Budget Special 1: An elephant in the room

In anticipating the UK Budget for 2011 many of us did not expect major surprises. After all the Conservative Party had set out its fiscal policies in advance of last year’s general election and their plans for a faster and deeper fiscal consolidation compared with Labour’s intentions were set out in the UK coalition’s post election budget in June 2010 and in the Spending Review announced in October 2010.

BUDGET SPECIAL Tomorrow finance analyst Madoc Batcup sets out the case for a lower rate of corporation tax for Wales. On Friday Dylan Jones Evans gives his view.

The £73 billion fiscal consolidation plan inherited from Labour was increased by £40 billion to £113 billion by 2014-15. Given that the UK Government’s thesis is that nothing short of this aggressive consolidation will maintain confidence in the bond markets, any early deviation from the course set last year could indeed undermine such confidence and lead to a weakening of sterling and higher interest rates. Thus the UK Government is boxed in by its earlier declaration of intent. Unsurprisingly, the Chancellor went out of his way to declare the latest budget “fiscally neutral”.

Since last year there have been two significant changes to the economic outlook. Firstly, forecasts of growth have been serially downgraded not only by City pundits but by the independent Office for Budget Responsibility (OBR). In its short life the OBR has repeatedly had to downgrade its growth forecasts.

The other significant change is higher inflation with the Consumer Price Index (CPI) at 4.4 per cent and the Retail Price Index (RPI) at 5.5 per cent. While the OBR was established by the current government, that other independent body, the Monetary Policy Committee of the Bank of England, established by Gordon Brown is also struggling with its credibility given that it is meant to pursue a monetary policy that ensures that the CPI remains within a narrow band of 2 per cent. This it has failed to achieve for some considerable time.

Critics of the UK Government’s consolidation plans will point to weaker growth forecasts as a vindication of their concerns that by precipitating lower growth, too rapid a consolidation will undermine the achievement of the consolidation being sought. A possible, unintended consequence of higher than forecast inflation is that this will increase the rate of consolidation. Many public and private sector workers are having their pay frozen and high inflation leads to higher than anticipated cuts in real pay with its knock-on effect on consumer spending. If the outlook for growth persists in being lower than planned then it might well be that by the next 2012 budget the Chancellor will be obliged to change his stance. This will not be a ‘Plan B’ as such, but a less severe ‘Plan A’ with the fiscal consolidation being spread over a longer period.

Because of the strategy embarked upon last year the Chancellor in this latest budget could only fiddle around the edges without announcing any major new measures. However, in terms of news management it was a minor triumph. Little was said of the big cuts in public spending which only start to bite seriously in April of this year – there were in-year cuts of £6 billion across the UK in the 2010-11 financial year – and which are planned to deepen over the coming four years. This is the ‘elephant in the room’. Clearly the Chancellor, having set out his stall last year, had no desire to draw further attention to it and Labour is wary given its fiscal legacy. The presence of Ed Balls on the Opposition front bench served as a timely reminder of who were the authors of our present troubles.

The Chancellor sought to set out plans for injecting growth back into the economy. With Vince Cable he released ‘The Plan for Growth’ on budget day. While this contains some good measures they will, perhaps inevitably, be of a second order compared with the impact of the government’s macroeconomic stance. After all, specific plans for growth that are inspired by governments usually imply additional expenditure or tax cuts. Yet, as the departing Chief Secretary to the Treasury, Liam Byrne helpfully pointed out in the note he left last May for his successor, the government had “run out of money”.

Acceleration in the planned cut in the rate of corporation tax will be welcomed by business. It is consistent with the strategy of injecting growth into the economy and looking to the private sector to make up for the loss of employment in the public sector. The OBR expects market sector employment to increase by approximately 1.3 million across the UK by 2015 with this partly off-set by a fall of around 400,000 in general government employment.

The increased tax allowances for research and development will also encourage greater investment by the private sector. The plan for 21 new Enterprise Zones in England and additional tax breaks for entrepreneurs and investors in start-up and early stage companies are other welcome measures as is the commitment to ease planning restrictions and cut red-tape. Time will tell how successful these measures will be but the key issue regarding growth is what will happen at the macroeconomic level.

The influence of the Lib-Dems could be seen in the decision to raise the personal allowance for income tax by £630 in April 2012. This is a modest step to the goal of having a personal allowance of £10,000. One of the measures announced last year which will start progressively to bite from this year is the decision to switch indexation of benefits, tax credits and public service pensions to CPI. By 2015-16 the Treasury estimates that this will save £10.6 billion. This is a stealth tax of which Gordon Brown would have been proud. The change sounds technical and obscure but bites ever deeper over time.

Cancellation of planned increases in fuel prices will be welcomed although the savings may soon be swamped by increases in the price of oil which are well beyond the Chancellors’ control.

The announcement that the feasibility of merging National Insurance and Income Tax will be explored had been well trailed, but in practice will pose formidable problems. Already Nigel Lawson has warned the present Chancellor that such a move could be an “elephant trap”. As well as simplification George Osborne may see advantage in greater transparency. If low and average earners realise that they are paying a marginal rate of tax of 32 per cent they may be less hostile to the idea of a smaller state and lower taxation.

Reviewing the UK budget and ‘The Plan for Growth’ from the point of view of Wales poses two challenges. It is not always clear whether or not announcements apply to the whole of the UK or to England only, and in any event there was scant reference to Wales. The UK Government’s commitment to seeking polices that lead to a more balance development of the UK economy both in terms of geography and in terms of sectors is to be welcomed as is the renewed focus on manufacturing.

One of the great failures of the last UK Government was its over concentration on the financial services sector and in particular the City of London and this to the detriment both of other areas of the UK and other business sectors, see ClickonWales 15/03/11.  However, in last year’s June budget capital allowances were cut by almost £2 billion a year which will seriously undermine the welcome cuts in corporation tax which will apply to all business sectors. With its higher dependence on manufacturing Wales will be disappointed with these cuts which take effect from April 2012.

Optimists might have hoped that there would be a commitment to review the way Wales was funded. But there was no mention of this. The promise to consider devolving power over corporation tax to Northern Ireland was reiterated but the Chancellor appears not yet to have caught up with the recommendation of the Conservatives’ economic commission in Wales which recommended a similar policy in the case of Wales. It will be interesting if the Conservatives include such a measure in their manifesto for the election to the National Assembly.

Turning to those elections what will be the impact, if any, of the UK budget? I suspect that there is little new in the budget to catch the attention of the average voter. There is already a loss of consumer confidence and foreboding about the spending cuts which start in earnest in April.  The positioning of the political parties is already fairly clear:

• The Conservatives will claim that there is no alternative and that they are having to clear up the mess left by Labour. The Conservatives are also differentiating themselves from the coalition partners in the Welsh Government by promising not to cut spending on health. They may also press for greater use of PFI as a means of countering the 41 per cent cut in capital investment over the next four years.

• Labour are positioning themselves as the party best placed to protect Wales from ‘Tory cuts’. While this will undoubtedly have a resonance for some, the question is how credible it is given that the cuts are a result of Labour’s financial legacy. For example, the cuts to the Welsh block grant, planned by Labour in the 2009 UK budget, were estimated by the independent Wales Audit Office to be £1.5 billion in real terms by 2013-14. These compare closely with the current UK Government’s cuts of £1.52 billion, although the cut of £860 million in the first year will be materially deeper.

• In addition to calling for fairer funding Plaid Cymru also wants an emphasis on delivery rather than rhetoric during the next Assembly term, an implicit criticism of the performance of successive governments in the first twelve years of the National Assembly. They have proposed a counter cyclical stimulus to capital investment cuts through their Build for Wales proposal. It will be in interesting to see if the other parties come up with their own proposals for overcoming the straightjacket of the block grant.

• The Liberal Democrats are in the difficult position as the junior partner in the UK coalition of having to defend a macroeconomic strategy which is very much the Conservative’s and with which they disagreed prior to entering the UK coalition. They will no doubt point to the concessions they won in terms of personal income tax allowances and claim a valuable role in ameliorating Conservative ‘excesses’.

No doubt some commentators will seek to attribute the outcome of the forthcoming election, in part at least, to measures in the UK budget. Given the modest measures set out by George Osborne this budget is unlikely to be a deciding factor.