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Chancellor of the Exchequer Rishi Sunak unveiled the 2021 Budget on Wednesday, outlining projected fiscal policy for the next five years. And with that, the UK became the first major nation to attempt to address the question, how will they pay for that massive mountain of COVID relief spending? The answer, at first blush, is “austerity,” which generally refers to raising taxes and cutting spending in order to reduce the deficit. That term featured in a lot of the press coverage we encountered. In our view, though, there is a bit more here than meets the eye. As outlined in the Treasury’s full Budget Report, most of the spending cuts amount to ending temporary pandemic relief spending—other forms of expenditure are scheduled to continue rising. Meanwhile, most of the tax rises are scheduled for 2023 or later, which we think gives the Treasury wiggle room to change course if things go better than expected economically—perhaps delivering a positive surprise to investors. Let us explain.
Based on our review of coverage, it seemed the figure getting the most ink in Wednesday’s press coverage was £470 billion. That is how much money the Office for Budget Responsibility (OBR) projects the Treasury will have spent on COVID assistance once all is said and done.[i] Echoing the general mood following Britain’s fiscal response to 2008’s global financial crisis, many UK financial commentators and politicians alike seemed focused on solving the how to pay for it problem as soon as possible—a notable difference from the US and much of Continental Europe, which seem content to kick the can for a while longer. Looking at the Treasury’s Budget report, we think officials probably have plenty of latitude to do the same if politicians preferred that path. For our research shows isn’t the total amount of debt outstanding that really matters to public finances’ sustainability, but how much the Treasury has to spend servicing it.
Even after the COVID-related borrowing binge, UK gilt interest payments are plunging—and projected by the OBR to stay low. In fiscal 2019 – 2020 (which ran from 1/4/2019 – 31/2/2020), the UK paid £36.6 billion in central government bond interest.[ii] In 2020 – 2021, when government forecasters expect new government borrowing to near £400 billion, debt interest payments are projected to fall to £23.9 billion. From there the OBR sees them inching a bit higher, but even five years from now, the OBR projects interest costs remaining below fiscal 2019 – 2020. Now, part of this is because the Bank of England restarted quantitative easing (QE) asset purchases, and it returns all interest payments received on its gilt portfolio to the Treasury. But interest rates fell to historic lows last spring and summer, helping the Treasury issue new debt for next to nothing.[iii] Even now, after a recent rise, 10-year UK gilt yields are just 0.78%, enabling the Treasury to refinance maturing gilts by issuing new ones at much lower rates.[iv]
As long as debt remains affordable, we think history shows countries don’t need to pay it off. Throughout the recent press coverage, we have seen many comparisons between COVID-related borrowing and the mountain of debt issued by America and Britain to pay for WWII. But one interesting point doesn’t usually get mentioned: The US never technically repaid wartime borrowing. It is still on the books. The US Treasury just paid interest and refinanced maturing debt as it came due. Meanwhile, the economy grew hand over fist, reducing the debt-to-GDP ratio even as the absolute level of debt never fell.
The UK had a similar experience, with the absolute level of debt trending gradually higher in the decades after the war.[v] Before that, public debt spiked as the Treasury borrowed to deal with the fallout of the South Sea Bubble’s implosion, fund the Napoleonic wars and finance Irish famine relief in the 19th century. But the first and second industrial revolutions brought astounding economic growth, reducing the overall burden even as the debt remained on the books. It wasn’t until 2015 that the government finally retired many of these securities—which were structured to pay interest indefinitely and never mature—by offering to redeem them with new long-term, lower-rate bonds.[vi] In our view, these episodes show a growing economy is all governments need to keep debt manageable, even when it spikes temporarily.
We say this not to quibble with the government’s choices, but to show why it isn’t at all guaranteed that most of the tax increases announced Wednesday ever take effect. It is possible (though of course not guaranteed) that a year from now, with the economy recovering nicely and interest payments plenty affordable, the government changes its mind. The UK’s next general election is due to take place in May 2024 (per the Fixed Term Parliament Act), and Labour Party leader Keir Starmer has stated he isn’t too keen on some of the government’s planned tax hikes. If the planned increase passes now and polls tighten over the next couple of years, scrapping it at the last minute to steal one of the opposition’s talking points would be crafty politics, to say the least.
For equity markets, we think much of this is noise. Based on our research on equity markets and financial policy globally, we don’t think there a strong link between fiscal policy and equity returns. Taxes and public spending are only two economic variables impacting a vast private sector. Our research shows tax hikes aren’t automatically bad (or good) for shares, and tax cuts aren’t automatically good (or bad). But big announcements like Wednesday’s help set expectations and can affect sentiment. In our view, the Budget’s tax provisions were much milder than the rumours circulating in recent weeks suggested. The widely rumoured scrapping of preferential capital gains tax rates didn’t happen, easing one of financial commentators’ larger perceived threats to UK markets. If tax increases get watered down further over the next few years, we think that could provide incremental positive surprise.
[i] “Budget 2021: Protecting the Jobs and Livelihoods of the British People,” HM Treasury, March 2021.
[iii] Source: FactSet, as of 3/3/2021.
[v] Source: UKPublicSpending.co.uk, as of 4/3/2021.
[vi] “UK Bonds That Financed First World War to Be Redeemed 100 Years Later,” Julia Kollewe and Sean Farrell, The Guardian, 31/10/2014.
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