kwarteng kwasi

The UK’s new Chancellor of the Exchequer Kwasi Kwarteng presented a “mini-Budget” statement on Friday 23 September. It represents a radical change in the fiscal policy stance following the recent change of Prime Minister and Chancellor. A number of major tax cuts were announced, and comparisons with the past have counted this as the largest set of tax cuts ever announced since 1972.

However, the total calculated includes not just early new tax changes but the abandonment of a major increase in corporation tax which had been announced from next year by Kwarteng’s predecessor Rishi Sunak; as well as the acceleration to next April of a personal income tax cut that had been promised for the following year.

The Budget outlook

The overall UK tax burden next year will remain high by past standards; and on the previous announcements it would have risen next year to the highest level since the 1940s. On such a long term comparison taxes on income and corporate profit are generally (with some exceptions) much reduced. However, indirect taxes - including some that are new or much transformed within recent decades, like value added tax (VAT) and insurance premium tax – are greatly increased.

Current public borrowing levels are already high. This reflects the cost of energy subsidies announced earlier and greatly enhanced in Friday’s package, and some ongoing impact from the effect of Covid lockdowns mainly in 2020.

Currently the independent Institute of Fiscal Studies is forecasting UK public borrowing for the current financial year as high as £190 billion. Subsequent levels will largely depend on to what extent energy subsidies may need to continue in the light of the crisis in European natural gas supplies through the Ukraine war. The Resolution Trust “think tank” forecasts that the combined effect of the mini-Budget and other recent energy subsidy announcements could add £265 billion to borrowing over the next five years.

The ratio of total UK national debt to gross domestic product (GDP) is close to 100 per cent and currently rising fast. It is still not yet high compared with other OECD countries. However, it rose considerably in the wake of the global financial crisis of 2008 which did lasting damage to tax revenues from the UK financial sector, stabilising at near to 90% of GDP before Covid pushed it higher again.

Ministers hope that the latest tax concessions will in the long run boost economic growth to 2.5% a year through “supply side” effects. They will certainly give some early support on the demand side. It is probable that the UK is currently in a technical recession (defined as two successive quarterly reductions in GDP). However, the National Institute for Economic and Social Research now forecasts that GDP in 2023 will grow by 2%.

The UK’s present fiscal position is an uncomfortable combination of a historically high tax burden with an exceptionally high public sector deficit. This is mainly attributable to a poor underlying growth trend of the economy (and hence in tax revenues) over the past 10-15 years, compared with annual growth at close to 2.5% over the period from 1990 to 2005. At the same time public expenditure commitments in areas like the National Health Service rise continuously.

Brexit developments to date seem to have exacerbated these trends. Overall business sector fixed investment underwent a sustained drop immediately after the Brexit referendum in 2016; and the UK’s trade in goods has suffered from the reintroduction of customs formalities, notwithstanding a new EU-UK free trade agreement, since the completion of Brexit transitions nearly two years ago.

Main tax rates

The Chancellor has cancelled the earlier plan to raise the corporation tax (CT) rate from 19% to 25% next April. However, the banking groups involved in asset finance will gain little from this. The CT surcharge for banks will stay at 8%, giving a total tax rate of 27%, in place of Sunak’s planned cut of the surcharge to 3%.

For individuals resident in England, Wales and Northern Ireland the basic income tax rate will fall from 20% to 19% next April. The additional tax rate of 45%, on incomes above £150,000 a year and in force since 2011, will at the same time be abolished, leaving a single higher rate of 40 per cent (the same as in the period from 1988 to 2010).

The Scottish government will be determining the corresponding rates under devolved powers for Scottish residents. It currently levies a top rate of 46%, with the same basic and 40% rates as elsewhere in the UK.

The increase of 1.25% in National Insurance contribution (NIC) rates for both employees and employers, which came into effect in April this year, is to be ended from November. The self-employed will gain by comparison, with their increase for the whole current financial year being cancelled.

A substantial increase in the exemption limit for NICs, put through by Sunak together with the higher rates, is to be retained. However, for income tax it seems likely that the corresponding exemption limit by way of personal allowances will remain frozen. Consequently, the average personal income tax burden is unlikely to be changed significantly over the two years to the 2023/24 fiscal year.

Investment zones

A new system of enhanced incentives for fixed investment in relatively disadvantaged regions is to be introduced. Nearly 40 such sites are under consideration by the UK government for England; and corresponding decisions for other parts of the UK will be for the devolved administrations.

The incentives in these investment zones (IZs) will include 100% first-year allowances (FYAs) for expenditure on plant and machinery, and a full write-off of expenditure on industrial and commercial buildings over five years. There will also be a complete NIC exemption for new employees taken on in eligible establishments, if they are paid below £50,270 per year.

In England at least, there will also be a full exemption from business rates in new or expanded premises in IZs, and from stamp duty land tax (for both commercial and residential properties). It is not yet clear for how long some of these benefits will be guaranteed to last.

Capital allowances

Fixed investment in plant and machinery, including vehicles, ships and aircraft, is subject to capital allowance (CAs) at statutory rates. For these are depreciating assets; and depreciation charges as adopted for accounting purposes are not themselves tax-deductible.

Currently, there is an enhanced capital allowance (ECA) rate for most types of plant, initially announced for a two-year period due to expire next April. This is a “super-deduction” whereby 130% of an eligible asset’s value can be written off over its whole life. It is available for most types of plant (though unlike all previous temporary or permanent CA regimes, only for companies and not for unincorporated businesses).

In May this year, Sunak issued a consultation document inviting comments on possible ECA regimes to replace the super-deduction next year, when the CT rate was due to be increased. The consultation period has now closed.

However, no relevant announcement was made in the mini-Budget statement. Pending any possible further announcement later this year, it seems possible that after the decision not to increase the CT rate, no general ECA regime will be in place from April.

In that event, the general rates of CAs on plant and machinery would revert to the last permanent rate. For assets with a useful life of up to 25 years, this is a system of annual writing down allowances (WDAs) on the “reducing balance” basis at 18%. It allows only around 55% of initial cost to be written off within the first four years. This rate clearly lags behind the true depreciation cycle of most relevant plant or vehicles.

Special CA considerations apply to leasing and asset finance transactions. Where the lessor is the party eligible to claim CAs, as in most pure lease agreements, they have been excluded from nearly all ECA regimes in force over recent years. In some contracts, including all those for hire purchase or conditional sale and also “long funding leases” – generally those running for over seven years with limited residual values – it is the lessee or hirer who claims CAs. While that circumvents the discrimination against lessors under ECA regimes, it reduces the practical value of CAs in cases where the lessee/hirer might be in a tax loss position (which rarely applies to finance companies) over all or part of the contract period.

Consequently, some asset finance players could have mixed feelings about the possible ending of the super-deduction without any new ECAs. Yet clearly that outcome would not help to incentivise business investment in general.

One CA announcement that the Chancellor did make this time concerns the annual investment allowance (AIA). This is a 100% FYA for plant and machinery that mainly benefits SMEs, since it is set at a maximum cash level per individual business (or group of connected firms). The AIA, currently at an enhanced rate of £1 million, had been due to revert to a permanent rate of £200,000 from next April. However, the £1 million amount will now be made permanent. Unlike other ECAs, lessors are eligible for AIA; but it is not of significant value to them in view of the scale of their finance business.

Other tax changes

Some other tax changes will be significant either for the UK economy in general, or for some sectors of asset finance. From next April, there will be a major easing in the IR 35 regime for determining the employment status for tax purposes of various kinds of personal contractors. Self-employed status can of course bring substantial tax advantages, mainly in respect of NICs, compared with being treated as an employee.

Currently there is a statutory regime for clients (i.e. putative employers) to account for the status of any of their contractors under IR 35 rules in their own tax returns. This became applicable to public sector clients in 2017 and to all but the smallest private sector ones in 2021.

In the road haulage sector, these reporting rules appeared to have the effect of making self-employment status unavailable to all truckers except for the owner-drivers (though the latter would include “hirer-drivers” with vehicle finance contracts). Some 5,000 of the affected drivers are estimated to have left the industry permanently as a result; and this was one of the factors contributing to the severe shortage of available drivers throughout the UK at one point last year.

In England and Northern Ireland there was an immediate lifting of the exemption limit from stamp duty land tax for residential properties from £125,000 to £250,000.

Some retailers will benefit from the reintroduction of VAT-free sales of goods for visitors from all overseas countries. Such a scheme was removed on completion of Brexit arrangements in 2021, when there was no basis for distinguishing by the visitor’s home state. It will now be reintroduced for all comers “as soon as possible”.

Bank bonuses

The Chancellor announced a number of regulatory changes designed to support economic growth. The one closest to the financial sector is the scrapping of the current limit on bonus remuneration in banking.

The bonus rule has been applicable to all banking group employees, but in practice most relevant to investment banking sectors where bonuses have always been a significant part of earnings. It was adopted across the EU in 2014, against strong opposition from the UK as the member state most affected, and tacked on to the Capital Requirements Regulations that were otherwise concerned with implementing the global Basel 3 banking capital rules.

Brexit has allowed the rule to be ended for UK based banking groups. However, banking and finance operations in the UK within the groups of banks headquartered in remaining EU states will remain subject to it.

The monetary impact

The heavy fiscal deficit will undoubtedly put pressure on the Bank of England to bear down on the inflation rate through restrictive monetary policies. Recorded inflation over the past 12 months has already come close to 10%. It is to some extent arguable how much of this could be attributed to factors that will not continue indefinitely, like the latest energy price spike; and how much could represent “ingrained inflation” from the fiscal and monetary easing since the start of the Covid period.

The Bank’s base lending rate (for money market transactions with the banking system) was already raised from 1.5% to 2.25% the day before the mini-Budget. Yet it is still very much in “negative real rate” territory when measured against the current inflation rate. Some forecasts suggest that the base rate could be up to 5% or more by mid-2023.

On the currency markets the mini-Budget went down badly, with the pound falling against the US dollar by 3% on the day. This adds to the pressures on inflation, and on UK interest rates.

As for longer term interest rates, the annual yield of UK government “gilt-edged” bonds at 10 years to maturity has shot up from 0.4% to 3.8% over the past 12 months. The Bank’s large current portfolio of gilts, built up through various instalments of “quantitative easing” ever since the 2008 financial crisis, is planned to be partially run down over the coming months – and with it, the Bank’s obligations on the liabilities side of its balance sheet to commercial banks in the form of their liquid “reserve balances”, which were in effect borrowed to buy the Bank’s gilts.

All of this will represent monetary tightening, and will make it more expensive for the government to borrow on the gilts market. It must also have effects on the pricing of asset finance agreements, even though some financiers may presently be hedged to a degree against rate rises.

First reactions

Initial reactions to the mini-Budget are considerably varied. Tony Danker, Director General of the Confederation of British Industry, is very supportive: “This is a turning point for our economy. Like Covid, the energy crisis has meant government has had to spend massively to protect people and businesses. That means we have no choice but to go for growth to afford it.”

At the other extreme, criticism came from Larry Summers, economics professor at Harvard University who served as President Clinton’s Treasury Secretary from 1999 to 2001. Summers has been critical of the high levels of US public borrowing under both the Trump and Biden administrations. He went further on the latest UK proposals, telling Bloomberg News: “No major country has tried increased borrowing on this scale. The UK is acting like an emerging market, turning into a submerging market…. I hope this package is soon reversed, unless I have somehow misunderstood something.”

Stephen Haddrill, Director General of the FLA (pictured above), hit a more balanced note: “The government’s commitment to growth and investment is good news, in particular the decision to make permanent the AIA at £1m which the FLA has been pressing for.

“However, to maximise investment growth, the type of capital investment that qualifies for relief must take account of the prevailing economic conditions. In times of uncertainty when many firms want to hold on to cash reserves, leasing is the way to get new plant and equipment into the hands of understandably cautious business owners.

“Government borrowing tends to put upward pressure on interest rates, so while the measures announced today will be welcomed in business circles, the future health of the economy will rely on keeping inflation, which is outstripping that of our international competitors such as the US, under control.”