Overall, the slower pace of austerity presents some upside risks to our growth forecast, while the introduction of the national living wage raises the risk of higher inflation…..
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Azad Zangana, Senior European Economist & Strategist – Schroders
Chancellor George Osborne delivered the first wholly Conservative Party led budget for 19 years to a raucous chamber. Unleashed from the shackles of coalition government, the Chancellor’s seventh budget is by far his boldest attempt to reform in-work benefits, and at the same time continue to make progress in cutting the government’s fiscal deficit.
Fiscal outlook: smoother path
In a surprise move, George Osborne has decided to smooth out austerity over this parliament rather than front-load it. Despite the pre-election rhetoric, the Chancellor does not seem to be in a rush to close the deficit. This suggests a certain level of confidence given that austerity fatigue usually kicks in by the middle of a government’s term, and then risks hurting its electoral prospects towards the end of its term.
Following the budget policy announcements, the Office for Budget Responsibility (OBR) expects the Chancellor to borrow an additional £18 billion between 2015/16 to 2019/20. Public sector net borrowing (PSNB) was revised down as a share of GDP from 4% to 3.7% for this financial year, but is revised up in the next three years by an average of 0.4% of GDP. The OBR also forecasts the government to run a small surplus in 2019/20 – one year later than previously planned.
Looking at the forecast change in the cyclically adjusted primary balance, also referred to as the fiscal impulse, the government is tightening policy by 0.4% of GDP more than previously thought this financial year, which is thanks to not needing to negotiate with a coalition partner as stated by the Chancellor. However, tightening is then forecast to be 0.6% of GDP lower in 2016/17 and 0.3% lower in 2017/18. It is then unchanged in 2018/19, before being 0.7% higher in 2019/20, and due to reach a fiscal surplus one year later. Note that despite the re-profiling of austerity, the overall scale is unchanged (about 5% of GDP), and remains almost twice the amount done in the previous parliament. This is because the government relied on the cyclical recovery to reduce the overall deficit, but when adjusting for the economic cycle and the impact of lower interest rates, the amount of austerity left to do is higher.
With regards to the stock of debt, as the economy is expected to outgrow the deficit in nominal terms from this financial year, public sector net debt as a share of GDP is set to fall over the forecast horizon. Net debt is forecast to fall from 80.8% of GDP in 2014/15 to 68.5% by 2020/21. This is broadly inline with the previous forecast.
Policy changes: the axe swings low
This is by far one of the most politically charged budgets for years. Osborne has borrowed some ideas from the opposition, re-branded policies that he has opposed in the past, and has set about dismantling policy erected by the previous Labour government.
The underlying strategy of the budget is to both increase the incentive to work versus remaining unemployed in receipt of benefits, but also to remove the state subsidy of low paid workers – claiming that these subsidies allow companies to pay their employees less than otherwise would be the case. The first part of the strategy has been well honed and implementation began during the previous parliament, largely to great success given the sharp decline in unemployment. However, the second part of the strategy is much more risky. Even more bold was the move to introduce the “National Living Wage”, and in effect, forcing companies to shoulder the burden. However in an odd twist, the estimated cost to corporations has been offset by a surprise cut in corporation tax (one percentage point). So other than the reduction of HMRC’s involvement in the tax/subsidy merry-go-round, has the burden really been shifted to the private sector?
Within the details, the Chancellor outlined broadly where £30 billion of savings will come from over the next three years. £13 billion will be from departmental savings, £12 billion from welfare spending reductions, and £5 billion from tax avoidance and evasion.
Departmental savings remain vague, and will probably be planned over the summer with individual departments. Helping to deliver those savings is the 1% pay freeze on public sector workers over the next four years.
Welfare spending cuts start with the lowering of the overall benefits cap from £26,000 to £23,000 for those in London, and to £20,000 for those outside London. Tax credits and universal credits will be restricted to two children affecting those born after April 2017, while the income threshold for tax credits will be reduced from £6,420 to £3,850. Working age benefits will be frozen for the next four years to allow private wages to catch up; however, maternity pay and disability benefits will be exempt. Rents in social housing will be reduced by 1% for the next four years, with subsidies for social housing and housing association tenants phased out for those earning more than £30,000 per year (£40,000 in London).
For pensioners, no change to the triple lock, but for younger people (18-21), the removal of entitlements to housing benefits. Also, student maintenance grants are to be scrapped with loans offered instead from 2016/17.
Soothing tax cuts
On taxation, the Chancellor followed up on his pre-election promise to lock in and not increase tax rates on income tax, national insurance and VAT for five years. However, to balance the impact of the cuts in welfare, there were of course some important tax giveaways. The tax-free personal allowance will rise to £11,000, and continue to rise to £12,500 by 2020. The point at which workers pay the 40p marginal rate of tax will also rise from £42,385 to £43,000. One change which will be popular with the party faithful will be the removal of inheritance tax on family properties worth more the £1 million. But separately, some landlords are likely to lose out as mortgage interest relief for buy-to-let homebuyers is to be restricted to 20%.
Otherwise, a policy borrowed from the opposition’s manifesto is the removal of the permanent non-domiciled tax status from April 2017, with those living in the UK for 15 of the past 20 years to pay the same levels of UK taxes. This is expected to raise £1.5 billion per year in revenues for the exchequer, but should not affect people that have recently qualified for the status, or prospective applicants.
Motorists will be pleased with not only the continued freeze of duties on petrol and diesel, but also the pledge to spend any additional revenues raised from vehicle excise duty (VED) on investment in new and existing roads. However, the recent announcement to put on hold investment in the trains network has already angered the green lobby, while the move to introduce higher VED bands on new cars from 2017 will infuriate them further. Osborne’s attempt to apply a progressive formula here means that some new cars with lower CO2 emissions will carry a higher VED rate than some older, more polluting cars. Perhaps the Chancellor should have another think about why VED is applied in the first place.
For corporations, there were a whole host of incentives for additional investment, but the big surprise was the proposed cut to corporation tax from 20% to 19% from 2017, and to 18% by 2020. Also, the banks’ levy will be phased out and replaced with an 8% surcharge on bank profits from 2016.
Lastly, the Chancellor aroused great cheers when he announced the new “National Living Wage”, effectively superseding the minimum wage for those over the age of 25. The current national minimum wage set at £6.50 will rise to £6.70 in October, and will then be replaced by the national living wage at £7.20 per hour from April 2016 – representing a 10.7% pay rise. This will then rise to £9 per hour by 2020, or about 6.2% per year. It is worth noting that the Living Wage Foundation estimates the living wage to be £7.85 nationally and £9.15 in London. While falling short of these levels, what is also curious is the lack of recognition in this policy of the higher cost of living in London, yet the geographic differential when it comes to the benefits cap.
In our view, the raising of the minimum wage is a major gamble on behalf of the Chancellor. Economic theory suggests that minimum wage policy set at or below the equilibrium market wage has no negative impact on the labour force, but if set above the equilibrium causes undue unemployment. At this stage in the economic cycle and given our recent analysis on the shortages in the labour market, we think that the forced increase in wages will probably not cause a rise in unemployment. After all, the latest data on the retail and repairs sector suggests annual wage inflation is running at 7.5%. However, if there is a sudden downturn in GDP growth or hiring, then there is a risk that the equilibrium rate could fall below the path set out for the national living wage. Moreover, the announcement of future increases will change the expectations of companies and encourage them to increase their prices in order to protect their margins ahead of time. At the margin, the policy is likely to raise inflationary pressures, and more so than a natural increase in wages through market forces.
Economic outlook: no change
Given the last budget was only back in March, the economic backdrop has not changed a great deal. The independent OBR revised down its forecast for 2015 real GDP growth from 2.5% to 2.4%, but that is largely due to upward revisions to 2014 (revised up to 3%). The OBR left the forecast for 2016 unchanged at 2.3%, but revised up growth in 2017 and 2018 by 0.1 percentage points in each year. The main reason behind the upward revision in later years is due to higher than previously forecast business investment (possibly due to some of the policy changes just announced), but also an upgrade to government spending in those years too.
The forecast for inflation is largely unchanged with slight downgrades over the forecast horizon. The profile of the OBR’s forecast remains consistent with that of the Bank of England’s – namely a pick up to over 1% in 2016, due to the dropping out of negative base effects from the fall in oil prices, followed by a steady increase to 2% by 2020. The assumptions for trend growth and the output gap (measure of spare capacity in the economy) are also largely unchanged.
Compared to the Schroders forecast, the OBR’s forecast for growth this year is a little higher (2.4% versus 2.2%), and more so for 2016 (2.3% versus 1.9%). However, given the re-profiling of fiscal consolidation announced in the budget, there is now some upside risk to our growth forecast for 2016, which is likely to bring it a little closer to the OBR’s forecast. On inflation, the OBR’s forecast is below ours, but that is because the OBR estimates that there is more spare capacity in the economy than we do.
Overall, the changes outlined in the budget present some upside risks to our GDP growth forecast in 2016 and 2017, but also increase the risk of higher inflation. In our view, the risk to the OBR’s fiscal forecast is that the government will not be able to deliver the savings on departmental spending, leading to an even more protracted austerity path.
As for monetary policy, the Bank of England will have to weigh up the impact of the cuts to in-work benefits against the lowering of total tax paid, but also consider the impact of the significant rise in the minimum wage. If by early next year the acceleration in general private sector pay growth becomes apparent, then the Bank may decide it needs to take a more hawkish stance, and bring forward interest rate rises.