Budget volatility

The government has disturbed markets, first briefing there would be an Income tax rise in the budget, then cancelling the idea. Bonds had been tightening, the government's cost for longer term borrowings going down, with markets anticipating a tax raising solution to the large deficit. This backdrop quickly reversed, leading to fears about the state of public finances.

The Chancellor will still say she has found ways to stay within her own fairly loose fiscal rules. They are based around how much the state will be borrowing in five years’ time, as measured by an Office of Budget Responsibility forecast. The trouble is no-one can accurately forecast the deficit in five years’ time. Small changes in growth rates, productivity progress, interest rates and the exchange rate can make a lot of difference to their numbers. The deficit is the difference between two very large figures, state spending and state revenues. When the Chancellor thought she wanted an Income tax rate rise, it was apparently based on news around lower productivity. When she ‘cancelled’, there was improved sentiment on interest rates and wage growth affecting taxes.

However, it does sound as if there will still be income tax rises for many to come. The government has carried on the policy of not increasing tax thresholds in line with prices or wages. As inflation advances, more are drawn into higher tax rate bands where they pay considerably more tax on the extra income. They are likely to extend this stealth tax further. There is still discussion of extra taxes on gambling and on more valuable homes: the Chancellor will need some further tax rises to make the sums add up. The stronger proposals to hit the rich harder look as if they have been moderated by a realisation that many higher earners and wealthier people are simply leaving the country to avoid the higher taxes. 

The choice of fiscal rules leaves the government vulnerable again next year. The idea that the first budget was a ‘done and dusted’ tax raising event has been overtaken by deteriorating forecasts. With consumer confidence and business growth now tested, there is a fear that further budgets will still need to focus on tax raising measures. As is evident, directed higher taxes does not always lead to improved revenue, as capital gains tax and spirits duty illustrate.

Most parties and experts agree that the way out of the bind of high taxes, high spending, high borrowing is to generate more growth. With growth slow, the unemployment and benefits bill goes up, while tax revenues from income and spending disappoint. The government has promised a growth strategy, but so far it has not put enough behind it. Planning relaxations are taking time to come through whilst fewer new homes are being built and bought. Homes are dear and unemployment is rising. Meanwhile, policy to ban new investment in the domestic oil and gas industry and to stop the production of petrol and diesel cars by 2030 has resulted in closures of two oil refineries and olefins plants.

The budget should avoid a meltdown in bonds by sticking to the fiscal rules and finding some more revenue. They could look to a further bank tax, or less interest paid to commercial banks by the loss-making Bank of England, to help the numbers. The Government will need to follow up any tax overlays with an improved growth strategy. Major infrastructure investments will help, but it will take time to get to the build out stage for new SMR nuclear power and for the new runway at Heathrow. There is much hope that substantial public and private investment in AI will give the economy a productivity boost. It is much needed. 

About the author 

The Rt. Hon Sir John Redwood has been a long-standing member of the EPIC Investment Partners Advisory Board. 

John is a well known commentator on governments and economies, with long experience of investment markets. Trained as an analyst at Robert Flemings, he moved to N.M. Rothschilds where he became a Manager and Director of pension and charitable funds and Head of Equity Research. He was seconded to become Head of the Downing Street Policy unit before chairing a large, quoted UK industrial business. He served as an MP and a government Minister.  

In 2007 he set up Pan Asset with a colleague, an investment management business that pioneered active/passive funds and models in the UK. Following the sale of the business to Charles Stanley, a quoted investment manager in the City, he became their Global Chief Strategist advising on non-UK markets and economies. He also ran a demonstration fund for the FT, writing articles about it and illustrating the use that can be made of ETFs in portfolios. 

He is now an adviser to EPIC, providing insights into the big investment issues of the day from the debt and spending problems of the major governments to the green and digital revolutions which have so much impact on equity markets. He is a Distinguished Fellow of All Souls College, Oxford, where he helps with their Endowment investments and gives occasional lectures on modern economics and politics.