Only three short
years ago, the British economy was considered to be the strongest in Europe.
Open and competitive markets made the U.K. the shining example for globalization
of the developed world. Its central bank's policies were considered to be
somewhat independent and prudent as compared to other major countries, producing
an economy that was seen as steady and rapidly expanding. British workers had
the reputation of not striking, its government officials routinely lectured
their counterparts in Euroland as to their superior fiscal policies, and even
British Airways was seen as one of the world's favorite airline. What a
difference a global recession makes — since 2008, the U.K.'s economy has been
hit harder than the U.S. and even Euroland despite their recent "PIIGS"
sovereign debt issues.
First the bad...
The dire state of
the current economy was the focal issue in the recent election. From the outset
of Britain's new coalition government, newly elected Chancellor Cameron's main
task has been to tackle the enormous fiscal deficit, which hit a peacetime
record of 11.1 percent of GDP for the 2009–2010 period. The recent recession
lasted six quarters, longer than any other G7 economy, thanks in part to
previous Chancellor Brown's overly optimistic policies in the good years and
massive government borrowing as a share of GDP, which is forecasted by the IMF
to be the highest in the entire G20 universe by year's end. The current state of
affairs necessitated the implementation of an "emergency" budget at the end of
June, with George Osborne, the new Conservative Chancellor of the Exchequer,
slated to work directly with Danny Alexander, a Liberal Democrat at the
Treasury, as they attempt to control the country's massive spending. The hope of
this cooperative effort should demonstrate a new cooperative approach in
government and help secure public support through the distribution of the
anticipated painful measures to protect its delicate economy.
step for the new government was to assess the depth of the current economic hole
and how to fill it. On June 14, the Office for Budget Responsibilities (OBR),
put the deficit for the year ending in March 2011 at GBP 155 billion (10.5
percent of GDP) before any changes made by the new government will take effect.
What matters the most in the short term will be the ability of the economy to
endure a possible shortfall until meaningful spending cuts are made and/or taxes
are possibly raised. The permanent weakening of public finances from the global
financial crisis and related recession are now seen at 5 percent of GDP, coupled
with the projected increase of government interest payments needed to service
the massive debt load via the aggressive Quantitative Easing (QE) measures of
the previous administration.
Osborne will need to consider the fragility
of the current U.K.'s economy before implementing his fiscal policies. The OBR
is far less optimistic than the previous government about its immediate
prospects, and actually believes the long-term growth rate will be lower. With
the current troubles in Euroland evolving, Britain's biggest trading partner
will be hard-pressed to buy what the U.K. is selling, making austerity measures
harder to implement.
A balance is needed to move
The options for healing the economy going forward appear
to be limited. If the slate was magically wiped clean, one extreme strategy
would be to rely solely on spending cuts with the other being to raise taxes. A
recent OECD study found that fiscal cures based mainly on spending cuts tend to
be more successful in stabilizing the economy, but raising taxes is also needed
when deficits are large like the U.K.'s. Carefully implemented spending cuts/tax
solutions will most likely be necessary recipe for a couple of
First, the previous administration became extremely dependent on
the buoyant receipts from the frothy financial and real estate markets. These
revenues are not expected to return to pre-crisis levels any time soon. Second,
fiscal consolidation will succeed only if the public sector accepts the economic
medicine, and only if the proposals are not seen as too ambitious. If 2 percent
of GDP is found through higher taxes, the remaining 5 percent will need to be
achieved through spending cuts, as the U.K. will face a tougher mix than all but
two of the ten biggest OECD deficit-cutting nations.
The legacy of
planned tax increases left by Osborne's predecessor Darling is scheduled to
build 1.2 percent of GDP by 2014–2015 timeframe, half of which will come from
higher income taxes via a new 50 percent top rate on annual incomes above GBP
150,000. Higher national insurance contributions will also raise a projected 0.4
percent of GDP, with the balance achieved through tax increases in alcohol, fuel
Osborne could choose to undo Darling's tax changes
altogether, as arguments for sweeping them aside persist. The new top income tax
rate may actually alienate more wealth taxpayers than raise tax revenues, and
proposed pension provisions are also viewed to be extremely complicated to
From a narrowly economic view, an increase to the current VAT
tax rate, or possibly a new "carbon tax," could be a better alternative.
Consumption taxes are generally thought to have smaller adverse effects on
growth and are seen as less distorting than increases to corporate or personal
income taxes. If for example, the main rate for VAT is lifted from the current
17.5 percent to 21 percent, it's projected to raise 1 percent of GDP — more, if
some of the current exceptions such as books and newspapers are removed. A
carbon tax could raise a similar amount, and if properly designed, could help
Britain to lower its emissions of greenhouse gases and promote itself as a
global "green leader." The snag to both is that they could be regressive,
meaning poorer households would contribute proportionally more of their income
than their wealthier counterparts. If the new coalition government is to
implement a plan that will not lead to serious protests, it may need to keep
some of the Labor Party's tax plans for the rich to help mitigate the impact to
the middle class.
On the spending side, the cuts needed to address the
remaining 5 percent of GDP will be a major challenge. The single biggest
spending component is welfare, which makes up 28 percent of the government's
expenditures, with approximately 55 percent spent on public services and health
and education and its associated administration costs being the main components.
The remaining costs consist of miscellaneous commitments, some of which include
debt-interest payments which are unavoidable.
Indiscriminate cuts in
welfare will run against the image of a "socially fair" package, since most of
the spending goes into state pensions and for the poor and needy. Unless
substantial savings are made in welfare sector, public services will most likely
take a disproportionate cut in spending reduction. For Britain to emerge from
its fiscal crisis, not only must the deficit shrink but the economy must grow,
and this means improvements to infrastructure should continue. Government's
internal payroll, which makes up a quarter of total spending will need immediate
attention, and could be addressed through a two-year pay freeze. The gross
savings are projected to be GBP 8.9 billion, or 0.4 percent of GDP. A squeeze in
public-sector employment will also produce substantial savings, perhaps 0.8
percent of GDP via attrition and hiring freezes.
The central positive during this transitional time is the
anticipated cut in public services, which should spur much needed fundamental
reforms. Concentrating on changes in healthcare and education should move the
country towards more of a co-pay and/or user fee system, which up to now has not
been the norm. The global financial crisis has also forced people to focus on
what the state is expected to provide, whether free, for a fee, or not at all.
The aging population will continue to require more spent on pensions,
healthcare, and social services in the next decade, so the forced fiscal
tightening could be the biggest silver lining for the U.K. in the future as the
world approaches better times.
The views expressed in this column are solely
those of the author and do not reflect the views of SVB Financial Group,
or Silicon Valley Bank, or any of its affiliates. This material,
including without limitation the statistical information herein, is
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