Britain’s Bifurcated Budget

Chancellor of the Exchequer George Osborne, responsible for all UK economic and financial matters, delivered his annual budget proposal to Parliament on Wednesday. But like many of the UK’s recent policy moves, it left us (and more than a few others) scratching our heads.

As a whole, the budget proposal wasn’t much of a surprise—it largely continues Osborne’s (in our view, misguided) taxing approach targeting reduced deficits and debt. His office expects the deficit to fall to 7.4% of GDP this year and 6.8% in 2013/2014. However, in the face of seemingly ongoing economic stagnation in the UK, hitting those targets will only get more difficult. In fact, the Office for Budget Responsibility (OBR) revised economic growth forecasts down in the proposal. The OBR now expects the UK economy will grow a mere 0.6% (instead of 1.2%) in 2013 and 1.8% (instead of 2.0%) in 2014. Government agencies aren’t known for their laser-sharp forecasting precision. But one can understand their rather tepid outlook.

Still, in our view, Osborne’s proposal does very little to address the UK’s real issue—bank lending. Cuts to the corporate tax from 28% to 20% are certainly a plus for the UK’s economic competitiveness globally. However, corporate taxes were already set to fall to 21% by 2014. A one percentage point reduction in 2015 hardly delivers a shot in the arm here and now. Similarly, measures raising the level of tax-free earnings to £10,000 (from £9,400) by April 2014 and freezing beer and fuel taxes aren’t likely to get the UK economy humming into output overdrive.

Under Osborne’s proposal, incoming Bank of England (BoE) Governor Mark Carney will have new marching orders too. Osborne seeks to change the Bank of England’s monetary policy focus to stimulating growth versus combating inflation. Likewise, the BoE would have leeway to use new tools, like “forward guidance”—announcing the path for future interest rates until GDP or other economic targets are hit (akin to the Fed’s efforts). Similarly, the proposal extends an existing program (“Help to Buy”) to provide interest-free loans of up to £120,000 to boost deposits of folks buying new homes. In total, the program is expected to support £130 billion worth of mortgages. Certainly nothing to sneeze at. However, the program’s success relies on UK banks to provide the rest of the financing. And that’s where Osborne’s policies get a little contradictory, in our view.

In announcing “Help to Buy” (and a slew of other as-of-yet unsuccessful programs in the past like the Asset Purchase Programme, Project Merlin, National Loan Guarantee Scheme, Funding for Lending and UK Guarantees) Osborne genuinely seems to understand a main part of the UK’s sluggish economy has been a lack of bank lending. But understandably, UK banks seemingly have been a bit reluctant to lend the last few years. They (and EU banks broadly) have been the target for political backlash that has served to sap bank eagerness to lend—including high and soon-to-rise capital requirements, looming ring-fence provisions and contractionary quantitative easing, which flattens the yield curve. Right now, banks have more incentive to park money at the BoE as excess reserves than to lend enthusiastically, and Osborne’s proposal does little to help that.

As part of his plan, a levy on bank balance sheets would increase from 0.13% to 0.142%, the sixth increase in the tax since its first announcement in 2011. Osborne said the hike would “ensure banks make a fair contribution (to the economy) and reflects the risks they post to the financial system and the wider economy.” Likewise, the proposal noted his intent to make sure banks did not benefit from the lower corporate tax rate. The measure is expected to pull roughly £2.5 billion out of banks’ coffers each year—certainly not helping their capital positions much either. But should lending continue to be tight in the UK, it’s likely this tax misses the revenue target again, as banks’ balance sheets (the tax base) shrink. (Seemingly, one factor contributing to the repeated hikes to maintain a “fair”—in Osborne’s eyes—economic contribution.)

To us, a much wiser path to boost economic growth for Osborne and the UK than their current modus operandi would be to reduce the overhang of regulatory uncertainty, cut through bank’s increasing red tape and put an end to hand-slapping taxes (like the bank balance sheet levy) that made banks so recalcitrant to begin with.