Thoughts Ahead of the Budget on Monday 29th

The Chancellor has succeeded in playing down expectations ahead of this Budget. This, plus the uncertainty over the exact exit path from the EU that the Government will take, suggests that this will be a holding Budget, in the sense that there will be no major policy changes announced. There will, however, be some tweaks to economic forecasts and fiscal plans.

The main focus is likely to be on how the Chancellor plans to fund the Government’s future spending increase on the NHS. The Government has committed to boost spending on the NHS, by £20.5 billion by 2023-24. The options to fund this are:

• raise taxes, which is not our preference, given the tax take is already high and the disincentives associated with many possible tax changes;
• to cut spending in other areas where spending plans are not protected, but this is difficult given the squeeze that has already taken place and is also not our preference;
• or, our preferred option, which is to recognise that public finances have passed a turning point, are on an improving trend and that this should continue with a steady future economic performance and higher tax revenues. This is a point we have stressed this year. ”

Not a Brexit Budget

Apart from a relatively small amount that has been set aside to prepare for leaving the EU, Brexit has not figured prominently in the Budgets since the June 2016 Referendum and that is likely to be the same again this time. To make a success of Brexit the UK needs not only a good future relationship with the rest of the EU but also needs to position itself globally and have a domestic economic agenda that delivers strong future growth. Thus, this will not be a Budget aimed at preparing the economy for Brexit.

Fiscal policy, naturally, has a strong role to play in the post Brexit world. For now, any post Brexit focus in fiscal policy will have to wait until the landscape becomes clearer. In the event of a no-deal one would expect a major fiscal boost. In the event of a Withdrawal Agreement being signed the focus would then be on the details of the future relationship – and here one issue would be whether or not the UK retains maximum flexibility for future tax and regulatory policy.

Although Brexit will not be centre-stage it has already had an impact on the economic picture and thus on the fiscal landscape in the last two years. Growth has been steady. Employment is at a record high. However, some investment plans have clearly been impacted and held back by the uncertainty, and thus the economy is probably about 1% smaller than it might otherwise have been. But once there is clarity about what lies ahead, we would agree with the Chancellor that there would then be a rebound in investment plans. This, plus wage growth rising in excess of inflation should boost spending. Alongside the Brexit negotiations the macro-economic backdrop facing the Chancellor is mixed.

The budget deficit is improving

First, the good news is that the budget deficit is on an improving trend. In the Spring Statement, made in March, the Chancellor talked of the public finances being at a turning point – and he was right. We have been positive in our comments about the budget deficit for some time, pointing out that the current backdrop of growth in nominal GDP (economic growth plus inflation) is well in excess of the rate of interest paid on government debt and provides a powerful dynamic in which the budget deficit can fall more than expected. This is happening.

The latest data shows that the budget deficit in September was the lowest for 11 years and the deficit in the first half of this fiscal year was £19.9 billion. This is £10.7 billion less than a year earlier and the lowest since 2002. If the Chancellor opted not to boost spending we would reach a budget surplus far sooner than currently expected. This improvement in the public finances gives the Chancellor significant room for manoeuvre in this Budget.

Yet spending more could force taxes up – a little

Second, the focus ahead of this Budget has been on whether the Chancellor will raise taxes. In this Budget the Chancellor is expected to outline the likely growth in public spending in coming years, with full details unveiled in the forthcoming Comprehensive Spending Review. But this helps explain why the focus ahead of this Budget is on whether the Chancellor will raise taxes. For many clients, investors and savers their focus in this Budget is on the implications for taxes.

But with the fiscal numbers turning out better than the Chancellor expected as recently as the Spring Statement this should remove his need to hike taxes in any appreciable way. In terms of the Chancellor’s thinking he will likely have one eye on the impact tax changes will have on behaviour – as incentives play a vital role in any economy – and the other eye focused on how much revenue taxes generate. A key focus, it appears, in the run-up to this Budget appears to be a focus on raising more taxes while minimising the disincentive effect, such as on future savings. We don’t think taxes should rise, particularly given the improving fiscal numbers, but tweaks can still not be ruled out.

Growth may be tweaked down in 2018, but up next year

Third, and key will be the growth projections. If economic forecasts project a low growth outlook then this would imply more of the budget deficit is structural, limiting the room for fiscal manoeuvre, hence explaining the desire to raise taxes, despite only modest growth and an already high tax take.

The economic picture for most economies in Western Europe, including the UK, is low growth, low inflation and low interest rates. The challenge is to break out of this. The approach President Trump has opted for is pro-cyclical fiscal policy driven by tax cuts. That is not the approach the UK is opting for. In turn, interest rates here, while set to rise, will only do so gradually and look set to stay relatively low. This Budget is likely to have a neutral impact on UK interest rate expectations.

The longer-term outlook for the world economy is a positive one, but one in which nine-tenths of global growth will come from outside of Western Europe. The shorter-term outlook is equally challenging, but in a different way, with fears of how economies and markets cope with monetary policy normalisation (principally, through higher rates and an unwinding of the printing of money) and whether there will be enough scope for policy to respond to another downturn.

In the spring of this year the official forecast was for UK growth of 1.5% in 2018 followed by 1.3% in 2019 and 2020, rising to 1.4% in 2021 and 1.5% in 2022. Inflation was expected to decelerate towards its 2% inflation target over the coming year, with wage growth outstripping inflation. These figures may be tweaked, but more so for 2018 and 2019 than further ahead. The latest summary of independent forecasts by the Treasury shows that growth is expected to be 1.3% this year and 1.5% next year, with inflation decelerating towards the 2% target.

The markets will likely take this Budget in their stride, given the political uncertainty, and view it as steadying the ship ahead of the challenges and opportunities ahead.

We will produce a Budget analysis after the Chancellor has delivered his speech next Monday.

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