Caledonia Asset Management - The View from 5 Charlotte Square - Quarterly Commentary (DRAFT)

While the highly successful vaccination programme should allow the UK recovery to start quickly from early summer, that recovery will take time.  The Office for Budget Responsibility (OBR) forecasts that UK GDP will reach the pre-COVID high-water mark only midway through 2022 and thereafter, the OBR predicts that economic output will remain permanently 3% below the pre-COVID trend (i.e. the size of the economy if the pandemic had not occurred), although admittedly this is at the more pessimistic end of a range of professional forecasts. 

The Chancellor has chosen to strengthen the public finances with an investment-led recovery plan with various incentives for firms to drive new growth in the economy. The government expects the recovery to be well underway by April 2023, at which point corporation tax on company profits will rise from 19% to 25%. But the rate will be kept at 19% for about 1.5 million smaller companies with profits of less than £50,000.

The overall market reaction to the Budget was muted. The pound was more or less unchanged on the Chancellor’s announcements. More stimulus today, but tightening further down the line, leaves expectations for monetary policy more or less unchanged too.

The national debt has risen to its highest level in more than half a century, and it will rise again to 109% of GDP by 2023. But the cost of servicing it, expressed as a percentage of government revenues, is cheaper than it has been in the last three centuries.  Government borrowing costs are low because both the real rate of interest and inflation have been driven lower since the 1980’s by profound structural forces such as demographic change, rising inequality, falling productivity and technological disruption. None of these forces are likely to have been reversed by COVID and some of them have been reinforced. In other words, while borrowing costs are likely to rise as the economy continues to normalise, they are unlikely to return to anything like the average of the last few decades. It is expected therefore that higher government borrowing to invest in projects that will grow the future tax base in the short term will contribute to future fiscal soundness.

Evidence from studies of historic economic and health-related shocks suggest that the main long term effects of this time are likely to be long-term unemployment and a lack of confidence in future wellbeing, leaving consumers with a lower propensity to spend and businesses with a lower propensity to invest. The majority of the almost £60 billion of new tax and spending measures this year are aimed at combatting these outcomes.

The furlough scheme will be extended to September, with only 10% employer contributions from July and 20% from August. Self-employed income support is also extended, and the 600,000 newly self-employed that were shut out of the scheme last year now have an opportunity to claim. Business grants of £5 billion are available to COVID-hit service and hospitality companies; business rates discounts are extended to December and the reduction on VAT applied to hospitality industries until September. A new recovery loan scheme will also be introduced.

To date, these schemes have successfully kept unemployment relatively contained, but the latest ONS Business Impact of COVID Survey suggests that 15% of businesses have low confidence they will survive beyond spring. Clearly, the extra support was needed to ensure that future layoffs are made at a time when the rest of the economy is in better health.

By far the biggest single stimulus measure announced in the Budget was the 130% “super deduction” for business investment spending, particularly equipment and machinery. This will cost the government £25 billion over two years. 

The very large increase in corporation tax from 19% to 25% in 2023 is the first rise in the headline rate since Denis Healey’s Budget of 1974. Because successive tax cuts since then also broadened the “tax base” (by removing loopholes, exemptions, etc.) the corporate tax take relative to the size of the economy has remained relatively steady. The announced tax increase will not simultaneously narrow the tax base, and so the OBR estimates that corporate tax take and indeed the broader total tax take will reach a percentage of GDP not seen since 1969.

One significant new addition was the announcement of a new National Savings product linked to green public investment.  Other countries are already starting to issue green sovereign bonds and the UK government is also embracing the idea that they can help meet climate change goals and objectives. For green bonds, strict use of proceeds will be required in order to ensure that financing is used only for projects aiming to achieve an environmental and social benefit.

As the Chancellor noted, it will take many governments many decades to repay the cost of the pandemic, and he made the case for starting this journey now. But as is the case for this Budget, even the longest journeys start with a small step; so changes to tax regimes were quite limited.

The Chancellor has maintained the pre-pandemic promise not to raise the UK rates of income tax, national insurance or VAT. But he plans to raise tax revenues by freezing the personal allowance at £12,570 and the higher rate income tax threshold at £50,270, from April 2022 to April 2026.

Scotland - As announced in the Scottish Budget on 28 January, there will be no changes to the Scottish rates of tax. All the bands will increase in line with CPI as follows;

Starter rate - £12,570 - £14,667

Basic rate - £14,667 - £25,296

Intermediate rate - £25,296 - £43,662

Higher rate - £43,662 - £150,000

Surprisingly, despite recommendations to the contrary by the Office of Tax Simplification, no changes to the capital gains tax regime were announced. The annual capital gains tax allowance will be frozen at £12,300 for individuals (and personal representatives) and £6,150 for trustees of settlements, until April 2026.  However the Government intends to publish further tax consultations on 23 March and we will have to wait and see if CGT changes are amongst them.

The band of savings income that is subject to the 0% starting tax rate will remain at its current level of £5,000 for 2021-22. The starting rate for savings is aimed at supporting savers on incomes of less than £17,570 for 2021-22. 

The inheritance tax (IHT) nil-rate bands will also remain at existing levels until April 2026. That gives certainty but if families’ wealth increases along with a recovery in the economy, so could their IHT liabilities which makes financial planning all the more important for families wishing to pass on a legacy to younger generations.

The nil-rate band will continue at £325,000, the residence nil-rate band will continue at £175,000, and the residence nil-rate band taper will continue to start at £2 million. Qualifying estates can continue to pass on up to £500,000 and those of a surviving spouse or civil partner can continue to pass on up to £1 million without an inheritance tax liability. With the bands frozen for a further five years, this will however bring more estates into the IHT net and increase the requirement for advice on estate planning. 

The business asset disposal relief, where entrepreneurs pay a reduced 10% rate of capital gains tax on qualifying disposals, remains unchanged with a lifetime limit of £1 million.

The changes to off payroll working, often referred to as IR35, will now come into force from April 2021. This will see large and medium sized private companies becoming responsible for deciding if contractors are effectively ‘employees’. If so, these companies must collect income tax and NICs from the contractor’s fee and pay it over to HMRC.  These new rules were due to be introduced from April 2020 but were delayed due to the COVID-19 pandemic.

The adult ISA annual subscription limit for 2021-22 will remain unchanged at £20,000 and the Junior ISA (JISA) and Child Tax Fund allowance will also remain unchanged at £9,000. JISA’s give children control at 16 and access at 18, an ideal way to teach children about money and investing. Many people fortunate to have remained fully employed over the pandemic period have built up considerable sums in savings during the last year as the majority of discretionary spending opportunities (holidays, socialising, events) have been severely reduced. Investing in a Stocks and Shares ISA is one way to support the growing economy over the next few years, while also taking advantage of the tax free growth environment they provide.