international businesses. Small companies’ tax will be reduced from 22% to 20% and a number of other measures will be introduced. This will benefit growth but will reduce the tax take. Rules on depreciation tax relief will help offset this although these look like they will be phased in.
Unsurprisingly the banks are not going to benefit from the lower corporation tax rates and they will be hit. The government is working with the IMF and international partners, but from January next year there will be bank balance sheet levies in place (with apparently the French and Germans agreeing to follow a similar plan).
Overall this was pleasingly pro-business, recognising that this is the key to growth.
Now the 23% of the deficit that comes from tax changes.
From 4th January 2011 the main rate of VAT will be raised to 20% (no surprise really). This is expected to raise an additional £13Bn per annum. Zero rated items like food and children’s clothing will remain.
For the moment there will be no increases in the duties announced in the last budget, but there will be a root and branch review of certain duties, such as fuel and alcohol reporting in the Autumn.
As expected CGT was increased; but basic rate payers will still pay 18%, but higher rate payers will pay 28% from tomorrow, although the exemption remains at £10,100. How this will be applied, with a change two and a half months into the tax year remains unclear and we await more detailed analysis.
CGT for entrepreneurs will remain at 10%, with the lifetime lifted from £2Mn to £5Mn. There will be no return of complex taper relief or indexation.
Income Tax faces reform with an increase the personal allowance by £1,000, up to £7,475, with the goal of setting the figure at £10,000 by the end of the Parliament, with the goal of supporting the lower paid. Higher rate payers however will effectively pay more as for the moment the thresholds remain frozen, so in real terms more will find themselves paying higher rate tax.
Pensioners at least will benefit, with a link to earnings being restored and a guaranteed rise of 2.5% per annum being targeted, regardless of average earnings or inflation figures (should they be under the 2.5% level).
Overall not as harsh as feared but we are sure there will be plenty more detail that comes out in the wash in the coming days
Back to Business
After a period where the fraught markets rather commanded attention Prometheus has had time to reflect upon events and hopes to provide some useful thoughts as we approach the first budget of the new government with a mix of curiosity and concern.
Monday’s report from the new independent Office of Budget Responsibility (OBR) brought some relief because while it indicated that the deficit was going to remain elevated for some time, the figures were a little less scary than we had seen before. Furthermore this was in conjunction with future growth estimates that are somewhat more realistic than those of the previous administration, although to be fair they are still at the optimistic range of projections.
If these figures are correct, however, it means that we may bring things under control a little earlier than predicted, and hopefully with a little less pain, particularly if the private sector can pick up the growth baton as the public sector suffers under the weight of the inevitable cutbacks.
This is not to say we will avoid pain. That unfortunately is inevitable after the years of excess; however at least, all other things being equal, we have a reasonable chance now of avoiding a double-dip or worse. However we are in a truly global economy and in our weakened state we remain extremely vulnerable to external risks, and unfortunately all other things are unlikely to remain equal.
We have covered many times before the problems confronting the Eurozone: that the politicians are burying their heads in the sand and that the maths no longer works. The very fact that we are told by Euro’ heads that the breakup of the Eurozone is inconceivable says it all. They are inevitably, totally, irretrievably wrong. It is perfectly conceivable. I’m doing it right now.
China meanwhile is facing testing times, with growing discontent forcing big wage increases across the country. This will add to the building inflationary pressures that have caused the government to withdraw much of the recent stimulus. This may seem inconsequential when underlying growth rates remain well above anything we can hope to see but with so much development based upon cheap funny money a property and general asset collapse remains a real risk. While this would not de-rail the long term story there may be consequences elsewhere, particularly among mining stocks.
Whatever happens to China it is important to remember that while it is growing rapidly it is still much smaller than the Eurozone or US economies. With Europe stuck in the slow lane the progress of the US becomes all the more important to the extent that we have discovered that a leading Asian fund manager currently spends much of his time analysing fundamental US data, such is its import to global growth. Again, however, the picture remains unclear.
On the positive side there seems to be evidence of a steady, self fulfilling recovery in activity, building confidence which in turn encourages more activity. It is to be hoped this continues and on balance this may well be the case; however there are a number of issues that still trouble. Firstly the trend in increasing employment appears to have stalled, with the May non-farm payroll figures very weak after the subtraction of new part-time census jobs. Likewise consumer spending has hiccupped and there are increasing fears that markets will eventually revisit the US budget deficit, which is comparable to our own. Perhaps the most worrying indicator however is the following chart on the money supply in the US (using the broad figure of MZM, which is similar to the M3 measure we would use in the UK), which despite the unprecedented stimulus thrown at the economy, is deeper into negative territory than at any time over the past ten years.
(Unfortunately due to a technical problem the chart is not currently displaying, but trust us, it looks bad)
In an economy trying to reflate into a recovery this is a worrying indicator that is garnering little attention. With so much riding on the US recovery perhaps Prometheus will shift focus a little bit as we watch events unfold, although Eurozone politicians will undoubtedly soon make fresh contributions for our amusement and horror.
A reminder not to pay too much attention to the opinions of those in authority:
During the Battle of Spotsylvania in the American Civil War Union commander General Sedgewick looked over the parapet at distant Confederate snipers and said “They couldn’t hit an elephant at this dist...”