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The UK coalition government’s emergency Budget, announced on 22nd June 2010, was billed as ‘tough but fair’. Measures, particularly the VAT rise and welfare savings will hit all segments of society, especially low and middle income households, and the public sector.

Businesses were given a helping hand with cuts in corporation tax and incentives for entrepreneurs. Higher unemployment and lower economic growth will risk a double-dip recession but measures will reduce government debt.

A raft of measures was introduced in the Budget aimed at reducing public sector net borrowing through a ratio of 77% spending cuts to 23% tax increases. The UK general government financial deficit was 11.3% of GDP in 2009 according to the OECD, amongst the highest of advanced economies;

Key points include:

  • an increase in Value-Added Tax (VAT) from 17.5% to 20.0% (existing exemptions on food, printed material and children’s clothing and shoes remain) from 4th January 2011;
  • a freeze on public sector pay for two years for those earning over £21,000;
  • an increase in the personal income tax allowance by £1,000 to £7,475 in April 2011;
  • a reduction in corporate tax from 28% to 24% over 4 years;
  • welfare and benefits savings worth £11 billion by 2014-15 including a freeze on child benefit. Tax credits for families earning over £40,000 will be reduced;
  • Capital gains tax increased by 10 percentage points at midnight to 28% for higher rate taxpayers;
  • Government departments will face a 25% spending cut.

The Budget is a test for the cohesion of the coalition government while it aims to cut public sector net borrowing from an estimated £155 billion or 11.0% of GDP in 2009-10 to £20 billion or 1.1% of GDP by 2015-16, according to HM treasury.

UK public sector net borrowing projections: FY 2009-10 – FY 2015-16
£ billion

Source: HM Treasury.

  • Raising VAT by 2.5 percentage points to 20.0% will result in higher prices for already beleaguered consumers still reeling from the effects of a global recession. A reduction in spending is likely, particularly as businesses may be quick to pass on this cost but could provide a fillip in spending on big-ticket items prior to the introduction of the rise in January 2011. However, higher VAT could add to inflation (CPI in May 2010 was 3.4%) which will squeeze consumer spending potential further;
  • Welfare savings will impact low-income households with cuts in housing benefit, the freeze in child benefit, the VAT increase and benefit increases being linked to the less generous CPI measure rather than RPI. However, this should be offset by an increase in child tax credits for the poorest families and the lifting out of income tax of 880,000 people through the increase in the personal tax allowance. In 2009, households in the poorest 10% of households (decile 1) accounted for 1.5% of total household annual disposable income;
  • Middle and higher income households will also be negatively affected through a reduction in child tax credits for households earning over £40,000 and the child benefit freeze. Although the new personal allowance for basic-rate taxpayers will add £170 per year, the government report detailed that there would be “a corresponding decrease in the levels at which the 40 per cent higher rate of tax and the two per cent rate of NICs are paid”;
  • Furthemore, given that middle-income families spend more on items qualifying for VAT, their income will be squeezed more. The average annual disposable income for the middle decile households (decile 5) was US$36,260 in 2009 and households in the middle-income deciles 4-7 accounted for 32.9% of total household annual disposable income;
UK household annual disposable income distribution: 2009
Source: Euromonitor International from national statistics Note: Deciles are calculated by ranking all of the households in a country by disposable income level, from the lowest-earning to the highest earning. The ranking is then split into 10 equal sized groups of households. Decile 1 refers to the lowest earning 10%, through to Decile 10, which refers to the highest earning 10% of households.
  • Businesses will benefit from the reduction in the corporate tax, which should encourage investment and highlight British competitiveness;
  • The two-year public sector pay freeze could see talented personnel leave teaching and social services, resulting in a “brain drain”. These workers will reduce their spending as funds will be reallocated to meet essential costs;
  • A levy on banks’ balance sheets was a populist move and, although lower than expected, could raise £2 billion per year. However, it could trigger another credit crunch as banks withdraw lending in order to protect their capital bases. An increase of 10 percentage points to 28% in Capital Gains Tax will discourage investment in the stock market and temper the buy-to-let market.

Prospects

The Office for Budgetary Responsibility (OBR), an independent body created by the coalition government in 2010, has reduced the UK’s real GDP growth forecast from the previous 2.6% to 2.3% in 2011, versus real growth of 1.2% in 2010.

The Spending Review, outlining details of the 25% spending cuts for government departments, will be announced on 20th October 2010. Such a savage cut could result in large-scale job losses both in the public and private sectors (cuts in the former will impact outsourcing to the latter), with some regions being hit harder than others. Euromonitor International expects unemployment will reach 8.6% in 2010 from 7.7% in 2009. It could also lead to civil unrest/strikes.

The proposed measures are such that a risk of a double-dip recession remains. However, Sarah Boumphrey, Head of Countries & Consumers at Euromonitor International commented that “the impact on economic growth is hard to quantify. With no plan in place to tackle the deficit the UK risked losing the confidence of the markets, but with a plan in place which will cause pain to many consumers then unemployment is likely to increase and consumer spending slow.

This increases the emphasis on net exports as the engine of growth – difficult considering the situation in the EU – the UK’s biggest trading partner. However, all things considered, the budget struck a good balance.” Consumer spending accounted for 61.7% of GDP in 2009 compared to 27.7% for exports of goods and services.

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