ICAEW chart of the week – Public debt

Ross Campbell, Director for the Public Sector for ICAEW, writes:

“Here is the latest Chart of the Week from the ICAEW.

This week’s chart shows that public debt has tripled over the last decade.

While economic growth has been at historically low levels over the last decade, reducing tax receipts, government borrowing has rocketed in order to keep paying for public services and social welfare. 

With the average life of borrowing now out to 18 years, as long as the government is still able to borrow, we won’t have to settle our debts anytime soon but we do have to pay the interest on all of this debt.  Let’s hope interest rates stay low!”

To comment, please visit the ICAEW Talk Accountancy blog.

Analysing the EU Exit Charge

Money will be a critical part of Brexit negotiations. In this report written for ICAEW, we reveal the key components of a deal and estimate the potential EU exit bill.

Key points to highlight:

  • Potential exit charges range from a low cost of £5bn to a maximum cost of £30bn, with the central scenario cost £15bn (based on an exchange rate of €1.20 to £1). This is equivalent to £225 per person expected to be living in the UK in 2019.
  • To put this in context, the UK’s share of the EU budget each year is approximately £20-£21bn, before an estimated rebate of £5-6bn, and spending returning to the UK of £6-£7bn.
  • While the estimated rebate is expected to be received back, the EU could attempt to withhold this if there is no agreement on wider exit charges.
  • Liabilities include EU staff pension and sickness payments which will be close to £63bn when the UK leaves, and of which the UK’s share is £10bn. This could be dealt with through a one-off settlement or the UK could agree to continue to contribute £0.2bn a year for the next 50 years or so.
  • The value of the EU’s fixed assets will also need to be determined, but as these are relatively small compared with other numbers revaluing them is unlikely to have significant impact on the total exit charge.
  • Additional areas for negotiation include the European Investment Bank (EIB), of which the UK has a 16% share. As ownership of the EIB is restricted to EU members, the UK may need to sell its stake to other EU members, or existing rules may need to change.
  • The EU is likely to argue that costs incurred caused by the UK’s decision to leave should be paid for by the UK rather than by other member states.

To find out more and to read the report, visit http://www.icaew.com/en/technical/economy/brexit/analysing-the-eu-exit-charge

Surprisingly, a lower corporate tax rate may actually discourage investment in the UK

The Autumn Statement is tomorrow, and the press is full of speculation that our new Chancellor Philip Hammond will not only hold to previously announced cuts in the corporation tax rate, but will announce a further reduction, despite an expected hit to the public finances from lower economic growth.

A reduction from the current rate of 20% is planned for this April when it is due to come down to 19%, with a further cut to 17% in April 2020. As a consequence it is likely that any new announcement will be in the form of a commitment to reduce the rate to 15% at some point in the next decade.

This definitely sounds attractive – the UK should be an even more rewarding place to base your business than higher tax jurisdictions, such as Germany with its 30%-33% rates, or the US with its combined federal and state tax rates in the order of 40% (albeit Donald Trump is proposing to reduce federal taxes so that the combined rate would come down to around 20%). The UK will perhaps be in touching distance of Ireland with its comparatively low 12.5% rate.

However, a 5% cut in the corporate tax rate is going to cost a lot of money – at least £10 billion a year. Will we really make up for this through increased economy activity and encouraging businesses to invest in the UK?

Perhaps it will. A lower tax regime should encourage businesses to invest in the UK, shouldn’t it? And more investment should mean more jobs, more spending in the UK and and more profits, each generating taxes to offset the cost of the lower corporation tax rate.

But, and there is a but. This change will provide an incentive for international businesses to shift spending out of the UK and into higher tax jurisdictions.

This may sound counterintuitive, but remember that most investment and spending in the UK economy comes from businesses already operating in the UK and internationally. And for them the equation is a little different.

For example, take a business already operating in both the UK and Germany, paying taxes on its profits in each jurisdiction. The lower corporation tax rate will provide an incentive to increase profits in the UK and to decrease them in Germany.

The orthodox answer is to do what the government would like – to prioritise investment in the UK over Germany. But in reality, there is a much easier way to take advantage of this tax differential and that is to do the opposite – to increase spending in Germany and reduce spending in the UK.

After all, this would provide a 30% or so tax deduction on the additional German costs, at the cost of 15% on the higher profits it would generate in the UK – a 15% saving for each pound (or euro) of spending shifted over to Germany.

Of course, life is a bit more complicated than this simple example. In theory the international tax system of “transfer pricing” should offset this sort of cost shifting. But in reality, outside of a straightforward manufacturing or product business, it probably wouldn’t. Especially as this would not necessarily be a clearly linked event, perhaps not even a conscious decision. It would just make financial sense to prioritise cost cutting in the UK over cost cutting in Germany.

There are many arguments for lowering the corporation tax from its current level of 20%; not all of them about the effect on the public finances and on economic activity. Indeed, in years to come, a 20% rate may seem very high, just like the 52% rate that applied in the 1970s seems extremely high to us today. Arguably those historic rate reductions have generated positive returns to the economy, certainly in making the UK an attractive place to do business.

But, I do wonder. Are we getting to the point where cutting the rates below 20% will be effective at stimulating the economy or is this a case of diminishing returns?

Government needs to reverse the trend in infrastructure investment argues ICAEW

In a letter to the new Chancellor, Phillip Hammond, ICAEW has urged Government to take action urgently and reverse the trend by increasing investment in public infrastructure. It also calls for new fiscal rules to support greater private investment.

In its paper ‘Funding UK Infrastructure’, ICAEW argues that for all the new initiatives announced by Government in recent years, public investment in economic infrastructure appears to be static or declining until the end of the decade, while attempts to encourage greater private investment have not been successful. It also reveals:

  • private finance initiative (PFI) contracts have been drying up, with only £0.7bn of projects reaching financial closure during 2014-15
  • although the Government announced that the total National Infrastructure Pipeline had increased from £411bn in 2015 to £425.6bn in 2016, the near term profile of investment grew by less than the overall growth in the economy, with investment in energy infrastructure declining
  • investment in social infrastructure – schools, hospitals and housing – is also static or declining, with claimed increases in social housing investment being offset by expected reductions in capital spending by housing associations

Vernon Soare, ICAEW Chief Operating Officer and Executive Director, said:

“In the past we have seen too much talk and not enough action on infrastructure. The combination of a new Chancellor, low interest rates and Brexit means that now is the time for decisions to be taken and investment to be made. Wavering on projects such as a new runway in the south east of England and a lack of public investment have meant that we are not getting the economic benefits that infrastructure can generate. If Government leads the way, private investment will follow.”

The new Chancellor has already made the decision to change fiscal rules to permit borrowing to fund investment. However, priority now needs to be given to infrastructure investments that provide a positive return to the taxpayer and so pay for themselves, while PFI contracts need to be brought back onto the balance sheet so that they no longer bypass fiscal targets and can be properly evaluated based on whether they provide value for money to the taxpayer.

Vernon Soare adds: “With cost cutting and austerity only getting the UK so far, it is now necessary to generate revenue growth. That will require more investment in key infrastructure projects and spades in the ground. There is now the potential to use borrowing to fund an immediate increase in infrastructure investment.”

Click here to see the full report.

Pressure on public services – is it immigration or people living longer?

During the current EU debate a frequent complaint from the Leave side is about the pressure that immigrants put on public services, while the Remain side reply with economic studies indicating that immigrants pay more in taxes than they take out.

Both sides have a point – there are definitely more people living in the UK as a result of migration and so there should in theory be a greater demand on public services. However, it is also true that new migrants are typically young, in good health and generally here to work, likely to be putting more into the system than they take out.

But can it be as simple as just that?  We are also regularly informed that the biggest pressures on public services are coming from an increasingly older population, so which is it: immigration or growing older?

I thought I would start by looking at what has happened over the last twenty years, when the population has grown by seven million people, from 58 million people living in the UK in 1995 to 65 million in 2015.

Of that increase, four million is due to net migration and three million from natural changes. So there you have it, migration is more than half the increase.

But then I looked at how the increase splits between older and younger people, i.e. those older or younger than 40?  It turns out that over the last twenty years, the number of people aged over 40 has increased by six million, while the number of people under 40 has increased by only one million.

And how much of that six million increase in the over 40s is down to migration?  Amazingly, I discovered that the answer is (approximately) zero.  17 million people reached the age of 40 over that time, much more than the just over 11 million people who died, a net increase of six million due to natural changes.

Now, just to be clear, there has of course been immigration amongst the over 40s. But, the numbers suggest that they have either been here for 20 years or more or, if they arrived more recently, that there has been equal and offsetting emigration by Brits over 40 who have left the country to work or retire abroad. For the over 40s, net migration has been effectively nil over the last couple of decades.

But of course now I was puzzled.  Looking at the overall population it appears that more than half the growth is due to migration, but if I just looked at older people of 40 and over, I discover that 6 million of the increase out of 7 million (85%) comes from those older people, with zero migration involved.

This becomes clearer when we look at the younger age group. This has only increased by 1 million people from 32 million to 33 million, an increase of just 3% over the two decades, compared with the 12% increase in the total population.

Where has all the migration gone you ask? Well, it hasn’t gone; there definitely has been a net 4 million increase in the number of people aged under 40 as a consequence of migration. But, this has been mostly offset by a reduction of three million in the number of younger people through natural changes.

Looked at in this way, it appears that three million migrants have replaced younger workers in the economy, with only one million going towards the overall increase in the total population.

A contrasting picture, as shown in this handy chart:

Immigration UK 1995 to 2015

So what is the answer? Is the increased pressure on public services due to the four million migrants arriving here over the last 20 years net of departures. Or is it down to the 6 million extra older people, which would have happened anyway even if there hadn’t been any immigration?

A question that I will leave with you to ponder.


Whole-of-Government Accounts for 2014-15 published at last

Yes, today is the day that the Whole of Government Accounts for 2014-15 have been published.  And, although it may be easy to criticise the 14 months it has taken since the end of the financial year to publish them, their publication is further evidence of the (quiet) revolution going on in the staid world of government accounting.

These accounts are the sixth set of financial statements published by the Government in this format, using International Financial Reporting Standards (IFRS), in line with the commercial accounting rules applied to listed companies and many other organisations.

Fourteen months is actually still an improvement over the 15 months it took two years ago when the 2012-13 financial statements were published, but it is a reversal from the twelve months it took last year and is disappointing given the Government’s ambition to reduce the time taken to nine months this time around.

The primary cause of the delays stems from problems in the preparation of the accounts for one of the Government’s major ‘subsidiaries’, namely the Department for Education. It has struggled to cope with the transfer of thousands of local authority schools from to academy chains under the control of central government, causing a knock-on impact on the overall financial reporting programme.

Despite that there have been improvements, with Network Rail now incorporated and further improvements in the quality of the accounts.  And, perhaps just as importantly, the Government has started to realise that it needs to do a lot more if it is cope with the financial implications of devolution.

Unfortunately, there has been a small step backward in terms of the commentary provided on the financial statements. It has been streamlined (something I generally welcome as a matter of principle), but in doing so I think the commentary has lost some of the analysis that would be expected in a listed company’s annual report and so makes it a slightly less useful document than it could be. However, I am sufficiently realistic to accept that there is limited usefulness in a detailed comprehensive financial commentary relating to a period that ended over a year ago.

That demonstrates the reason why it is important for the dedicated team at the Treasury working on the WGA to work with departments such as Education in order to return to the path of more timely reporting. It will only when the Whole of Government Accounts are published within a reasonable time after the end of the financial year that they will be able to come into their own as a vehicle for holding the Government to account for the management of the nation’s finances and to support more effective decision making.

Now to actually read them… mmm… I think the £1.5 trillion in pension liabilities might be worthy of a little further follow up….


The Curious Incident of the Surplus in the Night-Time

One of the challenges in getting to grips with the public finances is that government accounting can be just a little bit weird.  Without the strictures of double entry bookkeeping and balance sheets that (well) balance, it can often appear mysterious.

For example, take the Curious Incident of the Surplus in the Night-Time (or 2019/20 to be more specific).

A £10 billion surplus, according to the official forecasts published published just three weeks ago. If achieved, the Chancellor will have met his objective of balancing income with expenditure for the first time in decades. We will finally be in a position to start paying down some of the national debt, instead of just ‘inflating it away’ as a proportion of GDP.

But, hang on a second. Curiously, the Treasury is actually forecasting in the Budget that we will be £10 billion worse off in 2019/20, not £10 billion better off, with the national debt expected to increase from £1,715 billion to £1,725 billion over the year to 31 March 2020.

Even stranger, there is a forecast for £9 billion in asset sales, the proceeds of which we are told are used to pay off debt. So, a £10 billion increase in public sector net debt instead of the £19 billion reduction in debt that we might expect to see instead.

The Curious Incident of a Surplus in 2019/20.  One that doesn’t result in a positive improvement in the Government’s financial position.

A mystery indeed.


Budget surprises can be guaranteed

One of the challenges about trying to predict what will happen in the Budget is that the Chancellor has so many different levers that he can pull.  George Osborne could increase taxes or he could cut them.  He could increase spending or reduce it.  He could borrow more or he could reduce debt.

What makes predicting the Budget so difficult is that the Chancellor can and will do all of the above at the same time.

His existing plans to balance cash inflows with outflows requires tax revenues in 2019/20 to be £73 billion higher than this financial year, with £51 billion coming from economic growth and £22 billion from higher taxes.  With economic growth now expected to be lower he needs to find substantial sums to meet his revenue targets without damaging the economy in the process. This is why radical ideas like abolishing tax relief on pensions have been floated, as they are a way of raising substantial sums now, without (it is hoped) doing too much immediate damage to the economy.

With removing income tax relief on pensions rejected, he will be looking for a different route to raise the money he needs.  One possibility might be charging national insurance on employer contributions into private sector pension funds, while another might be to start cutting away at some of VAT anomalies, such as the lack of VAT on books and newspapers.  Together with rumoured increases in fuel and alcohol duties these measures could help him to meet his revenue target, even assuming phasing in over a number of years.

Of course, no Budget is possible without some form of tax cut or incentive to encourage good behaviour. Even as George takes pounds away with one hand, he will want to give back a few pennies with the other. Of course, this includes continuing the policy of raising personal tax allowances, but I would be surprised if there weren’t some other forms of tax giveaway in the offing. For small businesses, there might be some relief from increases in business rates.

He may need to increase the level of spending cuts he has to deliver, but that is more of an issue for 2018/19 and 2019/20 than it is for the new financial year. Yes, revenues will be lower, but low inflation and the extended period of low interest rates are likely to reduce some of the pressure on costs in the coming year.

If he does have any room to manoeuvre, the smart money is on George trying to increase investment infrastructure. With private infrastructure investment going into reverse following the ending of renewable energy incentives, the Chancellor may decide now is the time to increase the level of direct public investment. Boosting the economy with extra investment now may be the best way to ensure that the Government meets its revenue targets in four years time.

Headlines are likely to focus on whether the Government will achieve its objective of reducing debt as a proportion of GDP in 2015/16. This is dependent on the combination of inflation and economic growth increasing GDP and some £23 billion in asset sales to bring the ratio down. With both inflation and economic growth looking to be lower than expected, and with some of the planned asset sales deferred to the new financial year, this objective may not be met.

Perhaps more interesting will be the position going forward, especially in the three years between now and the 2019/20 financial year that George is committed to going into surplus. With lower deficits in the intervening years, he will have some flexibility in those years to borrow extra to fund investment or, if he chooses, to accept a slightly slower path in cost reductions just as he already has had to do with benefits in the form of tax credits.

So I am looking forward to the Budget on Wednesday. Surprises are guaranteed.

Time to embed Whole of Government Accounts into government

The IFS Green Budget, launched today in association with the ICAEW, contains a chapter on Whole of Government Accounts (WGA), the financial accounts for the UK government. They are prepared on a similar basis to those of millions of companies and other organisations around the world.

The first five years of WGA have covered a dramatic period in Britain’s fiscal history following the global financial crisis. They provide a more comprehensive picture of the public sector’s financial performance over that time than that available from traditional National Accounts reporting by capturing a wider range of financial transactions.

The reduction in the deficit on a National Accounts basis of 35% from £153 billion to £100 billion between 2009–10 and 2013–14 contrasts with a reduction of only 20% in the size of the annual accounting deficit to £149 billion over that same period.

There has been a significant deterioration in the government’s financial position, with net liabilities in the WGA more than doubling in five years, from £0.8 trillion at 31 March 2009 to £1.85 trillion at 31 March 2014. This reflects an increase in public sector pension obligations to £1.3 trillion in addition to the near-doubling of public sector net debt in the National Accounts from £0.7 trillion to £1.4 trillion.

Effective financial management for the longer term involves addressing the balance sheet as well as revenue, expenditure and cash flows reported in the WGA but not in the National Accounts. A relatively high level of asset write-downs, growing pension obligations and increasing charges to cover nuclear decommissioning and clinical negligence exposures are areas of particular concern.

The WGA also provide further insight when considering the vulnerability of the public finances to future economic shocks, with total liabilities at 31 March 2014 of £3.2 trillion, or 177% of GDP. This is substantially higher than public sector net debt, the National Accounts measure typically referred to in this context, which stood at £1.4 trillion, or 78% of GDP, at that date. The former may matter more when thinking about the government’s ability to cope in the event of a future downturn.

Improving financial management within government will become more challenging as further devolution increases the complexity of the public sector in the UK. A necessary first step must be to replace the current complex web of internal financial reporting data collection processes with a modern standardised financial consolidation system for all public sector entities, which should enable the government to obtain and utilise accurate comprehensive financial performance data from across the public sector within days rather than months.

For more information, go to the IFS Green Budget 2016 website and open Chapter 4.

IFS Green Budget 2016 – in association with the ICAEW

This year’s Institute for Fiscal Studies pre-Budget report for 2016, the ‘Green Budget’, will be launched on Monday 8 February.

In association with ICAEW and funded by the Nuffield Foundation, it will analyse the issues and challenges facing Chancellor George Osborne as he prepares for the UK government’s Budget in March.

The areas covered by IFS researchers will include:
– the government’s framework of fiscal rules
– risks to the public finances
– issues coming up for corporate tax policy
– the design of ‘sin taxes’
– the (changing) effects of Universal Credit

Oxford Economics will be giving their view on the prospects for the economy, while I have been working with the ICAEW on their contribution to this year’s report.

For more information go to http://www.ifs.org.uk/publications/8129.