Eurfyl ap Gwilym sets out the challenges for the Chancellor in tomorrow’s Budget
One of the paradoxes facing the Chancellor as he prepares for the forthcoming UK Budget is that despite record levels of employment, historically low interest rates, continuing cuts to public spending and the highest burden of taxation since the 1980s, the UK will continue to run budget deficits for the foreseeable future. Even in 2021-22, after more than a decade of tax rises and spending cuts, the deficit is forecast to be 0.7 per cent of national income.
Other key measures give conflicting signals. We are told that the UK economy is growing more rapidly (1.8 per cent in 2016) than most other western economies but, according to the IMF, of the 28 advanced economies the UK had the fourth highest budget deficit and the sixth highest debt as a proportion of GDP in 2015 (Note 1) .
Why is the UK performing so poorly from a fiscal point of view and what can be done? One key factor is poor productivity. Low productivity and low productivity growth have been hallmarks of the UK economy for many years. Of the G7 countries the output per hour worked in the UK is 18 per cent lower than the average for the other six countries: if productivity in the UK was at the average level of the other six members of the G7, then UK GDP would be roughly £440bn higher and this would lead to additional tax revenue of some £158bn a year: to put these figures in perspective total tax revenue 2016-17 is £772bn and health spending across the UK is £145bn (2). Another way of looking at this productivity gap is to note that output per hour is approximately 16 per cent below where it would have been had the pre-recession trend continued (3). Thus, the financial crisis of 2008 continues to cast a strong shadow over the economy.
If the UK is to overcome the current malaise low productivity needs to be addressed. Productivity is key because in the medium to long term prosperity is determined by productivity. Growth in real wages is a function of growth in productivity.
A number of factors drive productivity including:
- education levels;
- skill levels;
- pay structures;
- R&D;
- business investment; and
- infrastructure.
Some of these factors such as low education attainment and poor skills compared with our international competitors are long standing and will take time to correct but a short term measure is not to cut spending per pupil. In the shorter term what can be done regarding factors such as business and infrastructure investment?
Business investment in the UK has grown annually at 1.5 per cent since 2008 compared with 3 per cent per year over the previous forty years (4). Measured as a proportion of national output, investment has dropped to 9 per cent from 12 per cent at the turn of the century. The UK is a laggard compared with its international peers. In 2016 real terms business investment went down for the first time since the middle of the financial crisis in 2009.
In general, the fall in investment is not caused by a shortage of funding for business although there will be examples of where smaller businesses struggle to raise funds for expansion. The UK corporate cash pile stands at £600 billion (~30 per cent of GDP) (5). A Bank of England survey of 1,220 companies showed that only a quarter prioritise investment. Most company’s cash is paid out in dividends (£85 billion was paid out in dividends in 2016), used for stock buy-backs or held as cash and not invested productively.
Why are businesses hoarding cash rather than investing? According to a Bank of England survey (6) the minimum rate of return per year that most companies apply when considering investment projects – the hurdle rate – is ~12 per cent and somewhat surprisingly this has not reduced over recent years despite the fact that interest rates have fallen dramatically to an all-time low. Why is this? The principal reasons are perceived risk and uncertainty which are reflected in a sharp increase in the risk premium – the hurdle rate minus the cost of capital -that companies set when evaluating potential investment opportunities and which is related to perceived uncertainty. Thus, the potentially stimulating effect of lower interest rates has been offset by an increase in the risk premium.
Clearly one factor that has raised the risk premium is the financial crisis of 2008 and the resultant economic fall-out. As the growth and productivity figures show the economy has still not recovered from that shock. Another crucial factor which will raise the risk premium and threaten to choke off business investment is the huge uncertainty generated by Brexit and in particular the UK Government’s policy of a ‘hard Brexit’. The Institute of Directors reports that about a fifth of its member companies are reining in expansion plans in the UK since the referendum – decreasing investment, delaying hiring employees or considering moving operations abroad (7). If this is so the effects will be felt over the coming years.
The UK Government has tried to stimulate the UK economy through actual and planned cuts to corporation tax, generous tax treatment of R&D and intellectual property and the Chancellor’s injection of an additional £23bn investment in infrastructure and R&D as announced in the Autumn Statement (8), including £442 million in Wales. However it is clear that there is real danger that these recent measures could be fatally undermined by the UK Government’s hard-line approach to Brexit.
What should be the Chancellor’s response? There is probably little that he can do to stimulate additional business investment given the inevitable uncertainties that will persist for several years as a result of the referendum.
The Chancellor has already relaxed the fiscal framework and this will provide additional flexibility but welcome as they were his measures announced in the Autumn Statement are not bold enough to match the scale of the challenge. Whatever one’s personal views on Brexit, uncertainty is bound to be a major factor inhibiting business investment over the coming years. Most business leaders are not ideologically driven and will seek to contain risk until there is greater certainty about the UK’s future trading position in the world. Cutting corporate taxes further is unlikely to overcome the reluctance to invest due to Brexit induced uncertainties. A measure that the Chancellor could take is to create a ‘Brexit mitigation fund’ some of which will be earmarked to assist business make the transition from the Single Market. It is too early to prepare a detailed plan but a commitment to such a plan might give business greater confidence to invest.
Public investment is a different matter: it is to be hoped that the Chancellor having adopted a more flexible fiscal framework will take advantage of this leeway to announce bolder initiatives. In his Autumn Statement the Chancellor shifted the balance between current and capital spending. In 2007-08 central government spending on public services comprised 17p of capital spending for every £1 of day-to-day spending. The forecasts imply that in 2020-21 this will increase to 21p of capital spending for every £1 of day-to-day. However, there are limits on how much more current spending can be cut to pay for increased capital investment and could prove counterproductive in areas such as education and training. Thus, a second leg of the ‘Brexit mitigation fund’ should be to boost public investment but not at the expense of current spending on public services. For example, if such a fund were to be allocated 1 per cent of GDP for each of the coming five years this would amount to £100bn across the UK and up to £5bn for Wales. (This funding would be over and above the £23bn over four years announced by the Chancellor in his Autumn Statement.) Such an approach would boost business confidence and investment as well as improving the UK’s creaking infrastructure and help the UK break out of the cycle of increasing taxation and falling public spending it has experienced over recent years. In times of great uncertainty, we need brave and bold leadership for our economy. That is why the Chancellor must not shy away from the challenges ahead – on Wednesday Mr Hammond must be bold in the present for us to reap the benefits in the future.
Notes
- Table 3.11. IFS Green Budget, February 2017
- Budget Red Book 2016, HM Treasury
- Haver Analytics. Oxford Economics
- Sir Jon Cunllife. Deputy Governor Bank of England. Quoted in The Times 11.02.17
- Capita
- Bank of England Quarterly Report, 2017
- Financial Times, 23 February 2017
- Autumn Statement, November 2016, HM Treasury
