The Budget Statement, 2021

The Budget Statement 2021The United Kingdom is spending an unprecedented 407 Billion GBP on mitigating the devastating effect of the pandemic and accelerating recovery by stimulating job creation, investment and purchasing power. The bulk of the financing is planned to come from a progressive increase in corporate taxes which is a highly debated policy issue in academic circles.

The United Kingdom is spending an unprecedented 407 Billion GBP on mitigating the devastating effect of the pandemic. One can debate whether the magnitude, the timing and the targeting of this spending was optimal, but we can all agree that socially, economically and politically it was necessary.

This enormous amount of spending requires equally enormous and unprecedented (peace-time) borrowing. The Chancellor seems to understand that the main task of the medium-term (next 5-6 years) is to put back the economy on a sustainable growth path and at the same time keep national/government debt at a sustainable level.

There have to be economic incentives in place at the wake of recovery (starting now) to stimulate job creation, investment and purchasing power (hence both supply and demand factors). At the same time, there has to be a well-designed and well-communicated plan to reverse the unsustainable budget deficits and the resulting explosive debt dynamics. Communication and commitment to a medium run plan is key as expectations are key both for business investment and consumer spending on durables (e.g. real estate, vehicles, etc.). Finding a balance between these issues is the classical problem in public finance.

The plan of the Chancellor fosters job creation by extending reopening grants for all sectors with more substantial ones for the sectors most hit by the pandemic: the hospitality industry. These measures are accompanied by lower VAT rates and frozen duties for this sector. Continuation of the furlough scheme and the support for self-employed are also critical as they keep contractual relationships between employers and employees alive because we know once broken it may take time and resources to build these relationships again. The extension of these programs is also useful because they help boost consumer demand, which is complementary to the support given to the supply side of the economy during the recovery. The extension of the social assistance for the lowest-paid can be especially effective in this regard as they tend to have the highest propensity to consume out of additional income. Last, but not least, there is an enormous investment subsidy through super-deduction for two years starting now. This investment subsidy is also meant to increase job creation after September when all the short-run job creation incentives are phased out.

All these elements imply that we do not expect the government to cut deficits while the economy is navigating back to normality. The bulk of the financing starts indeed two years from now by the increase of corporate taxes for the more successful firms in the UK through a significant 6 percentage point increase of the profit taxes from 19 per cent to 25 per cent. The new system will make corporate taxes progressive as the current rates will be imposed for profits below 50000 GBP, and there will be an increasing rate between 50000 and 250000, where the maximum 25 per cent levy is achieved. The freezing of personal income tax brackets also implies a smooth and progressive tax increase as we expect earnings to grow together with the whole economy in the next six years. It is probably a good idea not to further burden personal incomes with higher tax rates in order to keep consumer demand growing.

This is a reasonable plan but it has some risks that worth discussing (and analyzing further beyond this blog).

First of all, the Chancellor’s argument for the super-deduction program is that the program is going to incentivize the many firms which are sitting on cash savings to invest in their businesses. There are reasons to be cautious with such an argument, however. Why do we believe that these firms will miss good investment opportunities with high returns in the first place? Given that many of these firms are sitting on cash savings, they should take these investment opportunities without additional incentives, in which case the additional incentives via subsidies may end up serving firms to invest in marginal projects with otherwise low returns. These low-return investments could hurt long-run economic growth even if they may help boost growth in the short run. The fact that this is a one-time subsidy with a two-year window may exacerbate the aforementioned possible negative effect by pressing firms in terms of time to choose even more suboptimal investment opportunities. A policy which targets productive firms which are financially constrained to invest might be a better strategy since these firms may be facing high returns to investment and are not able to invest due to credit constraints.

The new budget also foresees the progressive taxation of corporate profits. This is to a large extent an unprecedented idea with some built-in risks. First of all, business dynamism (firm growth from start-ups to multinational corporations) is one of the key engines of growth and job creation. Progressive profit taxation may reduce the incentives of small-business owners to try to make it to the next step of firm growth. Second, profits are to a large extent accounting notions. As such, firms may be willing to spend large resources to optimize their tax liabilities and they may find ways (e.g. splitting into smaller entities or offshoring of profits) to stay in lower tax brackets. The chancellor may also see this danger as another item in the budget is the strengthening of the investigative capacity of the HMRC.

At the more conceptual level, two long-lasting questions are how much higher corporate taxation distorts investment and who bears the eventual burden of these taxes. A key lesson is, as long as corporate profits reflect pure economic rents, it is in fact a good idea to tax them. However, if they compensate entrepreneurial effort, taxing them will distort investment and job creation, and hence, employees will bear some of its burdens. Which effect dominates and hence whether a corporate tax raise is optimal depends on many institutional and economic details (and assumptions). This calls for a thorough empirical and quantitative analysis. Nonetheless, given the growing concerns among many economists about the decline in competition and the rise in economic rents in developed economies in the last few decades, there may be an argument for the timing of the corporate tax hike in the UK.

Finally, another issue is that all these budget calculations are based upon projections, which are based on assumptions made about the expected path of the economy for the upcoming years. To be fair, the projections used in the budget seem to be reasonable. Nevertheless, prudent public finances need to have a plan B for worst-case scenarios (when some of the assumptions behind these projections are not satisfied). There was no mention in the speech of the existence of such a plan B, and no discussions of what the main underlying assumptions are.

We see four major risk factors.

  • Interest rates
    Interest rates have, indeed, been low for an unprecedently long period now and that make borrowing feasible and a debt level of around 100 per cent of GDP sustainable. However, at this level of debt, even a relatively small increase in interest rates can increase the burden of debt considerably. The recent financial crisis has shown that it can very damaging for public finances not only in Southern Europe but also in Ireland. The current projections assume that the interest rates will remain low; it is likely to be the case but there is no guarantee for that.
  • Inflation
    Many observers expect the recovery from this pandemic will be accompanied by a rise in inflation. On the one hand, it can relax the problem of debt sustainability by reducing the real value of debt. On the other hand, increasing inflation will reduce the purchasing power of households (which would be amplified by the frozen income tax brackets) and that can bring the economy towards another recession.
  • (Global) Economic Growth
    Even if all would go according to plan in the UK, there is a lot of uncertainty surrounding the recovery of the Global economy. Slow recovery at the global level and/or another crisis can jeopardize the projected economic growth in the UK. This could create a problem for the Budget since sufficient economic growth is necessary to keep the tax bases growing, which is critical in financing the increasing debt service.
  • Brexit
    Interestingly, during the 52-minute speech of the Chancellor, there was no mention of Brexit. First of all, it shows how times have changed here. At the same time, Brexit increased the costs of firms exporting or importing to and/or from the EU for now and presumably in the foreseeable future due to more administrative costs. Also, Brexit made the UK less attractive to foreign direct investment. From this angle, increasing corporate taxes may make matters even worse. Indeed, the Chancellor already mentioned some special reductions for the financial sector to increase competitiveness. These considerations may make the rise in corporate taxes less desirable and the government’s commitment to this plan less credible.
Professor Árpád Ábrahám and Professor Hakkı Yazıcı.

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