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Chancellor George Osborne

What kind of economy will we have under the tories?

27 July 2015

Chancellor George Osborne unveils some surprises in the first Conservative-only Budget for nearly two decades.

David Cameron did not expect it, and neither did George Osborne. Commentators said we should prepare for another hung parliament, and another coalition or a minority government.

There was a lot of talk of Ed Miliband as a Labour prime minister, propped up by the Scottish National Party. That may have helped the Conservatives. Whether it was that, or because Cameron consistently rated more highly as a leader and, with Osborne, more competent in managing the economy, the election delivered
a result even Tory die-hards barely dared hope for.

The dust has settled. We have had the Queen’s Speech and Osborne’s first Budget of the new parliament. You have to go back nearly two decades for the last time Conservatives in government were able to set out their legislative programme, or announce tax and spending plans without having to convince the Liberal Democrats first.

What did the Budget tell us? Beforehand, there was speculation that an unfettered Osborne would unveil a Tory Budget that would put a huge expanse of clear blue water between him and his political opponents. One theory was that, alongside £12 billion of welfare cuts, he would reduce the additional rate of Income Tax – the 45% rate on incomes above £150,000.

It was not quite like that. The chancellor did announce £12 billion of welfare cuts, but stretched them out over a longer period – three years rather than two – and mitigated the pain by surprisingly announcing the National Living Wage. For some time now the suspicion among ministers has been that some employers free-ride on the welfare system by paying the minimum they can get away with – the National Minimum Wage – leaving taxpayers to top up the incomes of the low-paid. So the chancellor launched an experiment. By introducing his new National Living Wage at £7.20 an hour from next April, rising to £9 an hour by 2020, he is banking on firms being willing to pay more, without this leading to big job cuts. So, just as the BBC is taking on the burden from the government of giving free TV licences to the over-75s, so the private sector will take on more of the burden of supporting the lower-paid.

Whether it works depends on the jobs market remaining strong. The independent fiscal watchdog, the Office for Budget Responsibility (OBR), thinks this living wage will cost 60,000 jobs in the next five years, but that this will be more than balanced by the one million jobs created overall. This, in turn, relies on recovery continuing. Despite the storm clouds over the world economy, the OBR expects 2.4% growth this year and, indeed, for the rest of the parliament. It may not turn out quite like that, but the chancellor would argue that preparing for future downturns is one reason why he is a fiscal conservative, as well as a political one.

On deficit reduction, Osborne was less brutal, unusually, than he had led voters to believe in the run-up to the election. In his March Budget he said he would achieve a budget surplus in 2018-19. Now he says he will do this in 2019-20. The reason was not just that his welfare cuts will be stretched over a longer period, but that the same will apply to other government spending. The rollercoaster profile for public spending set out in March – harsh cuts in the first two years followed by big spending increases in the run-up to 2020 – has been replaced with something more sensible, and more achievable.

That showed Osborne to be more of a pragmatist than he is sometimes given credit for. There was the expected £5 billion to be raised from a clampdown on tax evasion and avoidance, including restrictions on non-domicile status. But there were also explicit tax increases: a new tax on dividends (along with a £5,000 tax-free allowance) will eventually raise more than £2 billion a year; Vehicle Excise Duty reform will eventually bring in an extra £1 billion a year from motorists; Insurance Premium Tax rising from 6% to 9.5% will raise £1.5 billion a year; and landlords face a tax increase through the restriction in mortgage interest relief to the basic rate and reduced wear and tear allowances. Osborne delivered on his promise to raise the Inheritance Tax threshold for couples on main residences to £1 million – but not until 2020.

Most of the deficit reduction will still come from spending cuts in government departments, with details to be set out in the Autumn Statement. The Ministry of Defence has joined the list of protected departments, with a renewed pledge to spend 2% of gross domestic product on it, but the Budget tax increases will still be decent revenue raisers from a self-proclaimed government of low taxation.

What does all this mean for investors? If the adoption of a living wage was a surprise for business, so was the planned reduction in Corporation Tax to 18%. Most observers had thought 20% was as low as Corporation Tax would go. The drop to 18% by 2020 will mean the rate has dropped 10% in a decade.

It is the balance between the effect of these two changes which will determine whether the Budget was good or bad for business. Those in catering, retail and other low-wage sectors would happily forego the tax cut for not having to implement the new living wage. Overall, however, the Budget probably supported recovery and, in that sense, was a good one. Having ‘economic security’, to use Osborne’s expression, is important in the context of the planned referendum on EU membership – promised for no later than the end of 2017 but, in practice, likely to be held some time before that.

We know such tests of public opinion are unpredictable. Greece’s referendum on 5 July on whether to accept the latest bailout terms from its creditors was widely expected to be a close-run thing, with polls suggesting that voters were moving towards a ‘Yes’ verdict.

In the event, as everybody now knows, it was a resounding ‘No’, by 61% to 39%. That, and the fact that the pollsters also got Britain’s general election badly wrong, suggests that we should be cautious about second-guessing the outcome of the EU referendum.

Even so, a couple of things can be said with some certainty. One is that the attitudes of UK voters towards the EU vary according to the state of the European economy. The current picture, one of a recovering eurozone accompanied by major uncertainties, not least those over Greece, is one that will not do a huge amount to build support for continued EU membership. The other is that if consumer confidence is high – a recent GfK survey suggests UK consumers are more confident than for a decade and a half – then people are less likely to risk a big constitutional change such as leaving the EU.

The uncertainty was enough for Standard & Poor’s, the ratings agency, to put the UK’s sovereign debt on negative watch, saying the referendum ‘represents a risk to growth prospects for the UK’s financial services and export sectors, as well as the wider economy’. International investors could take a similar view.

Lastly, a key question for investors is what will happen to interest rates. It is so long since we had a hike in rates – the last was in July 2007 and the last move in either direction was in March 2009 – that we have almost forgotten what it feels like. The signals from the Bank of England have been confusing. While most members of the Bank’s Monetary Policy Committee (MPC) have suggested that conditions are falling into place for an eventual gradual rise in the cost of borrowing, Andy Haldane, the Bank’s chief economist and MPC member, says he has no bias on the question of whether the next change in rates will be up or down.

Eventually rates will begin to rise, and the smart money is on the first move being in the spring of 2016, a few months after America’s Federal Reserve starts the ball rolling by raising its key interest rates. It depends, of course, on whether the economy continues to strengthen. The MPC keeps a close eye on wages, and the new National Living Wage will have reinforced its belief that pay is likely to strengthen. If so, the chancellor will not mind a gentle rise in the cost of borrowing (and the return on savings). If not, the Bank has the luxury of being able to stay its hand.

Balance sheet George Osborne’s Budget had the expected welfare cuts and clampdown on tax avoidance, but the chancellor pulled a rabbit out of the hat with the announcement of the National Living Wage and a further drop in Corporation Tax.

The budget in brief

The main measures in George Osborne’s summer Budget:

  • A £12 billion reduction in annual welfare spending, to be achieved by 2019-20, including a freeze on most working-age benefits for four years.
  • A budget surplus of £10 billion, but not to be achieved until 2019-20, a year later than planned in March.
  • A reduction in the Corporation Tax rate to 19% in 2017, and 18% in 2020.
  • A new Dividend Tax. The first £5,000 of dividends will be tax free; above that, the tax will be 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.
  • An increase in the Insurance Premium Tax, from 6% to 9.5% in November.
  • An increase in Vehicle Excise Duty, which will see most motorists paying £140 a year.
  • Restrictions on mortgage interest relief and wear and tear allowances for landlords: mortgage interest relief will only be available at the basic rate, with the change phased in from 2017.
  • A £5 billion clampdown on tax avoidance, including new restrictions on non-domicile status.
  • A new £1 million Inheritance Tax threshold for couples on main residences, to be introduced by 2020.
  • Further restrictions on pensions tax relief for higher earners from 2016/17

The levels and bases of taxation and reliefs from taxation can change at any time. The value of any tax relief depends on individual circumstances.

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