A proposed tax cut announced at the end of September in the UK has generated a strong reaction of fear among investors. On September 26, the Pound hit an all-time low of USD 1.03, a value drop of around 5% in three days. In addition to becoming a credibility nightmare for the new UK Prime Minister Liz Truss, the plan has affected the Pound and triggered a massive sell-off in gilts -UK government bonds- as seen in the chart. Even the Bank of England was forced to carry out a temporary Quantitative Easing as a shock plan to stabilize this market.
In economic policy, correct timing is a crucial factor. This initiative failed to consider that the country is going through a difficult economic situation, particularly as winter approaches, amidst doubts regarding its power generation capacity to face it and the high associated costs. The main objection to the Government’s proposal is that even though a tax cut could, in some instances, boost the economy, it may also affect short-term fiscal stability. Among the actions taken, one of the most criticized was the decision to freeze the planned corporate tax increases, particularly considering that this would benefit higher-income individuals.
Chart 1: Own Elaboration Data by Bloomberg
The logic behind this move by the British Government is focused on pre-empting a possible recession by strengthening the economy’s productive structure by reducing the tax burden on companies, which constitutes an expansionary fiscal policy. However, as previously noted, there was a lack of understanding of the context, as August’s annualized price level was 9.9% -remaining at the century’s highest, and with the expectation, according to Bloomberg surveys, of closing the year at 9.0% and 2023 at 6.5%.
But the triggering factor for the markets’ reaction is the elevated budget deficit inherited from pandemic-related expenses: 13.1% of GDP for 2020 and 7.40% for 2021, with expectations of a further decline to 5.4% this year and 5.0% for 2023. So the announcement to reduce tax revenues through a tax cut plan has raised many concerns about the country’s fiscal stability. Additionally, the intervention of the Bank of England to stabilize the bond market through a QE program sends confusing signals in terms of monetary policy. On the one hand, in September, its rate was increased by 50 basis points, taking it from 1.75% to 2.25% – a contractionary monetary policy. On the other hand, the massive purchase of securities generates the opposite effect.
Finally, given the impact on the markets and public opinion, Liz Truss’s Government was forced to reverse the initial plan a week later. This decision brought some calm to markets, allowing the Pound to strengthen and the gilt yield rate to reverse its trend. In addition, Treasury chief Kwasi Kwarteng has pledged to present on November 23 a medium-term fiscal plan and economic projections prepared by the Office for Budget Responsibility, an independent entity. This presentation will be the event to follow to assess the UK government’s expectations for fiscal sustainability in the short term.
Tracking this plan’s reception is crucial to evaluate how damaging the impact will be on Liz Truss’s public image and the unity of the Conservative Party. Should this happen, the effectiveness of her Government in implementing reforms and policies amid an expected growth of 3.5% for this year and -0.3% for 2023 may be called into question, especially now that the UK situation becomes more complex as the winter arrives.
This report was prepared by Gandini Análisis for Supra Brokers for informational purposes only and should not be construed as an investment recommendation.