UK budget 2021: The Rishi rebound
The UK Chancellor, Rishi Sunak, recently announced his 2021 UK budget, with two significant goals in particular:
1. Provide support for households and businesses through the final stage of the coronavirus pandemic.
2. Provide a roadmap for how the government plans to reduce the fiscal deficit over time and pay for pandemic support measures.
The first goal was achieved through an extension of the various support schemes (i.e., furlough payments, universal credit top-up, hospitality VAT reduction and mortgage stamp duty holiday) to September 2021, in the majority of cases.
The chancellor has implemented plans for his second goal, with the announcement of two tax measures. The first is the freezing of income tax bands until 2026. This has the advantage of being a stealth tax increase, as rising wages and inflation do the work, avoiding a politically unpopular announcement of higher tax rates. This will raise an impressive £8 billion per year by 2025-26. The second is an increase in the corporate tax rate from 19% to 25%, which will take effect in 2023.
It is this second goal, however, that is likely to dominate the fiscal debate over the next few years.
Repaying the COVID-19 support debt
The level of support for businesses and individuals during COVID-19 has been unprecedented. The country now faces the challenge of repaying the vast amount of debt. There are four ways to reduce the ratio of government debt-to-GDP (gross domestic product): first, outgrow the debt burden; second, tighten fiscal policy; third, default; and fourth, inflate away the debt.
We can rule out default as a realistic option for the UK. This budget has attempted to achieve a balance between stimulating growth in the near-term and tightening fiscal policy over the medium-term to control the debt and deficit. The projections from the Office for Budget Responsibility (OBR) have public sector net-debt peaking at 109.7% of GDP in 2023-24 (a post-World War II record) and the budget deficit declining from 13.3% of GDP to be in balance by 2025-26. Tax as a share of GDP is projected to reach 35% by 2025-26, which will be the highest level since the late 1960s.
The other way that the debt burden can be lowered is through higher inflation—higher nominal GDP will lower the debt-to-GDP ratio. The OBR forecasts that inflation will rise from 0.5% in 2020 to 2.0% in 2025—an entirely unsurprising forecast, as we would not expect an official prediction of inflation above the Bank of England’s target. The incentives for government and central banks globally will be to allow inflation to drift higher, to protect against the risk of deflation and another round of negative interest rates and help lower government debt burdens.
This budget has set out a roadmap of near-term stimulus and longer-term tax increases to restore public finances, but the missing element is higher inflation. A return to 1980s-style inflation is unlikely, but 2% inflation by 2025 could be an underestimate.
What does this mean for GDP growth?
In 2020, UK GDP collapsed by 9.9%. The OBR expects a rebound to 4.0% in 2021 and 7.3% in 2022. These figures are broadly plausible, although it is possible to argue for a stronger rebound in 2021 given the speed of the vaccination program, with slightly lower growth in 2022. The OBR estimates that GDP will be back at pre-pandemic levels by mid-2022.
Where does it leave the Bank of England?
On hold, with the extended stimulus measures further lowering the odds of negative rates from the Bank of England (BoE). We expect that the U.S. Federal Reserve (the Fed) will be the first major central bank to raise interest rates, and we don’t think it will begin tightening before early 2024. The BoE is likely to lag the Fed by at least six months.
The bottom line
The 2021 budget is realistic, balancing an extension of pandemic support measures with longer-term tax increases to reduce debt levels. The continued stimulus should keep the BoE on hold. Additionally, financial markets were largely unmoved by the announcements, due to the majority of what was announced already being priced in.