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A tough fiscal reality awaits new government

Key Takeaways

The international macro backdrop is improving; US interest rate cuts have been revived and the ECB has trimmed rates.
In the UK, a strong GDP number in Q1 was revised up last week.
Longer-term, the outlook for UK budget finances remains distinctly gloomy, however.
A new government will have to raise taxes and the focus is likely to be on capital taxes.
Detailed discussions with the treasury and the office for budget responsibility await.

Transcript

There are just a few days to go until the UK general election. If the opinion polls or indeed the bookmakers are to be believed, then Labour are virtually guaranteed to form the next government. With this in mind, I’m going to talk a little bit about the background and the overall economy that they will inherit and discuss, very briefly, how they might choose to meet a really tough fiscal position.

I’ll be discussing all this in much more detail in a webinar on the 9th of this month. There’ll be lots of charts and more detail about everything so do register to watch live or on demand here.

So the macro background that the new government will face is improving in many different ways. First, from an international perspective. The US economy has slowed a touch and is now delivering lower than expected inflation figures. For most of this year the economy has been too strong and the inflation surprises have been on the top side, with the result that hopes of interest rate cuts have faded. They have now been revived.

Over in Europe, the ECB have actually delivered a rate cut -a quarter of a percentage point off official rates in June. More importantly the economy there too is improving, albeit from a weak base. The data are still uncertain but my guess is that European growth will beat rather low expectations and will produce a decent year in terms of inflation and growth.

Here in the UK, we have seen a significant improvement in growth with a strong GDP number in Q1 revised up last week. The key driver of improved growth is the consumer. Despite a savage real income squeeze, British consumers actually raised their savings in the last couple of years so fearful of notably high energy prices. Real incomes are now growing as the wage price spiral operates in reverse and confidence has improved allowing consumers to spend more of their incomes. We have seen spending, particularly in construction, held back by extraordinarily high rainfall but that too has given way to better weather since mid-June and let’s hope that continues.

In terms of economic surprises, the UK is already outperforming most other economies and I expect the upward revisions to economic growth to continue. Economic recovery is good for the fiscal balance and I think this could come in well below forecast. But the longer-term outlook for budget finances is distinctly gloomy.

Having taken the tax rate to record highs, the outgoing Conservative government has met its very weak fiscal rules only by totally unrealistic assumptions for government spending in unprotected areas like prisons and the justice system. The incoming Labour government are aware of this and will have to raise taxes. From a political point of view this is best done quickly. They have committed to leaving most of the main direct tax rates, as well as VAT, unchanged. The focus must, therefore, be on capital taxes.

They have said that they will stick to the Tories plan to leave tax allowances unchanged so income tax will go up but no change in tax rates according to their manifesto. Tax increases that they have announced will raise relatively little, VAT on school fees, the end of the non-Dom tax loophole, and ending the carried interest for most investments by private equity employees. My guess is that they will look across the board at possible tax increases, perhaps limiting ISA tax relief to people whose existing portfolio is below £1,000,000, restricting pension contributions to the basic rate for income of tax, introducing extra council tax levels and they could also close a number of inheritance tax loopholes, agricultural land relief, business property relief and perhaps even the exemption of SIPPS from inheritance tax.

For obvious reasons the Labour Party do not want to discuss any of these tax rises ahead of the election and they will need to have detailed discussions with the Treasury and the Office for Budget Responsibility before they implement them.

One area that my colleague, Chris Mahon, has highlighted relates to the Bank of England’s quantitative tightening policy. In contrast to other central banks, the Bank of England has aggressively been selling their stock of gilts. We think they should take a passive approach and allow them to mature but not actively sell. If this policy were announced, it could reduce gilt yields and that would reduce debt interest and significantly improve the fiscal outlook.

Another important step could be to introduce interest tiering on bank reserves. This is linked to quantitative tightening and is effectively a tax on banks. These two policies together could raise huge amounts of money, more than enough to finance the Labour party’s ambitious plans for an energy fund and a public private wealth fund. They will need to get the Bank of England on side however and that may be a problem.

The new Labour government plans to be both radical, ambitious and determined to avoid the financial crises that beset previous labour governments before Tony Blair. There is a whole series of other big judgments to make, in other areas, such as workers rights, minimum wage and so forth. We will have to see whether the new government get those judgments and balances right or stumble in their early years. I will be going through all of this, in much more detail, at the webinar on the 9th of July. I won’t be doing a market perspectives video next Monday so please tune into the webinar if you wish to get more information.

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Steven Bell

Chief Economist, EMEA

Steven Bell is a Managing Director, responsible for providing macro strategy input to a broader range of multi asset investment portfolios. He joined Columbia Threadneedle through the acquisition of BMO GAM (EMEA) in 2021, having previously been with BMO since 2013. He joined the group having run the GLC’s Global Macro programme for the previous seven years. Before that he was Global Chief Economist and Investment Head of the UK multi asset business at Deutsche Asset Management during his tenure 1984 – 2005. Steven began his career as an Economic Adviser at the UK Treasury and has degrees in economics from the London School of Economics and Stanford University, California.

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A tough fiscal reality awaits new government

Key Takeaways

Important information

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